Thursday, March 8, 2012

Housing Bubble Burst: American Style

The real estate market had been going through ups and downs in various parts of the world for a while however it probably wasn’t very noticeable until things started to spiral downward in America around the year 2005. Many had guessed correctly even during the dot com upheaval that there was a bubble forming in the real estate market. Things were being written and discussed in small scale, but nobody seemed to pay much attention. I guess when time is good why would anybody listen to such warnings? It is only then when the goliath comes crushing down people takes notice. If you are one of them who cannot make sense of the circumstances that caused the once glorious real estate market to crash down practically to dust in some parts of the country almost overnight you are not alone. Even today I doubt the so called experts can clearly explain the phenomena. Yes, it is possible to identify several primary reasons but narrowing them down can become a matter of individual perspective.

I am not an economist, my relationship with economics has been only on printed papers as I  read various columns often contributed by reputed economists to get some in depth analysis. Unfortunately time has changed, my confidence in them have waned away. As a result I have started to do my own analysis to see if I can come up with a layman proof solution to explain the mystery of the housing market fallout. One thing that had always baffled me is the situation where a house sells more than the seller asking for! Of course such anomaly happens when several buyers bid for the property – a very common observation during the peak time of real estate in America. I was living in the Boston area during that time working on a visa and thankfully stayed away from the temptation of being a home owner primarily because I did not yet have residency. However, that did not prove to be enough deterrent for some of my acquantances who had bought houses and later found them at the wrong end of the economy after losing their jobs. Many ended up forced out of the country leaving behind everything they had – house, car, furniture etc.

Anyway, lets get back to the curious point of a house selling more than the market price. It is not very dificult to figure out that the buyers were convinced that the ultimate value of the property they were about to purchase would eventually grow to such a height that their investment would return with a hefty profit. It didn’t happen, in most part of America, as we know now. Let alone profit, many homeowners either lost their homes to foreclosure or saw their equity evaporate with some even having to start their life all over again.
Now, lets try to identify the primary reasons that led up to one of the biggest man made economic disasters in American history despite being overcrowded with all kind of financial experts. 
Here are the events in chronologial order:

  • Due to the prosperity of dot com there were too much wealth floating in the market. Even though the wealth did not get equally distributed but still it trickled down to all level, more or less. As a result the overall standard of life increased, people had more buying power, there was a sense of life in the economy – one might wish for such good times to stay forever.
  • As the buying power of the general population increases so does the price of the essentials and especially the land which evidently brings up the house prices. 
  • On and after 1997 when dot com burst had started some prosperous areas took a huge beatings as a result many jobs were lost. Many had to declare bankruptcy. Many others lost a fortune in the share market. As a whole the prosperous market suddenly turned into a dead field, the so called wealth had turned into dirt.
  • In this kind of situation government is required to take some measures to help recovery of the economy. As a result they are always prone to reduce the prime lending rate as this rate can pump in new life into the economy by encouraging people to take advantage of the low rates. With the rates low the borrowers are required to pay less as monthly repayment installations and are left with some extra money in hand which they can spend on other items in the market, increasing consumer spending. Starting from the year 2000 American government continued to reduce the lending rate from 9% and went down to 4% by the end of 2003.  
  • At this point two things happened
    • People who had borrowed for higher rate refinanced their properties and received substantial amount back. As a result they now had quite a bit of disposable income which streamed into the market.
    • Another group of people who had reasonably safer jobs or wealth from other sources used their equity to buy even bigger houses. As a result demand for houses increased considerably pulling the price up as expected.
  • At this point started a new chapter in the epic story which many believe caused the actual havoc in the end.
    • As the interest rate went down many people became interested in purchasing houses, many of them neither had a good credit history nor the necessary money to deposit as a down payment. However, after the dot com burst as the market was down the businesses especially banks and investment companies were eager to pick up just about anything to bring back life into the market and rip off some profit. They eventually started to lend money to these high risk clients for zero down payments often allowing their representatives to resort to questionable means to show this potential clientele as eligible borrowers.
    • Many people who only had a modest earning took this advantage and became owner of large houses and expensive cars. As a result they started to spend practically all their earnings as living cost, about 80% of which went to the mortgage payment and other house related costs like taxes, utilities, maintenance etc. Some even went on to expensive vacations into the cherished destinations. They were basically living on the edge of a sword.
  • What happened next is not very difficult to understand. To describe in plain words
    • Anything that goes up must come down – accounting for gravity. Same happened in real estate. When the prices started to reach ridiculously high level the land pricing became target of revaluation immediately causing house price adjustments and resulted into drastic devaluation of many high priced properties.
    • At the same time to reduce inflation government had to increase the lending interest rate which went up to 7% around the end of 2007. This created another issue. As the interest rate increased the monthly mortgage payment went up too, in many cases this amount became too much for the homeowners to pay who already lived on the edge. As a result they simply walked out from their houses knowing that they risked very little to lose as they had practically no money invested in the house. Banks and investment companies now got stuck with many foreclosed houses with market filled with mostly sellers and few buyers. It eventually became so devastating that many companies could not even continue to operate while others required substantial government assistance to exist. Example – Fannie Mae, Freddie Mac.
    • From there on things continued to go down. The executives powering the banks and mortgage companies might have thought they had created a good herd of cash cows who would continue to pay interests on their long term mortgages keeping the cash flow in the market going forever but in reality their lack of sincerity, appropriate understanding of the market and possibly sheer greed had thrown the whole balance into a complete chaos causing the market to crash.  

To summarize, one might simply state that if it wasn’t for the greedy banking and investment sectors things might have not turn so bleak in such short time. Clearly the executives of the failed companies appeared to conspire against the general population showing total disregard for appropriate financial practice. As a result house market in America still going through a slow and painful recovery process with no guarantee on its eventual success.  

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