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Causes of the Subprime Fiasco

By Chris | December 5, 2007

I tutor a Principles of Macroeconomics class and today I helped some students prepare for a final exam question on the causes of the subprime housing meltdown. We discussed how the packaging and sale of securities on Wall Street provided the wrong incentives for banks granting loans. The tendency of appraisers to overvalue homes was considered. Low interest rates and irresponsible (occasionally fraudulent) borrowers were also mentioned as culprits.

Growing up in the 90’s my mom was constantly looking for a new house. We went to a lot of open houses. It got to the point where she knew most of the Realtors in my hometown of 50,000 on a first name basis. And while, she never found anything with the charm and location of our brown house with black walnut trees, perusing houses with my mom gave me a pretty good pulse on the housing market. And prices always went up, at a surprising rate. Initially, I thought a growing population was the driver of price increases. Land, as a finite resource, will become more expensive as more people are alive to demand it. But, population growth alone can’t explain real estate prices. The U.S. population grows at approximately 1 percent per year. Moreover, land is usually a small percentage (maybe 25% at most) of the cost of a new house. In California, and elsewhere, restrictions on land use have likely contributed to higher housing prices. But, the root of growth in national housing prices lies elsewhere.

While median income has grown slowly over the last decade and a half, consumers tastes and preferences have changed dramatically. One need look only to the most recent subdivision to see that today’s median home dwarfs those built in the 1960’s and 1970’s. I found the argument made by this article very compelling:

People have become so enthralled with status that they seem to have forgotten the reason why we live under a roof and between four walls–shelter.At one point, that’s all a home really was. Nowadays, things are a bit different. Owning a home has not only become the equivalent of owning a piece of the American dream, it has become a way to measure success.

An overwhelming number of people embraced this concept during the most recent housing boom. Home prices began to swell beyond reasonable levels as more and more people bought into the market.

It wasn’t long before it became impossible for most people to buy median-priced homes on median incomes. By 2005, people were spending 60 percent more on average in the largest metro areas to buy rather than rent.

Median income doesn’t capture the entire picture. Higher incomes in the top percentiles have been growing at a faster rate than median income and some of that income is being plunked into real estate. Nevertheless, in a country so image conscience that average annual savings is often negative, is it really surprising that lots of homeowners have bit off more than they can chew when purchasing their home?

Topics: Economics | 4 Comments »

4 Responses to “Causes of the Subprime Fiasco”

  1. laura Says:
    December 5th, 2007 at 5:33 pm

    The housing price in China has also increased dramatically in recent years. One important reason is that many investors predict the return rate in housing market much higher than that in stock market, and then transfer their investment directly to real estate. Such booming demand for housing hurts the benifit of normal consumers by raising the price with a shocking rate. Most poeple, I mean those with median-level-income, are under the big pressure of affording a house, some of them need ten years to pay the loads of a house. To regulate the real estate market and protect normal consumers, the government created a high tax on those who sell the house within five years they bought it and decreased the tax of relatively smaller and cheaper houses, which are least likely to be the object of investment.

  2. Chris Says:
    December 5th, 2007 at 6:14 pm

    Interesting. I’ve heard of similiar laws being passed by regional governments in the United State. For example, this law being considered in Hawaii:
    Do you think speculation is a bad thing? Speculators can’t afford to hold onto empty houses indefinitely, they must either rent them out or sell them quickly. Plus, if speculators realize the homes are currently undervalued, and buy them, they provide a market signal for more construction. Price should fall in the long-run. Speculators, make markets more liquid and increase product offerings in other markets (scalped tickets, antiques). Why are they particularly despised when it comes to housing?

  3. Tom Says:
    December 6th, 2007 at 12:41 am

    ***I just noticed how long this is, sorry for the novel***

    I feel there are a number of reasons the housing market is turning sour right now.

