The Housing Bust
"Almost since the phrase, The American dream, was coined in the early 1930s, it has been synonymous with homeownership. In a way that isn't true in most other countries, homeownership is something that the vast majority of Americans aspire to. It suggests upward mobility, opportunity, a stake in something that matters" (McLean 6). A home is a place of refuge and a place where one can be connected with family. A home is one's most prevalent asset and greatest financial obligation. The booming of the housing market made it easy for homebuyers to purchase a home. However, once the housing market peaked, it was only a matter of time before the meltdown ensued and the market collapsed. Dating back to the mid '90's, during the Clinton Administration, there were policies put in place by the government that led to the easing of loan regulations. These policies were expanded upon by the Bush Administration in order to allow low income people to buy a home. This led to mass loan defaults from subprime mortgage loans that were given to people who could not afford them. These new policies allowed people who normally would not be extended a loan, to be presented a loan that they could not afford. Once these policies were put in place and took effect, it pushed the housing demand to an unprecedented level never yet seen in the history of the United States, because people could now afford to buy instead of rent. The repercussions of these policies also drew homebuyers and investors into the mix whereby they saw a new way to make huge profits by the purchase and resale of property. The bursting of the housing bubble was a direct result of government policies in the '90's, the offering of subprime mortgage loans to unworthy borrowers, along with homebuyer and investor speculation.
To begin, the sequence of lending money to homebuyers has historically been the most profitable business in which a bank could invest. However in the '90's, the government concocted a way to recreate the housing market by binding mortgage securities (Zandi 11). According to economist, Mark Zandi:
[Mortgage Securities] were tailored so that investors could receive payments based on how much risk they were willing to take. Those seeking a safe investment were paid first, but at a lower rate of return. At least that was how it worked in theory…The benefits of securitization were substantial…Now lenders could originate loans, resell them to investors, and use the proceeds to make more loans. As long as there were willing investors…the credit tap could never run dry…Government regulators and policy makers also liked securitization, because it appeared to spread risk broadly, which made a financial crisis less likely. Or so they thought…With funds pouring into mortgage-related securities, mortgage lenders avidly courted homebuyers. Borrowing costs plunged and mortgage credit was increasingly ample. Housing was as affordable as it had been since just after World War II…Borrowers with less than perfect credit-or no credit-could now get a loan (11-14).
As a result, mortgage securities fueled the rapid spread of risky mortgage lending across America, and the quality of loans were significantly diminishing (Lowenstein 287). Moreover, "securitization severed that critical link between the borrower and lender. Once a lender sold a mortgage…[the] repayment became someone else's problem…but no one seemed to realize that the poorly underwritten loans that securitization seemed to encourage was a monstrous red flag" (McLean 83-84).With the help of government sponsored enterprises, such as Fannie Mae and Freddie Mac, the housing market was destined to crash and burn (Shiller 16).
During the boom, no one was concerned with imposing rules and discipline on lenders, or with addressing the frightening increase in home prices (Morgenson 220). Banks always had strict guidelines to follow in regards to loans (Acharya 36). The arrangement between the banker and the borrower was simple. For example, a bank would loan hopeful borrowers money for a house, and over time the money would be paid back. Before securitization, lenders had to check background and credit history of borrowers (36). Lenders were afraid to take the risk of giving loans to unworthy borrowers who had low income, because if the borrower defaulted, the lender absorbed the loss (McLean 83).
However, this changed when new policies were put in place in 1995, when President Clinton launched his National Homeownership Strategy. This strategy was made to increase the number of homeowners in America by 8 million by the year 2000 (McLean 32; Morgenson 1). This left minorities and low income families vulnerable, and in jeopardy if an economic collapse took place. A branch of Clinton's strategy was the Taxpayer Relief Act of 1997 (Fletcher 132). Prior to 1997, it was not easy for homebuyers to liquidate their homes without having complications (Evans 14). The Taxpayer Relief Act made it possible for the middle and lower classes to acquire equity from their homes to buy additional properties (Acharya 44). In addition, this law gave homebuyers the ability to purchase a property with no down payment, live in the home for a period of time, and sell it within two years to make a profit (Evans 15). A homeowner would have the ability to do all of this, tax free as long as the property is their personal residence (15).
In 2000, President George W. Bush was elected into office. After about a year in office, the terrorist attacks on September 11, 2001, bombarded Americans with fear and confusion. The terrorist attacks affected the economy, and particularly the housing market (2). After the attacks, many people stopped travelling, because they wanted bigger homes (Andrews 7). As a result, home sales were at an all-time high, prices were skyrocketing, and home builders could not keep up with the demand for new homes (30).
Over a year after the attacks, President Bush expanded upon Clinton's National Homeownership Strategy, by launching his American Dream Downpayment Initiative (24). This program was created to help families with paying off their down payment, and closing costs on their homes (Rubino 96). Moreover, the American Dream Downpayment Initiative was invented to help further strengthen America's housing market. Bush wanted to make the American Dream of owning a home possible for millions across the country, especially for minorities and low income families (McLean 168). With these new policies in place, the rules and regulations for mortgage lending and home buying were eased tremendously (Sowell 37).
