In December of 2008, the National Bureau of Economic Research declared that the United States had been in a recession since December 2007 (Holt, 2009). The 2007 recession was caused by the credit disaster, which was caused by the burst of the housing bubble. Many scholars and economists have identified several causes of housing bubble and its subsequent collapse. Among the causes identified by Holt (2009) are mortgages with low interest rates and low underwriting standards in the mortgage industry. Schiller (2005) has written extensively on the concept of irrational exuberance as being central to the real estate market price collapse. This notion is usually applicable to investors but in this case, it also applied to homebuyers and the rest of the industry.
Mortgages with low interest rates and low underwriting standards had been sold on the secondary market not only to domestic investors but also to foreign investors (Bernanke, 2009). Mortgage backed securities in the United States had traditionally been a good investment. However, these mortgages were not of the same quality as they had been in previous investment periods. According to Bernanke, United States mortgage underwriting standards had been in decline for six years before the crash. Investors had not taken note of this phenomenon except in a nominal way because of the continuing increase in property values (2009). Traditional underwriting standards had decreased in many areas, especially as the underwriters allowed a higher and higher debt-to- income ratio and higher loan-to-value percentages (Gwartney & Connors, 2009).
The roots of the modern United States mortgage lie in the 1930s when residential mortgages had low loan-to-value rations. Most people put fifty percent down on their homes and borrowed the other fifty percent. Mortgage lenders on these short-term home loans, typically five to ten years, could allow the homeowner to refinance if the loan had not been paid off. However, many unscrupulous lenders denied refinances to homeowners and repossessed their houses thinking there was enough equity in the home to make a profit by selling it to another buyer. This resulted in massive foreclosures from 1931 to 1935 (Collins 2002).
During the Great Depression, ten percent of homeowners saw their homes taken from them via foreclosure. When banks tried to resell the homes they were unsuccessful, leading to bank failures. Because these defaults were dragging down an already floundering economy, the federal government established the Federal Housing Administration (FHA) in 1934 to slow down defaults by offering longer-term mortgages (20 years) and to shield lenders from the financial disasters due to defaulted loans (Collins 2002).
The federal government developed the fixed-rate, long-term mortgage to avert further economic crisis. However, the federal government did not want to be the security holder for the new mortgages, so it developed the Federal National Mortgage Association (FNMA) in 1938 to buy the FHA loans. Thus, FHA loans were marketed to investors via FNMA.
To make FHA loans more appealing to mortgage investors the government created the FHA insurance program whereby if the borrower defaulted the investor would still receive the full balance with interest. According to Holt, FHA and FNMA did help people buy homes, however the federal government did not organize these institutions in order to promote homeownership (2009). Collins (2002) concurs that FHA and FNMA were created to assist investors, not homeowners. Lending became dull after the creation of FHA and FNMA. During the Great Depression and World War II builders were not building many homes nor where buyers looking to buy homes.
The idea of homeownership as part of the American Dream had been around since the founding of the United States. In the late 1800s, “The American Home: The Safe-Guard of American Liberties” became the motto of the United States League of Local Building and Loan Associations. The job of the motto and the association was to encourage people to buy homes. James Truslow Adams put the term “American Dream” on the map in 1931. Ironically, Adams’ characterization of the American Dream was counterintuitive optimism; much the same as Schiller’s 2005 term irrational exuberance. The 1944 G.I. Bill of Rights gave momentum to the idea of homeownership as the American Dream when the federal government created the Veterans Administration home loan program. This was the beginning of the low down payment mortgage (Green & Wachter, 2005).
The VA home loan program was a combined result of patriotism and marketing strategy. The construction industry wanted a way in which to tap the market of the newly released service population. In order to further stimulate the economy and inspire buyers to invest in the housing market post WWI, FHA relaxed its terms. By 1949, the income to debt ratio increased to 20%. The FHA loan increased to 30 years, making payments lower. By the 1950s, FHA had lowered its down payment requirement to 5% for new construction (Green & Wachter, 2005).
Schiller’s idea of irrational exuberance and Adam’s notion of counterintuitive optimism both encouraged buyers in the 1990s to become, in essence, speculators. Irrational exuberance motivated the parties involved in real estate to assume housing prices would continue to rise no matter what. Schiller states that irrational exuberance caused a “speculative fervor” (2005). Everyone thought that home prices would increase because home prices had not decreased for such a long time. Thus investing in real estate became a sure way to make a profit.
According to Schiller, the federal government did not worry about increased housing prices because they did not listen to critics who claimed this rise was a bubble. Lenders did not worry about prices because there was so much activity there were not an alarming number of foreclosures to contend with plus the promise of equity gains were there if lenders did foreclose. Secondary market investors did not concern themselves with the continual rise in prices because they could resell a foreclosed property for a profit (2005).
