Professional Documents
Culture Documents
http:www.uvu.edu/woodbury/jbi/articles
By JEFF HOLT*
A recession began in December of 2007. The general consensus is that the primary
cause of the recession was the credit crisis resulting from the bursting of the housing
bubble. This paper discusses the four primary causes of the housing bubblelow
mortgage interest rates, low short-term interest rates, relaxed standards for mortgage
loans, and irrational exuberance. This paper concludes that the combination of
these factors caused the housing bubble to be more extreme and the resulting credit
crisis to be more severe.
the shadow banking system. Zandi (2009) prices had decreased by over 32 percent
emphasized how the increased securitization from their 2006 peak. However, home prices
of home mortgage debt contributed to relaxed were still 57 percent higher than they had
mortgage lending standards. Keys, Mukherjee, been in the 1st quarter of 1997. Additional
Seru, and Vig (2008) found that existing secu- decreases in home prices were quite possible.
ritization practices adversely affected the In this section the four primary causes of the
screening incentives of lenders. Piskorski, housing bubble will be discussed: (i) low
Seru, and Vig (2008) found that loans that mortgage interest rates, (ii) low short-term in-
were securitized had a higher foreclosure terest rates, (iii) relaxed standards for mort-
rate than loans held by a bank. Mian and Sufi gage loans and (iv) irrational exuberance.
(2008) found a close correlation between the (i) Low mortgage interest rates. Even
expansion in mortgage credit to subprime zip though the U.S. savings rate was low during the
codes and the increase in securitization of housing bubble, an influx of saving entering the
subprime mortgages. Gwartney, Macpherson, U.S. economy from countries such as Japan
Sobel, and Stroup (2008) identified four and China helped to keep mortgage interest
factors leading to the housing bubble and rates low. Investors in these countries sought
credit crisis: (1) relaxed mortgage lending investments providing relatively low risk and
standards, (2) low short-term interest rate good returns. As Wall Street developed new
policy of the Fed, (3) increased leveraging ways to funnel savings from worldwide sources
by investment banks, and (4) increased debt- to the U.S. mortgage market (e.g., mortgage-
to-income ratio for households. Shiller (2008) backed securities), U.S. mortgage interest rates
emphasized irrational exuberance as the cause were kept low. Mortgage interest rates in the
of the housing bubble. U.S. peaked at 18 percent in 1982, as the
However, to the best knowledge of the Federal Reserve drove interest rates skyward
author, no study so far has provided a simple in a successful attempt to squeeze inflation out
explanation of the housing bubble and the of the economy. Mortgage interest rates gener-
credit crisis. This paper will summarize the ally fell over the next twenty years, with the
primary causes of the housing bubble and rate on a 30-year fixed mortgage falling below
the resulting credit crisis. Section II of this 6 percent late in 2002. The rate stayed below 6
paper is devoted to the primary causes of the percent most of the time through 2005. Figure
housing bubble. Section III deals with the 1 depicts the historical evolution of the average
bursting of the housing bubble and the 30-year fixed mortgage interest rates from 1982
resulting credit crisis. Section IV provides to 2005.
some concluding remarks. Mortgage interest rates were falling
despite the low savings rate in the U.S.
II. Primary Causes of the Housing Bubble because of an influx of saving entering the
U.S. from other countries. Most of this saving
Home prices were relatively flat came from countries with high savings rates
throughout most of the 1990s. According to such as Japan and the United Kingdom and
the S&P/Case-Shiller Index, home prices in- from countries with rapidly growing econo-
creased by about 8.3 percent from the 1st quar- mies such as China, Brazil, and the major oil-
ter of 1990 to the 1st quarter of 1997. Then exporting countries. According to Bernanke
home prices began a rapid increasepeaking (2009), the net inflow of foreign saving to
in the 2nd quarter of 2006 over 132 percent the U.S. increased from about 1.5 percent of
higher than they had been in the 1st quarter of GDP in 1995 to about 6 percent in 2006.