Once this law took effect, lenders and bankers misused their newfound freedom by "competing for new business by offering attractive incentives, such as low introductory rates, reduced down payments, and interest-only loans" (Hunnicutt 12). As a result, borrowers were quick to take advantage of these eye-catching incentives; however, many were not properly educated and warned of the dangers involved with their new loans (Hunnicutt 12; Morgenson 275). The American Dream Downpayment Initiative gave lenders and homebuyers the freedom to lend and buy faster, but with more risk involved. Borrowers who never had been able to receive a loan were now able to receive one, because of the new policies put in place by the government (Morgenson 35). In addition, lenders and borrowers began lying on loan applications by exaggerating their incomes (Andrews 4). As a result, mortgage lending was overflowing with fraud, exaggerations, delinquencies, and lies which heightened the mounting housing bubble, because unworthy borrowers could now receive a loan (4). Furthermore, by exaggerating their income and credit scores, unworthy borrowers received loans for homes they could never afford (217). Lenders were aware that these borrowers would never repay the loans; nevertheless, they offered loans to them not considering the consequences (217). With the receiving of these loans, the floodgates were opened and the Subprime Mortgage loan emerged, along with its sidekicks, the Adjustable Rate Mortgage loan, and the Alternative A-Paper loan, to turn the way Americans bought homes upside down.
Next, the offering of subprime mortgage loans to unworthy borrowers was another main component that led to the bursting of the housing bubble. A subprime mortgage loan is a loan habitually offered to low income borrowers, and people with low credit scores (Barth 42; Hunnicutt 10). These borrowers do not qualify for a prime loan, because they have a history of bankruptcies and payment delinquencies (Zandi 32). In contrast, a prime loan is generally given to people with high credit scores and reputable backgrounds (Hunnicutt 10). Furthermore, lenders are eager to extend loans to prime borrowers, because of their clean credit histories. With new loan policies in place, many homebuyers used these risky subprime loans to purchase their homes (Fletcher 51). Borrowers with subprime loans were more likely to default, because they had little to no down payment on the home (Rubino 108). Moreover, lenders no longer required a borrower to have proof of income (Hunnicutt 11). As a result, borrowers lied about their income so that they could acquire a loan (Barth 159).
The Alternative A-Paper loan, or the alt-A, is a loan that is, "not quite prime and not quite subprime" (Zandi 32). Borrowers that use alt-A loans have good credit; however, these borrowers may have tarnished credit history that would bar them from receiving a loan (32). Many subprime borrowers had the Adjustable Rate Mortgage loan, or ARM loan. ARM loans were appealing, because buyers expected their incomes to increase within a few years which would allow them to be extended a prime loan (Sowell 21). Lenders made ARM loans attractive to borrowers by offering teaser rates. Teaser rates were tempting, because they offered low initial rates to the borrower (Barth 476). In addition, ARM loans were popular, because they adjust within one to five years, depending on the loan (Fletcher 50; Shiller 12). For example, if one buys a home and lives in it for two years, then the loan payments adjust to a higher price. After the first two years, payments adjust again every six months (Zandi 37).
There are two types of ARM loans called interest only and option ARMs (Acharya 86). First, interest only ARM loans are fixed at a low rate for a period of time (Barth 146). This allows borrowers to pay only the interest on their homes for the first few years (Sowell 19). After, the specified period, the payment of the loan will adjust upward, and the borrower will have to pay a higher monthly payment over time (19). Second, option ARM loans allow borrowers to choose different payment options for each month (Fletcher 52). Borrowers can pay full interest and principal, pay only the interest, or make a low minimum payment (Andrews 49). However, the borrower using the minimum payment option could result in owing more money than the remaining total of the mortgage (Sowell 19). The option ARM loan was attractive to low income borrowers during the housing boom, because the borrowers only concentrated on the cheap month to month expenses, and not on the long term expenses that would come in the future (Fletcher 52).
The subprime market boomed from 2004 to 2007 (Shiller 5). The housing and subprime markets peaked in 2006 and 2007, because people began to default on their loans (7). Almost immediately, homebuyers and investors could no longer sell, because no one was buying and home prices were rapidly declining. From 1997 to 2007, homebuyers and investors seized every opportunity to buy bigger and nicer homes to sell and flip.
