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English: Causes of the Housing Bubble

Overview

See the United States housing bubble and subprime mortgage crisis for in-depth discussion and citations. A brief summary of each vertical "string" of causes is included below. While there are many factors that influenced the housing bubble, fundamentally a bubble is built one transaction at a time. Risky lending decisions were made by institutions and risky borrowing decisions were made by both individuals and institutions. According to the Pew Research Center, “There is a broad public consensus regarding the causes of the current problems with financial institutions and markets: 79 percent say people taking on too much debt has contributed a lot to the crisis, while 72 percent say the same about banks making risky loans.”^[1]

Lending Decisions by Institutions

• Banks and investment banks funded the housing boom and also packed mortgages into MBS for sale or their own accounts. Investors demanded MBS, as they were considered safe investments that paid a higher rate of return than treasury bills during the boom period, when defaults were minimal. Credit risk insurance was available through credit default swaps (CDS). Both MBS and CDS are relatively opaque investments and once the bubble burst, their valuation became difficult to determine.
• Loanable funds (capital) was readily available due to: low interest rates early in the decade; abundant foreign capital flowing into the U.S.; low taxes and deficit spending supporting robust economic growth; and the recent dot-com stock bubble bursting.
• Credit rating agencies assigned optimistic "AAA" ratings to subprime MBS, which made the investments easier to trade (liquid) and supporting demand for them. Credit rating agencies are paid by those whose instruments they are rating.
• Rather than using the boom period to build their reserves, banks increased risk as evidenced by higher debt to equity ratios also known as financial leverage, which multiplies profits during a boom but reduces them during a bust.
• The financial regulations did not cover the shadow banking system, non-bank entities that were assuming increasingly leveraged and important roles in the financial system through MBS and credit default swap (CDS) derivatives. Non-banks did not have the same leverage restrictions as commercial banks.
• Incentive structures on Wall Street tended to be short-term rather than multi-year. Bankers received over $26 billion in bonuses during 2006.
• For decades, GSE-Government Sponsored Entities (Ginnie Mae, Fannie Mae & Freddie Mac) have purchased mortgage from a variety of mortgage companies and banks and sold bonds. These bonds represent the first mortgage-backed securities (MBS). These loans are referred to as "qualifying" or "prime" when they meet the GSE underwriting standards. The GSEs have missions that included helping provide housing to lower-income Americans by purchasing mortgages from originating firm. A small percentage of these loans are non-prime. A variety of politicians supported this mission both formally and informally.^[2]

Borrowing Decisions by Individuals

• In a competitive lending environment, mortgage brokers developed a variety of "innovative" mortgage products that were increasingly high-risk to the lending institutions and to borrowers. These included adjustable-rate mortgages and interest-only payment terms. Many homeowners were encouraged to purchase high-risk mortgages due to the belief that increasing home values would enable them to pay for the property.
• The American Dream as recently interpreted includes a house with several bedrooms, a yard, and a picket fence. This is reinforced widely in the culture, through television and movies. America is a consumption-oriented culture, with a negative savings rate. During the housing boom, many made significant profits through speculation or heard stories of massive home appreciation. The housing bubble developed for over a decade, with housing prices peaking in June-July 2006. Between 1997 and 2006, American home prices increased by 124%.
• Speculation in real estate was a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, nearly 40% of home purchases (record levels) were not primary residences. With such an upward trend, housing seemed a safe investment, particularly after the dot-com bust.
• American household debt relative to income increased to record levels, to nearly 140% during 2008.
• Economist Robert Shiller argues that speculative bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming."^[3]

Transition to the Subprime Mortgage Crisis

thumb|A diagram of the elements of the subprime crisis Once housing prices began to fall in June-July 2006, homeowners were often stuck with mortgages they could not afford or refinance. Delinquencies and foreclosures increased dramatically. As mortgage payments fell, the money flowing into MBS decreased during 2007. Many financial institutions suffered enormous losses, with hundreds of mortgage companies and several major financial institutions going bankrupt. Due to uncertainty regarding the financial condition of many financial institutions and banks dramatically increasing lending standards, loanable funds liquidity became less available. This is further described in the second subprime crisis diagram at right.

Additional Sources

Comprehensive discussions of housing bubbles and the crisis are at:

• Blackburn - The Subprime Crisis
• Economist - The Global Housing Boom

Other Specific contributing causes:

• Rating Agencies: Financial Times - We Must Not Rely on Only the Rosiest Ratings
• The outdated regulatory regime and discussion of causes: Gelinas - Stormproofing the Economy - City Journal
• Bubble psychology and other causes: Samuelson-Good Times Breed Bad Times-Newsweek

Caveats

• The main diagram helps illustrate how the housing bubble was built. It does not illustrate the ripple effect through the housing market, financial markets, and economy, which is shown as a thumbnail diagram.
• The diagram does not assign relative importance and key factors are not included. Some factors are critical to the housing market or the financial markets; some are critical to both. Experts disagree on which factors matter most.
• The many elements of the diagram interact and provide feedback on each other to varying degrees. This is a very simplistic representation. It would take a rather complex computer simulation to show the interaction of the two meta markets--the housing market and the financial market.

Sources

The letters from Fed Chairman Bernanke provide a helpful explanation of the subject.^{[4] [5]} Further, several cover stories and in-depth articles appeared in the Economist^{[6] [7] [8]} and Business Week.^[9] Former Federal Reserve Chairman Greenspan wrote an Op Ed piece for the Wall Street Journal that summarizes the crisis from a variety of angles.^[10]

Economist Joseph Stiglitz summarized his views on the causes of the crisis.^[11]