The Housing Market: Boom, Bust, and Oh Boy!
By Steve Shurick and Jenn Weir
For Dr. Doina Vlad
Principles of Microeconomics
SEC 101-98
Seton Hill University
October 13, 2007
For years, economists have argued whether or not a housing market “bubble” existed in the United States. Some believed over-inflated home prices were limited to certain regions while others saw a problem that would affect the aggregate real estate market. Now, in the midst of falling home values, rampant foreclosures, the collapse of the subprime market, and the risk of a real-estate-induced recession, experts neatly conclude, “we had a bubble”
[1]. As access to financing becomes more difficult and as manufacturers and retailers predict consumer spending will decrease in 2008 because of the subprime shockwave, the rollercoaster that is our economy is sure to take a down-turn. In its wake, we will find a surplus of overvalued homes, lenders in bankruptcy, homeowners who are in over their heads, and investors backing out of the market at a rapid pace. Could this be the precursor to a market crash? We hope not, but in the mean time, let us explore the history of the United States real estate and lending markets, how this recent bubble happened, where we are now, and what the future might hold for our economy.
History of Real Estate and Lending
From the late 1800’s the real estate market has had it shares of ups and downs. Many substantial increases and decreases of values were due to major world events. Some of these were World War I, The Great Depression, and World War II. When World War I began, the real estate market dropped dramatically. This was because many of our citizens were either fighting in the war or involved in some other way. Our economy was driven by the war and supplying for it. The demand for purchasing a home was decreasing. This continued for a few years until the war was over. U.S. citizens started to purchase more homes and the economy began to rise. This lasted only a few years until The Great Depression took hold of the country. Once again, this brought the market down and kept it relatively low through World War II. This period was one of the lowest in the U.S real estate market. This was in direct correlation to the overall U.S. economy. At the end of World War II, market values and home sales began to rise once again. From 1942 to 1946 the real estate market values increased 54 percent. From this point the market stayed relatively the same by fluctuation within 10 to 12 percent until 1997. From that point until now, the real estate market has jumped 83 percent! There was a rapid increase in that 10-year span. How could the market change so much in such a short period of time? There are many factors which contributed to this housing “boom”.
Housing Bubble
According to the American Heritage New Dictionary of Cultural Literacy, the term “bubble,” when applied to the housing market, refers to a period of time when home prices are inflated beyond their real value.
[3] These prices inflate disproportionately in comparison to income and other cost-of-living indicators. Starting around the year 2000 until about 2006, areas such as Phoenix, Las Vegas, Hawaii, D.C., parts of California and Florida, and other regions experienced an increase in home prices of more than 80%
[4] while the national median household income only rose approximately 10% in that same time.
[5] 
[6] - U.S. Hot Spots in Home Prices
There are several theories about how this bubble was created. But first, it is important to recognize the conditions of the economy just prior to the erratic rise in home prices. Similar to the real estate bubble, the United States was involved in another speculative economic bubble in the late 90’s: the dot com bubble. By March of 2000, investments in online companies had skyrocketed and the Nasdaq (the technology index market) soared to above 5,000 points. Investing in technology-based businesses was all the rage. However, by October of 2002, the Nasdaq closed at barely over 1,100.
[7] What happened to the U.S. technology index in that time?
Like most bubbles, the market in question was over-valued, difficult to predict from the supply and demand standpoint, and prices swung uncontrollably. When investors got wind of problems in the market (the businesses they were investing in were superficially valued and generally worthless), most jumped ship. It did not take long for them to find a replacement. On the Barron’s Internet site, Yale economist Robert Shiller offers his take on the bursting of the dot com bubble and its outcome:
“Once stocks fell, real estate became the primary outlet for the speculative frenzy that the stock market had unleashed. Where else could plungers apply their newly acquired trading talents? The materialistic display of the big house also has become a salve to bruised egos of disappointed stock investors. These days, the only thing that comes close to real estate as a national obsession is poker”[8] (Laing).
For many people, their home is their biggest asset. Most people buy a home, live there for several years, home values appreciate, and come selling time, the happy seller thinks they have made money on the deal. In some cases, this is actually true (though the time-value of money and inflation rarely enter their minds, but that is another project). Because of this, real estate is often thought of as a solid and lucrative investment. People believed housing prices would never fall and that buying property was a sound practice. After investing in something as intangible as an Internet company, people wanted something secure. Two additional important market conditions influenced the coming of the real estate investment “froth”: the brief recession following the dot com crash and the tragedies of September 11.
