It has been over a decade since the Global Financial Crisis that had its roots in the U.S. housing market. In that time I haven’t seen any attempt to explain it all in ways that most people could understand. So I’ll give it a try.
Prior to the mid-1990s, house prices had moved roughly with the overall rate of inflation. Thus there was a prevailing wisdom that “house prices always go up”. (That wisdom would loom large, as we’ll see.) Here are a few numbers to paint the overall picture of the time.
1) From 1980 to 2001, the ratio of median home prices to median household income (a measure of ability to buy a house) fluctuated between 2.9 times and 3.1. By 2004 it rose to 4.0, and in 2006 it hit 4.6 times.
2) Between 1997 and 2006 (the peak of the housing bubble), the price of the typical American house increased by 124%.
3) The US home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004.
4) From 1993–1997, home owners used home equity lines of credit to extract from their homes (using built-up equity as a piggy bank) an amount of between 2.3% and 3.8% of GDP. By 2005, this figure had increased to 11.5% of GDP.
5) The Federal Reserve also played a role, lowering short-term interest rates from 6% in 2000 to 1% by 2004, thus driving down mortgage rates.
6) US household debt as a percentage of annual disposable personal income was 77% in 1990, versus 127% at the end of 2007.
The politics of the time vis-a-vis housing can be described as bipartisan, with both Presidents Clinton and G. W. Bush (43) promoting homeownership, finding ways for low income folks to more easily access the market. So government had its hand involved, through Fannie Mae, Freddie Mac, and the Community Reinvestment Act of 1977. Fannie Mae, in particular, had its issues (e.g. accounting fraud) and was clearly involved in the early buildup of sub-prime mortgages. But it is a fact that by the time the housing market was kicking into high gear, non-bank mortgage firms had become the dominant issuer of these products. Anyone pushing the idea that government was the sole, or even the main, cause of the bubble needs to do their homework. I will just present three curious facts. The biggest price bubbles and subsequent collapses were NOT in the inner-cities of Chicago, Detroit, or Philadelphia, but in places like Phoenix, Orlando, and Las Vegas; Fannie Mae and Freddie Mac had nothing to do with commercial real estate, where prices rose by 91 percent in the seven years to October 2007; and housing boomed throughout much of Europe and parts of Asia during that time.
So what else was happening to sow the seeds of the bubble? Here is where we get deep into the weeds, so to speak. The roles of fixed income markets (a.k.a. bonds) and the rating agencies that grade those instruments, Wall Street firms, non-bank mortgage firms, real estate appraisers, unsophisticated home buyers ALL played a part.
20 years ago there were trillions (with a “t”) of dollars globally being invested looking for safe ways (usually bonds) to collect interest on their funds. Those investors were always looking for the highest return that also was deemed safe. In the wake of the Dot Com bubble of the late 1990s, and the Federal Reserve lowering short term interest rates, the result was lower returns on safe investments like U.S. Treasury securities. As bond investors began hunting for higher returns, Wall St. saw an opportunity to use a then little known instrument, mortgage backed securities (MBS), to sell to investors. These had been around for decades, with Fannie and Freddie being two of the biggest issuers. Each security contained hundreds of mortgages, and had historically consisted of standard 30 year fixed, or prime, loans. MBS were deemed as safe as Treasuries, since they were both rated as AAA, the highest rating. As the housing market began flourishing, MBS were being created with sub prime loans added to the mix. Sub prime had a higher interest rate than prime loans, thus the returns to investors were higher. These became very sought out by investors, and Wall St. was making great profits on fees from selling them. More and more mortgages were being created (originated) by non-traditional non-bank lenders who were much less restricted by government policies, and there were ready buyers (the sellers of MBS) to immediately take them off the mortgage brokers’ hands, so they had no concerns about the borrowers’ ability to repay the loans. Lending standards that were used to determine qualified borrowers began a steep descent.
By 2002-2003, the bull market in housing was gaining momentum. With business booming, Wall St. and the mortgage brokers were looking for even more ways to “create product”. Adjustable rate mortgages were well established, but new, exotic forms of loans were now being created. The worst were called “option ARM’s”, where the borrower could choose to pay LESS THAN the interest that was accruing on the loan, meaning that not only was the principle not being paid down, the unpaid interest was being added to the principle. But the only thing that mattered was that it kept the monthly payment as low as possible. This was a very popular selling point to the borrower, and thousands of unsophisticated people chose this type of loan. The low introductory rate reverted to regular interest rates typically after two years. It was only then that many borrowers realized they could not afford the new payments, eventually creating an avalanche of defaults. Then there were the “flippers”, investors who bought a home to sell it not long after, for a profit. A 2011 Federal Reserve study had this to say: “In states that experienced the largest housing booms and busts, at the peak of the market almost half of purchase mortgage originations were associated with investors. In part by apparently misreporting their intentions to occupy the property, investors took on more leverage, contributing to higher rates of default.” The Fed study reported that mortgage originations to investors rose from 25% in 2000 to 45% in 2006, for Arizona, California, Florida, and Nevada overall, where housing price increases during the bubble (and declines in the bust) were most pronounced. In these states, investor delinquency rose from around 15% in 2000 to over 35% in 2007 and 2008.
There were also many documented cases of appraisers (who decided how much the property was worth, and thus the size of the mortgage) being pressured by the lenders to give as high a value as possible. This is how the Financial Crisis Inquiry Commission described the era. “Some real estate appraisers had also been expressing concerns for years. From 2000 to 2007, a coalition of appraisal organizations circulated and ultimately delivered to Washington officials a public petition; signed by 11,000 appraisers and including the name and address of each, it charged that lenders were pressuring appraisers to place artificially high prices on properties. According to the petition, lenders were ‘blacklisting honest appraisers’ and instead assigning business only to appraisers who would hit the desired price targets”.
The FCIC Report then describes the scale of this epidemic of loan origination fraud.
“One 2003 survey found that 55% of the appraisers had felt pressed to inflate the value of homes; by 2006, this had climbed to 90%. The pressure came most frequently from the mortgage brokers, but appraisers reported it from real estate agents, lenders, and in many cases borrowers themselves. Most often, refusal to raise the appraisal meant losing the client”. Those that didn’t play along, saw their business shrink.
Now we need to circle back to getting all those mortgages packaged together to be sold to investors. Like virtually all bonds, MBS need to be given a grade by one of the three ratings agencies — Standard and Poors, Moody’s and Fitch. Though in retrospect it seems obvious that an unusually large portion of mortgages issued during that time had very high risk of default, that hadn’t yet become an issue. The housing market had always been reliably stable, and house prices were still going up. Computer models looking at the risk of default kept assuring the ratings firms that risk was low, since each security being graded included so many mortgages. A few bad apples won’t spoil the whole bunch, as the saying goes. The agencies were also well aware that they depended solely on Wall St. for their business, and that Wall St. liked getting the highest ratings possible, which made it easier to sell those securities to their clients, which increased their profits.
This was just the lead up to the crisis. There is much more to come.