1997. By the 1st quarter of 2009, home
122 JOURNAL OF BUSINESS INQUIRY 2009
Figure 1:
Investors in these countries sought low-risk because they had received favor-
investments providing low risk and good able ratings issued by highly respected credit
returns. Initially, they focused on U.S. rating agencies such as Moodys and Stan-
government securities. Seeking better returns, dard & Poors. The low mortgage interest
they branched out into mortgage-backed rates contributed to the housing bubble by
securities issued by Fannie Mae and Freddie keeping monthly mortgage payments afford-
Mac, two enormous government-sponsored able for more buyers even as home prices
enterprises (GSEs). Foreign investors assumed rose.
that these securities were low-risk because, if (ii) Low short-term interest rates.
trouble arose, the federal government would From 2002 to 2004, the Federal Reserve
step in to bail out Fannie and Freddie. pushed the federal funds rate down to his-
Eventually, the foreign investors grew torically low levels in an attempt to
bolder, investing in mortgage-backed securi- strengthen the recovery from the 2001 reces-
ties issued by Wall Street firms. These sion. The U.S. economy entered into a re-
mortgage-backed securities appeared to be cession in March of 2001. Over the course
Vol. 8 HOLT: A SUMMARY OF THE PRIMARY CAUSES OF THE HOUSING BUBBLE 123
AND THE RESULTING CREDIT CRISIS: A NON-TECHNICAL PAPER
of 2001, the Federal Reserve lowered the and thus contributed to rising home prices.
federal funds rate eleven times, from 6.50 When the interest rate on the mortgage adjusted
percent to 1.75 percent. When the economic upward (typically after two years), the higher
recovery proved sluggish and no sign of sig- mortgage payments proved unmanageable
nificant inflation appeared, the Fed continued for many home buyers.
its low interest rate policy, lowering the fed- The second way that low short-term
eral funds rate to 1.25 percent in November interest rates contributed to the housing
of 2002 and to 1.00 percent in June of 2003. bubble was by encouraging leveraging (in-
The Fed began gradually increasing the rate vesting with borrowed money). With short-
in June of 2004, but the rate remained at term interest rates extremely low, investors
2.00 percent or lower for more than three could increase their returns by borrowing at
years. low short-term interest rates and investing in
The low short-term interest rates con- higher yielding long-term investments, such
tributed to the housing bubble in two pri- as mortgage-backed securities. For example,
mary ways. First, the low short-term interest suppose XYZ Company invests $10 million
rates encouraged the use of adjustable rate in mortgage-backed securities paying 7 per-
mortgages (ARMs). As home prices rose cent interest. XYZs return on equity is 7
faster than household incomes, many pro- percent. If XYZ borrows $100 million on
spective home buyers were unable to afford short-term loans at 4 percent interest in order to
house payments under fixed rate mortgages. invest an additional $100 million in mortgage-
But ARMs could provide the buyer with a backed securities paying 7 percent interest,
lower monthly payment initially since short- XYZ is now leveraged at 10 to 1 ($10 in
term interest rates were lower than long- debt for every $1 in equity). XYZs return
term interest rates. For example, the monthly on equity will now be 37 percent (profit of
principal and interest payment on a $3.7 million on equity of $10 million).
$200,000 30-year fixed rate mortgage with The practice of leveraging increased
an interest rate of 6 percent would be about the financing available for mortgage lending
$1,200. The monthly principal and interest and thus contributed to rising home prices.
