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Part One
What Happened and Why, Where Are We Now, and What Does the Future Hold?
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Chapter 1
What Happened during the Housing Bubble?
Talk to your parents or grandparents about buying their first home and theyâll tell you it was the fulfillment of the American dream, long process that involved years of saving and sacrificing to gather enough cash for the 20 percent down payment. Theyâll tell you that the day they bought their first home was one of the greatest days of their lives, that it represented more than just a place to live. In fact, that home was the single biggest purchase most would ever make, and it represented stability, safety, and security for themselves and their families.
In those days a mortgage was regarded as a sacred obligation, to be paid off steadily over time. And when it was paid off, there was often a mortgage-burning party to celebrate owning the house free and clear.
Home Prices over Time
Historically, there was good reason to believe that homes represented stability, safety, and security. For more than half a century, home prices had marched steadily upward at a rate exceeding inflation by about one-half of 1 percent annually, with very little volatility, as shown in Figure 1.1.
Figure 1.1 Real Home Price Index, 1950-2000
SOURCE: Robert J. Shiller, Professor of Economics,Yale University, Irrational Exuberance: Second Edition, Princeton University Press, 2005.
Beginning around 2000, however, home prices started to rise at a rapid rate and became completely disconnected from their historical trend line (shown in Figure 1.2).
There were many reasons for the upward movement, as weâll explain in detail in Chapter 2, but the biggest driver of the housing bubble was the simple fact that the amount an average homeowner was able to borrow to buy a house tripled in a relatively short period of time, as shown in Figure 1.3.
Prior to 2000, the typical borrower could borrow roughly three times his income to buy a house. Figure 1.3 shows that in January 2000, a person with pretax income of nearly $34,000 (the national average) could take out a mortgage of 3.3 times this amount, or $110,000. Of course, the borrower had to have a 20 percent down payment and a decent credit history, and banks were rigorous about evaluating the ability to repay. But all this began to unravel as the years passed.
By January 2004, average pretax income had risen 9 percent to $37,000, but the amount that could be borrowed rose 60 percent to $176,000, a 4.8Ă ratio. A year later, the figures were $38,000, $274,000, and 7.2Ă, and by January 2006, with income of only $39,600, the amount that could be borrowed to buy a house was an astonishing $363,000, a 9.2Ă ratio. This enormous borrowing power persisted for another year-and-a-half until the housing bubble began to burst in mid-2007.
Figure 1.2 Real Home Price Index, 1950-2008
SOURCE: Robert J. Shiller, Professor of Economics,Yale University, Irrational Exuberance: Second Edition, Princeton University Press, 2005, as updated by the author.
Figure 1.3 Average Income and Borrowing Power
SOURCE: Amherst Securities.
There were a number of factors, including falling interest rates, driving this threefold increase in borrowing power in only six years, but by far the biggest was that lenders grew willing to lend up to the point that debt payments consumed 60 percent of a borrowerâs pretax income, whereas historically the permitted ratio didnât exceed 33 percent. Worse, little or no down payment or documentation was necessary, and interest-only loans proliferated.
Suddenly throwing such a massive amount of capital at a relatively stable asset base caused prices to skyrocket, which led to a self-reinforcing cycle: In order to afford a home, prospective homeowners had to borrow more and take on risky, exotic mortgages instead of conservative 30-year, fixed-rate, fully amortizing mortgages. In turn, exotic mortgages and loose lending terms allowed homeowners to borrow much more money, thereby driving prices ever higher.
The bubble manifested itself in different ways in different parts of the country. As discussed later, in inner cities like Detroit, equity-stripping schemes were common; in Florida, Arizona, and Nevada, there was widespread speculation and overbuilding; and in California, which has 10 percent of the nationâs homes but is where 34 percent of the foreclosures are happening (44 percent by dollar value), the bubble was primarily an affordability problem. Thatâs not to say there wasnât equity stripping in Californiaâs inner cities nor an affordability problem in Florida, but these are the general characterizations.
