The Real Causes of the Housing Bubble and Credit Crisis
The
three main causes of the housing bubble were historically low interest
rates, government policies that encouraged home ownership by as many
people as possible, and rampant speculation. It was a “perfect storm”
as all three factors converged at the same time to create an
environment where common sense was replaced by greed, ignorance, and
incompetence.
The
initial trigger that began to inflate the bubble was the tragic events
of September 11, 2001. A year earlier, the federal funds interest rate
was 6.5%. The terrorist attacks prompted the Federal Reserve to start
chopping interest rates dramatically as it feared that dire financial
repercussions would quickly paralyze the economy. Hindsight clearly
shows that they overreacted when forecasting the potential economic
impact, but the effects of the continuing rate cuts were not obvious at
the outset. With the exception of the travel industry, particularly
the airlines, the economy remained relatively robust.
As
the fed funds rate continued to drop to 1.0% over the next two years,
this provided rocket fuel to homebuilders as they ramped up land
purchases and massive housing developments. At this point, the housing
bubble was fully underway. At the same time that interest rates were
plumbing historic lows, certain members of Congress were pressing
Freddie Mac and Fannie Mae to expand their lending policies to be more
inclusive of people who would not normally qualify for a home
mortgage. This was accompanied and exacerbated by new and creative
financing schemes that featured no principal payments for the first
five years and teaser variable rates that were locked in for the same
period of time.
Gone were the good old days when banks would only lend you three times your income. In fact, many people were paying far more than a third of their income on their mortgage. The map below shows the percentage of homeowners in each state that were spending more than one-third in 2006 (% Burdened). It should come as no surprise that the red and orange states have suffered the biggest price declines since then.
"Burdened" Homeowners by State (2006)
Those adjustable mortgage rates were then adjusted upward as the Fed began to comprehend the error of its
ways and started to methodically increase rates. The proverbial cat,
however, was already out of the bag. The speculators, some of whom had
been burned in the dot-com stock implosion just a few years earlier,
had turned to real estate as the next get-rich-quick scheme. Greed
quickly replaced reason as “flippers” bought up homes and condos at an
alarming rate, with the intention of holding them for a matter of
months and then reselling them at a big profit. In many cases these
transactions were accomplished before construction on the properties
was even completed.
This
lethal combination of cheap money, easy credit, and gambling on future
price inflation eventually undercut the housing market which was
essentially a house of cards built on a foundation of quicksand. The
effects of this were especially severe in those areas that were most
overbuilt and where speculation reached extreme levels. Parts of
California, Florida, Arizona, and Nevada experienced exponential price gains as
people refinanced their existing homes to buy investment properties.
This leveraging couldn’t last forever and it didn’t, as buyers walked
away and sellers flooded the market. The resulting foreclosures across
a wide price spectrum further compounded the problem, as prices
cascaded downward in many hard-hit parts of the country.
Unfortunately, it’s not over yet.
Once again, the graph below shows that the hardest hit states were the ones where home buyers borrowed far more than they could afford to repay.Equity Distribution by State (3rd
quarter 2010)
The implosion of the housing bubble is only step one in the destruction of the American economy. Step two is now well underway and the final step is right on the horizon. The Baby Boomers are starting to retire in 2011 and the major entitlement programs are all going bankrupt. Do the math. The mother-of-all crashes is coming.