    1) Whenever stocks do poorly, people get into real estate
    2) Sloppy lending criteria from lenders for purchasers
    3) The message from the culture that you need nice things – living beyond your means is a good thing?
    4) Over-supply of housing
    5) Stupid agents/loan officers
    6) Stupid consumers

    1) This is not a trend many people notice. Generally, whenever there is a large push to purchase stocks, real estate doesn’t do much appreciation-wise. Stocks go up substantially with this increased interest. When you start to hear how well the stock market does every minute of every day, you should be very worried.

    Look back to the internet bubble. Just prior to the pop, you heard how average people with no additional information than their neighbor was making thousands of dollars day-trading per day. You heard about how stock ABC or the IPO of XYZ shot up 100% during the day. You heard this news during every minute of every day. The media was telling you that now was the time to get in, stocks were a stellar investment. The market was highly irrational, but then the bubble popped.

    The money then shifted to the real estate market where it enjoyed a nice run up until the summer of 2005. At this time, you saw the same phenomenon as the internet bubble. You heard of people making ten’s or hundred’s of thousands of dollars just purchasing a home and holding on to it for a 6 months to a year. You heard of someone purchasing a home, fixing it up, then reselling it for a substantial profit. An important thing to note is that in the summer of 2005 (the peak for prices), the media was in a frenzy over real estate and how good an investment it was – much like before the internet bubble popped!

    The moral of this is to sell homes when everyone else is buying, and to purchase stock when everyone else is selling. In other words, sell your stock/investment homes when you hear about how good an investment it is multiple times every day.

    2) Lenders are another cause of this whole fiasco. Money was too easy to get and too cheap to use. The lenders were way too lax in their criteria in giving out money to borrowers. Like you said, they were motivated with ulterior motives to package and sell the mortgages to Wall Street – even if they were far riskier than they should have been. Then the FED can partly be blamed too since they kept the federal funds rate almost artificially low too long to fuel the economy – goes back to the cheap money.

    For a long time, the only mortgage that you could use was the traditional mortgage 20% down, 80% financed. You could also get a second mortgage to help make up that difference if you didn’t have the 20% down. Exotic mortgages such as ARM, Interest-only, etc… were introduced in the late 80’s/early 90’s at the trough of the last real estate downturn to speed things up and drum up business for the lenders. People then found out they could purchase homes they couldn’t afford…

    There are always the cheaters, scam-artists, etc… that are drawn to this easy money. There were many purchasers that lied when they filled out their “liar’s loans,” i.e. No-Doc loan where they state their income with essentially no proof, to purchase their homes and then run off with the cash. There are those that inflated the appraisals so they could get cash back at closing. There are a myriad of other ways people cheated the system, but overall this was a very small portion of the statistical population.

    3) Popular media is another cause of this whole fiasco. Consumers are assaulted everyday by messages to purchase this new gadget or that new toy or this new car – they also hear the message that they can finance it for 120 months at 10% interest so it’s okay! In the last couple decades, consumers seem to have shifted to the idea of the affordable monthly payment from the idea of looking at the total purchase price. If they can make payments on time then they don’t need to worry about the purchase price. This culture always seems to praise those that have the “mostest of the bestest.” Those that have money saved up in the bank and are driving a 10 year old car are looked down upon by society. Saving money isn’t cool, living beyond your means and having cool stuff is.

    4) The supply of housing helps magnify the cyclical nature of real estate. When developers and builders see that home prices are going up and there is a greater need for homes, they start the process to build. Mind you, from inception to completion takes about 1.5 to 2 years for a subdivision, so there is a large lag from when they see the need to when it is fulfilled (or over-fulfilled). When the builders see a need, almost all the time other builders see that need as well. What results is an over-abundance of homes when it is all done and said for. If it was possible, when builders saw this over-abundance of homes in the pipeline, logically they’d stop. But I feel there are two reasons they keep going, 1) they feel they know more than their neighbor and they feel they are a genius, but more likely 2) the bank won’t let them stop building; the lenders lent the money and once the builder gets past the “point of no return” they can’t stop, since the lenders want a return on their money. This “point” is generally very early on in the process, i.e. after permits, but before ground is broken.

