The central element in the current financial crisis is the housing bubble. The irrational exuberance surrounding this bubble created an environment that was ripe for the cowboy financing that got Wall Street and the country into so much trouble. Of course the cowboy financing fed into the bubble, allowing it to grow to proportions that would not have been possible with a well-regulated financial system.
This essay first describes the circumstances under which the bubble began to grow. It then discusses how financial innovations and the lack of a proper regulator structure allowed the bubble to grow to ever more dangerous levels and eventually to crash in a way that has placed unprecedented strain on the country’s financial system. The third part outlines key principles for reform of the financial system.
In the mid-2000s many regular folks knew that something was weird in housing. Of course everyone was aware that there was a short term windfall to be made if you could flip. But there were normal discussions about the bubble, and when it would burst, or if the weird arguments by some economists and the real estate industry that there wasn’t a bubble were true. In contrast regular people weren’t aware of the possibility of a financial crisis. I recall saying stupid things about the “Great Moderation,” parroting what I’d heard smarter people who I assumed knew better say, in the summer of 2008. Or take a look at some of the comments when I mooted the possibility of a recession in mid-2007: “They’re practically glorified hiccups nowadays. I don’t get what the big deal is.”
People were searching for the “housing bubble” query probably because it wasn’t saturating the media. Once it was they had no reason to search, it was confirmed as a bubble. I vaguely recall similar issues in late 1999 and early 2000. Before the “internet bubble” burst we were all talking about it. Once it burst it was kind of depressing and we didn’t want to talk about it, but the news wouldn’t stop covering it.
The origins of the housing bubble
The housing bubble in the
The stock wealth induced consumption boom also led people to buy bigger and/or better homes, since they sought to spend some of their new stock wealth on housing. This increase in demand had the effect of triggering a housing bubble because in the short-run the supply of housing is relatively fixed. Therefore an increase in demand leads first to an increase in price. As prices began to rise in the most affected areas, prices increases got incorporated into expectations. The expectation that prices would continue to rise led homebuyers to pay far more for homes than they would have otherwise, making the expectations self-fulfilling.
Government data show that inflation adjusted house prices nationwide were on average essentially unchanged from 1953 to 1995. Robert Shiller constructed a data series going back to 1895, which showed that real house prices had been essentially unchanged for 100 years prior to 1995.By 2002, house prices had risen by nearly 30 percent after adjusting for inflation. Given the long history of stable house prices shown in the government data, and the even longer history in the data series constructed by Shiller, it should have been evident that house prices were being driven by a speculative bubble rather than the fundamentals of the housing market.
The fact that rents had risen by less than 10 percent in real terms should have provided more evidence to support the view that the country was experiencing a housing bubble. If there were fundamental factors driving the run-up in house sale prices they should be having a comparable effect on rents. However, the increase in rents was far more modest and was trailing off already by 2002.
The second phase of the housing bubble
The run-up in prices in both the ownership and rental markets was having a substantial supply-side effect, as housing starts rose substantially from the mid-90s through the late 90s. By 2002, housing starts were almost 25 percent above the average rate over the three years immediately preceding the start of the bubble (1993-95). The increase in building showed up first as an over-supply of rental housing, with the vacancy rate rising to near record levels above 9.0 percent in 2002, compared to a rate of 7.5 percent in the mid-90s.
If the course of the bubble in the
In addition, the economy was very slow in recovering from the 2001 recession. It continued to shed jobs right through 2002 and into the summer of 2003. The weakness of the recovery led the Federal Reserve Board to continue to cut interest rates, eventually pushing the federal funds rate to 1.0 percent in the summer of 2003, a 50-year low. Mortgage interest rates followed the federal funds rate down. The average interest rate on 30-year fixed rate mortgages fell to 5.25 percent in the summer of 2003, also a 50-year low.
To further fuel the housing market, Federal Reserve Board Chairman Alan Greenspan suggested that homebuyers were wasting money by buying fixed rate mortgages instead of adjustable rate mortgages (ARMs). While this may have seemed like peculiar advice at a time when fixed rate mortgages were near 50-year lows, even at the low rates of 2003, homebuyers could still afford larger mortgages with the adjustable rates available at the time.
