What Caused the Bubble Rally?

In an earlier post, How Sub-Prime Lending Created the Housing Bubble, I gave a brief description of the impact of adding a large number of new buyers to the market. However, the title is somewhat misleading because it does not fully explain how the bubble was inflated. In this post, I hope to provide a more detailed explanation of what factors and conditions combined to drive prices so high.

The Great Real Estate Bubble was caused by 4 interrelated factors:

  1. Separation of origination, servicing, and portfolio holding in the lending industry.
  2. Innovation in structured finance and the expansion of the secondary mortgage market.
  3. The lowering of lending standards and the growth of subprime lending.
  4. Lower FED funds rates as a catalyst (Lowering mortgage rates was not a big factor.)
  5. The negative amortization loan (Option ARM.)

The secondary mortgage market came into being in the early 1970s to provide greater liquidity to banks and other lending institutions to facilitate home mortgage lending. Freddie Mac and Sallie Mae were set up to package loans together into pools and sell them to investors as mortgage-backed securities.

As the secondary mortgage market continued to grow, lending institutions began to sell the loans they originated rather than keeping them in their own portfolio. The banks began to make money by originating and servicing loans rather than through keeping them and earning interest. This was a dramatic shift in lending practices.

With this shift came an equally dramatic shift in incentives: lending institutions stopped being concerned with the quality of the loans because they didn’t keep them, and instead they became very concerned with the volume of loan origination and the fees this generated. This fundamental change in the behavior of lenders leads inevitably to a lowering of lending standards. Lower lending standards opened the door for lenders to provide loans to those with low FICO scores: subprime borrowers.

Subprime Mortgage Percentage of Market

Subprime lending as an industry barely existed prior to 1998. There were no lenders willing to loan to people with poor credit, and there was no secondary market to purchase these loans if they were originated. The growth of subprime was the direct result of the lowering of lending standards created by the change of incentives brought about the creation of the secondary market.

These factors alone were not enough to create the Great Housing Bubble, but they provided the basic infrastructure to allow house prices to take flight. The catalyst for the inflation was the Federal Reserve’s lowing of interest rates in 2001-2003.

Many mistakenly believe the lower interest rates themselves were responsible by directly lowering mortgage interest rates. This is not true. Mortgage interest rates declined during this period, and this did allow borrowers to finance somewhat larger sums with the same monthly loan payment, but this was not sufficient to inflate the housing bubble. This is also why a lowering of interest rates will not be able to save the housing market. The only thing that would do that would be another massive influx of capital.

Contract Mortgage Rates

Notice that mortgage interest rates have ranged from a high near 7% in 2001 to a low near 5.5% from 2002 to 2005. The drop from 7% to 5.5% would have supported a 15% increase in prices, not the 150% increase in prices which actually occurred.

Interest Rate Table

The lower Federal Funds rate did cause an expansion of money supply, and it lowered bank savings rates to such low levels that investors sought other investments with higher yields. It was this increase in liquidity and quest for yield that drove huge sums of money into mortgage loans.

This is where another of the lending industry’s innovations comes into play: structured finance. Debt is money. If you can find a way to create more debt, you create new money. The problems comes when you create more debt than there is cashflow to service it which is where we are now. There is a tipping point where the debt service exceeds the cashflow, and when this tipping point is reached, the entire debt structure collapses in a deflationary spiral. The structured finance products such as collateralized debt obligations and their derivatives are highly leveraged instruments with a very sensitive tipping point. This is why the hedge funds at Goldman Sachs imploded so quickly and so completely.

With a huge influx of capital into the secondary mortgage market, the industry was under tremendous pressure to deliver more loans to hungry investors. This caused the already-low loan standards to be all but eliminated. All of the worst “innovations” in the lending industry occurred during this period: Negative Amortization loans, Stated-Income loans (Liar Loans,) NINJA loans (no income, no job, no assets,) 100% financing, FICO scores under 500, one-day-out-of-bankruptcy loans, etc. The joke was if you could “fog a mirror” or if you “had a pulse,” you could get a loan for as much as you wanted to buy a house.

