What Started The Recession Part 2: The Housing Bubble Goes Pop

Jan 02, 09 What Started The Recession Part 2: The Housing Bubble Goes Pop
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While credit default swaps pose the most significant new risk to our economic health, the bursting of the housing bubble is the primary cause of the current recession.  Now that may appear to be a simple proposition.

However, the underlying causes of the housing bubble, and the consequences of its collapse, are both wide and deep.  A modicum of self-examination will reveal that we all have to accept some culpability, granted, some more than others.

Even a cursory glimpse into the origins of our current dilemma will reveal an irrational exuberance fueled by a unique form of Americanized greed.  This consequence free lifestyle helped us live well beyond our means for far too long.

We blithely ignored risk, to our ultimate detriment.  The bursting of the housing bubble, and its subsequent calamitous effects on every aspect of the economy, will force us to look anew at the very way we conduct our financial affairs.  Today we examine the origins and effects of the collapsing housing market.

1.)  The Growth of the Bubble

When the dot-com industry collapsed between 2001-2002, the country entered into a mild recession.  In theory, that recession should have cooled the wild speculation that inflated the dot-com bubble way past rationality into Candy Land.

Instead, Bush kept encouraging Americans to spend more in the wake of 9/11.  Fueled by low interest rates and foreign dollars, people turned to real estate as a safer investment than traditional stock.

The Federal Reserve lowered short-term interest rates to 1%.  In addition to easy access to capital and credit, economists point to a particularly American view of home ownership.

Many Americans believed that the housing market provides investment opportunities that continues to grow in value over time, more often than not impervious to other economic shifts.  Over-speculation, rather than tempered, was merely transferred from one place to another.

2.)  C.R.E.A.M.

Depending on your vantage point, either the implosion of subprime mortgages was the cause of, or the result of, the housing market collapse.  Frankly, in a seemingly risk free environment, where home values continued to spiral out of control, subprime mortgages were another avenue for the haves to exploit the have nots.

Let’s examine why lending to subprime borrowers was such a lucrative proposition for lenders who should have been much more risk averse.

Subprime mortgages are mortgages made to “subprime” borrowers, or borrowers that have a decreased ability to repay the loan.  There are a few types of mortgages that are generally made to subprime borrowers.

Adjustable rate mortgages are basically loans where the interest can be adjusted based on any number of variable events.  These mortgages allow borrowers to make lower initial payments because they assume the risk if interest rates rise.  Unfortunately, as the housing market began its correction and interest rates rose, many borrowers were unable to pay their ARMs.

Interest only loans can be made to borrowers who agree to pay only the interest on the principal balance for a set amount of time.  While the early payments are lower, unless the borrower pays more than the minimal payment, they do not make a dent in the principal balance.

The borrowers often agree to interest only mortgages because they are attempting to predict how the market will perform.  However, if they predict wrong, the borrower’s payments increase, and they lose equity and the ability to refinance.

Stated income loans are approved based solely on the borrower’s word.  The lenders do not verify the borrower’s income.  This loophole was created to assist self-employed individuals and other people with non-traditional sources of income.

However, it has been used to exploit individuals with bad credit and little prospect of meeting the obligations of a long-term loan.

Economists attribute a concept known as moral hazard as the reason why subprime lending continued to grow despite their risky nature.  Each link in the mortgage chain freely took their profits and then passed on the risk to another entity.

People desperate to own homes took on mortgages that they did not qualify for and could not pay back.  Lenders issued subprime mortgages, despite the risks.  Instead they took their fees and sold the right to receive mortgage payments through the pooling of these assets into securities.

Mortgage backed securities (MBS) and collateralized debt obligations (CDO) were bought by large banks and investment firms, who then hedged their bets in the form of credit default swaps.

3.)  …And It All Falls Down

Although the housing bubble continued to expand until 2005, the warnings started to sound as early as 2003.  Many people that should have known better willfully ignored those warnings.

The irrational speculation, coupled with the relaxed lending standards, created a toxic environment where one weak link in the chain would bring the whole enterprise down.  In this instance, credit risk increased because interest rates decreased at the same time home values began to deflate.

Once people began to miss mortgage payments, which snowballed into foreclosure, all of the MBS began to lose equity at an exponential rate.

Even though the primary investors in MBS sold credit default swaps as a safeguard, the massive number of foreclosures combined with the vast quantities of unknown toxic debt, made the sellers of CDS unsure of whether the buyers of CDS would be able to pay if the financial event occurred.

The first bailout empowered the federal government to buy these MBS so that banks and investment firms could remove this unknown debt from their ledgers.

4.)  2009 and beyond…

Many analysts predict that as unemployment rates increase, the housing market will continue to decline.  The previous government bailout is considered ineffectual at best.

While it propped up the financial markets and provided a temporary psychological salve, the next bailout will be much broader in its scope.  The manner in which the housing bubble grew and collapsed provides stark lessons for us all.

From the American consumer, consumed by consumption, to greedy and unscrupulous lenders all too willing to take advantage of our fever, to a government that turned a blind eye towards its responsibilities, we all have some water to carry.  Let us hope that our well has not run dry.

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