Value of Real Estate Loans Issued By Commercial Banks - Essay Example

Value of Real E Loans Issued By Commercial Banks al Affiliation) Introduction The commercial banking sector holds a central role in propagating the direction of any economy encountering macroeconomic shocks. During every recession period, commercial banks are pivotal in determining the width and depth of the economic contractions. In addition, this argument is backed by the observations witnessed in the Great Depression of the early 1930s, which partly was attributed to the widespread failures of commercial banks. Similarly, many researchers and financial analysts alike have attached the 1990 economic downturn realized globally to the banking sector crisis (Bassett and Marsh, 2014). Similarly, the weak recovery from the deep depression that hit many advanced economies in the wake of the 2007 to 2009 financial crisis finds links between bank lending, financial stability, and the economic performance. Nonetheless, many international and national banking institutions have regulations and incentives that have the potential of influencing the economic outlook of a nation and the globe at large. This paper focuses on the values of the real estate loans issued by commercial banks from the year 2005 to 2012. This analysis aims at highlighting the trends experienced in these values during the financial crisis of 2007 to 2009. Therefore, it will give a chronological examination of the different values, and establish the main reasons behind the trends, taking into concern the fact that commercial banks play a central role in defining the direction of the economy during a recession period. Discussion The onset of the new millennium brought many developments for the banking sector globally. As such, the increased knowledge about mortgages and advanced exposure to access of finances meant that commercial banking business was as competitive as it was enjoying demand. In the year 2005, the United States economy was experiencing increased interests in housing and property development. Besides, the commercial banks increased their lending incentives in a bid to acquire the largest customer base of the growing credit demand. In the first quarter of 2005, the real estate loans for residential, commercial and farmland were 1.43%, 1.12%, and 1.70% respectively (Federalreserve.gov, 2015). The low interest rates in comparison to those of the fourth quarter of 2004 acted as incentives for consumers who wanted to capitalize on the credit availability opportunity provided for by the low interest rates. As depicted in the Figure 1 below, the rates of exposure to loans for both Commercial Real Estate (CRE) and Construction and Land Development (CLD) was gradually increasing, thereby approaching the peak in 2005. Figure 1: Commercial Real Estate Exposures (Bassett and Marsh, 2014) The loan incentives put in place by commercial banks encouraged borrowing for risky mortgages, which threatened to go up, as is always the case of property appreciation for assets in high demand. The first quarter of 2006 indicated the beginning of the gradual discrepancies in the interest rates, as the real estate loans for residential, commercial and farmland settled at 1.60%, 1.02%, and 1.53% (Federalreserve.gov, 2015). The increase in the interest rates for residential loans indicated an increased demand for this investment. However, the commercial and farmland interest rates remained relatively low, hence encouraging further borrowing, as depicted in Figure 1. Increased investments in real estate property meant that the supply of real estate property exceeded the demand. In light of this, the interest rates begun to skyrocket, between the quarters of the year 2006 and into 2007. Many of the borrowers who invested their credit on real estate were encountering a crisis, as they were unable to repay their loans within their expected short terms. With this, the real estate property prices begun to plummet, as the borrowers feared further increases in the interest rates, which could have severe implications on their investments. At the beginning of the year 2007, the real estate interest rates for residential, commercial and farmland purposes increased drastically to 2.03%, 1.43%, and 1.48% respectively (Federalreserve.gov, 2015). These increases meant that the commercial banks were no longer considering the borrowing incentives towards the consumer. As illustrated in Figure 1, this reduced the exposure to real estate investment loan in equal drastic measure. The year 2007 marked the beginning of the financial crisis, which obligated the implosion of several hedge funds belonging to financial firms within the US. For instance, the Bear Stearns investment bank had mortgages that translated to the values of their invested securities. However, with the drop of the security values, the investors lost confidence and demanded the provision of collateral by the hedge funds, which obligated the sale of the mortgages. In the year 2008, the interest rates were increasing at an alarming rate, as the demand for real investment loans dropped dramatically. Consequently, the real estate loans for residential commercial and farmland investments increased to 3.69%, 3.50%, and 1.47% respectively (Federalreserve.gov, 2015). During this year, the average prices of housing in the US decreased by approximately 19%, just two years after the high prices record. In the midst of the financial crisis, the mortgages attracted higher interest rates, while the worth of the property translated to less than the value of the payment (Bassett and Marsh, 2014). The negative equity on the mortgage property was further influenced by the inadequate aggregate credit, which forced many businesses to retrench workers in a bid to remain competitive within their respective industries. In the year 2009, the interest rates for real estate loans for residential, commercial and farmland purposes increased to 7.85%, 6.59% and 2.48% respectively. The reduction of the aggregate credit in the US economy triggered the financial crisis. In the year 2010, these rates rose further to 11.26%, 8.75% and 3.44% respectively, with the highest interest rates on real estate being realized in the second quarter of this financial year (Federalreserve.gov, 2015). At this point, the exposure to real estate loans dropped significantly, as the consumption behavior towards this investment changed, considering the interest rates charged on acquiring these loans. However, the years 2011 and 2012 witnessed an increased exposure to the real estate loans, as the US economy was beginning to recover from the effects of the crisis. The trends witnessed in the values of real estate interest loans between the years 2005 and 2012 relate to the financial crisis. During the beginning of the investment boom in real estates, the commercial banks had put in place incentives that encouraged borrowing for this form of investment. However, the increased access to loans led to the reduction of aggregate credit, which could not be reversed due to the macroeconomic conditions influencing the US economy such as the rising oil prices and increased government military spending. During the financial crisis, the high interest rates charged by the commercial banks on real estate loans contributed squarely to the intensity of the crisis. As evident in Figure 1, increases in the real estate interest rates translated to decreased exposure to real estate loans, which championed further decline of the US economy, as the borrowers sold their property at lower prices to avoid further accumulation of interest (Bassett and Marsh, 2014). On the other hand, inadequate aggregate credit in the economy was caused by reduction in the commercial bank intermediate credits, whose rates kept rising amidst the stable direct credit interest rates. Consequently, inadequate availability to funds in the economy contributed to the reduction in the value of assets within all sectors of the economy, while the bank loans demand decreased significantly. In conclusion, the supply of credit by the commercial banks would be instrumental in reducing the effects of the crisis, especially on the real estate sector. The main cause of the financial crisis, nonetheless, was the inadequate aggregate demand of credit within the economy arising from the increased investment in the real estate sector, which subsequently pushed the interest rates high, hence subjecting the US economy to a financial crisis. References Bassett, W. and Marsh, W. (2014). Assessing Targeted Macro prudential Financial Regulation: The Case of the 2006 Commercial Real Estate Guidance for Banks. SSRN Electronic Journal. Federalreserve.gov, (2015). FRB: Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks. [Online] Available at: http://www.federalreserve.gov/releases/chargeoff/delallsa.htm [Accessed 6 Nov. 2015]. Read More