The National Bureau of Economic Research identified a recession beginning in March of 2001 and reaching its trough in November of that same year.
[9] This meant, surprisingly, the United States was undergoing expansion only two months after the events of September 11. After such a blow to our nation and our economy, how did we recover so soon? This bout of recession and national tragedy spurred the government to take matters into its own hands. The Federal Reserve Board lowered interest rates 11 times in 2001.
[10] By June of 2003, interest rates were lower than they had been since the 1950s.
[11] How does this all relate to the housing bubble? The dot com crash soured people on trendy tech stocks. To revive the economy, the feds lowered interest rates to historic lows. And, people needed an outlet for their investing itch. Voila! The housing bubble begins. It is not quite that simple, however. It is theorized there were other factors involved. Reality “flipping” shows on cable television stations may have spawned a “Do It Yourself” rehab-and-sell band wagon. Unfortunately, not every flipper has enough business savvy or DIY knowledge to turn a profit in turn-key real estate transactions. “Creative” mortgage products and lenient lending standards allowed even those with a poor credit history to obtain a home loan. And let’s face it, most people would rather owning a home is the American dream.
So how bad is the housing market? Right now, 4.5 million homes are sitting on the market for ten months on average.
[12] Compare that to the height of the real estate bubble in 2005 when only 2.8 million homes stayed on the market for roughly half that amount of time. This surplus of homes has created a downward spiral in housing prices. The more houses on the market, the more buyers can choose from, the more competitive the seller must be, and the more the prices are lowered to interest potential buyers.
Housing prices began their steep incline at about the turn of the century.
Blame (and Demand) Shifting
In a recent issue of Money magazine, authors Stephen Gandel, Amanda Gengler, and Paul Keegan, blame four groups of people for our real estate woes in their article, “Scenes from a Bubble.”
[14] On the hook are the buyers, the brokers, the appraisers, and the investors. While the authors tactfully explain how the complexities of financing a mortgage can be “a steep learning curve” for the average homeowner, the underlying message is that these consumers need to make informed decisions before signing on the dotted line (Gandel, Gengler, and Keegan, 117-118). Unfortunately, many home buyers sought the advice of mortgage brokers who did not act in the borrower’s best interests. To get these people into the homes of their dreams, many mortgage brokers turned to risky financing and subprime lending.
With new lending strategies, mortgage agents were able to provide financing for many people who could not and would not before. Banks were still providing traditional loans to excellent clients with below prime rates. However, there was an entire slew of people who did not qualify for traditional mortgages because of blemishes on their credit reports, insufficient income history, or other reasons. Banks, mortgage companies, and brokers tapped into this market by providing financing to willing customers at higher costs. Lenders were using variable rate loans with initially low rates and payments to lure borrowers. What many lending agents did not explain was how much these seemingly low monthly payments can actually rise with a few additional percentage points when the rates were reset.
In January 2001 the prime rate was at 9.50 percent. This was the highest point it has been in years. The market was becoming a bit dangerous. From this point we began to see a change. From January 2001 to January 2002 the prime rate dropped to 4.75 percent! This was a 50 percent decrease and it didn’t stop there. From January 2002 to July 2003 the prime rate dropped to a record low of 4.00 percent. This created a huge stir in the real estate market. More people began refinancing their homes and more people could afford to purchase or build a new home.
As you will see from the following graph, interest rates plummeted to 4.00% in 2003 and 2004:
Within this two year span of the prime rate being in the four percent range, lenders had much room to work. They could easily sell an adjustable rate mortgage (ARM). With a teaser rate of prime or better and the prime rate making little change, why wouldn’t a home buyer want to save lot of money and have a low payment? Unfortunately, many buyers chose to finance with an ARM and because the rates since reset, they cannot afford the increased payments.
An often overlooked culprit in this bubble calamity is the real estate appraiser. Independent appraisers are hired to formulate a fair market value of a property. The authors of “Scenes from a Bubble” explain that appraisals are needed for the bank to make the loan, to insure against fraud as required by regulators and mortgage investors, and to give the buyer a sense of what the property is really worth.