Last, homebuyer and investor speculation triggered the collapse of the housing market. Home prices continued to increase, giving homebuyers the ability to refinance their mortgages in order to postpone the higher payments of their mortgages (Faber 158-159). In addition, people continued to receive loans and buy homes they could never afford (179). The market rose quickly, because first-time homebuyers frequently continued to buy and sell their homes, "for larger, more expensive homes, second homes, or investment homes" (Evans 36). By doing this, homebuyers made the bubble expand faster by raising the prices of their homes when they resold their homes. Investors took advantage of the growing market by buying homes for less than market value to fix them, and resell them promptly for a much higher price to make a profit (53). This method of resale is commonly called flipping (53). Flippers are people who buy homes that are in foreclosure, or in need of renovation (54). For example, a flipper would flip a home by fixing it up, or by waiting until the home's value increased. Then, they would sell the home quickly to make a profit. By flipping, rising home values begun a change in consumer spending. Many people felt richer as they bought and sold for nicer homes. According to Wall Street financial analyst, John Rubino, homeowners felt wealthy because:
[There was a] change in consumer spending…caused by rising home values. This is known as the wealth effect, and it's derived from the idea that if we feel richer because our investments are rising in value, we spend more, even if we don't actually cash out any equity. Think about it: If your home value goes up by $20,000 this year, spending an extra $5,000 on a big-screen TV still leaves you up $15,000 (Rubino 105).
The continuous buying and resale of homes along with increased consumer spending added to the immense bubble, because houses were being sold for more than they were worth to people that could not afford to pay for them. The income of subprime borrowers remained the same as they continued to purchase homes out of their price ranges. With this in mind, "rising home prices aren't necessarily a problem, [but only] if home buyers' incomes are rising along with them" (45). However, this was not the case for subprime borrowers.
In addition, housing prices shot up drastically in many places, and some areas were affected by the housing boom more than others. The areas that were affected the most include the "sand states" such as California, Florida, Nevada, and Arizona (Lewis 97). The housing prices in the sand states "had risen the fastest…and would likely crash the fastest in a bust" (97). This prediction became true in late 2006 and 2007, when the market peaked and came crashing down (107). When home prices started to fall, many people stopped paying their loans, because they were trapped by loans they could never pay back (Faber 159). In 2005, credit card delinquencies climbed, because Americans could no longer pay their debt (Lewis 54). Americans started saving more, and were spending and shopping less (Lowenstein 274). As a result, the retail market was weakened (274). Furthermore, once the market peaked, all of the jobs that had been accumulated during the boom vanished (284). Additionally, housing prices fell at record breaking numbers, millions defaulted on their shoddy loans, and foreclosure threatened families across the country (Lewis 137). The housing bubble burst, and the boom ended thereby beginning the recession and collapse of the economy.
In final analysis, greed is what continued to feed the housing bubble. It infected everyone in America by causing the economy to fall apart (Faber 180). The bursting of the housing bubble was caused by people who misused their power to make poor decisions which ultimately led to the collapse of the market. The Clinton Administration put new policies in place for the housing market which were expanded upon by the Bush Administration. In doing so, this allowed lenders to offer subprime loans to unworthy borrowers which caused heartbreak when they defaulted. Homebuyer and investor speculation fueled the mounting bubble as people were buying, selling, building, and flipping homes in a race to grab their slice of the American Dream. However, for many people, their American Dream turned into a nightmare when they could no longer pay their mortgages. Nevertheless, "there was no single, dramatic event that set this off…A whole series of very questionable decisions by many people, in many places, over a period of years, built up the pressures that led to a sudden collapse of the housing market and of financial institutions that began to fall like dominoes as a result of investing in securities based on housing prices" (Sowell 1).
Acharya, Viral V. Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance. Princeton: Princeton UP, 2011.
Andrews, Edmund L. Busted: Life Inside the Great Mortgage Meltdown. New York: W. W. Norton, 2009.
Barth, James R. The Rise and Fall of the U.S. Mortgage and Credit Markets: A Comprehensive Analysis of the Market Meltdown. Hoboken, NJ: Wiley, 2009.
Evans, Blanche. Bubbles, Booms, and Busts: Make Money in Any Real Estate Market. New York: McGraw-Hill, 2007.
Faber, David. And Then the Roof Caved In: How Wall Street's Greed and Stupidity Brought Capitalism to Its Knees. Hoboken, NJ: John Wiley & Sons, 2009.
Fletcher, June. House Poor: Pumped up Prices, Rising Rates, and Mortgages on Steroids: How to Survive the Coming Housing Crisis. New York: Collins, 2005.
Hunnicutt, Susan. The American Housing Crisis. Detroit: Greenhaven, 2009.
Lewis, Michael. The Big Short: Inside the Doomsday Machine. New York: W.W. Norton, 2010. Lowenstein, Roger. The End of Wall Street. New York: Penguin, 2010.
McLean, Bethany, and Joseph Nocera. All the Devils Are Here: The Hidden History of the Financial Crisis. New York: Portfolio/Penguin, 2010.
Morgenson, Gretchen, and Joshua Rosner. Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon. New York: Times / Henry Holt and, 2011.
Rubino, John A. How to Profit from the Coming Real Estate Bust: Money-Making Strategies for the End of the Housing Bubble. [Emmaus, Pa.]: Rodale, 2003.
Shiller, Robert J. The Subprime Solution: How Today's Global Financial Crisis Happened and What to Do About It. Princeton, NJ: Princeton UP, 2008.
Sowell, Thomas. The Housing Boom and Bust. New York: Basic, 2009.
Zandi, Mark M. Financial Shock: A 360° Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis. Upper Saddle River, NJ: FT, 2009.