Transcript | 2. lecture: Mortgage Bubble - University for modern Slovakia

As we mentioned in the previous lecture, mortgage bubble was inflated in the years 1998 - 2006 and was significantly driven by FED's expansionary monetary policy, which wanted to avoid a recession after the dot-com bubble burst in 2000. What happened and why did it happen? We have already mentioned that the recession after the internet bubble burst was first during which the prices of real estate had not fallen. The most important cause of inflating the real estate bubble, according to the Austrian school, is the FED policy, which is also partially the opinion of Krugman, who criticize Greenspan for being unsuccessful in identifying and eliminating the "irrational exuberances on asset markets".  

Another fundamental cause lies in the policies of the U.S. government (Clinton and Bush), which through artificial interventions increased the supply and demand for mortgages in order to expand the middle class and improve the availability of housing. How did the government achieve that? Here are the most important tools. The government pressured banks to relax the lending requirements for mortgage applicants. They specifically used the Community Reinvestment Act (CRA) originating from the era of Jimmy Carter, to which the Clinton government had breathed a new life and which meant for banks a threat of lawsuits if they were not to give out loans to minorities (e.g. Hispanics or African Americans) in extent deemed sufficient by the government.

There is ample evidence of direct and indirect political pressure on banks in order to ensure more accessible housing for disadvantaged groups of population. It should be added that banks were easy to convince to provide high-risk loans benefiting from the rapidly growing market, which accelerated the bubble inflation. Later, we will explain that the market had grown rapidly also because of new financial instruments, and financial globalization multiplied and internationalized the volume of resources that were circulating in this business.

Another instrument that was used by the U.S. and that further inflated the mortgage bubble was the tax policy. Interest on mortgages is an important tax-deductible item, through which the state benefits the purchase of real estate with mortgage compared to lease or purchase for cash. Moreover, the sale of property is also exempt of tax, which greatly strengthened the motivation of purchasing real estate as an investment, i.e. purchase and subsequent resale.

Fannie Mae and Freddie Mac also inflated the bubble, which are giant, state-sponsored mortgage agencies, which do not provide direct mortgage loans, but purchase mortgage from banks on the so-called secondary market. The bank gives a mortgage loan and promptly sells it to one of the FM, which will keep them or further sell them through various mortgage derivates. FM & FM are very special institutions. Although they are listed on the New York Stock Exchange (NYSE), they are also connected to the state and have very special privileges, such as exemption from regulation of financial markets, exemption of tax on capital adequacy, but mainly implicit government guarantees in the event of their insolvency, which was confirmed in September 2008, when the U.S. government took over (nationalized) both institutions.

The key role that played FM & FM in inflating the mortgage bubble is confirmed by the fact that while, prior to the bubble inflation, they were only small players on the secondary mortgage market, and on the eve of forced nationalization they possessed half of the existing and two thirds of new mortgages. A large amount of cheap money in the market, political pressure to provide mortgages along with the general belief that the prices of real estate cannot fall, together with increasing revenues in this market had led to a relaxing of requirements under which mortgages were provided.

Banks literally pushed the mortgage loans to people, without any down payment, without any warranty. Anyone could get a mortgage, with no problem whatsoever, on a house, whether new or in which he already lived, for its full value, and only had to underwrite this house or apartment. And meanwhile the prices kept growing, leading to massive increase in investments in real estates. It is estimated that in the couple of years prior to the crisis, speculative purchases of real estate (i.e. buying a house for a lower price and then reselling it for a higher), comprised up to a quarter of the entire real estate market. Why did the bubble grow so quickly and why did it burst so suddenly, I will explain on the example of buying an apartment in the value of 100k USD.

Prices are growing and you believe they continue to do so, banks are offering you cheap mortgage without down payment and all you need to underwrite is the apartment itself. You take the mortgage, buy an apartment and in two years you sell it for 140k USD (price really grew so fast between the years 2004 and 2006), which is a decent net profit since it even is exempt of tax. In this situation with such a huge increase of free and cheap money, it is quite clear that these examples will attract mass investments, causing a rapid inflation of the bubble. This is how it went until the July 2006, when the price had stopped growing and slowly began to fall. What happened then?

Imagine that you purchase the very same apartment in 2006. You paid 140k USD and after two years (when you were only repaying the interests, not principals) your apartment has a value of 100k USD, but you owe the bank 140k USD and you only underwrote the apartment. It is obviously advantageous for you to stop paying the mortgage installments even if you have the money. The apartment passes to the bank and you saved 40k USD. This is exactly what happened, but in epic proportions. This is why the bubble inflated so quickly and then exploded so suddenly.