In Western Pennsylvania, real estate appraisers and home inspectors are a dime a dozen, so the market would seem extremely competitive. What lengths would an appraiser go to in order to get the job? Gandel, Gengler, and Keegan have uncovered how lenders and appraisers sometimes work in cahoots (119-120). They reference a scheme that loan officers or mortgage brokers have used to obtain their desired loan value. A loan officer might contact several different appraisers asking them to supply a value of a given property for a certain dollar amount or higher regardless of the homes actual value. For example, one broker would send an email to five or six appraisers, asking for an appraisal in upwards of $365,000 so that her client could refinance. Unfortunately, the property’s real value was probably far less than that.
This essentially created a bidding war among appraisers and superficially drove up the housing values. An overvalued appraisal would allow the lender or broker to offer a homeowner or home buyer additional money supplied by the home’s “equity.” Now that home prices in many areas have cooled or worse, depreciated, many property owners owe more on their mortgage than their house is worth.
Gandel, Gengler, and Keegan also blame investors for the housing market folly. Bond traders had their hands in real estate through the stock market. Investors are buying and selling “bonds that are backed by the mortgage payments of ordinary homeowners (Gandel, Gengler, and Keegan, 121). As we saw from the dot come bubble, this fad is now over.
A different type of investor has contributed to both the inflation of home prices and also the high rate of mortgage defaults. Commonly referred to as “house flippers” or just “flippers,” these people purchase a property either with a traditional mortgage, an ARM, or with other investors, and they have made up a sizeable amount of property purchases during the housing boom. The aim of a flipper is to get in and out of a house in the shortest amount of time, spending only enough money to make the house “move-in” condition. In the midst of a surplus of homes for sale, it is no longer so simple. Houses are sitting on the market for months at a time, zapping the flippers profits.
Les Christie of CNNMoney.com has found that in the month of June in Nevada, “32% of all prime mortgages in default and 24% of subprime defaults were on non-owner occupied properties.”
[16] In other words, investment properties. While walking away from a house is never easy, a flipper can do so more painlessly than a family who actually lives in the home.
Surprising contributors to this boom bust are the builders or developers. In an article by Mara Der Hovanesian of Business Week magazine, she explains how builders got in on the mortgage lending business as a way to boost new-build home sales.
[17] Backed by investment bankers, builders were able to broker the same risky mortgage products to customers desiring new-build homes. This enabled builders to move inventory faster and provide “one-stop” shopping to their clients. Unfortunately, like the situation with the mortgage brokers and subprime lenders, builders often offered loans to people with less than desirable credit and sometimes encouraged prospective buyers to falsify information on their loan applications. Many borrowers have also complained that these builders/lenders neglected to spell out the terms of their loans and underestimated expenses such as property taxes and home owners association fees. The Securities and Exchange Commission, the Justice Department, and several Attorney General Offices are investigating complaints regarding builders who have mislead homebuyers.
The Aftermath of the “Burst”
From July 2004 to September 2007, the prime increased to 8.25 percent. This has created a dramatic increase in mortgage payments. Most people with an adjustable rate mortgage or any type of mortgage become comfortable with their payment. When it changes by a few hundred dollars per month, this can severely change a person’s entire financial situation. The Option ARM is loan that must be concerted carefully. Many people took the option because of the low payments that were set up for the first few months. The minimum monthly payments consisted of initially low rates, which for the most part didn’t cover all interest owed creating a negative amortization.
Why would anyone consider this option of paying back so much in interest without touching the principle? A thought that buyers relied on was that the market was booming so rapidly. Even if they did not pay into their equity, they could just sell the home in a few years and still make a profit.
Unfortunately, the market did not continue the path it was following these past few years. As the market started to decline, the interest was continually increasing while the housing values are going down. Now, many people are barely staying afloat or walking away from these properties all together. If this isn’t bad enough, some buyers could also be subject to prepayment penalties. These usually consist of penalty of 3% of the balance within the first year, 2% in the second year and 1% in the third year. There is really no positive outlook if someone has been caught up in this situation. The only hope is to get out before more money is lost.
For example, San Diego, one of the priciest areas in the United States, boasted a median home value of $579,000 in 2006
[18]. It is astonishing to learn, in spite of this, that the median family income in San Diego is only $59,775
[19]. In August of 2007, some areas of San Diego saw a 14% decrease in home values.
[20] Imagine paying over $500,000 for a home and the following year it is worth $70,000 less than what you paid!