These extraordinarily low interest rates accelerated the run-up in house prices. From the fourth quarter of 2002 to the fourth quarter of 2006, real house prices rose by an additional 31.6 percent, an annual rate of 7.1 percent. This fueled even more construction, with housing starts eventually peaking at 2,070,000 in 2005, more than 50 percent above the rate in the pre-bubble years. The run-up in house prices also had the predictable effect on savings and consumption. Consumption boomed over this period with the savings rate falling to less than 1.0 percent in the years 2005-07.
Of course the bubble did begin in burst in 2007, as the building boom led to so much over-supply that prices could no longer be supported. The record vacancy rates switched from the rental side to ownership units in 2006. By the fourth quarter of 2006, the vacancy rate on ownership units was almost 50 percent above its prior peak. By the middle of 2007, prices nationwide had peaked and began to head downward. This process accelerated through the fall of 2007 and into 2008.
Just as the bubble created dynamics that tended to be self-perpetuating, the dynamics of the crash are also self-perpetuating, albeit in the opposite direction. As prices decline, more homeowners face foreclosure. This increase is in part voluntary and in part involuntary. It can be involuntary, since there are cases where people who would like to keep their homes, who would borrow against equity if they could not meet their monthly mortgage payments. When falling house prices destroy equity, they eliminate this option.
The voluntary foreclosures take place when people realize that they owe more than the value of their home, and decide that paying off their mortgage is in effect a bad deal. In cases where a home is valued far lower than the amount of the outstanding mortgage, homeowners may be to able to effectively pocket hundreds of thousands of dollars by simply walking away from their mortgage.
Regardless of the cause, both sources of foreclosure effectively increase the supply of housing on the market. In the first quarter of 2008, foreclosures were running at a 2.8 million annual rate (RealtyTrac), which was nearly 60 percent of the rate of sales of existing homes in the quarter. In many of the hardest hit areas, the number of foreclosures actually exceeded existing home sales. In effect, by forcing more foreclosures, lower prices were leading to an increase in the supply of housing.
A similar dynamic took hold on the demand side. During the run-up of the bubble, lending standards grew ever more lax. As default rates began to soar in 2006 and 2007, banks began to tighten their standards and to require larger down payments. The most severe tightening took place in the markets with the most rapidly falling prices. With lenders in these markets requiring down payments of 20 percent or even 25 percent, many potential homebuyers were excluded from the market. These thresholds not only excluded first-time buyers, but even many existing homeowners would have difficulty making large down payments, since plunging house prices had destroyed much of their equity.
By the end of 2007, real house prices had fallen by more than 15 percent from peak. House prices in many of the most over-valued markets, primarily along the two coasts, had fallen by more than 20 percent. Furthermore, the rate of price decline was accelerating, with prices in these cities falling at more than a 30 percent in annual rate at the beginning of 2008. The rate of price decline in the Shiller indexes imply that real house prices will be down by more than 30 percent from their 2007 peaks by the end of 2008. This would mean a loss of more than $7 trillion in housing bubble wealth (approximately $100,000 per homeowner). The lost wealth is almost equal to 50 percent of GDP. There is no way that an economy can see a loss of wealth of this magnitude without experiencing very serious financial stress.
The excesses of the housing bubble
As the house prices grew further out of line with fundamentals, the financial industry adopted more sophisticated financial innovations to support its growth. A key part of the story was the growth of non-standard mortgages. Until the boom began to take off in the mid-90s, the vast majority of mortgages had always been fixed rate mortgages. However, adjustable rate mortgages became a growing share of mortgages issued during the boom, peaking at close to 35 percent in 2004-06. Not only did these mortgages not provide the security of fixed rate mortgages, they were often issued with below market “tea ser rates” that would reset to higher levels after two-years, even if interest rates did not rise.
These “2-28” mortgages were especially common in the subprime segment of the mortgage market. Subprime mortgages were loans issued to people with poor credit histories. Homebuyers who got subprime mortgages were typically people with intermittent employment records or who had defaulted on some loans in the past. The interest rates on subprime loans were typically two to four percentage points higher than the interest rate available at the time on prime loans given to people with solid credit histories.
The subprime market exploded during this period, rising from less than 9 percent of the market in 2002 to 25 percent of the market by 2005. In addition to this explosion in subprime loans, there was also a boom in the intermediate “Alt-A” mortgage category. These were loans given to homebuyers who either had a mixed credit record (better than subprime, but not quite prime) or who provided incomplete documentation of income and assets.
