Financial financed by debt for instance: mortgage loans.

  Financial bubble is the price of a good highly increasing while not
based on the fundamentals of the demand on the market or value of the good,
just a faith that the price of the good will keep increasing. Housing bubble is
a type of an economic bubble that occurs is because of a temporary increase or
rapid growth in demand on the housing market. Due to the increase in demand
which too many buyers are keen to buy and lead to drive up the price of
residential or housing markets. But when the bubble bursts, it is resulting in
a sharp drop and decline in prices of the housing market. The interest rate is
the amount charged with a percentage of principal by a lender for use of its
money. Besides that, interest rate also is a key monetary policy tool called
discount rate, for the government to regulate or manage the country’s economy
by charge commercial banks with interest rate. The changes in interest rate
significant effect on consumer spending due to a large proportion of house
ownerships and housing market is important because housing investment will
directly enter into GDP (Gross domestic product) which the total value of
everything produced by all people and companies in the country. In an addition,
buying a house is a household’s biggest purchase or investment will make in
their lives, normally they were financed by debt for instance: mortgage loans.
In United States, mortgages are households’ largest liability and lenders’
largest loan exposure. During 2007 to 2009 financial crisis, housing bubble
became one of the main factors to credit crunch due to heavily exposure of
financial institutions to US subprime mortgages. Northern Rock, Britain’s
fifth-biggest mortgage lender was nationalised, and Lehman Brothers was filed
for bankruptcy.

One of the main explanation on the effects of interest rates on housing
bubbles is the changes in general interest rates also the amount of monthly
repayments on variable-rate mortgages, if interest rate rise will significant
effect on increasing the cost of mortgages and lead some existing home-buyers
to sell their house because they unaffordable on the monthly repayment. This
has resulted in increasing of sellers and declining of buyers which may effect
on house prices fall. But in a different way, if interest rate fall will significant
effect on decrease the cost of mortgages and attract more buyers keen to
purchase houses. Hence, resulting in decreasing of sellers and increasing of
buyers which may drive up the price of houses. Based on Himmelberg et al.
(2005) study, a housing bubble may happen when house owners have unreasonably
high expectations about future capital gains lead perceive their user cost
lower than fundamental value, therefore, buyers are paying too much to purchase
a house. Through the formula of annual cost of ownership, we able to compare
the cost of owning a house (“user cost”) and the income level of rental costs
to determine whether the cost of owning is out of line with the cost of
renting. The first term is the house owner may have earned by investing in
other investment than a house which is the cost of foregone interest. The Pt
times the risk-free interest rate rf is calculated as the price of
housing on the cost of one year. The second part is the one-year cost of the
property taxes and it calculates as house price times the property tax rate wt.
The third part counteracts the benefit to the tax deductibility of mortgage
interest on namely or owning and property taxes is for who itemize on their
federal income taxes. This is able to predict the effective tax rate on income
times the estimated mortgage and property tax payments: Pt ?t (rm + wt). The
fourth term is maintenance costs on the house and it conveyed as a fraction ?t
of house value. The fifth term gt+1 is expected capital gain (or loss) during the
whole year and the sixth term is representing an additional risk premium to
compensate house owners for the higher risk of own a house versus rent a house
(Pt ?t). The total of the six elements has calculated the total annual cost of
homeownership: Pt ut = Pt rft + Pt wt – Pt ?t (rm + wt) + Pt ?t – Pt gt+1 + Pt
?t. From the housing market equilibrium implies that the expected annual cost
of own a house should not exceed than the annual cost of rent a house. The key
determinant of user cost of housing is the real interest rate. When the real
interest rate is lower could reduce the user cost and attractive to house
owners because they able to afford the mortgage monthly payments.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!

order now

The Federal Reserve has a significant impact in choosing the policy instrument
where there are two basic types of instruments which reserve aggregates and
short-term interest rates. The long-term interest rate is not directly affected
by a Federal Reserve tool but it is linked to the actual goals. Besides that,
Federal Reserve have set an interest rate target, known as inflation targeting
to hold up future inflation. There are some criteria for choosing policy
instruments to monitor on future inflation and impact to the economy growth.
The first criteria is observable and measurable, the short-term interest rates
will be observe instantly but is more accurate to measure cost of borrowing by
real interest rate. The second criteria is controllability, which for aggregates
and interest rates have the uncontrollable parts that not able to totally
control on the monetary aggregates. It can control on the short-term nominal
interest rates but they cannot directly control on the short-term real interest
rates. The third criteria is predictable effect on goals, the link between the
interest rates and monetary policy goals is better than the link between
monetary aggregates and inflation. Normally Federal Reserve is using short-term
interest rates as their policy instrument because it offer the best links to
monetary goals but they are still use reserve aggregates. Besides that, Federal
Reserve has using a fed watcher for responsibility to predicts when interest
rates high and acquire funds to lower the interest rate. Meanwhile, the fed
watcher need to predict when interest rates low and make loan at high interest
rate to higher the interest rate. Some of argue that low interest rates had
contributed to the housing bubble because Federal Reserve had hold interest
rates too low for too long time. During 2001-2002 recession, the Federal Reserve
dramatically lowered the interest rate from 6.5% to just 1% and this had led
many banks for easy credit to make a lot of loans. But in 2006 Federal Reserve
had increased the interest rate to 5.25% led the demand on purchase house had
decreased, the main reason is because burden of increased monthly payments for
long-term mortgages. After the increasing on the interest rate had lead the
foreclosures increased because the mortgage borrower not able to make monthly
payment and dropping the housing price. The former chairman of Federal Reserve
of the United States and an American economist, Mr. Alan Greenspan had
confessed one of the reason caused the housing bubbles was declined long-term
interest rates. Some people had criticized the Federal Reserve decreased the
interest rates that inflated the housing bubble. During 2000 and 2003, the
interest rate on 30 years fixed-rate mortgages had dropped 2.5% and interest
rate adjustable rate mortgages had dropped 3%. Decreased in mortgage interest
rates had reduced the cost of borrowing mortgage attracted many people wanted
to borrow money to purchase a house and this had led the price of house keep
increasing. Many people borrowed money from mortgage and securitized it turned
into AAA-rated securities. The people belief on house prices would not
decreased started inaccurate because of the delinquency rate get higher and the
price on mortgages–backed securities had led the house prices decreased
promptly. The cost of cleaning up after the housing bubble burst is expensive
because it need take time to slow recovery. 

