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Anatomy of the Financial Crisis: The Housing Bubble

Posted on March 9, 2010 by Adam

This is the first in a series of posts dedicated to explaining the series of events and phenomena that led up to and caused the most recent financial crisis.

The Time Magazine cover from July 13, 2005, the peak of the housing bubble, extolling the virtues of buying real estate.

There are many terms thrown around when folks talk about the financial crisis. Last year especially, the news was awash with terms like “Credit Crunch,” “Bailouts,” “Derivatives,” and you guessed it… “Housing Bubble.”

The financial crisis can seem complicated, but I view it as being very simple, and I will attempt to try and explain exactly what happened in this series of articles. I’m starting here because the crisis really started with the real estate market. If you can understand what the housing bubble was and what caused it, you can make sense of all the other events that went on among the mayhem.

Introduction to the Housing Bubble

First, some background. After the recession of 2001-2003, buying real estate was cool. As Tony Soprano would say, “Buy land, kid - they’re not making any more of it.” Whether it was due to the too-good-to-be true rates of adjustable rate mortgages, Federal regulatory policy that encouraged home ownership, and skyrocketing prices, everybody who was anybody was buying a house.

It wasn’t just wannabe homeowners either. In fact, the bubble was fueled by opportunistic institutional investors and speculators who identified value in real estate from early on. Banks, insurance, hedge funds, and loads of institutional money poured into real estate with reckless abandon, and many people made a ton of  money doing it.

As with any bubble, the housing market eventually peaked. In a twist of ironic fate, that peak likely occurred on the exact day that Time magazine published the cover shown above. If you look at a chart of Tol Brothers, TOL, one of the largest homebuilders, you will see that the stock price reached a maximum on that very day, June 13, 2005.

Toll brothers, one of the largest housing stocks, peaked on the exact day that Time published its house-loving cover.

Lending and Mortgage Speculation

Banks and other mortgage lenders, caught up in the housing frenzy, made it incredibly easy to obtain mortgages at low rates. But what exactly were these mortgages and why were they so popular?

Mortgages, like options, futures, and swaps, are derivatives that derive their value from an underlying asset. Mortgages derive their value from property. A mortgage essentially allows you to posses property at a fraction of the price, so they are a highly leveraged asset. The homeowner then becomes indebted to the bank.

Banks like to invest in mortgages because over time the homeowners will pay back the bank along with the interest accrued during the payback process. The bank then sets the rate of the mortgage using a complex risk model that theoretically takes into account all risk factors for the loan.

High risk borrowers are charged higher interest rates in order to compensate for the greater chance of default, or inability to pay back the loan. Low risk borrowers are charged lower rates, since they are less likely to default on their loans. Theoretically, the banks should make money no matter what.

Notice how I use the word, “theoretically,” when describing the risk models used by banks to determine the appropriate interest rate.

In engineering we learned that no model is perfect, and the banks’ risk models were no exception. Unexpected disturbances or variables that were not accounted for in the model may surface and cause instability. The now defunct Fannie Mae and Freddie Mac are perfect examples of mortgage lenders who developed some incredible risk models to allow them to price some very complicated adjustable rate mortgages. It turns out that they failed to account for macroeconomic factors that were beyond their control. More on that later.

It is important to keep in mind that many of the mortgages out there were not very simple. Terms abound for complicated mortgages, which were sold a dime a dozen to now homeowners. Most of these were adjustable rate mortages, or ARMs, which, unlike fixed rate contracts, were subject to changed interest rates. Many homeowners were taken by surprise when their mortgage rate increased to more than double than what they had expected to pay.

The end result of the mortgage frenzy is that hundreds of thousands, if not more, Americans were tied up in mortgages for homes they could not afford. Enticed by the sweet prospect of owning their own piece of the American dream, these men and women found themselves up to their eyeballs in debt.

The Rise of the Mortgage Backed Security

The housing bubble might not have been such an enormous problem were it not for mortgage backed securities. These securities allowed the risks assumed by various financial institutions to spread out through the entire financial sector, and may well have contributed to the violence we saw in the stock market in 2008 and 2009.