Buyers did not worry about repaying their mortgages because they assumed they could resell their house in a short while for a great profit. Speculation soared and millions of people decided to buy their single family home with an eye toward profit rather than a means to secure a family home. Holt (2009) points out that this type of speculation by average folks is a recent phenomenon in the United States. Before the 1960s, average people did not count on their homes as being a source of profit. Later, television infomercials and the internet promoted real estate investing as a way to make quick cash.
Information and encouragement about investing in real estate was plentiful. By 2000 accounts of bidding wars made internet headlines. This caused panic and excitement among people who hoped or feared that housing prices would continue to rise (Holt, 2009).
Shiller (2005) claims that people thought the housing market was a sure thing because they recall prices from decades past. When parents died, their adult children were amazed at the amount of equity in the homes they inherited. In the fifty plus years that their parents had owned their homes the values had increased. Therefore, the profits seemed significant. Assuming these parents had not refinanced to pull out equity the inheritors reaped a good amount of profit. Shiller points out that this resulted in unfounded expectations about real estate as an investment. People did not take into account that the consumer price index was eight times higher than it had been when those homes were first purchased. In the end, over a 50 year period there was an increase of about 1 percent per year (2005).
Before the housing bubble of the late 1990s, the modern high dollar mortgage most was a 30-year fixed rate loan. The standard down payment was 20 percent. These loans, called conventional loans, were not the same as government loans like FHA and VA. Buyers’ debt-to-income rations were around 30%. Zandi (2009) explains how web access caused the underwriting for conventional loans to relax because buyers did not have to go to a local lender. The web allowed buyers to shop for rates and terms. The lenders who attracted the most borrowers took most of the market share leaving traditional lenders a choice between losing out in the marketplace or lowering their underwriting criteria.
The competition to offer lower interest rates fueled home buying even as housing prices began to decline. The low start rates and loose underwriting guidelines that characterize the mortgage business from 2002 to 2004 became the norm. To keep rates down and buying high the Federal Reserve lowered its rates as well. The Federal Reserve lowered its rates eleven times during this period (Zandi, 2009).
Adjustable rate mortgages (ARMs) proliferated and homebuyers bought more expensive homes. Buyers believed they could resell the homes at a profit before the rate adjusted upward. ARMs expanded in type with some lenders creating loans that had not only a low start rate but also had features such as interest-only payments. Usually the interest rate adjusted upward after a two-year period, but sometimes sooner, and then borrowers could not afford the payments. Nor could they sell their houses (Holt, 2009).
Another problem with having homeowners become speculators is that homeowners do not have the cash reserves that professional investors have. Many homebuyers hoping to make a quick profit borrowed the money for the down payment. When housing prices fell, borrowers not only defaulted on their home loans but also on the money they had borrowed for the down payment. These double defaults not only caused mortgage-backed securities to destabilize but also other sectors of the economy as well (Holt, 2009).
Liebowitz (2008) documents the crash year by year. Home prices were still rising in 2006. The crash began midway through that year but investors did not recognize it as such, they interpreted it more as a leveling off of housing prices. Prices had fallen two percent by the end of 2006. However, pre-foreclosures increased by 43 percent over this same period. By 2007, pre-foreclosure rates had increased by 75 percent.
In retrospect, home loan defaults began as soon as prices stopped climbing and began to fall. People who had gone with low or no-money-down financing abandoned payments almost as soon as home prices dipped. Borrowers with ARMs could not sell as soon as they had hoped and could not refinance because they had little or no equity in their homes (Liebowitz, 2008).
When the housing bubble burst in 2007, foreclosed homeowners received much publicity and sympathy in the news. However, the big losses were in the financial sector. Construction nearly collapsed and its decline affected the gross domestic product (GDP). The crash of housing prices negatively affected consumer buying power. Unemployment went up and the entire economy became unstable.
The burst housing bubble that resulted in a credit crisis and thereby the 2007 recession was caused by a combination of speculation by buyers and others, low interest rates, and lax underwriting standards. Low interest rates exacerbated this housing bubble making it different from previous bubbles. In the 1980s, there had been a housing bubble but the interest rates were not so low. People could not qualify for homes at such high rates.
However, in the late 1990s and early 2000 millions sought mortgages they could not ultimately afford. Irrational exuberance not only turned homebuyers into speculators, it also turned lenders and investors into speculators. The extensive publicity on television and on the internet fueled the idea that home prices would climb into the stratosphere. In addition, relaxed standards for mortgage loans would not have led to such a large increase in subprime mortgages without irrational exuberance.