The Alt-A loans were in many cases of more questionable quality than the subprime loans. Many (perhaps most) of these loans were for the purchase of investment properties. Furthermore, the Alt-A loans were more likely to be issued with incomplete documentation, earning some the status of “liar loans.” The Alt-A loans were even more likely to have very high loan to value ratios, with many buyers borrowing the full value of the purchase price, or in some cases even a few percentage points more than the purchase price. Also, many of the Alt-A mortgages issues in the years from 2005-2007 were interest only loans or option-ARMs, which required borrowers to just meet interest payments on their mortgages, at least until a reset date, which was most typically five years after the date of issuance.
The subprime and Alt-A categories together comprised more than 40 percent of the loans issued at the peak of the bubble. The explosion of loans in these higher risk categories should have been sufficient to signal regulators, as well as investors, that there was a serious problem in the housing market. Just to take the case of the subprime market; it is absurd to think that the number of credit worthy people in the subprime category had more than doubled from 2002 to 2004, even as the labor market remained weak and wages lagged behind inflation. The increase in subprime lending over these years, by itself, was an unmistakable warning sign of the problems in the housing market. Unfortunately, instead of taking this warning, political leaders and most experts on housing celebrated the record rates of homeownership.
The end of the bubble and the meltdown
The bubble began to unravel after house prices peaked and began to turn down in the middle of 2006. This led to rapid rises in default rates, especially in the subprime market. While the worst abuses in the mortgage market were in the subprime segment, the main reason that defaults were initially concentrated so heavily in this sector is that subprime homeowners were the most vulnerable segment of the population. They did not have retirement accounts that they could draw down or family from whom they could borrow, when they found that they could no longer meet their mortgage payments. As a result, when they no longer had equity in their home against which to borrow, many subprime homeowners had little choice but to default on their mortgage.
It is worth noting that many of the subprime loans that began going bad in 2006 and 2007 were not purchase mortgages but rather mortgages used to refinance homes. Subprime lenders aggressively, and often deceptively, marketed mortgages for refinancing to low and moderate income homeowners as a way of getting access to extra money to meet bills or pay for big purchases like a care or home remodeling. As a result of these new subprime loans, families who had been secure suddenly faced the loss of their home.
The spread of defaults in the subprime market led to a sharp reduction in the valuation of MBS that contained substantial quantities of subprime mortgages, as well as the various derivative instruments that were based in whole or in part on MBS with substantial subprime components. The fact that so many instruments and institutions were exposed to serious risk from the subprime market led to the series of credit squeezes that hit financial markets beginning in the winter of 2007. Investors could have little confidence in the security of a wide-range of assets and institutions, since it was not generally possible to know the extent that they were exposed to bad mortgage debt.
This financial meltdown also has important feedback effects on the housing market. On the supply side, the flood of foreclosures ensures that a large supply of housing will be placed for sale, since banks are generally anxious to sell properties on which they have foreclosed. In many of the most affected markets the number of foreclosures was running at levels that were close to the number of sales in the fall of 2007 and winter of 2008.
On the demand side the growing stress in financial markets has helped to dampen demand, since banks are far more reluctant to make loans than had been the case two years ago. With banks recognizing that they had been overly lax, and that prices are now falling, they are now demanding much larger down payments (20 percent in some of the most rapidly deflating markets) and insisting of much fuller documentation of income and asset information. There are millions of people who had been eligible to receive loans in 2006 who would not be able to take out a loan under the current standards. As a result, the number of potential buyers has contracted substantially over the last two years.
The continued flow of houses for sale, coupled with the sharp cutback in demand, is leading to rapid declines in house prices in many markets. In the first quarter of 2008, house prices were falling at more than a 20 percent annual rate in the Case-Shiller 20 City Index. House prices were falling at more than a 30 percent annual rate in the most rapidly deflating markets like
While a quick end to the housing bubble would be desirable in many respects, it will almost certainly lead to more financial turbulence. Banks around the world have already written down losses of more than $200 billion in connection with the collapse of the housing market, the total figure for write-downs is likely to be closer to $1 trillion. The additional writedowns hitting the market will almost certainly cause more banks to become insolvent and will impose serious stress on Fannie Mae and Freddie Mac, the two government sponsored corporations that are the backbone of the secondary mortgage market. The weakness of the housing market and the financial institutions with heavy exposure to the sector will worsen the recession , which will in turn aggravate the problems in the financial sector.
Submitted By : Nupur Dua, Section-B
Nupur - a good try but no referencing and title not as per the guidelines. The structure not followed too...
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