payment on a $200,000 30-year ARM with When the housing bubble eventually burst
an initial interest rate of 4 percent would be and home prices fell, the impact of the burst-
only about $950. ing of the housing bubble was increased by
As the housing market heated up, the degree of leverage in the economy. The
mortgage lenders became more creative with necessity for deleveraging after the housing
ARMs, developing option ARMs. With an bubble burst is illustrated in the following
option ARM, the borrower could choose example. The bursting of the housing bubble
to make standard payments of both principal led to increased mortgage foreclosures and
and interest (thus reducing the balance out- caused the value of mortgage-backed securi-
standing on the loan each month), or could ties to fall. If the value of the mortgage-
choose to make payments of interest only backed securities held by XYZ Company
(thus not changing the balance outstanding from the above example falls by more than
on the loan each month), or could choose to $10 million, XYZ Company becomes insol-
make payments of only a portion of the in- vent and will be unable to obtain new short-
terest due (thus increasing the balance out- term financing. XYZ is forced to deleverage
standing on the loan each month). ARMs by selling some of its holdings of mortgage-
made monthly mortgage payments afford- backed securities. Many other highly-
able (at least temporarily) for more buyers leveraged firms are going through the same
124 JOURNAL OF BUSINESS INQUIRY 2009
deleveraging process, driving the price of payment requirements and income require-
mortgage-backed securities still lower. ments. Historically, mortgages taken out by
(iii) Relaxed standards for mortgage lower-income households often did not con-
loans. Standards for mortgage loans were form to these strict standards. Beginning in
relaxed as a result of the following factors: 1996 the Department of Housing and Urban
new governmental policies aimed at foster- Development began to increase the per-
ing an increase in home-ownership rates centage of mortgage loans to lower-income
among lower-income households, greater households that Fannie and Freddie were
competition in the mortgage loan market, required to hold in their portfolios. This
the increasing securitization of home mort- caused Fannie and Freddie to relax the stan-
gage debt, and the irrational exuberance that dards that mortgages had to meet to be classi-
engulfed all parties involved in the mortgage fied as conforming and thus eligible for
lending process. purchase by Fannie and Freddie. Down
Standards for mortgage loans were payment requirements and income require-
fairly consistent in the decades prior to the ments were reduced.
development of the housing bubble. Most With the Internet came greater compe-
mortgages were 30-year fixed rate loans re- tition in the mortgage loan market. Home
quiring a down payment of at least 20 per- buyers were no longer limited to borrowing
cent or mortgage insurance if the 20 percent locally but could search the Internet for the
down payment requirement were not met. mortgage provider who would offer the most
The borrowers also had to prove that their favorable terms. The increased competition
income was sufficient to ensure that the in the mortgage loan market is exemplified
monthly mortgage payments would be man- by the drop in mortgage fees. For example,
ageable. according to the Federal Housing Finance
Governmental policies have long en- Board (2009), the average fee on a mortgage
couraged home ownership, e.g., the tax- loan fell from around 1 percent of the
deductibility of mortgage interest and real amount of the loan in 1997 to less than .5
estate taxes. In 1997 the tax law was percent from 2002 to 2005.
changed to permit homeowners to exclude The greater competition in the mort-
from taxation a gain of up to $500,000 from gage industry contributed to relaxed mort-
the sale of a home. gage standards. Mortgage lenders who were
In the mid 1990s new governmental willing to lower their standards could gain
policies were enacted that contributed to a market share. Zandi (2009) points out that
relaxing of standards for mortgage loans. In more conservative mortgage lenders either
1995 the Community Reinvestment Act was had to lower their standards or lose market
modified to compel banks to increase their share.
mortgage lending to lower-income house- The increased securitization of home
holds. To meet the new requirements of the mortgage debt also contributed to relaxed
Community Reinvestment Act, many banks mortgage standards. Zandi (2009) discusses
relaxed their mortgage lending standards. how securitization undermines the incentive
Fannie Mae and Freddie Mac are gov- for responsibility in the mortgage market.
ernment-sponsored enterprises that increase Quoting Zandi, No one had enough finan-
the funding available in the mortgage market cial skin in the performance of any single
by purchasing mortgages from loan origina- loan to care whether it was good or not.
tors. Fannie and Freddie buy only mortgages When mortgage debt is securitized, the origi-
that conform to certain standards for down nator of a mortgage sells it to another party,
Vol. 8 HOLT: A SUMMARY OF THE PRIMARY CAUSES OF THE HOUSING BUBBLE 125
AND THE RESULTING CREDIT CRISIS: A NON-TECHNICAL PAPER
Since home prices had not fallen 1997. Yet it would not have been wise for
nationwide in any single year since the the average homeowner to bail out of the
Great Depression, most people assumed housing market at this point to avoid being
that they would not fall. This almost univer- caught up in the housing bubble. For exam-
sal assumption of rising home prices led the ple, if the average homeowner had sold his or
participants who contributed to the housing her home in the 1st quarter of 2003, for fear of
bubble to make the decisions that created the the housing bubble bursting, he or she would
bubble. Government regulators felt no need have sold it for 28 percent less than he or
to try to control rising home prices, which she could have received in the 2nd quarter of
they did not recognize as a bubble. Mort- 2007, one year after home prices peaked.
