It is obvious without any shadow of the doubt that the main cause of the current financial crisis is the housing bubble. This bubble was growing for more than a decade and was being fuelled by bad lending decisions and lack of financial control from the American central bank. In this part of the project I will attempt to explain haw this bubble started, haw it grew exponentially in size and haw it burst during the financial crisis and almost toppled the biggest economical power in the world.
The housing bubble in the United States originated in the mid-90s and grew alongside the stock bubble (.com or internet bubble) in the late-90s. The logic behind this positive correlation is very simple people that made extraordinary returns in the stock market in the 1990s were spending this money, which caused a spending boom in the late 90s with savings rate falling from 5% to 2% in less than five years. This increase in income and spending led to consumers buying bigger and more luxurious houses. This extra demand for housing lead to an increase in real-estate prices since short term supply for homes was very limited. The more the prices went up the higher the expectations got and this led home owners to pay substantially more than they otherwise would have which made this a vicious self fulfilling circle.
A study done by "Robert Shiller" it was obvious that price of real estate remained unchanged ( after counting for inflation) from 1895 to 1995 but between 1995 the price increased by more than 30%. After comparing this increase in prices with the historical stability of home market we can conclude that this increase was being fueled by speculation and the expectation that the price of real-estate will keep climbing causing this bubble. In parallel prices or rent had only increased 10% during the same period which should have indicated that there was actually a bubble in the housing market.
As explained earlier in the 90 there were 2 bubbles growing alongside each other the housing bubble and the stock bubble, such dual bubbles were also present in Japan and the collapse of the first caused the collapse of the second. But it the USA the collapse of the stock bubble between 2000 and 2002 actually fuelled even further the housing bubble. Investors having lost faith in the stock market turned their sights towards the historical safety of the real-estate market and billions upon billions of dollars were thrown into this market which fed the bubble and caused it grow exponentially.
In addition the recession after the stock market dip had a very slow recovery which led the federal reserve board in the us to decrease interest rate to 1% in 2003 (a fifty year low) mortgage rates also followed and dropped to 5.25 in 2003 also a 50 fifty year low, which enticed home owner wannabes to apply for loans to purchase homes further fuelling this bubble by increasing demand.
Adding fuel to the fire Federal Reserve Board Chairman Alan Greenspan suggested that homebuyers were taking wrong investment strategies by applying for 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.
This very low interest rate accelerated the run ups in house prices. Between 2004 and 2006 home prices rose around 31% fuelling construction. In 2005 housing starts peaked with 2,070,000 (around 50% above the pre-bubble rate) .this increases in home prices naturally had an effect on consumption and spending reducing savings rate to less 1%.
In 2006 evidence of instability in the housing market began to linger in the horizon with record vacancy rates in the rental market around 50% higher than the previous peak. And in 2007 the bubble burst as the over construction led to an oversupply in houses and high prices could no longer be maintained. Prices peaked in 2007 and then a downward spiral began and accelerated trough late 2007 and 2008. As prices declined more and more home owners face foreclosure. This foreclosure was in part voluntary in others forced.
Some home owners didn't want to leave their homes so they borrowed against equity to meet their monthly installments but falling home prices destroyed equity and maid this option very hard. Others noticed that they owed more than the actual value of their properties and decided to save hundreds of thousands of dollars by simply not paying. Both types of foreclosure gave the same outcome they increased the supply in a more than saturated market which pressured prices to go down even more( in some places the number of foreclosures exceeded the number of home sales) .
Also during the bubble lending decisions became even more lax and in the beginning of 2007 as default rates started to clime banks tightened lending which limited the availability of loans to customers decreasing demand for homes and pressured prices to go down. The most sever tightening took place in the regions were markets seemed the most volatile and were prices were free-falling in such areas bankers required mortgage seekers to finance between 20 and 30 percent of the total amount.
By the end of 2007 home prices had fallen by around 15% along the east, west coast and other over valued areas home prices had fallen more than 20%. In the beginning of 2008 annual rate of decline was accelerating and in some places it reached 30%. Some economist forecasted that the housing market will lose around 30% of its value (from the 2007 peak) this will amount to a staggering 7 trillion $ almost 50% of the American GDP.
This bubble grew out of proportions mainly by the fact that financial institutions created more and more innovations to support this growth. Also historically speaking we can see that the majority of mortgages has always been fixed rate mortgages but during the boom a lot of new exotic mortgages became more and more common peaking during the height of the bubble at 35%. Not only did these mortgages not offer the security and stability of the fixed rate mortgages they usually issued with a teaser rate that would be rest in 2 years even if interest rate in the market remained unchanged.
These types of mortgages were mostly present in the subprime mortgage sector and given to people with very bad credit rating and history, and naturally had a much higher interest than prime loans (between 2 and 5% higher). During the boom of the housing market subprime loans exploded to 25% (pre bubble subprime percentage was 9 %). There was also an exponential increase in ALT-A loans (rating better then subprime but not normal rating usually with incomplete paper work concerning revenue). This type of loans was in most situations questionable to say the least (in some situation worse than subprime loans), and were mainly used to purchase investment properties, and were issued with incomplete documentation and given the status liar-loans. Most of these have very high loan to value ratio with a lot of investors borrowing the full amount of the loan. Some of these loans were purely speculative loans were only interest was paid until a rest date were interest increased (generally 5 years). These "less the prime loans" formed together around 40% of the total mortgage market, this dramatic increase in risky loans should have signaled to investors and, banks and especially regulators that something was very wrong in the housing market. Its illogical to think that in bad economy, such as the one between 2001 and 2006 were the labor market was weak and wages lagged behind inflation that the number of credit worthy people in the subprime category doubled. Instead of noticing these very strong warning signs investors and politicians praised these strong home ownership and construction numbers.
Another fact that didn't help was the very loose appraisal system were rating companies were pushed to say the least to give better ratings for mortgage issuances ( a loan with a bad rating can't be issued ) and if a rating company gave a bade appraisal it will never b hired by the bank again. Also the fact that securitization was booming banks made moneys by issuing mortgages and selling them in the secondary market and not by keeping them therefore eliminating the loses from default. This meant that banks issued more loans with little concern about the ability of repayment of the customer; the one with the risk was the holder of the mortgaged back security. There was also the matter of incentives were managers got paid based on how well they performed on the short not the long term. They got huge bonuses based on the immediate returns over the long run profitability and even survival of the company.
As expected the trouble began in the subprime section were default rates began to increase in an alarming manner and many home owners were no longer able to borrow against equity in their homes and had default on their mortgages. And since construction already was at all time high this increased demand even further this led to a huge over supply, and since buyers were no longer to be found at these prices and banks were getting more and more careful how to give money to this decreased demand greatly pressuring prices to go down.
