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The Housing Bubble was a Credit Bubble

Published by Lawrence Roberts | December 26th 2008 | Views:

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The Great Housing Bubble was not really about housing; it was about credit. Most financial bubbles are the result of an expansion of credit, and the Great Housing Bubble was no exception. Housing just happened to be the asset class into which this capital flowed. It could have been stocks or commodities just as easily, and if the government gets too aggressive in its actions to prevent a collapse in housing prices, the liquidity intended to prop up real estate prices will likely flow into some other asset class creating yet another asset price bubble.

The root causes of the Great Housing Bubble can be traced back to four interrelated factors:

1. Separation of origination, servicing, and portfolio holding in the lending industry.
2. Innovation in structured finance and the expansion of the secondary mortgage market.
3. The lowering of lending standards and the growth of subprime lending.
4. Lower FED funds rates as an indirect and minor force.

As the secondary mortgage market continued to grow, lending institutions began to sell the loans they originated rather than keeping them in their own portfolios. The banks began to make money by originating and servicing loans rather than by keeping them and earning interest. This was a radical change in lending practices and incentives; lending institutions stopped being concerned with the quality of the loans because they did not keep them, and instead they became verns to those with low FICO scores in great volume: subprime borrowers. When combined with the widespread belief that home prices would never go down, the combination inflated the Great Housing Bubble.

Subprime lending as an industry barely existed prior to 1994. There were few lenders willing to loan to people with poor credit, and there was no secondary market to purchase these loans if they were originated. The growth of subprime was the direct result of the lowering of lending standards created by the change of incentives brought about the creation of the secondary market. These factors alone were not enough to create the Great Housing Bubble, but they provided the basic infrastructure to allow the delivery of capital that caused house prices to take flight. The catalyst or precipitating factor for the price rally was the Federal Reserve's lowering of interest rates in 2001-2004.

Many mistakenly believe the lower interest rates themselves were responsible by directly lowering mortgage interest rates. This is not accurate. Mortgage interest rates declined during this period, and this did allow borrowers to finance somewhat larger sums with the same monthly loan payment, but this was not sufficient to inflate the housing bubble. The lower Federal Funds rate caused an expansion of the money supply, and it lowered bank savings rates to such low levels that investors sought other investments with higher yields. It was this increased liquidity and quest for yield that drove huge sums of money into mortgage loans.

The Great Housing Bubble was inflated by a massive expansion of credit. There were a number of precipitating factors, but once the price rally got going, it was a self-reinforcing feedback loop where rising prices stimulated more buying and caused prices to continue rising. When the credit stimulus was removed from the system during a default-induced credit crunch, the credit stimulus was removed, and prices crashed back down to fundamental valuations seen prior to the bubble.
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