Some professionals are warning foreign investors away from the current United States market cautioning the worst is not over yet. Foreign experts predict that the United States housing and mortgage bubble has not burst completely. Others claim the United Sates real estate market is on its way to another bubble. They cite the still high United States foreclosure rate and the lack of relief offered by the federal government (Snytkova, 2013). According to these experts, United States banks and investment firms siphoned billions off programs such as the 2008-2009 Home Affordable Modification program (HAMP) with seemingly little intention of actually assisting homeowners to avoid defaulting on their loans (Agarwal, 2012).
The federal government intended HAMP to pacify a public that was out-raged by the collapse of the real estate market and the number of homes in foreclosure. The plan was that lenders would renegotiate loans made on homes with insufficient equity or in the case where rates had adjusted to the point that the homeowner could not afford the payments. If HAMP had worked the number of loans renegotiated would have been modest. It did not work. Lenders accepted the HAMP money to fund programs but in the end, they did not renegotiate a significant number of loans. The largest lenders were the most sluggish in their negotiations with borrowers (Agarwal, 2012).
Abandoned real estate in the United States continues to grow in number. Commentators liken this to the 2007 crisis. These experts warn that the slow recovery of home sales in most of the United States indicates economic stagnation and foretells another decline in housing prices. Additionally they cite little reform in the lending industry with lenders still offering low interest rates and ARMs. The United States Federal Reserve lowers and increases rates that affect homebuyers, and the federal government insists on keeping rates low. The ever-increasing federal deficit is a warning sign to investors who hesitate to put money into an economy that may or may not recover (Snytkova, 2013). There are indices used to determine whether the United States is about to enter another housing bubble. According to some economists, those indicators are already present (Holstein, O'Roark & Min, 2013).
In order to forestall another melt down like the one caused by the housing bubble economics commentators have proffered a variety of solutions. Some recommend that FNMA be privatized. To them, FNMA and FHA were created during the Great Depression and are no longer relevant in the modern United States financial market. Mortgage insurance as well could be privatized; thereby avoiding the same underwriting mistakes that occurred when federally trained personnel approve loans in a market they did not understand (Holt, 2009). FNMA and FHA have encouraged the idea that all borrowers are created equal. Mortgages with low interest rates and low underwriting standards were promoted as a way to increase home-ownership rates for previously disenfranchised groups. They loaned the same monies to high-risk borrowers as they did to low-risk borrowers. In many ways, this allowed all borrowers to become speculators. Investors in favor of privatization argue that FNMA and FHA as well as other government-backed programs keep interest rates artificially low thereby increasing the risk that mortgages will go into default. Additionally, the United States federal government is guaranteeing loans with money it does not actually have (Green & Wachter, 2005). The idea that the federal government is guaranteeing billions of dollars in loans that it cannot repay will cause the United States real estate market and mortgage market to continue to appear unstable to domestic as well as international investors.
The latest housing bubble revealed to investors worldwide that the United States was lending money not to homeowners who would keep the mortgages and faithfully pay them off. Rather the borrowers were people who had no additional resources and walked away from the loans they had agreed to pay. If borrowers and lenders paid the market rate of interest determined and required by a privatized mortgage industry then there would be safeguards against another period of amateur borrowing frenzy followed by a burst house bubble (Green & Wachter, 2005).
Promoters of disbanding or privatizing FNMA and FHA note that these were designed as short-term solutions to address a specific financial crisis in the United States. No other country offers such an extensive selection of mortgages to their consumers. Consumers of United States mortgages may not understand their loans. However, they feel secure in the knowledge that the United States' mortgage system is designed with protections against foreclosure. The publics’ perception that the FNMA collapse was the problem of the federal government was obvious when homeowners expected and received a federally backed mortgage bailout programs in 2008 (Green & Wachter 2005). The failure of those programs is still the subject of debate as well as Congressional hearings.
Olefson (2009) and others counsel homebuyers to rethink and research the history and intent of homeownership. Traditionally, ordinary people bought homes not as investments but as a place to live with their families and as a legacy for their heirs. Olefson advises buyers to assume their homes will not be worth what they paid for them when purchased. Potential buyers should not try to watch the market as if they were investors.
Homebuyers need to take the long view of home ownership as a way to enhance one’s life. Seek long-term stable mortgages that average working people can afford for years to come rather than the expectation that the lowest possible start rate will buy time under the home-selling market recovers (Olefson, 2009). As Schiller noted in his book, “life was simpler once; one saved, bought a home as part of normal living and didn't think to worry about what would happen to its price” (2005). Speculation fueled by low interest rates and lax standards caused the recent housing bubble and changed the lives of many people. Whether it changed attitudes and practices toward home ownership and its associated financial culture has yet to be seen.
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