    5) In the world of agents (I refuse to use the made-up word Realtor) and loan officers, they are generally greedy bunch – there are probably many exceptions though. They are both sales jobs where their motive is to make sales so they can bring home a paycheck every month. In the up-swing of the market, they can do very well, very easily since there are many people willing to pay top-dollar for homes – often there is a bidding war among multiple buyers and they eventually pay over the asking price.

    The agent always try to get the consumer to purchase the most house they can afford since that means more commission money for them. Then the loan officer puts the consumer in the loan, or the consumer asks for the loan, that they eventually won’t be able to afford over the long term – in the case of this last run-up, the exotic mortgages.

    After the market peaks, there is still a massive inflow of new agents and loan officers who wanted the easy money from the boom times. With the increased number of competitors, they either dropped out or got far more aggressive to maintain business – often to the detriment of the purchaser; there have been loan officers that have faked loan documents, remember “liar’s loans” mentioned earlier?, so the purchaser could get the home and the loan officer his commission.

    6) Consumers are incredibly stupid. George Carlin said it best… “50% of the people out there have less than average intelligence.” Consumers are sheep – they follow what the media, the current pop icons, etc… tells them to do. They just happen to say that “Bling” is all the rage. Cool, expensive things are what is “in.” This includes the massive 4000+ sqft houses with granite countertops, stainless steel appliances, hardwood floors, home theaters, private gym, along with the 4 car garage for those two new $50,000+ leased cars/SUVs.

    But how can we purchase the bling so we can be like our pop idols? CREDIT!!! If they don’t have to pay for it now, that means they can get it now. Very few people today seem to have any patience when it comes to purchasing decisions. This trickles down to the home as well. Consumers signed any mortgage document put in front of them. As long as they could afford the monthly payments they were set. Little did they know (or pretend they didn’t know), their initial rates would change since it had an adjustable rate. The way the culture has trained them, if they ran into problems, it wasn’t THEIR fault.

    In regards to the speculators/investors that helped fuel the market, I feel there are three types of speculators when it comes to any housing market.

    1) Those that purchase at full market value and are *gambling* that the prices go up in the short term
    2) Those that purchase homes and in turn rent them out – which they hope will cash-flow
    3) Those that purchase homes below the current market value and then resell after a short while

    1) The first set of investors are merely hoping the market will turn in their favor. These were purchased by people looking to make a quick buck. They saw other people doing this making money and they thought they could too! Their rationale was something like, “hey, that person made money, so I can too! Plus housing prices never go down!” As we all know, no one can control the market, but this set of investors is just begging to be chewed up and spit back out onto the street for being so naive. Markets are always cyclical – they always go up, down, ad nauseum. Another thing to mention, this set of investors add NO perceived value to the property – which is bad.

    The condo market in Florida is a perfect example of this. Thousands upon thousands of condos were purchased by this set of so called “investors” (gamblers) who hoped that the market would go up. It didn’t – it’s falling fast. To make matter worse, there are thousands more condos in development. This is partly due to a couple different factors; the developers can’t stop a project half-way through because there is a “point of no return” in each project they take on and second, the banks need them to finish the project so they can get their capital back!

    When the market is going up, builders see a need to build, so they do. Unfortunately, the whole process takes a couple of years from conception to completion, so there the cyclical nature of the industry is amplified greatly. With excess supply and very limited demand, housing prices will fall in the areas that have seen a massive run-up in prices and the amount of homes being built. Add to this the fact that these areas have the highest concentration of exotic mortgages (i.e. sub-prime interest only loans, ARMs, etc…) – i.e. in California, a year or two ago said that roughly two-thirds of all mortgages were non-traditional.

