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Sorry to Burst your Bubble
What caused the housing bubble to burst? Unfortunately there’s no simple answer to that question. There are many opinions on how and why it happened. Many Americans claim that they never saw it coming; however, some economists say that the bubble was obvious. I can’t say I was paying close enough attention to the U.S. housing market when prices peaked in 2005, but I can tell you that in my opinion, the housing crisis was fundamentally caused by greed and stubbornness.
According to Money Magazine, home prices in the United States, as of 2006, had increased, on average, by 5.5% per year over the last 20 years. Early in this decade, it wasn’t uncommon to see a 30% increase in a home’s value in as little as one year’s time in some markets. This consistent return spurred domestic and foreign interest in the U.S. housing market. An easy way for entities to invest without directly purchasing real estate was in residential mortgage-backed securities (MBS). In short, MBS’s are a pool of mortgages pulled together, given a risk rating by an accredited credit rating agency, and sold as an investment vehicle.
Mortgage-backed securities sound like a nice, safe way to invest in U.S. real estate. For years they were; but what happens when the mortgages that make up this security stop being paid? We all know the answer to that question, but why weren’t payments being made? These were good borrows in the eyes of bank underwriters; after all they did give them the loan, and in the eyes of the credit agency that “stamped” these securities. Right? Yes and no. This is where I contend that greed and stubbornness were at the heart of this burst bubble.
Greed was a factor on both the consumer and corporate end of things. Lenders hungry for profits were finding creative ways to grant loans to people in the form of sub-prime mortgages, adjustable rate mortgages and no-document loans. Not to mention the fact that they were encouraged to do so by then Chairman of the Federal Reserve, Alan Greenspan. Subprime mortgages are loans granted to those borrowers who, due to their poor credit, would not normally qualify for conventional financing. Adjustable rate mortgages are loans where the interest rate periodically adjusts depending on the indices it’s tied to. No-document loans are loans issued to credit worthy borrowers but without income or asset verification.
Where the blame falls in regards to these loans going sour can be an opinion paper in and of itself. Some contend that the consumers placed too much faith in the fact they could get the loan and that they should have known they were stretching themselves too thin to comfortably afford the payments. Others say that the lenders should have never granted the borrower the loan in the first place.
In my opinion, consumers were greedy because they saw their appreciating home as an ATM machine. Home values kept rising by hefty numbers and consumers took advantage of home equity loans and cash out refinancing. They saw how much their neighbors were selling their homes for and figured that they could safely tap the equity in their home because when they went to sell it, it would be worth even more money than today. This greed, by both consumers and lenders, fueled a vicious cycle that helped over-inflate home values and create a dangerous state of financial leverage. Once home values began to decrease people found that as they were looking to sell their homes, they owed more money than then they could sell it for. This forced some people to stay in homes they could not afford for one reason or another. When adjustable rates went up, homeowners found themselves unable to make monthly payments, leading to foreclosures.
It’s my opinion that stubbornness played a key role in the housing crisis as well. In the early part of this decade the United States was experiencing this boom in real estate value and people were feeling pretty good about the overall economy. The stock market was doing well, we were coming out of a recession, jobs were being created, homeownership rates were at the highest levels ever and consumer confidence was high. Most people were stubborn to think that this exponential increase in housing prices would continue and some Wall Street executives used the term “forever” to describe the length of this boom. If there is anything that history has taught us, it’s that all good things must come to an end and in 2007 we began to find that out the hard way.
The housing bubble burst was just one part of the “perfect storm” that came together to create the deep recession that we are still in today. Had the housing bubble not burst, I believe we still would have entered into a recessionary period of time but the main reasons for the burst, greed and stubbornness can be applied to the other contributing factors that created today’s recession.
About the Author
Wayne McKillop