The Bubble Bursts

When a bubble in a financial market pops, it does not explode in spectacular fashion like a soap bubble; it is more comparable to a breached levee which releases water slowly at first. [1] Once the financial levee is ruptured, the equity reservoir loses money at increasing rates. It washes away the imagined wealth of homeowners who bought late in the rally or used home equity lines of credit to fuel consumer spending until the reservoir is nearly empty and the torrent turns to a trickle. Ultimately, the causes of failure are examined, the financial levee is repaired, and the reservoir again holds value, but not until the dreams and equity of many homeowners are washed away.

Denial runs deep in the financial markets. The vast majority of participants either wants or needs prices to steadily increase. Any facts or opinions that run counter to the idea of ever increasing prices must be quelled in order to prevent a catastrophic collapse of prices due to panic selling. One of the more glaring examples of this phenomenon was the slow leak of information regarding the debacle in the housing market. In February and March of 2007 as the subprime lending implosion became front page news, market bulls were presented with a major public relations problem. It was imperative for the bulls to convince buyers the damage from subprime lending was “contained” and would not “spill over” into other borrower categories and ultimately into the overall economy. [ii] The supposition was that the widespread use of exotic loans was not the problem; it was the practice of giving these loans to those with low credit scores. In other words, it was not the loans, it was the borrowers. This was wrong. It was not the borrowers; it was the loans. Exotic loans were given to people of all credit backgrounds. Subprime borrowers where the first to show distress, but the Alt-A and Prime borrowers had the same problems and experienced the same outcome.

Conventional wisdom (or market spin) was that the risk of default from subprime would not spill over into Alt-A and Prime loans. This argument was made because these two categories have historically had low default rates. Of course, this argument ignored the “liar loans” taken out by those with higher credit scores, the unmanageable debt-to-income ratios, and payment resets for interest-only and Option ARM loans which were also given to the Alt-A and Prime crowd. Historically, this group had not defaulted because they have not been widely exposed to these loan types.

An adjustable rate mortgage resets to a different (usually higher) interest rate or payment schedule at a time specified in the loan agreement. The increase in payment may be caused by an increasing interest rate or it may be caused by a recast of the loan to a fully-amortized payment schedule. In either case, the monthly payment will rise. If a borrower is unable to make the new payment because wages did not increase or perhaps the payment increase was simply too large, the borrower will need to refinance to a new loan with an affordable payment structure. If at the time of refinancing the borrower is not eligible for available loan programs because the borrower or the property no longer meets the prevailing loan standards, the borrower may have no choice but to default on the existing loan and go through foreclosure on the property. In short, if borrowers cannot make the new payment or refinance, they will lose their homes. This is how many borrowers lost their homes during the Great Housing Bubble.

Loan standards vary over time as the credit cycle loosens and tightens. Many borrowers in the bubble rally were qualified with low credit scores, very high combined-loan-to-values, high debt-to-income ratios, and little or no income verification. When the ensuing credit crunch occurred, all of these standards were tightened and many of those who previously qualified did not qualify under the new standards. If no other conditions changed, this tightening of standards would have forced many borrowers into foreclosure; however, this credit tightening caused a chain reaction sending market prices for residential real estate which were already falling into an even steeper decline.

Figure 27: Adjustable Rate Mortgage Reset Chart

The Adjustable Rate Mortgage Reset Chart produced by Credit Suisse in 2007 details the dollar amounts of mortgages facing payment resets in the six years from 2007-2012. The bulk of the first two years (24 months on the chart) are loan resets from subprime borrowers who purchased in 2005 and 2006. These subprime borrowers paid peak prices for properties. Most of these borrowers were given 100% financing (if they could have saved up for a downpayment, they probably would not have been subprime,) and they were often only qualified based on their ability to make the initial payment rather than on their ability to make the payment after the reset. There was a special loan program called a 2/28 that most subprime borrowers purchased. [iii] This loan fixed a payment for two years; afterward, the payment would increase to a higher interest rate and on a fully-amortized schedule over the remaining 28 years. The payment shock was extreme. This created a condition where most subprime borrowers could not refinance or make their payments, and many of these borrowers defaulted on their loans. Data from early 2008 showed the 2006 and 2007 vintage of subprime loans default rates running close to 50%, and this was before the resets were coming due. Most of these subprime borrowers who went into default lost their properties in foreclosure, and these foreclosures were added to the supply of an already overwhelmed real estate market.

