The Self Reinforcing Housing Loop

The subprime mortgage crisis was undeniably an asset bubble. The fundamentals had not changed on the ground. The people had not started making twice as much money as they were making earlier. Neither had the price for constructing the houses fallen by half. However, still the prices of houses across the United States doubled in a very short period of time. This rise in prices was way above the usual rise and had no basis to support it. In this article, we will have a closer look as to how the economy reached this position wherein the market could turn into an unsustainable bubble.

We will look at the subprime mortgage crisis through the lens of the asset bubble theory and make an attempt to identify the feedback loops that were operational.

Low Interest Rates

The entire process started when the US government cut the interest rates to 1.75%. Interest forms a huge part of the mortgage payments. So much so that in the first 5 years or so 75% of the payments made go towards interest charges. Hence, slashing the interest rates to a fourth of what they were resulted in the first step of the asset bubble. For any asset bubble to arise there has to be easy access to a lot of money. When the Fed cut the lending rates, it literally pumped it billions of dollars in the market and with the political motives surrounding home ownership, the biggest chunk of this newly created money ended up in the mortgage markets. The common denominator amongst all asset bubbles in the recent past has been extended periods of low interest rates.

Speculative Activity

This excess money in the market caused the people to indulge in speculative activity. Historically, for the last five decades, the United States had witnessed a steady rise in housing prices. Housing prices would increase at the rate of inflation. Hence, when money was in abundance, inflation was bound to be high. A high inflation combined with a low interest rate meant that anybody who could get a mortgage would end up making a big profit on their investment. This is because the mortgages are highly leveraged and even a small movement in the price creates a big change in return.

Also, since the construction industry is the second largest employer in the country, the housing boom was seen as a good thing. However, most of the new houses being built were out of the city areas and as many as 22% of the houses were vacation homes and a large portion of them were second homes. The people holding these 30 year mortgages had no intention of holding them till the end, most wanted to make a quick buck and move on. Hence, the low interest rates had created the first stage of the bubble i.e. the boom.

Secondary Mortgage Markets

Low interest rates had unleashed a lot of money into the market. However, even a lot of money would have quickly dried up with the amount of loans that were being made. That did not happen because the US investment banks had found a way to recycle the same money over and over again. They spent the 1990’s and 2000’s perfecting the secondary mortgage markets. Thus banks did not have to hold on their investments till the end of the mortgage. Rather within a couple of weeks, the funds would be recycled and banks would be flush with cash to make more and more loans. The secondary markets took a majority of the blame for the crash. However, they were only a small reason behind the crisis.

More Speculation

The speculators described in point number 2 above ended up making some serious money on their investments. The success of the speculators did not go unnoticed by the media and the community at large.

Many of these speculators further reinvested their earnings into the housing market buying multiple houses giving rise to even more speculation. Moreover, seeing the success of the early movers, even the average guy started plunging into debt to enter the mortgage market. This debt binge was made possible by the availability of easy loans. However, the temporary success of many peers seemed to be the catalyst.

At this point in time, the fundamentals had begun to deviate from the reality. There were young people, insolvent people and jobless people who had houses and had no idea how they were going to pay off the mortgage. They also had no intention of holding on to the mortgage.

The housing market had become the new stock market. In an ideal scenario the market would have went bust by now. However, the extended period for which the interest rates were held low as well as the secondary mortgage markets made it possible for the bubble to inflate further.

Unsustainable Conditions

The last three to four years before 2008, were like the beginning of the end of the Ponzi scheme that the United States housing market had become. Housing prices had doubled in tripled in most parts of the country in the last six years or so. If anyone had any money there was only one place they wanted to invest that is the housing market.

Couple this with the fact that no money was required to buy a house and an unsustainable boom emerges. Cases of bartenders with multiple homes and immigrant workers with beach houses were not uncommon during this period. The fundamentals had deviated too far from what was the reality.

The reality was that these mortgages could not be paid off and that it was only a matter of time before the system fell apart. Many people had seen this coming and made a lot of money predicting the failure of these banks. However, if anyone had been paying attention to the asset bubble theory they could have easily predicted the market bust.

Authorship/Referencing - About the Author(s)

The article is Written and Reviewed by Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.