Figure 1.4 shows what happened to housing affordability in three cities in southern California: Los Angeles, Riverside, and San Diego. One can see that the percentage of households that could afford the average home in these three cities, as measured by the National Association of Home Builders (NAHB)/Wells Fargo Housing Opportunity Index, plunged as this decade progressed, to the point that fewer than 10 percent of households could afford the average home using a standard mortgage.
Figure 1.4 Home Affordability in Three Cities
SOURCE: Copyright © National Association of Home Builders 2009. All Rights Reserved. Used by permission. âNAHBâ is a registered trademark of National Association of Home Builders. âWells Fargoâ is a registered trademark of Wells Fargo & Company.
Homes as ATMs
Another factor was at work as well: As home prices rose and interest rates dropped, millions of Americans were able to refinance their mortgages at lower rates but alsoâthis is criticalâtake out bigger mortgages, thereby converting the rising value of their homes into cash. Called a cash-out refinancing or refi, this practice soared during the bubble. In total, as shown in Figure 1.5, Americans pulled more than $2.5 trillion out of their homes from 2004 to 2007, fueling consumer spending and accounting for approximately 8 percent of total disposable income during that period.
The combination of these factors meant that Americans were taking on more and more mortgage debt and had less and less equity in their homes, as shown in Figure 1.6. In fact, in 2007, for the first time ever, American homeowners had more debt than equity in their homes.
Figure 1.5 Net Home Equity Extraction
SOURCE: Updated estimates provided by James Kennedy in âEstimates of Home Mortgage Originations, Repayments, and Debt on One-to-Four-Family Residences,â by Alan Greenspan and James Kennedy, Federal Reserve Board Finance & Economics Discussion Series (FEDS) working paper no. 2005-41. Home equity extraction is defined in the paper as the discretionary initiatives of homeowners to convert equity in their homes into cash by borrowing in the home mortgage market. Components of home equity extraction include cash-out refinancings, home equity borrowings, and âhome turnover extractionâ (originations to finance purchases of existing homes minus sellersâ debt cancellation).
Figure 1.6 Mortgage Debt and Home Equity
SOURCE: Federal Reserve Flow of Fund Accounts of the United States.
The Collapse of Lending Standards
Lending standards collapsed to an almost unimaginable degree during the great bubble, to the point that in some areas if you had a pulse, you could get a mortgage.The collapse manifested itself in many ways.
In 2001, the combined loan-to-value ratio for the average mortgage was 74 percent, meaning the buyer had put down 26 percent of the cost of the home (see Figure 1.7). When doing any kind of lending, itâs critical that the borrower has meaningful skin in the game, so there is a strong incentive to repay the loan, even if the value of the asset falls.
Over the next five years, the average loan-to-value ratio rose to 84 percent, meaning that the average borrower was putting down only 16 percent, affording lenders much less protection in the event home prices tumbled. The situation was even more extreme for first-time home buyers, who were putting down only 2 percent on average by early 2007.
Figure 1.7 Combined Loan-to-Value Ratio
SOURCE: Amherst Securities, LoanPerformance.
Not surprisingly, the percentage of mortgages for which the borrower put no money downâand was effectively getting a free call option on home price appreciationâsoared from virtually nil to one-sixth of all mortgages in 2006, as shown in Figure 1.8.
Figure 1.8 Mortgage Loans with 100 Percent Financing
SOURCE: Amherst Securities, LoanPerformance.
Another change in lending practices compounded the problem. Historically, a lender was careful to verify a borrowerâs income and assets by asking to see pay stubs and tax returnsâan obvious precaution to ensure that the borrower could afford the payments on the mortgage. There were exceptions made for certain self-employed borrowers like doctors, but this was not common. During the bubble, however, such requirements went out the window as low- and no-documentation mortgages rose to account for nearly two-thirds of all mort...