gage lenders continued to make increasing The S&P/Case-Shiller Index was at 130.48
numbers of subprime mortgages and adjust- in the 1st quarter of 2003 and was at 183.03
able rate mortgages. These mortgages would in the 2nd quarter of 2007.
continue to have low default rates if home The irrational exuberance that occurs
prices kept rising. Investment bankers con- during price bubbles is hard to recognize,
tinued to issue highly leveraged mortgage- hard to avoid, and not necessarily advanta-
backed securities. These securities would geous to avoid. Housing was a good invest-
continue to perform well if home prices kept ment up until just before the peak of the
rising. Credit rating agencies continued to housing bubble. Likewise, stocks were a
give AAA ratings to securities backed by good investment up until just before the dot-
subprime, adjustable rate mortgages. These com bubble burst in 2000. For example, at
ratings, again, would prove to be accurate if the time Alan Greenspan made his irra-
home prices kept rising. Foreign investors tional exuberance comment, the Dow Jones
continued to pour billions of dollars into Industrial Average had risen by an incredi-
highly rated mortgage-backed securities. ble 364 percent over the previous nine years
These securities also would prove to be and stood at 6437.10. However, this would
deserving of their high ratings if home not have been a good time for an investor to
prices kept rising. Insurance companies con- bail out of the stock market. The DJIA
tinued to sell credit default swaps (a type of would increase by another 75 percent over
insurance contract) to investors in mortgage- the next three years.
backed securities. The insurance companies
would face little liability on these contracts III. The Bursting of the Housing Bubble
if home prices kept rising. Home buyers and the Credit Crisis
continued to purchase homes (often for
speculative purposes) even though the This section of the paper examines the
monthly payments would eventually prove bursting of the housing bubble and the re-
unmanageable. They assumed that they sulting credit crisis. Home prices reached
would be able to flip the home for a profit their peak in the 2nd quarter of 2006. They
or refinance the loan when the adjustable did not fall drastically at first. Home prices
rate increased. This too would work if home fell by less than 2 percent from the 2nd quar-
prices kept rising. ter of 2006 to the 4th quarter of 2006. Ac-
Actually, home prices kept rising for a cording to Liebowitz (2008) foreclosure-
long time. Warnings of a housing bubble start rates increased by 43 percent over these
were issued as early as 2002. By the 1st two quarters, and increased by 75 percent in
quarter of 2003, home prices had risen by 2007 compared to 2006. This implies that
about 59 percent from the 1st quarter of
Vol. 8 HOLT: A SUMMARY OF THE PRIMARY CAUSES OF THE HOUSING BUBBLE 127
AND THE RESULTING CREDIT CRISIS: A NON-TECHNICAL PAPER
mortgage default rates began to rise as soon Most of the losses were not incurred by
as home prices began to fall. homeowners but by the financial system.
Speculators who bought homes (often Large losses were incurred by the following
with no money down) simply walked away groups:
from the property when the home price fell. 1. Mortgage lenders. According to Zandi
Many never made even the first monthly (2009), since the bubble burst a third of the
payment. Homeowners with adjustable rate top 30 mortgage lenders have either been
mortgages found that they could not refi- acquired (e.g., Countrywide Financial by
nance because the decrease in home prices Bank of America), have filed for bankruptcy
meant that they had negative equity in their (e.g., New Century Financial), or have been
homes. When their rates adjusted upward, liquidated.
their monthly payment was no longer man- 2. Investment banks. Since the housing bub-
ageable. Foreclosure rates for adjustable rate ble burst, the five largest U.S. investment
mortgages increased much more than foreclo- banks have either filed for bankruptcy
sure rates for fixed rate mortgages. According to (Lehman Brothers), been acquired by other
Liebowitz (2008), from the 2nd quarter of firms (Bear Sterns and Merrill Lynch), or
2006 to the end of 2007, foreclosure rates become commercial banks subject to greater
for fixed rate mortgages increased by about regulation (Goldman Sachs and Morgan
55 percent (prime) and about 80 percent Stanley).