These arcane financial instruments are derivatives of derivatives, meaning that they derive value from a security that derives its value from an asset. As such, they are highly leveraged and a small move in property values can cause big value swings in the mortgage backed securities.

I am not an expert in exactly how these derivatives were constructed, but in the simplest sense, this is how I would describe them. Financial institutions took many different mortgages, sliced them up into multiple pieces, and categorized them by risk level. They then mixed pieces of equal risk level together and packaged them up into financial products and started trading them.

Picture a piece of music, written down on paper. Think of it as a derivative, in that it derives its value from a song. If there are a lot of eager musicians, lots of songs will be written, and lots of risk takers are willing to finance those musicians, in the hopes that the song will make it big like all songs seem to be doing at the moment.

Now, imagine taking that sheet music and cutting it up into sections: verses, choruses, movements, whatever. Then decide which sections are the best and which are the worst. If you own lots of different pieces of music, then you decide to compile all the good sections into one folder, the average sections into another folder, and the bad sections into another. Then you sell those folders, claiming that the buyer will have the rights to the portions of the songs included in the folder. Buyers who buy the high quality music have the best chance of making money off the folder, but they pay a high price. Buyers who purchase the bad music don’t have a very good chance of profiting, but they don’t have to spend that much.

A mortgage backed security is like a folder of good, bad, or medium music snippets, only you replace the music snippets with mortgage slices. If the value of the underlying asset, whether it be music or homes, decreases, then everyone who owns some of these securities is in big trouble.

Financial institutions took a big hit when housing prices started to fall, but the pain was exacerbated by the systematic nature of the risk and the leverage associated with these securities. The slicing and dicing of the mortgages made it very difficult to know which properties were involved with which securities, and caused risk to be spread out all over the globe. This is why the US government uses terms like systematic risk when describing the crisis. The risks taken by lenders went from being individual risks to being systematic risks. If property values tank, then the entire system fails. That is exactly what happened.

Then the Housing Bubble Burst

I don’t claim to know a whole lot about bubble economics, but what I do know is that they burst. I don’t know why they happen, but they do. As a trader I see bubbles come and go all the time. Stocks become overbought and oversold all the time. It’s a shortfall of our economic system.

When the housing bubble burst, here is what happened:

When housing prices started to fall, financial institutions that were long real estate (most of them) started to see huge losses. It was a systematic problem, due to the widespread nature of mortgage backed securities, and 30:1 leverage only added fuel to the fire.

In order to compensate, the lenders went back to their risk models, which spit out a new number. To combat the loss in value, the lenders increased rates on their borrowers. As rates went up, more homeowners defaulted on their loans.

If you bought a house thinking it was worth $1 million, putting $100,000 down, and saw its value drop to $500,000, it makes much more sense to walk away from the mortgage than it does to continue to pay out money to the bank for a house that is worth half of what you are paying for it.

Banks then raised rates more, which in turn caused more defaults, and so on, in a positive feedback cycle. The risk models used by mortgage lenders were unstable under these conditions.

All of the lenders were then left with billions of dollars in worthless homes on their balance sheets with no foreseeable prospects for making much of that money back. Trying to sell the homes at fire sale prices didn’t seem to make much sense either. Banks were facing huge losses, and it seemed that nothing they could do would fix it. Investors don’t like to see that, let me put it that way.

By early to mid 2007, most financial stocks reached a high. From there, financial stocks started to creep downhill. In order to cover all their debts, retail and institutional investors began to liquidate their assets, which, in many cases, meant selling stock. So not only did bank stock prices suffer, but the stock market as a whole started to go downhill.

Conclusion

Banks were in a tough spot. They were left with lots of bad assets and no way to get rid of them. Amidst these challenges, the banks were forced to curb their lending. Without lending, the credit markets quickly froze, and suddenly nobody could get any business done. That will be the subject of the next article in the series: The Credit Crunch.