When the Great Real Estate Bubble burst in 2008 it triggered the worst recession
since the Great Depression.
You would think that ten years after the bubble's peak that we would have come to
some consensus on what caused it and how to prevent another one. But nope,
there's still no consensus. People are still arguing after all these years. So I
spent a couple of months trying to figure it out for myself and found an
easy way to explain the basic economics behind the Great
Real Estate Bubble.
Economists like to say about inflation that prices are determined by
how much money is chasing how many goods. The "how much money" part measures demand and
the "how many goods" part measures supply. It turns out this simple frameword also works
great for explaining the boom and bust in home prices in the Great Real Estate
Bubble.
So let's get back to basics and look at how much money was chasing how many
homes in the Great Real Estate Bubble. First let's look at the second part,
"how many homes." Homes are the textbook example of what economists called
inelastic supply.
Most products are kind of like iPhones, if the new iPhone is a hit, great, Apple
makes a zillion more iPhones but they don't increase the price of iPhones. Homes are
different.
If your town suddenly became super cool and cool people all over the world
want to move there, home prices in your town would skyrocket. The supply of homes
is fixed in the short term.
So even small increases in the amount of money chasing homes can cause big
increases in home prices. In the long term in cities where it's easy to build
new homes,
prices will come back down but in cities where it isn't, they won't.
Now let's go back and look at the first part of that equation,
"how much money." Two factors determine how much money is chasing homes,
how much money people have and how much money people can borrow. And two huge
factors that determine how much money people can borrow our
interest rates and how loose mortgage companies are with their money, or with
money. From the early 1990s to the peak of the Great Real Estate
Bubble mortgage companies became a hell of a lot looser with their money. They
loosen up slowly at first but then faster and faster and crazier.
FHA became loser. Fannie and Freddie became looser.
Subprime companies became looser and in addition the number of subprime
mortgages skyrocketed.
Back in the early 1990s, if you couldn't get a prime mortgage
you might not be able to get a mortgage at all. Then some small enterprising
mortgage companies started to sell high cost, subprime mortgages to people with
iffy credit histories who couldn't get low-cost, prime mortgages.
by the late 1990s, easier mortgages and a strong economy we're
making a lot more money available to chase homes.
Home prices started to rise fast in some cities. For example, the home price index
for Los Angeles increased 14% in one year alone, 1998. Then the
Dot-Com bubble burst in 2000, the stock market crashed and a recession
began. To pump up the economy, the Federal Reserve lowered interest rates
drastically. Interest rates on 30-year fixed-rate mortgages felt 3
percentage points from 2000 to 2003. The lower rates meant people could borrow a
lot more money
to chase homes, if they wanted to anyway. With the same monthly payment you could
borrow nearly 40% more money in 2003 compared 2000. If
you switch to an adjustable rate mortgage, you could borrow 60%
more. If you switch to a subprime mortgage, you could borrow even more.
Los Angeles, for example, already had a really tight real estate market and its
economy wasn't as hard hit as others by the Dot-Com bubble burst,
so the new, low interest rates sort of freed prices in LA to rise. Higher prices
made people want to buy homes right away before prices increased even more. So
prices
increase even more. With the rapidly rising home prices, subprime mortgages
became more popular because people wanted to borrow more money and more
people want to borrow.
Everyone was talking about home prices. It was as if the Dot-Com mania is simply
shifted over to real estate. California real estate speculators were making big
bucks.
Some took their winnings and moved on to Las Vegas and Phoenix which triggered
bubbles there.
I should mention the most US cities did NOT have real estate bubbles. Home buyers
in non-bubble cities could have borrowed a lot more money to chase after
homes, if they wanted to, but they didn't want to.
So, why not? Most likely they didn't need to.
Their real estate markets weren't that type. Home buyers could find homes they
wanted to buy without borrowing more money and bidding up prices. And part of
it MIGHT be that the people in the non-bubble cities were just less
comfortable taking risks than the people in California and Florida. They avoided
taking bigger and riskier mortgages
even though they could have. Upward price spirals never really got started there.