The real culprit in the housing bubble was the negative amortization loan. No other innovation or practice drove prices higher than this one because it allowed borrowers to take on so much debt.

Amortization Value Table

The same monthly housing payment with an Option ARM finances double the loan balance. As I stated in, The Anatomy of a Credit Bubble, “Stop for a moment and ponder the math: the same payment now finances 100% more money. Is it any wonder the real estate market was 100% overvalued at the top? People purchasing with Option ARMs were buying at the rental equivalent value. From a financing perspective, the market was not overvalued. People were paying exactly what they should have been paying. They were just doing it with loan terms which were going to destroy them — hence the term “suicide loan.” ” Now that Option ARMs are disappearing, what do you think will happen to house prices?


First, the infrastructure was built to deliver capital to the housing market, which in turn changed the incentives in the lending industry. Next, the FED created conditions where large amounts of capital was seeking a new home (pun intended.) Finally, the lending industry “innovated” and found unique — and inherently unstable — ways of putting this capital to work. What you get in the end is a massive asset bubble.

There is a larger issue here pertaining to the FEDs monetary policy that I hope you see. The creation of the secondary market for mortgages alone was not the problem. The change in lender incentives might have created some issues, but without a huge influx of capital to put pressure on the system, it probably would not have broken. When the FED stimulates the economy through lowering interest rates and increasing the money supply, that money will go somewhere. When it does, it creates massive distortions in asset values and with it a commensurate inefficient use of investment capital. This is not free-market capitalism, it is government welfare doled out to the investment class. Ben Bernanke is taking us down this road yet again. If he continues to lower interest rates, investment capital will flow into a new asset class (no, it will not flow into housing and save the day.) How many more bubbles must we endure before the FED stops creating them?

51 thoughts on “What Caused the Bubble Rally?

  1. covered


    Nicely done. I am in particular agreement with your conclusion about the Bernanke Fed. A true free market is allowed to correct its excesses. This increase in the money supply and the acceptance of mortgages on boats (I kid you not) at the discount window is the stuff of banana republics. Sadly, the smoke and mirrors act may keep the asset class afloat temporarily, but our hard earned US dollars will keep devaluing as the price of this nonsense.

  2. Don from the Tanning Salon

    Cold, clear logic. Unusual for the internet, but standard operating procedure on this blog.

  3. MalibuRenter

    This is good. However, along with Robert Shiller, I would advocate adding expectations of appreciation to the list of causes.

    If someone expects the price of houses to rise at 3-4% a year (near its long term historic average for the US, their carrying costs are about the same as rent (7% interest, 1.25% taxes and assessments, 2.5% annual maintenance costs and insurance, 33% State + Fed marginal tax rate = ~8% annual cost of ownership. Subtract 4% appreciation and you get ~4% cost after appreciation, around $2,350 for a $700,000 house).

    Now watch what happens with exactly the same numbers and a 12% rate of expected appreciation. The expected carrying cost after appreciation is negative $2,317! Yes, the house pays you to own it, even if it sits vacant.

    That is an important point. For expected appreciation rates where cost of ownership is moderately less than rent, it pays to be an owner. It also pays to buy a house and rent it out.

    When the expected rate of appreciation is high enough, you expect to make money on a house even if it sits vacant and you don’t get any rental income. What do many people do under this circumstance? Buy as much property as they can.

    If the actual appreciation matches their expectation, they make money. And many people made money for a while on vacant homes. Many lending institutions were willing to make these loans, because they also thought prices would go up, and borrowers would be able to sell for more than the purchase price.

    The problem comes when either people slow down lending to such borrowers (a credit contraction), or the expectation changes.

    Going back to the math, take a guess what the expected cost of buying a home today is, versus buying in a year? If you think prices will decline 10%, the cost is about 18% of the value of the home (8% actual carrying cost + 10% loss). That’s about $10,500 per month on a $700,000 home.

    Under those circumstances, renters with money don’t convert to buyers until the expected short and long term rates of appreciation go positive again.

