Who Caused the Housing Bust

It's no secret that median home prices in some parts of the country rose a whopping 40% during 2005. But who can remember the appreciation when we had a balanced market between 2002 and 2004? Not many. To refresh your memory, median home prices rose a measly 4% between 2002 and 2004.

Over the past few months, mortgage lenders began cutting off the supply of money, which is like oxygen to the housing market. If we compare current home prices with historical pricing trends, the market is facing a 15-20% downward correction.

No one is to blame when everyone is making money. But when a market correction is staring us in the face, people are quick to point the finger. Just check out the blog sites that are bashing real estate agents, mortgage brokers and overzealous investors. But who or what really caused the housing bust?

As interest rates fell from 1995 to 2005, the mortgage and housing business boomed as more and more money found its way into housing. With lower rates, more people could afford to buy houses. I know some people that bought seven or eight.

But all the madness could not have been fueled by low rates and optimism alone. People who couldn't normally qualify for a loan, due to credit or income problems, were allowed into the market. These higher risk loans are called "subprime" loans. New financial products were engineered to offset the risk associated with subprime loans. A new security, called a residential mortgage backed security, or RMBS, was invented to pool together individual mortgages into large bundles called "tranches". It was believed that these tranches were safer because the obligation was spread among thousands of homeowners. As long as the default rate remained below 3%, the buyer of the RMBS was guaranteed a nice return.

With home prices rising and interest rates falling, almost every RMBS was safe. Even if a homeowner got into trouble, he could still sell his home for more than he paid or find a way to refinance the debt. As the market surged, everyone made money, which attracted still more money into the market. Housing prices skyrocketed. The higher prices created more equity...consumers used that equity to take on more debt. This led to the housing bubble.

The first sign of trouble was an unexpectedly high default rate in subprime mortgages. Beginning in early 2007, studies of 20-month-old subprime mortgages showed a default rate greater than 5%. The higher-than-expected defaults led to hedge fund wipeouts and then to mortgage broker bankruptcies. Unfortunately, spread of the subprime disease didn't stop there.

With Wall Street bundling together thousands of mortgages from different underwriters, it's likely that hundreds of financial institutions around the world have traces of bad subprime mortgage debt on their books. Hedge fund investors quickly figured this out and were forced to sell.

Liquidity fears began to sweep through Wall Street. Not because the mortgages themselves were all bad, but because investors knew a wave of selling was on the way. What happened in August of 2007 was a good old fashioned "run on the bank". Everyone wanted their money back and no one wanted to buy.

With no RMBS buyers, mortgage lenders began tightening lending guidelines and cutting loan programs, starting with the riskiest of loans. These include subprime loans, loans to real estate investors, Jumbo loans and loans that don't require the borrower to provide income or employment documentation.

If Wall Street's investment firms can find additional capital they might weather the storm. For the housing market, these events will spell a one-way slide in prices.