The Housing Bubble, How it Happened, and What it Means
Economy Shattered-Dreams Destroyed, Jobs lost and Homes Foreclosed
Was it a bird, a plane or a tulip? No, It wasn’t Tulip Mania or the South Sea Bubble. It was our own invented in the U.S. “Housing Bubble”. Housing prices went up 25% between 2002 and 2006 and fell 30% since then. Housing starts have cratered. 10% percent of US workers are unemployed and the unemployment rate is effectively higher. Foreclosures have soared and as many as 10% of US homeowners are expected to lose their homes. Many people’s retirement plans are worthless and families are overwhelmed with debt. Merrill Lynch failed, Lehman went bankrupt and Bear Stearns is just a memory. Bank of America and Citibank continue to wobble as they deal with housing and credit card losses.
US Debt climbed during 2000’s and helped fuel the housing bubble. As tax revenues fall, unemployment benefits increase, and the government attempts to stimulate the economy; the U.S. Debt heads to record levels. 60% of the U.S. thinks unemployment is our major problem and 40% think the national debt is the real problem.
Most People Missed the Signs
David Lereah, former chief economist of the National Association of Realtors (NAR), distributed “Anti-Bubble Reports” in August 2005 to “respond to the irresponsible bubble accusations made by your local media and local academics.”
Former U.S. Federal Reserve Board Chairman Alan Greenspan said “We had a bubble in housing”, and also said in the wake of the subprime mortgage and credit crisis in 2007, “I really didn’t get it until very late in 2005 and 2006.”
He was better than some; In July of 2010, Phil Gramm, John McCain’s economic advisor said that we were in a mental recession and that our economic problems were caused by a bunch of whiners. He added that McCain would implement a program of reduced taxes and spending.
Why didn’t we see the crisis coming and take steps to head it off? The crisis was not obvious to the general public until the summer of 2008 or later. However, the housing bubble was obvious to many people including speculators such as John Paulson who made millions of dollars at the expense of certain banks and their customers.
There were some clues:
- Housing prices peaked in 2005 after increasing by 25% in early 2000’s
- November 2006 new home permits dropped 28% from year before ( a big clue)
- The subprime mortgage industry collapsed in March of 2007 because of record defaults.
- On December 30, 2008 the Case-Shiller home price index reported its largest price drop in history (an even bigger clue).
What happened?
- The Federal Reserve and the administration kept interest rates low to fight any sign of recession
- Congress lowered taxes on investors to increase supply of investment capital.
- Oil money from the Middle East flooded in looking for a place to invest.
- We had a huge increase in the supply of low cost money all chasing a return on their investment Government bond were at 4% to 5%, prime mortgage loans were at 7.5% and subprime loans were yielding 10%.
- If you pooled the subprime loans and sliced and diced them so they could be rated; the ban
Low cost money was flooding the markets and Wall Street came up with a high profit plan to help the investors find a new place to put their hot money.
The bankers had an all American plan:
- Wall Street convinced the rating agencies that a pool of subprime loans placed into a tranched mortgage pool or CDO qualified as a “AAA” investment as long as the originator diversified the risk geographically and set aside a tranche of about 15% of the pool to protect the AAA investor from defaults.
- A pool of tranched, sliced, rated subprime loans enabled the banks to make an additional 5 basis points; an extra $50,000 for every $1,000,000 pooled. Many were placed in pools called CDO’s. The CDO’s enabled the banks to put other loans, other mortgages and credit card paper in the CDO’s.
- Wall Street devised the Credit Default Swap that enabled banks and investors to buy a type of credit insurance that spared them the task of checking out or doing “due diligence”, on the portfolios.
- Unscrupulous mortgage brokers found that they could falsify loan applications because no one performing due diligence. 60% of subprime loans were originated by independent mortgage brokers rather than banks or S & L’s.
- Subprime loan originations increased from $160 billion in 1996 to $600 billion in 2006.
- AIG sold a record number of Credit Default Swaps.
- The Wall Street guys invented the Synthetic CDO’s and mortgage pools using Credit Default Swaps. With a Synthetic CDO or mortgage pool, a bank or investor could bet on the market without having to actually buy or sell all those mortgages. The Synthetic CDO, which was also rated, simply tracked an existing CDO. Wall Street issued more Synthetic CDO’s than regular CDO’s. One of the nice things about regular mortgage pools and CDO’s is that they actually funded real home building.
- Bankers could buy CDO’s at a 6% return; buy a credit default swap that protected them from loss for ½ % per year and make money by borrowing all the money at a rate of 3% to 3.5% per year. The Banks could make $2 million per year for each $100 million of subprime loans they purchased if they financed 100% of the purchase. Demand soared for both real and synthetic mortgage pools and CDO’s.
Everyone was happy. The mortgage brokers made big fees. The Wall Street Banks made record profits, individual bankers made million dollar bonuses and guys that never owned a home had a home with a pool. The average American felt wealthier because of the appreciated value of his home. Many Americans took out second mortgages and spent the money on everything from breast implants to new cars.
What Happened to All that Pretty Music?
- First the subprime loans started defaulting and the default rate quickly went to about 40% and higher. The 15% cushion made no difference. Mixing Arizona and Florida loans with Detroit loans did not help either.
- The banks obscured the losses as long as possible and claimed the Credit Default Swaps protected them against loss.
- Credit Default Swaps defaulted.
- The panic spread to US businesses
- Housing prices dropped from 30% to 60% from their peak value and 25% of all home loans were underwater.
- The newly unemployed homeowners whose home was often worth 25% less than their mortgage loan and they began defaulting in large numbers.
Where Are We Now- Next Post