Many people caught up in this disaster were forced to file for foreclosure. In 2006 there were 1.2 million homes that had foreclosure filings. This number was up 42 percent from 2005. With so many people creating problems on their credit, this also sets up problems for purchases in years to come. A foreclose is one of the worst black spots that can appear on a credit report. It takes many years to rebuild a credit score after taking such a great hit.
The Bigger Picture
The results of risky lending practices are killing both the housing and lending markets. More and more borrows are unable to make their adjustable rate mortgage payments every time there is a reset. Homeowners who are trying to get out from under their heavy mortgage(s – if they have two) cannot sell their house because of the surplus of homes on the market. Foreclosure rates in August were up 36% from July, with a total of 243,947 foreclosure filings in the month of August alone.
[21] [As of October, this number has jumped to 49% from September]. Subprime lenders are declaring bankruptcy, going out of business, and slimming down. The largest subprime lender in the United States, Countrywide Financial, is planning to lay off more than 20% of its workforce which tallies to about 12,000 employees.
[22]
While people living in a stable housing market might scoff at the messes in New York, Las Vegas, Atlantic City, Sarasota, Riverside, Phoenix, Miami, and other areas in crisis, the rest of our economy could suffer. We have already seen more than 21,000 job cuts in the housing and finance sectors just in August alone and with the subprime meltdown, more jobs are sure to be lost. With the loss of these high-paying jobs comes the loss of consumer spending. In an article written by the Christian Science Monitor for MSN Money, they speculate that other areas of the economy will begin to hurt, too.
“Many of these jobs in finance and real estate are relatively high-paying, which has helped car dealerships and high-end retailers. To be sure, all sorts of jobs are affected, because when a house changes hands, a small army of brokers, appraisers, pest-control inspectors, title searchers and lawyers send out invoices.”[23]With all of these people losing business or becoming unemployed, it is not surprising that The Economist magazine reports big box retailer, Wal-mart, is offering sorry predictions for its profits for the remainder of 2007. The article adds further doom by stating that “sagging confidence, as a result of falling markets and troubles in the banks, would only make matters worse.”
[24]
The Economist sees another, larger problem. Foreign investors in the United States bank funds and the stock market are panicked. They report that “margin calls have forced hedge funds to raise cash that has often meant purging their most liquid assets, such as oil. Speculative selling, as well as fears about the health of the American economy, have dragged oil prices well below their peak…”
There have even been predictions of a recession. Dean Baker, co-director of the Washington-based Center for Economic and Policy Research, foresaw what USA Today writer Barbara Hagenbaugh calls a “housing-led recession.”
[25] CEO Richard Syron of Freddie Mac (Federal Home Loan Mortgage Corporation) is also boldly forecasting a “40-45% chance of a recession” because of falling dollar prices and rising oil prices – typical inflation indicators of a possible economy downturn.
[26]
Help for Homeowners
With such a glum outlook for the housing and mortgage markets, not to mention our entire economy, what can be done to fix our current problems and prevent such an occurrence in the future? Ours is not a free market economy and the government has deemed it necessary to step in and bail us out (though many argue Greenspan and the feds were the reason for this mess to begin with because of the how long interest rates stayed so low). Government agencies have already taken initiatives to help those directly affected by the housing and lending mess. There are several other programs in the works which will not only aid homeowners in need, but will also assist future home buyers in making sound borrowing decisions.
Senior writer for CNN Money.com, Jeanne Sahadi, reports about the types of programs that are available now or could become available in the future for troubled homeowners.
[27] First, the Federal Housing Administration has set up a program called the “FHA Secure Act.” This act will grant many current ARM mortgage holders the ability to refinance when they were not able to do so before because of formerly strict FHA refinancing guidelines.
This act will also give relief to some homeowners who are behind on their mortgage payments. The FHA has begun making interest free loans to borrowers who are four to 12 months behind. These loans will make borrowers current with their lenders and do not need paid back until the home is sold or the mortgage paid off. Another option offered by the FHA for delinquents is the ability to refinance into an FHA loan. Sahadi states that “even with the premiums FHA charges, an FHA-insured loan could save a borrower $100 or more a month for every $100,000 borrowed compared to the payments they'd owe under an adjustable-rate mortgage that readjusts upward by 3 percentage points.”
