I created a Medium blog called “Bubble Notebook” in 2016 which developed into the blog post “The Great Real Estate Bubble – Explained” and its YouTube video. The YouTube video is pushing 100,000 views!
I don’t agree with all of my thinking back then but most of it is still right.
Bubble Notebook
May 7, 2016
Thinking out loud about the Housing Bubble
I’ve been trying to figure out what the hell happened during the Great Real Estate Boom and Bust.
I’m shocked that 11 years after home sales peaked and 7 years after the “end” of the Great Recession there isn’t a conventional wisdom about what happened.
Hopefully by focusing on it, I can make some sense of it all.
Here, I’m going to try using Medium as my notebook.
May 7, 2016
The Rise & Fall of Savings and Loans
Early in the Great Depression (before Roosevelt?), a new federal banking charter was created for savings and loans. Savings in federally chartered S&Ls were insured so people felt safer leaving money in S&Ls and S&Ls in turn would then have money they could lend to people to buy homes.
It worked. From the 1950s until the 1980s, savings and loans were by far the primary source of U.S. home mortgages. Savings and loans did everything themselves, they would make, hold and service mortgages, and when necessary, foreclose on them too.
The incredibly high interest rates in the 1970s and early 1980s, however, pretty much wiped out the savings and loan industry. Their market share of home mortgages fell from roughly 40% (1980) to 10% (2000). (I’m not sure if those numbers are total outstanding mortgages or originations in those years. Probably total outstanding.)
May 8, 2016
The Rise of Fannie & Freddie
The mortgage system that replaced Savings and Loans was;
- Banks and mortgage brokers making individual mortgages,
- That were immediately sold to Fannie and Freddie,
- Who then put thousands of those mortgages together to create one “mortgage-backed security” which owned the flow of future mortgage payments,
- Shares in the mortgage-backed security were sold to large investors, and
- Fannie and Freddie took the money from the sale, bought more individual mortgages, created more mortgage-backed securities, sold them, and so on.
Fannie and Freddie’s share of the mortgage market rose from roughly 10% (1980) to 50% (2000).
May 9, 2016
The Miracle of Mortgage-Backed Securities
In the olden days, when savings and loans (and banks) made and held mortgages on their own books, they bore the entire cost when bad loans defaulted. There was a direct link between the loans they made and their profits.
The securitization system broke that link 3 or 4 times.
Mortgage-Backed Security System
Mortgage originators. It wasn’t the job of banks and mortgage brokers to determine “good” mortgages. Their job was to make sure the mortgages they originated met Fannie and Freddie guidelines so they could sell them immediately to Fannie and Freddie. If Fannie and Freddie bought it, it was a good mortgage.
Flash Forward: Most of the predatory and fraudulent lending that happened by loan officers during the boom wouldn’t have happened under the saving and loans model where the loan officers are direct employees of companies that would end up owning the loans and taking any losses.
Fannie and Freddie. It wasn’t the job of Fannie and Freddie to determine “good” mortgages. Their job was to buy mortgages they could resell to investors as mortgage-backed securities. If investors bought them, they were good mortgages.
Flash Forward: Fannie and Freddie lowered their lending standards a spoonful at a time but investors keep buying their mortgage-backed securities so Fannie and Freddie kept lowering their lending standards a spoonful at a time.
Ratings agencies. It wasn’t the job of the rating agencies to look at the individual mortgages in mortgage-backed securities. Their job was to take the information Fannie or Freddie gave them about a particular mortgage-backed security, run it through their mathematical models, give it a rating, and get paid by Fannie or Freddie. If the math said it was AAA, it was AAA.
Flash Forward: The ratings agency methods and “smartest guys in the room” mathematical models turned out to be complete crap.
Investors. It wasn’t the job of investors to analyze the quality of individual mortgage-backed securities. Their job was to buy and sell investments for their large institutional investors. If a rating agency said it was AAA, it was AAA.