    For an owner with a vacant depreciating house, renting it will slow the cashflow bleeding, but won’t do anything about the depreciation.

  4. irvine soul brother

    Great article IR! I will definitely be rereading and sending this out to some people!

  5. Bob

    Excellent post as usual. As many have said the Fed can stimulate the demand for loans but they cannot make people want to give the loans. I think this is why your last comment that the Fed cuts won’t save RE is accurate. Unless of course the investors like our fearless leader can’t remember the famous saying: “Fool me once, shame on you, fool me twice, shame on me.”

  6. BRian

    “Ben Bernanke is taking us down this road yet again. If he continues to lower interest rates, investment capital will flow into a new asset class (no, it will not flow into housing and save the day.) How many more bubbles must we endure before the FED stops creating them?”

    That is one possibility. However, I would like you to consider my argument:

    Real estate probably has the distinction of being the highest ‘market cap’ asset class. Where else does the median ‘share’ cost 250k?

    Without another costlier asset class, there isn’t anything to leverage against. Additionally, lower rates will not necessarily lead to a reflation of the credit bubble. Lenders are very cautious. Unwinding risky bets suddenly sound like more fun than making more of those bets. We don’t even need a majority of the lending community to be on board with this. Enough of them have probably looked over the cliff here that it will take a while until history gets forgotten again. Large providers of capital have received a bloody nose. They are likely to be wary of another huge bubble.

    I believe that the only reason that the appetite for leverage and the bubble mentality took hold so quickly after the tech bust is that people thought “real estate is different – it only goes up”.

    The only asset class that I can think of that maybe would drive speculative behavior higher is farmland.

    Think of it – you have all the elements:
    *Not making any more land – check
    *People have to eat – check (a substitute for ‘people have to live somewhere’)
    * Blah, blah, biofuels, blah, blah
    * Doesn’t rely on subprime home borrowers.

    I think that despite Bernanke’s best efforts to inflate, when the derivatives eventually crash, it will not be orderly, and the effect will be deflationary. After all, the fed funds rate was already trading below the target. Ben isn’t driving it down, he lowered the target to where it was already trading.

    The flight to quality has just begun.

    Comments would be appreciated.

  7. carl


    I think you are mistaken that there was no subprime market prior to 1998. There was a thriving one in the late 1980s. One pioneer in this field was “The Money Store”. Anyone who lived near Sacramento in the early 90s will remember their ludicrous “Egyptian Pyramid” looking headquarters they built on the banks of the Sacramento river. Such hubris is usually followed by an ass whipping. In this case, it came in the form of the last California housing meltdown which blew The Money Store out of the water. They laid off legions of brokers and were acquired with a whimper.

    Obviously, when normalcy returned to the housing market, no one learned the lesson of the Money Store (since making money in fat times without thinking about lean times is the American way). I would say the subprime market this time around was about an order-of-magnitude larger. We are currently witnessing the obviously much larger meltdown.


  8. awgee

    I think you touched on it here.
    “Lenders are very cautious. Unwinding risky bets suddenly sound like more fun than making more of those bets.”
    My guess, and admitedly this is only a guess because the actual information is hidden off balance, is that the big banks, hedge funds, and others are hoarding liquidity, (cash), and will continue to do so no matter what B-52 Ben does. Why do I think this? What possible logic is there to hoarding cash, (short term and longer term treasuries paying squat) ? I am guessing they need to stay liquid because they are getting ready to pay out on massive amounts of credit default derivatives. Anyways, it’s just a guess.

  9. Sue

    The Foreclosure Pickings Are Plentiful but Not Easy


    In the second quarter of this year, an estimated 620,000 mortgages, or 1.4 percent of 44.3 million mortgages, were at some stage of the foreclosure process, according to the Mortgage Bankers Association, though only a fraction of that number will actually go into foreclosure. As a percentage of all mortgages, the record was 1.51 percent in the first quarter of 2002. While stark, the recent figures are not so surprising considering that homeownership is at a record high.