    2) These investors are in it for the long haul. Ideally, they find properties that will cash flow nicely after all expenses and the mortgage. There are two subsets to this category. There are some people who think it is a good investment to purchase a home, rent it out, and either break even or even lose money every single month, even when rented. Then again, these investors that are happy with no/negative earnings are trying to have their cake and eat it too – they’re mainly in it for the appreciation. Also, you’ll find that these people are those that take out exotic mortgages as well. You’ll find these people are generally in the higher priced areas that have widely fluctuating real estate cycles.

    The second subset are those that purchase properties and rent them out while cash flowing after all expenses and mortgages. They’re in the game to build their passive cash flow. These are generally in areas that have low home prices, but high rents – think Oklahoma, Missouri, et al. These areas generally do miss out on one important thing though, large run-ups in home prices. They usually have constant, single-digit appreciation just ahead of inflation. These are generally people that take out the traditional mortgages because the homes are generally still affordable. These people add value to the local economy by providing a service to those that are willing to pay for it (or have the government pay for it – Section 8 Housing – that’s a whole ‘nother can of worms entirely…)

    3) This last set are the investors that do this as a full-time job, or a second job in their spare time. They find homes, or have others find them for them, that are truly below market value. Homes CAN be purchased for below true market value due to any number of events including death, divorce, job transfer, two house payments, selling another house, foreclosure, etc… It all comes down to whether or not the owners are motivated enough to sell quickly. Any asset can be sold quickly, as long as there is a discount though. Generally, these investors add value to the property through improvements or in the manner in which they sell it (owner financing, lease-option, etc…). The financing used in these transactions are short-term financing, capital from private financing, cash, or traditional or exotic mortgage products.

    The first type of investor is bad for the housing market because they purchase based on a hope or dream that the price will go up. The first subset of the second type of investor is better, but they are still bad for the housing market since they are betting on appreciation as well – they can only have the home as long as the can continue with the amount lost each month.

    The second subset of the second type of investor and the third set of investors are good for the housing market because they add value to the local economy through their services.

    Ending this lengthy response, I have to say the blame for this whole fiasco rests squarely on the consumer – even though there are many other minor factors involved. Each of these minor factors do play a part in it though, they helped mold and shape the consumers ultimate decisions. The consumers decided to shift to real estate after the stock market crash. The banks saw the consumers wanted financing so they could afford larger homes. The consumers wanted to compete life-or-death with the “Jonses.” The builders were responding to the consumers when they built the new, bigger and better homes. The agents/loan officers were responding to the consumers need of wanting to buy a home. Consumers just are not as informed as they should be when they make large purchasing decisions.

    The consumer needs to be smart and informed in the purchasing and they need to read the fine print (especially in loan documents!), but they weren’t. They over-extended themselves and the house of cards has come crashing down right on top of them.

    Time for the whole cycle to repeat itself!

  4. laura Says:
    December 6th, 2007 at 4:37 pm

    Generally, I do not think speculation is a bad thing, but in real estate, it is, for the following reasons:
    1, Housing is necessity with almost no substitute, consumers have no choice, but staying in the market to suffer the loss. Very good mention of scalped tickets and antiques, Chris, the former one is something with enough accessity of its substitutes, the latter one is a sort of luxury goods, like LV bags to me, most people still lead good lives without them. But how can you transfer to another market or leave the market with no less utility? True, the price should drop in the long run, but how long it would be? I suppose at least ten years. Anyone will compensate for the loss of consumers during these ten years, No.
    2. It worses the problem of income inequality in China. The increase of the price of one good means the decrease of the real income. Since the expense for housing constitute a large part of total income, the consumers loss caused by the increasing price of housing could be tremendous. Speculators in real estate are invisibly redistributing the income of normal consumers, which has huge population in China, and investors, unfortunately, in an undisirable direction.
    3. It might affect the economic growth of China. Tom mentioned internet bubble in US. That is what Chinese government afraid of. Real estate market directly or indirectly influences the industry, which is vital to the economy. The booming real estate market in China is motivating the industry to prosper, well, it shoud be in smoothy, healthy, and long-lasting way. Because China and Chinese people can not afford the price of the big fluctuation in this field.