Based on the article of the former Federal Reserve Board Chairman, Mr.
Alan Greenspan on 11 March 2009, he had mentioned that the Federal Reserve
didn’t cause the housing bubble. The one of the reason led U.S. housing bubble
is the easy money policy, a money policy to 
increase the money supply by lower the interest rates and the purpose is
a country’s central bank let new cash flows bring into the banking system.
Another factor is lower interest rates on long-term or fixed-rate mortgages had
developed the speculative euphoria. There is a highly significant correlation
between house prices and mortgages rates. In 2004, mortgage rates had failed to
tighten as Federal Reserve expected and from the data showed the house mortgage
rates gradually decoupled from the Federal Reserve monetary policy. For a long
time, U.S. mortgage rates had not linked to U.S. short-term interest rates. But
between 2000 and 2005, the long-term interest rates gradually lower because the
central had planned to increase dynamic and export-led market competition. A
large number of emerging market and highly growth in China led to an excess
intended of savings advance to global. The regulators had underestimated the
scale of the asset price bubble. The real-estate capitalization rates declined
had converged global and led to the global housing price bubble. The main
developed economy had declined to single digits while the long-term interest
rates and house mortgage rates had driven by International Monetary Fund. The
“Taylor Rule”, a useful and approximate to monetary policy but consistently
unable to anticipate on the financial crises had implied that kept short-term
interest rates at the level would prevent the housing bubble. In the period of 2003
to 2005, the Federal Reserve had inappropriate use of short-term rates and
failed to address the unusual structural developments in the global economy.
Between 1996 and 2004, the US current account had deficit increased by $650
billion and these deficit required to borrow large sums of money from abroad.
Due to a highly demand funds from abroad, therefore they created various types
of financial assets and raising the prices of the assets while lowering the
interest rates. The housing bubble maybe caused by the broader global forces
and created complex financial products even through global market competition
and integration in goods and services have given great gains. Exclude the fault
on monetary policy, we could attributes the housing bubble crisis to overseas
regulators and the U.S. credit rating agencies. The solutions for the housing
bubble crisis is higher capital requirements, higher collateral requirements
and a wider prosecution of fraud.  The
new regulations should more effectively bring a nation’s savings into most
productive capital investments.

In conclusion, the interest rate could be bring effect to housing
bubbles crisis because the when real interest rate constant less than zero
during the period had led to developing the housing bubble. During the
low-interest rate period, buyers able to borrow money from mortgage loans to
purchase a house easily and they belief that the asset price wouldn’t decrease
instead keep increasing. From 2000 to 2003, the Federal Reserve lowered the
federal fund’s rate from 6.5% to 1.0% developed an easy credit conditions and
lower interest rates encouraged borrowing. Many house owners refinancing their
house at lower interest rates by taking out second mortgages secured by price
appreciation. But there is still exist of other factors that developed housing
bubble crisis. For instance: U.S. credit rating agencies, collateral debt
obligation (CDO), weak and fraudulent underwriting practices.  The collateral debt obligation (CDO) enabled
the financial institution to get funds from investors to finance subprime and
increase the housing bubble. These collateral debt obligation and
mortgage-backed security were ratings by the credit rating agencies. The credit
rating agencies had given their highest ratings to three dollars of loans to
house buyers with bad credit and undocumented incomes. On August 2008, 9.2% of
U.S. mortgages were outstanding because the people do not afford to make
monthly payments led delinquent rate get higher or foreclosure happened.
Another factor is the lending standards dropped, many lenders required FICO
score dropped from 660 to 620 for getting more easily to make subprime loans
lending to more risky business. The widest acceptance of subprime mortgage
product is (NINJA) mortgage which who was no income, no job, no asset
verification required. From these instance, we can understand that the interest
rate not the main reason for developed the housing bubble but it bring some
effect to the housing market.