Introduction
A bond price is the total amount of money paid to
purchase a bond. The prices of bonds are negatively related to interest rates
meaning that as interest rates increase, the bond prices will fall and when
interest rates fall, the bond prices will increase. When interest rates rise,
the rise puts upward pressure on the cost of borrowing. It, therefore, becomes
more expensive to borrow funds. As a result, the demand for bonds will fall forcing
their prices to fall as well. On the other hand, when interest rates fall, the
cost of borrowing also falls. It, therefore, becomes cheaper to borrow money.
As a result, the demand for bonds will rise which will, in turn, push their
prices up. The sale of bonds is one measure used by governments and businesses
to raise money. The relationship between the price of bonds and interest rates
implies that Bond prices are affected by many economic sectors and activities.
The aim of this paper is to discuss the effect of the United States’ sub-prime
mortgage sector on bond prices.
The US
sub-prime mortgage market
Since, the private sector had principally prolonged its
function in the mortgage housing market, which had until that time been under the
control of government-sponsored institutions such as Freddie Mac. The private
companies focused on innovative types of mortgages, particularly sub-prime
lending to borrowers who had meager credit records and feeble certification of
income. These borrowers had been rejected by prime lenders such as Freddie Mac.
Sub-prime lending gained momentum in the US housing market and by 2005 it had
extended from inner-city regions throughout the nation. By then, the proportion
of sub-prime lending companies in the total market stood at 20 percent, and
they were predominantly well-liked among new immigrants who were trying without
much progress to purchase a residence for the first time in the popular housing
markets such as Northern California, Arizona, and Washington, DC (Brenner, 2003).
The risk involved in sub-prime lending is great not just for the lenders but
for the borrower as well. This is because the conditions are too lenient and a majority
of people including those of low-income brackets can gain access to the loans
offered. As a result, the sub-prime loans were granted at higher interest rates
than the comparable prime loans. The higher interest rates were intended to
cater to the great risk associated with the loans. The high-interest rates were
to provide higher returns for the lenders to compensate them for the high
risks. The introduction of sub-prime lending created a high demand for houses
across the US which in turn increased the prices of houses leading to the
housing bubble that is commonly blamed for the recent global credit crunch.
The
American economic condition during the housing bubble
When the housing bubble began, the performance of
finance in the United States was most impressive. With the exception of the
economic downturn year of 1998, financial profits had, from the mid-1990s,
benefited from a practically unbroken record of increase, and in the first
quarter of 2003 they were, in excess of 35 percent beyond their level of 1996.
Spending among consumers, founded to a great extent on household borrowing against
home equity, as well as the increasing housing prices, had pushed the demand
for retail trade, wholesale trade, and other services upward. Profits resulting
greatly from mortgage-associated business, in addition to the trading and
underwriting of bonds – all a result of falling interest rates – made it
possible for the banks and other financial institutions to keep on attaining
considerably growing prosperity. The economic growth was fueled chiefly by the
debt-reliant consumption and growing bubbles that were a result of the
government’s reduced rates of interest and growing deficits. This was
regardless of the massive decline in the prices of equity and huge decreases in
the growth of corporate borrowing. The fragile economic situation forced the US
government to take drastic measures to avoid the possibility of collapse.
Staring from the mid-2000 and continuing till early 2003, the Federal Reserve
reduced the interest rates on its short-term loans from 6.5% to 1%. The
interest rate was further reduced from 1% to 0.25% in June 2003. During the
same period, the fiscal state of the US government shifted from a surplus of
1.4 percent to an anticipated deficit of 4 percent of gross domestic product.
During the first six months of 2003, the interest rates
on long-term loans had fallen to levels that were comparable to the period
following the Second World War. The economy continued to perform badly, and the
growth of sub-prime investors interested in high risky ventures soared. The
government during this time kept its promise of keeping the cost of borrowing
down pending the end of the deflation. This it did by maintaining low rates of interest.
The result of all these measures was the blowing up of the bond market bubble
(Consigli, MacLean, and Zhao, 2009). However, when, seemingly in the center of
an escalating crusade to stop falling prices, the Fed abruptly exposed its
conviction that the economic position was improving, the previously
over-purchased bond market viciously overturned itself, and interest rates on
the long term loans increased significantly to a level not experienced for a
long time. The concern was that this was only the start and the rates of
interest would not only additionally rectify themselves, but also they would
keep on rising, as the speedier increase of demand led to higher prices and a
higher demand for loans. If this had happened, the housing bubble would have
ceased and the mortgage equity extraction would have begun to fall. This would
have gravely diluted the enduring high consumption levels that had fueled the
economy since the end of 2000 (Brenner, 2003, p.310).
The bond
market conundrum
The bond market conundrum refers to “the failure of
longer-term interest rates to respond to changes in the Federal funds rate in
the normal fashion,” (Iley and Lewis, 2007, p.67). The bond market conundrum
was one of the signs of the low inflation-adjusted rates of interest. The
surfacing of this condition in the US began in the era from mid-2004 when the
Federal Reserve began the lengthy procedure of eradicating surplus monetary
relief and stabilizing the level of policy rates. This condition has to some
degree hindered policy-makers in trying to lessen the costs or permanent effect
of the deflation insurance measures on the American economy (Iley and Lewis,
2007).
Bond
prices during and after the burst of the housing bubble
The prices of bonds fluctuated significantly before,
during, and after the housing bubble in reaction to the changes in interest
rates adopted by the government. Iley and Lewis (2007) argue that “In the six
tightening cycles preceding the 2004-2006 episode, the yield on the 10-year
Treasury note was on average almost 100 basis points (where 100bp equals 100%
point) higher after one year,” (p.67). By the middle of 2005, the yields on the
10-year Treasury note were 70bp lesser than at the beginning of the tightening
policy. It was not until mid-2006, with the Federal funds rate increased by
425bp to 5.26% that yields on the 10-year T-note lastly shifted up by 60bp two
years following the beginning of the tightening policy. However, the yield on
the 10-year note declined in the second half of 2006, at last concluding the
year at 4.40%, 7bp more than the 2005 close of 4.33% (Iley and Lewis, 2007).
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