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It is very hard to pick a ground-zero for the housing bubble that pushed the whole world into The Great Recession. Allow me to begin our trip in late 1989 in Japan. The stock market – symbolized by Nikkei 225 index, peaked at approximately 39,000, while the real estate market climbed the summit at approximately $1 million per square meter. This March, Nikkei traded as low as 7,200 while the property tags lost on average 90% of their peak values. We should notice that Japan experienced a dual-bubble shock and that has been underemphasized by many economists. In contrast, America witnessed two consecutive and somehow connected bubbles: the dot-com bubble and the housing bubble. In 2000, many of the Silicon Valley dot-com companies that never made a profit, paid $2 million for a 30-second Super Bowl commercial. Sparking investors’ euphoria, technology companies pushed the Nasdaq index as high as 5,132 points. In October 2002, Nasdaq traded at 1,140 points, wiping out $5 trillion of investors net worth.
Many analysts believe that investors who took a hit during the dot-com bubble burst moved their money into the real estate space. Over the last decade or so, there were some events that had a critical effect on the formation of the housing bubble:
• July 1997: The Taxpayer Relief Act that set a $500,000 married/$250,000 single exclusion of gain on the sale of a home, available once every two years. This encouraged people to invest in second homes and investment properties, such that in 2005, 28% of homes purchased were for investment purposes, with an additional 12% purchased as vacation homes
• November 2000: Fannie Mae announced that the Department of Housing and Urban Development (HUD) would require it to dedicate 50% of its business to low- and moderate-income families and its goal was to finance over $500 billion in Community Investment Act-related business by 2010. As a consequence, if in 1994 the subprime mortgages amounted to $35 billion (5% of total originations), by the end of 2006 the subprime loans reached $600 billion (20% of total originations)
• 2001 – 2003: Federal Reserve lowered the benchmark interest rate 12 times, from 6.5% to 1.0%
• 2003-2007: Federal Reserve failed to use its supervisory and regulatory authority over banks and mortgage underwriters, which abandoned loan standards (employment history, income verification, down payment, credit rating score, property loan-to-value ratio and debt-servicing ability), emphasizing instead lender’s ability to securitize and repackage subprime loans. For instance, in 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever.
On top of these points, I should underscore that mortgage lenders have created new and innovative mortgage products, mostly designed to lower the borrowers’ payments in the first few years of the mortgage. Many of these products allow borrowers to buy homes that they traditionally could not afford, but these exotic products come with an additional risk. Amongst these esoteric mortgage loans, I would mention:
• 40-Year Mortgage – this is similar to a 30-year fixed rate mortgage, except the payment is being stretched over an extra 10-year period
• Interest-Only Mortgage – it allows the borrower to pay only the interest for the first so many years of a mortgage (grace period)
• Negative Amortization Mortgage – it allows a buyer to pay less than the full amount of interest and the difference between the full interest payment and the amount actually paid is added back to the balance of the loan
• Short-Term Hybrids – they are very similar to Adjustable-Rate-Mortgages (ARM) with fixed-rate for a limited time and then interest rate that floats
Stay tuned for the next episode!