While boom/bust cycles meander up and down over decades—usually in correlation with the economy as a whole—housing bubbles can spring up anywhere, at any time, independent of larger economic factors. But what makes the current situation unique is that the traditionally local industry of housing appears to have succumbed to a nationwide housing bubble.
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Housing bubbles generally occur in areas of the country where demand is incredibly high. For example, there have been numerous bubbles in Southern California due in large part to its desirable location, appealing climate, and thriving economic base—qualities that make it attractive to consumers. Housing bubbles can also coincide with a rise in a particular localized industry. Similarly, the discovery of a natural resource in an area, such as oil, can fuel housing bubbles.
But with a country as vast and regionally diverse as the United States, how is it that a nationwide housing bubble could form?
One reason, according to Seiders, was the availability of cheap money to homebuyers throughout the country. “Clearly the housing finance system fueled this buying activity whether by owner occupants or by investors,” he said.
The housing credit system that exists today is very different from the system that had successfully provided mortgages to homeowners for more than a century. Recently, the whole manner in which houses are bought and paid for morphed into a much more aggressive enterprise. Banks and mortgage companies began offering loans to borrowers regardless of credit history (so-called subprime loans), down payments were no longer required, and low initial interest rates—often referred to as “teaser” rates because they teased buyers with manageable monthly payments before adjusting to much higher rates after a few years—allowed buyers to purchase homes they simply couldn’t afford.
In contrast, the old system was much more conservative. Underwriting standards were very strict, 10 to 20 percent down payments were often required, and when a mortgage was issued to a buyer, the lending institution that issued the loan was the same that provided the money.
According to Seiders, the new system was built on the principle of “originate and distribute” in which mortgage brokers (with no financial obligation whatsoever) sold mortgages to homebuyers on commission. The incentive in this system is to sell product, not necessarily to prove the borrower is qualified to receive—and can actually afford—the loan. These mortgages would then be packaged with other mortgages into enormous hedge-funds (sometimes worth billions of dollars) and traded on international financial markets by investors around the globe.
The collapse of the subprime lending market earlier this year is due in large part, according to Seiders, to the failure of accurately reporting the risk associated with packaged mortgage securities. "One of the villains [in this] are the financial rating agencies," he said. "The investment community was depending on these agencies to tell them something about how risky [the investments were]."
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