  10. rkp

    Which asset class do you think this money will flow into? I hate bubbles but if I see a bubble coming again, I want to enjoy the ride and forget about fundamentals for a while.

  11. tonye

    I’m gonna incorporate and IPO my corporate persona.

    Then, I’ll take a lot of investment because I have so much potential.

    At some point, I’ll create four subsidiaries, move the cash to my holding company, move the debt into the subsidiaries and I’ll move to my own Private Idaho.

    Get ready for the next bubble:

    “The personal potential IPO: leverage your potential skill set to enhance the value to our partners in the financial ecosystem.”

    Oh, btw, good post.

  12. SMF

    Suppose I were an investor buying houses to flip for a profit.

    It would make sense to minimize my payments, as my profit would come not from paying down my equity, but by holding the asset long enough for appreciation to occur.

    This would apply as well to flippers who rehabbed for profit.

    Hence, these investors should have used Option ARMs for their purchases.

    I hate to see it mentioned how subprime borrowers used them, when even those with far better means were using them to increase the size of their ’empires’.

  13. lee in irvine

    If Angelo Mozilo (the Tan Man), over at Countrywide has his way, we’re gonna see a lot more foreclosures in the coming year.

    From Paul Krugman @ the NY Times:

    “Countrywide made more questionable loans than anyone else – and its postbubble behavior does stand out. As Ms. Morgenson reported in yesterday’s Times, Countrywide seems peculiarly unwilling to work out deals that might let borrowers hold on to their homes – even when such a deal, by avoiding the costs of foreclosure, would actually work to the benefit of both sides”.


    “Countrywide can make money from the fees it charges on foreclosures, while the losses from mortgages that could have been saved, but weren’t, are borne by others.”


  14. graphrix


    You make a good point. Do you remember Guardian Savings? They used to be the joke in the 90s if you could fog a mirror you had a loan. They collapsed and IIRC they were bought by Long Beach Mortgage which was bought by WAMU and now shut down by WAMU.

    Wash, rinse and repeat.

  15. lendingmaestro

    Liquidity is number one for banks right now, not earnings.

    The sub prime CDO scare back in feb/mar was just the tip of the iceberg. All that did was get the wheels turning in loss mitigation departments across the country.

    Wall St realized that they were utterly foolish and their going to end up looking like idiots for not accurately assessing risk.

  16. carl


    I do remember Guardian Savings. I also remember that in the late 80s, when subprime was first available in a big way, there was a big stigma associated with it that obviously went away. It was akin to getting a payday loan, which also seems to have lost its stigma.

    Perhaps there will be a return to stigma that will hopefully reduce the pressure to push these loans on people.


    PS People here seem to think we are headed for 160X price-to-rent ratio… I dunno… if prices in Turtle Rock get back to 2003 pricing (about 700k for a 2000 sq-ft SRF), I’ll bite the bullet and jump back in. People always underestimate California.

  17. Major Schadenfreude

    Excellent post IR!

    Amazing that such a concise analysis of the Bubble can not be found in the Business section of any newspaper.

    Or perhaps I shouldn’t be surprised.

  18. Law_Student

    Another reason for the runup:

    Subprime buyers are generally of low intelligence.
    This is why they are subprime in the first place.

    They will pay the maximum price for a home if they are allowed to borrow the money.
    This drove up the price as much as anything.

  19. Subprime

    I seem to remember a bunch of subprime lenders that were located in Irvine in the early to mid 90s that suddenly went out of business. I vaguely remember reading somewhere that the founders of New Century were involved in one of these earlier companies.

    In 1998 Consumer’s Report published a study about lending fraud in California. Nothing seems to have changed in the last ten years.


  20. Sue

    What We’re Hearing

    Last week, we reported how loan brokers were getting blamed for the nation’s current mortgage mess. I received a ton of e-mails, several with epithets aimed at consumer advocate Bruce Marks of Neighborhood Assistance Corp. of America who before Congress likened brokers to a pest commonly found in several Jersey City apartments that I rented in my youth. Let’s just say many brokers were offended by Mr. Marks’ comments.