(subprime). During this same time period, 3. Foreign investors (mainly banks and gov-
foreclosure rates for ARMs increased by ernments) who had invested in mortgage-
about 400 percent (prime) and about 200 backed securities.
percent (subprime). 4. Insurance companies (e.g., AIG) who had
Just as rising home prices reinforced sold credit default swaps. Credit default
the continuing rise in home prices, falling swaps are a type of contract that insures
home prices reinforced the continuing fall in against the default of debt instruments, such
home prices. The increase in foreclosures as mortgage-backed securities.
added to the inventory of homes available The bursting of any housing bubble
for sale. This further decreased home prices, would be expected to have a negative effect
putting more homeowners into a negative on the economy for two reasons: First, home
equity position and leading to more foreclo- construction is an important economic activ-
sures. ity, and the decline in home construction
The increase in foreclosures also de- would reduce GDP. Second, the decrease in
creased the value of mortgage-backed securi- home prices would also reduce household
ties. This made it difficult for investment consumption due to the wealth effect. But
banks to issue new mortgage-backed securi- the bursting of this housing bubble caused
ties, eliminating a major source of financing more severe and widespread harm than
for new mortgage loans and contributing to would be predicted from just these two rea-
the continuing decline in home prices. sons. As mentioned previously, most of the
The bursting of the housing bubble led losses were suffered by the financial system,
to enormous losses. Some of those losses not by the homeowners. The bursting of the
were incurred by homeowners, particularly housing bubble sent a shock through the en-
those who bought their homes or who took tire financial system, increasing the per-
out home equity lines of credit against the ceived credit risk throughout the economy,
value of their homes too close to the peak. as indicated by the TED spread (the differ-
ence between the interest rate on three-
128 JOURNAL OF BUSINESS INQUIRY 2009
month U.S. treasury bills and the interest standards all contributed to the housing bub-
rate on three-month interbank loans as ble. But the absence of any of these three
measured by the London Interbank Offered causes would not necessarily have prevented
Rate (LIBOR)). the housing bubble. For example, if mortgage
The TED spread is considered a good interest rates had not been at historically low
indicator of the perceived credit risk in the levels, a housing bubble still could have
economy. Historically, the TED spread has happened. A housing bubble occurred in the
ranged between 0.2 percent and 0.5 percent. late 1980s at much higher mortgage interest
In August of 2007 the TED spread jumped rates. Likewise, without low short-term inter-
above 1 percent and generally stayed be- est rates or relaxed mortgage lending stan-
tween 1 percent and 2 percent until mid- dards, a housing bubble still could have
September of 2008, when it began spiking occurred though it would have been less ex-
upward, reaching a record level of over 4.5 treme.
percent on October 10, 2008. The TED The one essential cause of the housing
spread finally fell back below 0.5 percent in bubble was irrational exuberance. The hous-
June of 2009. ing bubble would not have occurred without
The increased perceived credit risk the widespread belief that home prices
throughout the economy meant that not only would continue to rise. Irrational exuber-
home buyers but also commercial real estate ance contributed to the other three causes.
investors, corporations seeking financing for Mortgage interest rates would not have been
investment, municipalities seeking to issue so low if foreign investors and credit rating
new bonds, and others would find it more agencies had not believed that U.S. home
difficult to obtain financing. As a result of prices would keep rising. Low short-term
the credit crisis, real investment spending interest rates would not have led to such ex-
decreased by 32 percent from the third quar- tensive use of ARMs and such a high degree
ter of 2007 to the second quarter of 2009. of leveraging without irrational exuberance.
And relaxed standards for mortgage loans
IV. Concluding Remarks would not have led to such a large increase
in subprime mortgages without irrational
The severe recession that began in exuberance.
December of 2007 was caused by the
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