Figure 28: ARM Reset through Foreclosure to Final Sale

There is a sequence of events which occurs between the mortgage reset and the final sale of a property to a new owner on the open market. After the borrower is faced with a mortgage reset, many try to make the new payment and keep their houses. They may borrow from other sources including credit cards or even their retirement accounts–anything to make the payment and keep their homes. Depending on the resources available and the burden imposed by the new payment, the borrower may stay afloat for an indefinite period of time. Some chose to give up immediately and 30 days later, they are in default. Once a borrower defaults on a loan, in most states the lender is required to wait 90 days to give the borrower a chance to get current on their payments. Once a borrower is 90 days late, he receives a Notice of Default from the lender. Following the Notice of Default, there is another 90 day window where the borrower can make good on their payments. If he is unable (or unwilling) to do so, the lender will file a Notice of Trustee Sale and schedule a public auction for 21 days later. If the borrower cannot pay back the loan or find other ways to delay the process, the property is put up for public auction, generally on the courthouse steps in the jurisdiction where the property is located. At this auction, the lender will generally bid the amount of the outstanding loan and hope another party bids more and pays them off. If the lender is the highest bidder, which is often the case, the lender ends up owning the house.

During the bust, the vast majority of properties at auction went back to the lenders because the loan amounts usually exceeded market value. Properties purchased by the lender at a foreclosure auction are called Real Estate Owned or REO. Lenders are not permitted to keep REOs on their books for long, so these properties are offered at market prices, and they must be sold. It will take some time for the property to be prepared for sale. Once the property is finally listed for sale in the conventional resale market, the lender will follow loss mitigation procedures intended to maximize revenue from the property. This often delays the eventual sale 90 days or more. The whole process from mortgage reset to final sale in the market takes at least a year, and it may take much longer.

The subprime borrowers made up the bulk of the mortgage rate resets in 2007 and 2008. Since the default rates were very high, and since prices were already falling before these REOs were added to the market, the subprime foreclosures pushed prices down significantly. This effect was not uniform as subprime borrowers were often concentrated in specific areas or communities. Markets with large concentrations of subprime were decimated first, but all markets are interrelated, as all real estate markets within driving distance are linked together by commuters. When the subprime-dominated markets declined, they created a drag on prices and sales volumes in nearby markets. There was a price differential that enticed people to fringe markets. This created a price drag on the primary markets as some potential buyers were siphoned off by the fringe markets. In California, the collapse of the real estate market was like a land tsunami: it started inland and made it way overland to the coast leveling everything in its path.

The loan reset issue is not confined to those who bought late in the bubble rally. Many borrowers are homeowners who refinanced to take advantage of more favorable loan terms. During the Great Housing Bubble, prices rose dramatically in nearly every market nationally. With such a dramatic increase in prices, one would expect the total home equity for homeowners to increase dramatically as well. If fact, the opposite occurred; home equity declined during the rally of the real estate bubble. By the end of 2007, home equity as a percentage of home values was at record lows. Where did all the equity go? Existing homeowners spent it, and many new homeowners had such low downpayments, that they had very little equity to begin from the start. Refinancing and home equity withdrawal is the primary reason home equity did not rise as prices increased. There was a great deal of conspicuous consumption in the bubble rally, particularly in California. It seemed every house had two luxury cars in the driveway, the malls were always full of shoppers, and every homeowner was busy competing with her neighbor to see who could look richer. Many also spent their “liberated” equity to acquire other properties which was a major driver of the prices in the bubble rally.