  21. Stupid

    (Note: this comment is about the speculators – both prime and subprime)

    It’s not stupid to take zero risk (ie. already have bad credit, no down payment, bad job, no hope of ever making a lot of money otherwises) for a shot of hitting the jackpot with someone else’s money. Worst case scenario – free rent until foreclosure.

    It is unethical though.

  22. ochomehunter

    Irvinerenter, so based on where we are today and no news insight on credit crunch, where is the economy heading? People are getting into stocks like crazy and you mentioned possibly another asset class, but wait, US consumer spending is the one that drives earnings of these large companies. When they start to lose homes and jobs, consumer spending will curtail and will negatively impact the earnings.

    How long before reality sets in? Fed will keep cutting as we saw these guys are more worried about the recession (rightfully so) in lieu of imflation, but true inflation since 2000 is running at around 10% if we take out the non-discretionary (discretaionary – food, energy, consumables), will falling $, we will only see rise in consumer costs.

    Anyone here can predict the next 12 months??

  23. Michael

    When you said Golman Sachs I believe you meant Bear Stearns. It was the Bear Stearns sub-prime hedge funds that blew up early last summer.

  24. ochomehunter

    Of all the financial brokers, only Goldman Sachs made a stunning quarter…….. no surprise here, they were shorting their own business (mortgage and securities).

  25. Elizabeth

    Great post.

    I would add mortgage fraud – both the outright illegal and the shoulda been illegal type – seller financed downpayment assistance programs. DAPs were a significant enabling factor in certain markets like Sacramento, starting in the late 1990s.

  26. covered


    I was waiting for someone to bring this up. Just like everything else in this mess, after the curtain is pulled back, there will be massive fraud exposed. There was last time (S&L scandals) and there will be this time. There was just too much money out there for the taking. Although IR believes we are in either the fear or panic stage of this bubble and supports his thesis with some pretty good proof, I still think we’re in the mass denial stage.

    This stock market rally today is a good example. The Citigroup pre-announcement that they lost 60 billion in MBSs and still closed up over 2% on the day was treated by traders as a signal that Citi had come clean and the worst is over. Maybe for on balance sheet liabilities, but not off balance sheet. Same with the rest of the biggies. The corporate bodies are going to be washing ashore piecemeal, one at a time.

    There will come a time when this toxic debt HAS to be priced to sell–or “marked to market” and that’s when we’ll all know. Bernanke just gave them a little more time to concoct some cockamamie spin. It’s coming. Tick tock.

  27. IrvineRenter

    You are correct. I had to go back and read the post again to make sure I said Goldman Sachs instead of Bear Stearns. I meant Bear Stearns.

    I guess they are all the same. My mind thinks one and types the other…

  28. Sue

    Yep. Makes sense. Likely why the Fed keeps trying to inject liquidity – they just don’t want to lend it out.

  29. doug r

    Could be an investment bubble in green energy biofuels/solar/wind technology, but is that so bad?

  30. doug r

    Like the saying goes: There’s no inflation-as long as you don’t eat or go anywhere!
    Fuel and food majorly up. Housing prices insane. No real inflation to speak of, for sure….

  31. Waiting to buy by and by

    I have had no small confusion about the role of rating agencies myself. How do AAA ratings become BBB overnight?

    Then again, if the ratings reflect market value and the market suddenly changes, seems to me the ratings must suddenly change as well (if the raters are doing their jobs).

    So it should not be a surprise that in the face of low delinquencies or foreclosures (before the bubble burst) that risky pools might have had a good rating and that the sub-prime implosion may have adversely affected that rating and triggered the subsequent down-grading of those investments.

    So if somebody is in the know, please tell us, were Moody’s and other ratings agencies accomplices in this mess, or were they doing their job and are simply “guilty by association”?

  32. IrvineRenter

    The highrise market will likely see the most serious declines in value. The fees are very high, which makes the cashflow value very low. I would not be surprised to see 75% declines on these units.

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