In the works are more efforts to help homeowners in distress. Currently, homeowners with jumbo mortgages would be ineligible to participate in the FHA Secure Act program because the loan limits are in the $360 thousand range for a single family home. The House is reviewing a bill to raise that limit to $417 or $500 thousand so more borrowers facing financial difficulties will be able to take advantage of refinancing with an FHA-insured loan. Another hurdle the FHA plans to address is waiving the 3% equity rule or cash equivalent. To those homeowners experiencing negative amortization, this would eliminate a potentially huge down payment in order for them to refinance.
Another problem for homeowners who have filed for foreclosure or for those who have worked with their lenders to cancel a portion of their debt is the taxable income realized under IRS tax law. According to the IRS web site, “under the tax law, if the debt wiped out through foreclosure exceeds the value of the property, the difference is normally taxable income.”
[28] Sometimes this “income” is enough to push a taxpayer into the next tax bracket.
For example, a person who owns an overvalued home cannot afford his monthly payments and cannot sell for what he owes on his mortgage. He decides to walk. He files for foreclosure, the bank takes possession, and he is no longer responsible for this loan. The bank is unable to sell the house for what is owed on it and takes a moderate loss at auction. Come tax time, the original borrower will receive a 1099-C Cancellation of Debt form from his prior lender for the amount the bank could not recoup on his outstanding loan. He will have to treat this as taxable income and depending on the amount forgiven, he will most likely owe tax liability.
President Bush’s administration has identified this problem and is attempting to work with Congress to make provisions to the tax code.
[29] On the White House web site, the transcript of President Bush’s discussion regarding homeownership financing unveils his plans to pass legislation which will help exempt taxpayers with cancelled real estate debt. Bush believes this will “make it easier for people to refinance their homes and stay in their homes.”
Bush also announced that his administration is working on a “foreclosure avoidance initiative” which would link “government sponsored enterprises,” like Freddie Mac and Fannie Mae, as well as FHA-insured lenders to homeowners in need of foreclosure counseling and refinancing. In an attempt to prevent future lending problems, Bush is also moving forward with tighter regulations for the mortgage industry. Banking regulators are working to make mortgage disclosure statements more comprehensible. Bush believes that a “better informed” borrower could be the key to prevention. Bush would also like to see more stringent lending practices so that borrowers are not given mortgages more than they can afford. The Department of Housing and Urban Development, the Department of Justice, the Federal Trade Commission, and other agencies have already launched a full-scale criminal investigation into the mortgage industry.
The Bush administration has also formed a coalition to try to help the two million borrowers who will be facing the ARM reset at the end of the year. Joined by mortgage service companies, counseling agencies, investors, and large trade organizations, the “HOPE NOW” initiative will work to help borrowers stay in their homes. More is to be announced about how this coalition plans to address the issues of falling home prices and burdensome ARM loans.
[30] Another suggestion being called for by both homeowners and lenders is to freeze the ARM rates. In general, banks do not like to repossess a home because it looks bad on their books, they usually do not recoup all of their court and filing costs, and with housing prices going so low, they could end up upside down on the deal. It would be in their best interests to work out a deal with the homeowner to keep them on track with their payments and to keep them in their homes. Federal Deposit Insurance Corp. Chairman Sheila Bair comments on the CNN Money web site: “Keep it at the starter rate. Convert it into a fixed rate. Make it permanent. And get on with it.”
[31] It is unlikely that this will occur, however, as investors and borrowers with fixed mortgages would be slighted in the process.
An Opportunity Presents Itself
If you are a person looking to invest in the near future, it is wise to take caution. Even though there are still good investments to be made, make sure you do the necessary research before investing your funds. As the real estate market declines, it could be a good time for buyers to pick up a home. Keep in mind, however, the market could go lower.
As we see how fast the housing market increased and decreased we must realize that this will most likely occur again. The market will decrease to a certain point and the homes for sale will generally become lower and market should be able to rebound. It would need to keep a smaller appreciating level so this bubble does not occur again.
Hope for the Future?
Economists, businesses, and government officials are split about what the future has in store for home prices, the lending industry, and our economy in general. Predictions range from double-digit housing decline to a widespread market cooling to a two to five year full recovery. While it is impossible to predict the outcome of the economy, we are sure to see more government intervention in the lending sector and more public programs aimed to educate potential borrowers. Will these efforts prevent another housing bubble or mortgage market crash? Hopefully, but to be sure, it is up to us to be wise consumers and educated citizens.
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