Figure 29: Total Home Equity, 1985-2006

Aggregate home equity statistics can be misleading because approximately 30% of US households have no mortgage at all. Also, during the bubble rally, home ownership increased 5% nationwide, and many of these new homeowners were subprime borrowers who utilized 100% financing. This will have some impact on home equity statistics, but it is not sufficient to cancel out a 45% increase in home prices without massive home equity withdrawal. If the home equity statistics are viewed in the context of those households that have a mortgage, total equity nationwide was around 35% in 2006.

The initial price declines caused by defaulting subprime borrowers set the stage for defaults by Alt-A and Prime borrowers by lowering property values. At the time of this writing, the Alt-A and Prime borrowers have not yet faced the prospect of their loans resetting to higher payments as they start facing resets in 2009 that continue through 2011; however, it is not difficult to speculate on what will happen. Both new homes and foreclosures are must-sell inventory. The presence of must-sell inventory in the market forces prices lower. Builders aggressively cut prices in many markets in 2007 and 2008, and it did not help sales. The builders will be forced to lower prices more in 2009 and beyond until prices bottom in the new home market. Foreclosures increased dramatically in all markets in 2007 as the pressure of large debt loads overwhelmed many borrowers. The number of new units and foreclosures is not a problem in a healthy market, but in a declining market with large numbers of REOs, this must-sell inventory drives prices lower. The lowered property values will make it difficult for these borrowers to refinance because they will no longer meet the more stringent loan-to-value ratios that will be required to refinance. It is likely many of these borrowers will not be able to afford the payment at reset, and they will lose their homes just as the subprime borrowers lost their homes. If Alt-A and prime borrowers had utilized conventional mortgages as they had in the past, they would not be facing the mortgage reset time bomb, and they could simply ride out the subprime debacle just as many homeowners did through the declines of the early 90s. However, it is different this time. This time, the loans they have taken out are going to ruin them. It’s not the borrowers, it’s the loans.

The Credit Crunch

In 2007, the financial markets were abuzz with talk of a “credit crunch.” It was portrayed as some unusual and unpredictable outside force like an asteroid impact or a cold winter storm. However, it was not unexpected, and it was not caused by any outside force. The credit crunch began because borrowers were unable to make payments on the loans they were given. When lenders started losing money, they stopped lending money: a credit crunch.

New Century Financial is the poster child for the Great Housing Bubble. New Century Financial was founded in 1995 and headquartered in Irvine, California. New Century Financial Corporation was a real estate investment trust (REIT), providing first and second mortgage products to borrowers nationwide through its operating subsidiaries, New Century Mortgage Corporation and Home123 Corporation. The company was the second largest subprime loan originator by dollar volume in 2006. On April 2, 2007, the company filed for Chapter 11 bankruptcy protections. [iv] The date of their financial implosion is regarded as the day the bubble popped. The death of New Century Financial has come to represent to death of loose lending standards and the beginning of the credit crunch. Subprime lending was widely regarded as the culprit in starting the cycle of credit tightening, and New Century has been linked to this problem, but the scale and scope of the disaster was much larger than subprime.

The massive credit crunch that facilitated the decline of the Great Housing Bubble was a crisis of cashflow insolvency. Basically, people did not have the incomes to consistently make their mortgage payments. This was caused by a combination of exotic loan programs with increasing payments, a deterioration of credit standards allowing debt-to-income ratios well above historic norms, and the systematic practice of fabricating loan applications with phantom income (stated-income or “liar” loans). The problem of cashflow insolvency was very difficult to overcome as borrowing more money would not solve the problem. People needed greater incomes, not greater debt loads.