Flash Forward: Investors bought the hell out of the “risk-free” AAA-rated mortgage-backed securities which made everyone else down the line want to create more and more of them.
It’s a Miracle!
A system that wasn’t making money for the S&Ls was somehow converted into a system that was making big bucks for banks, mortgage brokers, Fannie, Freddie, the ratings agencies and Wall Street investors.
It was a miracle of modern financial engineering and innovation to create big profits where few existed before.
They did it by hiding risk.
In the S&L system, default risk was always top of mind. In the mortgage-backed security system, people just did their jobs.
Default risk was hidden by the complexity and deniability of the mortgage-backed security system.
It didn’t spread risk, it hid risk.
Additional Notes
Federal Agencies. “It’s not my job.”
Politicians. “It’s not my job.”
May 10, 2016
Colossal Failure of Rating Agencies
The ratings agencies (Moody’s, Standard & Poor’s and Fitch) had a terrible track record even before the Great Real Estate Bubble and the Great Recession.
- Enron was rated AAA days before its collapse in 2001.
- They didn’t foresee the spectacular collapse of Long-Term Capital Management in 1998.
Despite these and other warnings, Wall Street and regulators did nothing to stop the problems.
Everyone screwed up. They trusted the rating agencies.
Race to the bottom. Remember, there were 3 ratings agencies. If Fannie or Freddie didn’t like the rating they got on one of their mortgage-backed securities, they could always try another rating agency.
Over-ratings – particularly of subprime mortgages, particularly in the later years of the boom – were key to the explosive growth of 1) mortgage-backed securities, 2) the amount of money chasing homes, and 3) home prices.
Without their colossal over-ratings, the real estate boom would have been far smaller and we may have avoided the bust entirely.
May 11, 2016
There’s Subprime and There’s Subprime
Subprime is the top villain in most explanations of the Great Real Estate Bubble but not all subprime mortgages were created equal.
On one extreme, you have borrowers with;
- slightly low credit scores
- good income
- good down payment amounts
- who get 30-year fixed rate mortgages
These are called subprime mortgages but they will probably not default much more often than prime mortgages.
On the other extreme, you have borrowers with;
- very low credit scores
- not enough income for the size of the mortgage (often no doc loans)
- who put no money down
- who get interest-only or option ARMs
- and who qualified using the 2-year teaser monthly payment
These are also called subprime mortgages but they’re incredibly more likely to default.
As the Great Real Estate Boom progressed, not only did the number of subprime mortgages increase dramatically but the toxicity of some subprime mortgages also increased dramatically.
May 12, 2016
Crowdsourcing Housing Bubble Prevention
An economist at the Bank of International Settlements looked at 60 countries and found the most common housing policy changes over the last few decades.
#1. Minimum Down Payment Percentage
- 27 countries introduced minimum down payment requirements
- 29 countries that already had minimum down payments increased them
#2. Maximum Debt-to-Income Ratio
- 22 countries introduced a maximum debt-to-income ratios
Both policies dampen real estate bubbles by dampening the expansion of credit and home prices increases.
Credit and home prices feed off each other. When the amount of money people can borrow to buy homes increases, home prices have a strong tendency to increase and when home prices increase, the amount of money people can borrow to buy homes has a strong tendency to increase.
In both the United States and Switzerland, for example, surges in credit expansion coincided with rapid home price appreciation.
Macroprudential regulations. Countries have these policies – minimum down payments and maximum debt-to-income ratios – to dampen real estate booms and busts. Real estate busts very often lead to major economic recessions.
Canada, I know, has a minimum 5% down payment rule and Canada did not have a real estate bubble last decade when many other countries did.
Better for dampening booms. The article I linked to above points out that maximum debt-to-income regulations are better at controlling credit expansion during booms because they don’t increase your maximum available credit when home prices increase. The maximum amount of money you can borrow is tied to your income and total debt. You can’t borrow more money just because home prices increased.
