The Real Estate Bubble

For a decade housing prices rose nationally at unsustainable rates. There were many forces which contributed to this incredible rate of appreciation. The most visible participants fall loosely into three categories.

The continuum of entities which facilitated mortgage issuances was the most visible group as these were the larger, more recognizable participants. Investment banks, rating agencies, lenders and mortgage brokers were compensated through fees based on the number and dollar size of the mortgage volumes they facilitated. The individuals that facilitated home transactions at the local level were also active and vital cogs in the Housing Bubble machinery. Real estate appraisers and brokers execute home purchases but also exist, in theory, to bring rationality and experience to a transaction between parties without such expertise. Such, transactions and mortgage originations could not have transpired without complicit buyers and investors who willingly or naively engaged in leveraged momentum investing. Each of these parties suspended common sense in favor of an optimistic perspective of the future and the pursuit of short term profits.

None of these contributions to the Housing Bubble disaster should be minimized, especially when it comes to adopting restrictions on future activities designed to prevent such abuses from recurring or when it comes to punishing those criminally liable.

Another interesting contributor to the phenomenon was the Federal Reserve and Alan Greenspan. His decision to cut interest rates to historical lows created the conditions necessary to propel the Housing Bubble into a more frenzied state and made an economic collapse inevitable. The Federal Reserve’s initial interest rate cuts may have seemed reasonable given the Internet Bubble inspired economic downturn. Greenspan’s actions were understandably complicated by the tragedy of September 11th. Regardless of these factors, the severity of the interest rates cuts and their persistence exacerbated the Housing Bubble, diverted large sums of capital to house construction and home purchases, and directly contributed to the housing mania from 2002 through 2006.

The subprime securitization model further facilitated the home construction and mortgage boom. Investment bankers and credit rating agencies failed to appreciate the risks of subprime securitizations being sold to investors. Excessive amounts of capital were attracted to and invested in U.S. housing based on false assumptions and facilitated by the rosy mathematics of securitizations. The securitization model changed from the repackaging and sale of sound mortgages generated at the local level, to attracting large sources of capital that could be profitably deposited in home mortgages. Mortgages were no longer exclusively driving the need for securitizations. The ability of investment banks to attract capital was in some degree driving a demand for mortgage product regardless of quality. This dynamic distorted the risk profile of some mortgages.

There is plenty of blame to go around for causing the Housing Bubble. The forces listed above defined the mania of the latter years of the housing boom. In reality, though, the Housing Bubble had been percolating for years before any of these abuses rose to prominence or began distorting the market.

When did the Housing Bubble Begin?

While a detailed analysis of the predictable and inevitable excesses of capitalism during the latter years of the mania is interesting, an analysis of the root cause of the phenomenon is necessary to gain a real understanding of the Housing Bubble.

Any analysis of national housing appreciation rates or of most local markets which defined the Housing Bubble definitively demonstrates that the phenomenon began between 1996 and 1997. National and city-specific prices began to rise during this period after having stagnated for years. Price appreciation began to outpace inflation and accelerated uniformly until the Housing Bubble hit the wall in 2005 and 2006.

I have included S&P/Case Schiller Home Price charts for cumulative index value and annualized rate of appreciation. These charts reflect the performance of a specific pool of the largest cities in the United States, but are demonstrative of the national appreciation phenomenon. A city by city review of the same data reveals the abruptness with which prices accelerated nationally during this time frame.