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 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.

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.

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.

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?

Conclusions

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?