Housing Bubble

Housing Bubble

Shattered dreams and lost hopes are the order of the day in today's world when the whole world is engulfed with financial panic caused by the housing bubble. This paper throws light on some of these issues to gain a better understanding of the crisis and discusses the economic policies that were relevant during the crisis.

The origins of this bubble can be traced back in the ruins of another recession in the early years of this decade caused by the dot com burst in 2000. To jumpstart a weak economy, the Federal Reserve lowered interest rates from 6.5% to 1.0% to combat the perceived risk of deflation. The expansionary fiscal policy introduced by the feds and large inflows of foreign funds created easy credit conditions for a number of years. Subprime lending got easier contributing to an increase in home ownership rates and in the overall demand for housing, which drove prices higher. In addition to this, the inelastic nature of supply buildable land in place like Los Angeles, San Francisco and Miami increased the demand for homes and shot up the house prices up to the roof.

One of the main causes of the bubble is the expectation of higher prices which make people buy assets based on that expectation rather than fundamentals. There were mistakes made by the lenders (supply side) as well as the borrowers (demand side) that caused the bubble to form. During old times the home buyer would be required to pay 20 percent of the value of the home and the bank would loan the remaining 80 percent. Verifiable documentation also had to be provided. Even after their 20 percent put down if the their estimated annual property taxes and home owners insurance was more than 30 percent of the verifiable income the banker would be reluctant to lend them the money and incase of a default the local bank would take the loss. All this changed with the introduction of new financial instruments like mortgage backed securities. The evolutionary changes in the mortgage market resulted in the local banks immediately selling your mortgages to government sponsored enterprises Fannie Mae, Freddie Mac and other financial institutions that wrote them and would securitize them and then sell shares of it to investors. The qualification guidelines kept getting looser in order to produce more mortgages and more securities. This led to the creation of NINA - No Income No Assets (sometimes referred to as Ninja loans). Basically, NINA loans are official loan products and let you borrow money without having to prove or even state any owned assets. All that was required for a mortgage was a credit score. The local banks no longer counseled home owners against borrowing more than they could afford. They did not verify the income or assets of the borrower and merely consulted the credit agencies. If your credit was good enough they would sell your mortgage to Fannie Mae or Freddie Mac within days. This reduced the risk of any one bank going bankrupt as a result of a local economic downturn. In doing so this reduced the risk to investors and thereby reduced home mortgage interest rates in late 1980's mortgages began to spring up where the buyer would have to put down only 5 percent or 10 percent.

Beginning in 2002, interest only mortgages and even negative amortization mortgages began to become popular with home buyers because they allowed someone of modest means to get into a home they might otherwise not be able to afford. The home buyers were convinced that the ever increasing value of their homes would allow them to take out a second mortgage with a home equity line of credit. Cultural pressure for home ownership and perception of home as a safe investment together with all the favorable factors to buy a house resulted in house prices soaring to unrealistic levels. While housing prices were increasing, consumers were saving less and both borrowing and spending more.

Some in the financial system began to openly worry about the collapse of the mortgage market. This fear created an instrument that only added