When more money and debt was created than incomes could support, one of two things needed to happen: either the sum of money needed to shrink to supportable levels (a shrinking money supply is a condition known as deflation,) or the amount of money supported by the available cashflow needed to increase through lower interest rates. Given these two alternatives, the Federal Reserve chose to lower interest rates. The lower interest rates had two effects; first, it did help support the created debt, and second, it created inflationary pressures which further counteracted the deflationary pressures of disappearing debt and declining collateral assets. None of this saved the housing market.

Credit availability moves in cycles of tightening and loosening. Lenders tend to loosen credit guidelines when times are good, and they tend to tighten them when times are bad. This tendency of lenders often exacerbates the growth and contraction of the business cycle. During the decline of the Great Housing Bubble, the contraction of credit certainly played a major role in the decline of house prices. Lenders continued to tighten their standards for extending credit for fear of losing even more money. This meant fewer and fewer people qualified for smaller and smaller loans. This crushed demand for housing and made home prices fall even further.

Figure 30: Personal Savings Rate, 1952-2007

One of the biggest problems for the housing market was the reinstatement of downpayment requirements. During the bubble rally, 100% financing was made widely available. This made it unnecessary for people to save money to get a house. People respond to incentives (Deming, 2000). This is basic economic theory. The availability of 100% financing removed the incentive to save for a downpayment. People responded; our national savings rate went negative. [v] Potential homebuyers, who ordinarily would have been saving money for a downpayment to get a house, stopped saving, borrowed money and went on a consumer spending spree. This created a situation in the aftermath of the bubble crash where very few potential entry-level buyers had any saved money for the newly required downpayments. This created very serious problems for a market already reeling from low affordability, excess inventory, and a large number of foreclosures.

100% Financing

Once 100% financing became widely available, it was enthusiastically embraced by all parties: the lenders suddenly had a huge source of new customers to generate high fees, the realtors and builders now had plenty of new customers to buy more homes, and many potential buyers who did not have savings were able to enter the market. It seemed like a panacea; for two or three years, it was. There was a problem with 100% financing (which was masked by the rampant appreciation brought about by its introduction): high default rates. The more money people had to put in to the transaction, the less likely they were to default. It was that simple. The borrowers probably intended to repay the loan when they got it, however they did not feel much of a sense of responsibility to the loan when the going got tough. High loan-to-value loans had high default rates causing 100% financing to all but disappear, and it made other high LTV loans much more expensive, so much so as to render them practically useless. It was all part of the credit tightening cycle.

Besides stopping people from saving for downpayments, 100% financing harmed the market by depleting the buyer pool. In a normal real estate market, first-time buyers are saving their money waiting until they can make their first purchase. This usually results in a steady stream of first-time buyers that enter the market each year. When 100% financing eliminated the downpayment requirement, it also eliminated any need to wait. Those who ordinarily would have bought 2-5 years in the future were able to buy immediately. This emptied the queue. This type of financing appears periodically in the auto industry, especially in downturns when it is necessary to liquidate inventory. The term for this is “pulling demand forward,” because it reduces demand for new cars in the next few years. This might not have been a problem if 100% financing would have been made available to everyone forever; however, once downpayment requirements came back those who would have been saving were already homeowners, so there were few new buyers available, and any potential new buyers had to start over saving for the downpayment they thought would never be required. The situation was made worse because those late buyers who were “pulled forward” from the future buyer pool overpaid, and many lost their homes. This eliminated them from the buyer pool for several years due to poor credit and newly tightened credit underwriting standards. Thus, most who thought 100% financing was a dream come true found it to be a nightmare instead.