Mortgage interest rates fell throughout 2001 and 2002 so a huge number of people
decided to refinance their homes. When they switched into lower interest rate
mortgages, many people also got larger mortgages. That way they can get cash out
when they refinanced.
They ended up with less equity in their homes but more cash in their pockets. In
2003, an incredible 20% of us homeowners with mortgages refinance
their homes. About half of all mortgages made in 2004, 2005 and 2006 were
for refinancing. Home prices had skyrocketed
which meant people can get huge cash outs, if they wanted to. They could get even
bigger cash-outs if they refinanced into low down payment, subprime mortgages.
Unfortunately, they ended up with less equity which would come back and bite
some people when home prices tanked
after the bubble burst.
As the refinancing boom was ending in 2003, the subprime mortgage boom really
started to take off. And at the same time subprime mortgages were getting riskier -
credit scores fell, down payments fell, maximum loan amounts rose, fraud rose.
Subprime lending standards fell so far that from 2005
to 2007
the median subprime mortgage had zero down payment. And by 2006 half of all
mortgages were some prime. Some people chose subprime because they couldn't get
prime mortgages. Others chose subprime so they could borrow more money.
Either way the increase of subprime mortgages meant people could borrow a
lot more money to chase homes, if they wanted to anyway.
Combined with the low interest rates,
home prices absolutely skyrocketed in the bubble cities during 2004 and 2005. On
top of this, the Fed began slowly increasing interest rates in 2004
but instead of slowing things down people became even more manic about
buying homes right away before the low interest rates were gone forever.
Eventually, home prices got so high in the bubble cities that the market
psychology changed from, "These home prices seem crazy high but they're increasing
crazy fast
so let's buy a home ASAP" to simply, "These home prices seem crazy high and they're
not increasing crazy fast anymore, so let's just wait and see.
The spell was broken. And anyway,
pretty much anyone with any inkling to buy a home already had bought one. In
2005, the number of home sales peaked. In 2006, home prices peaked. The spell, however,
wasn't broken for the mortgage industry. They continued to lower their lending
standards in a desperate attempt to keep the music playing. Many subprime
mortgages made in 2005, 2006 and 2007,
especially the no money down mortgages, made it rational for investors to stop
paying their mortgages as soon
as they realized that home prices weren't increasing anymore.
If they put no money down, the only money they had lost was the first few monthly
payments they made. The sooner those investors stopped making payments,
the smaller their losses. In 2006, after home prices stopped increasing,
foreclosures started increasing. By 2007, home prices started to fall and
foreclosures of subprime mortgages started to take off. By 2008, foreclosures
of prime mortgages started to take off and home prices in bubble cities began
to freefall. Then the stock market began to freefall. And then the government
stepped in with the first in a series of huge financial interventions. By the time
home prices finally bottomed out in 2012,
home prices fallen 30% nationally, 40% in Los Angeles
50% in Miami and 60% in Las Vegas. The Great Real Estate
Bubble triggered the Great Recession which turned out to be the deepest and
longest recession since the Great Depression.
Here's why. When the stock market falls, it doesn't have a huge impact on the
wealth of lower-income Americans, they don't own stock.
Remember how quickly the economy bounced back from the 50% crash in the
stock market in the 2000 Dot-Com bubble. When home prices fall
30%, however, it hurts a lot more people and wipes out most of what
little wealth lower-income Americans have. So consumer spending crashes hard.
That's why the worst recessions, like the Great Recession, are usually tied to real
estate bubbles.
I think the money chasing homes framework does a great job of decoding
the chaos of the Great Real Estate Bubble and even partially explains why
during the bust
we saw home prices fall in cities that didn't even have booms. After the bubble
burst,
mortgage companies freaked out and tighten lending standards everywhere.
The money chasing homes was reduced
everywhere, even in cities that didn't have real estate bombs. And currently, the
money chasing homes framework helps explain why home prices are skyrocketing
in Vancouver, the U.S. West Coast, Miami and some techie cities,
it's an influx of foreign and/or tech money chasing homes in those cities.
The first step to preventing another Great Recession is to understand what
caused the Great Real Estate Bubble.
I hope this video helped you get a better feel for what happened
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