Minimum down payments, on the other hand, don’t control credit expansion as well. When home prices increase, you can borrow more money as long as you also have the extra cash needed for the higher down payment.
Better for dampening busts. I’d like to add, however, that minimum down payment regulations are better at preventing real estate busts.
Many studies of the U.S. real estate bust found that low and zero down payment mortgages were the first and most likely to default and be foreclosed on during the bust.
Minimum down payments are a nice double-edged stabilizer, dampening booms and, especially, busts.
We learned during the U.S. real estate bust that foreclosures have a huge negative externality.
When foreclosures are above a certain level, they bring down home prices for everyone in an area and that has huge negative economic impacts on every homeowner in the area and the economy as a whole.
May 14, 2016
Fannie and Freddie Financial Innovations
“Fannie Mae and Freddie Mac were statutorily required to hold mortgages with at least 20% down payment. The way the GSEs [Fannie and Freddie] got around this restriction was to have private mortgage insurance.” Source.
Private mortgage insurance protected Fannie and Freddie but it didn’t protect neighborhood home prices from the high foreclosure rates of their low down payment mortgages.
June 11, 2016
2 Ignored Impacts of “Too Low, Too Long”
The Fed’s drastic reduction in interest rates following the Dot-Com stock market bust is often described as “Too low, too long.”
The policy is blamed by some for triggering the housing bubble and by many for amplifying the bubble.
In addition to the basic point about cheaper money spurring higher home prices, I think the policy had 2 ignored consequences.
1) Refinancing Bust Spurred Subprime Boom
20% of all homes with mortgages were refinanced in 2003.
Boom. The huge refinancing boom in 2003 also created a hiring and profit boom in the mortgage industry.
Retrench? As the number of refinancings returned to earth, the enlarged mortgage industry looked for new business to replace the lost refi business.
Roaming army. It was as if an army of underemployed mortgage professionals were searching for new lands to conquer.
New territory. Some expanded into subprime. For example, some large traditional mortgage companies added subprime products after the refi boom.
The number of subprime mortgages skyrocketed in 2004 and 2005.
If the Fed hadn’t lowered rates so low, the boom in refinancings would have been a bit smaller, the army of new mortgage professionals it created would have been smaller and, likely, the shift toward subprime mortgages after the bust in refinancings would have been a bit smaller as well.
2) Increasing Interest Rates Increased Buyer Mania
Some people blame the bust, or at least the timing of the bust, on the higher interest rates in 2006 and 2007. There’s a lot of truth to that.
Cheap money. The monthly payment would be significantly higher with higher interest rates no matter the price of the home. The higher rates made homes, in essence, more expensive.
More mania. People, however, don’t usually talk about how increasing Fed rates so slowly from the summer of 2004 to the summer of 2006 contributed to the mania.
It’s a good time to buy. The mortgage industry was constantly hammering the point that interest rates were historically low and they wouldn’t last forever.
Sword of Damocles. When the Fed started to slowly increase the Fed Funds rate in the summer of 2004, many homebuyers thought mortgage rates would soon take off.
Mortgage rates didn’t actually increase much until fall 2005 but from the time the Fed started to increase the Federal Funds rate in the summer 2004, a lot of people felt they would miss out on the lowest interest rates in modern history if they didn’t buy a home soon.
FOMO. With rapidly rising home prices and now with most people expecting higher interest rates, many felt they would be priced out of the market forever if they didn’t buy their home soon.
Federal Reserve Policy Made Bubble Worse
It’s no secret that real estate is especially sensitive to changes in interest rates. Rates low enough to boost the general economy will often cause real estate booms.
It appears, “Too low, too long” exacerbated;
- The subprime boom, and
- Home buyer mania.
Considering all impacts, a more stable Fed policy would have destabilized the housing market less and likely could have greatly reduced the real estate boom and bust and the damage caused.