Table 9: Increasing Interest Rates Impact to House Prices

Rising Interest Rates

Mortgage interest rates are determined in an open market and are subject to the forces of supply and demand. These rates are the sum of three main components: riskless rate of return, risk premium, and inflation expectation. The Great Housing Bubble was characterized by historic lows in the federal funds rate, risk premiums and inflation expectations which resulted in the very low mortgage interest rates. When credit tightened as prices started to decline, the federal funds rate was lowered in an attempt to provide liquidity to the financial markets. This did temporarily lower one of the three components of interest rates; however, since other central banks around the world did not immediately follow with similar rate cuts, the value of the dollar declined and inflation began to rise. This increased the inflation expectation among investors. The impact of increased inflation expectation was greater than the drop in short-term interest rates, and mortgage interest rates rose steadily. Declining prices also caused losses for lenders as many borrowers defaulted on their loans and the value of the collateral was not sufficient to recover the loan balance. As lenders and investors lost money, they began to demand higher risk premiums. The greater risk premiums and higher inflation expectations caused interest rates to rise and house prices to fall.

Higher interest rates had a dramatic impact on exotic financing as it became more expensive for borrowers. Interest rate spreads grew and the qualification standards tightened to the point they were not usable. This was driven by the defaults and foreclosures. In the heyday of negative amortization loans, lenders qualified borrowers based only on the teaser rate payment without regard to whether or not they could afford the payment at reset. For more sophisticated borrowers, lenders allowed stated income or “liar loans.” Basically, borrowers would tell lenders how much they wanted to borrow, and lenders would fill out fraudulent paperwork showing the borrowers were making enough money to afford the payments. This is amazingly irresponsible lending, but it was widespread. Once the price crash began, lenders required borrowers to be able to actually afford the payments; of course, this makes many borrowers unable to obtain financing. When a negative amortization loan costs 13.8% rather than 3.8%, few borrowers wanted it, and if lenders required borrowers to actually afford the 13.8% interest rate, few borrowers qualified. Either way, negative amortization loans died, and the fate of stated income loans was no better.

Mortgage rates for prime customers were very low because they rarely default. During the rally few defaulted because prices were rising; people just sold if they got in trouble. This allowed banks to originate risky loans at very low interest rates because the loans did not appear risky. Once the market stopped rising, the underlying risk started to show with increasing default rates and default losses. When prices crashed, default rates increased for all borrower classes. Prime borrowers did not default at the high rates of sub-prime borrowers, but they still defaulted at rates higher than in the past; therefore, interest rates increased for prime borrowers as well. The crash in house prices caused all mortgage interest rates to rise. Banks have to make enough money on their good loans to pay for the losses on their bad loans and still make a profit. Higher interest rates make for lower amounts of borrowing, and this in turn leads to lower house prices.

Summary

The ratio of house prices relative to incomes rose considerably during the Great Housing Bubble. Some of this increase was due to lower interest rates, but in bubble markets most was due to supply constraints, regulatory delays, deteriorating credit underwriting standards, and irrational exuberance and the belief that prices were going to rise forever. People stretched to buy real estate as evidenced by the increasing debt service burdens they took on during this time. The rally reached affordability limits where buyers could not push prices any higher. Once these limits were reached, lenders were forced come up with new programs allowing borrowers to take on even more debt to push prices higher, or the rally was going to end. Once prices stopped rising, people lost their incentive to buy and ultimately prices began a decline. This decline is expected to continue unabated until prices fall back to fundamental valuations, or perhaps even lower.

[1] Robert Shiller noted that the causes of a major turning point signifying the popping of a real estate bubble are “fuzzy.” (Shiller, Historic Turning Points in Real Estate, 2007) Any events associated with the end of a speculative bubble may be simply coincidental.

[ii] Federal Reserve Chairman Ben Bernanke gave a speech (Bernanke B. , 2007) in front of the Joint Economic Committee of the U.S. Congress on March 28, 2007 when he claimed, “Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.” In short, the FED Chairman completely missed the scale and scope of the problem. Either that, or he knew how bad the problem was and chose to lie for public relations impact.

[iii] According to Credit Suisse, 80% of subprime loans were the 2/28 variety.

[iv] The information on New Century Financial comes from their website.

[v] Studies have shown people feel less need to save when house prices are increasing in value (Baker D. , 2002).