It’s a Lending Bubble Stupid

I have been following the residential housing market closely for many now years and have tried over and over to make the case to friends, colleagues and family members that reduced lending standards were the primary driver behind skyrocketing real estate prices over the past five years; not the economy, not interest rates and certainly not immigrants, which is a favorite fallback rationale for the mortgage industry and the real estate trade groups. As I now watch the sub-prime lending market disintegrate in front of my eyes, I am reminded by a letter I wrote in 2002 in response to a Boston Globe article on the residential real estate market, which addresses this point head on:

Professor Segel,

I was very interested in the Globe article this weekend about the real estate bubble debate. Halfway though, I noticed your quote on the top of the page. I have studied this subject very closely and do believe there is a major real estate bubble in certain residential markets. In many of the recent articles on the current real estate market, I have seen that it is common for the author to point out that prices are likely to slow because the personal income to house price ratio is so high. I find it interesting that the same authors often fail to point out the major cause of the this deviation; the lax lending standards and creative new loan products that that allow people to buy more house than I believe they can really afford. This ratio will continue to widen and prices will continue to rise so long as the banks are free to leave people out to hang on their debt levels. I am not sure if Freddie and Fannie are solely to blame for all of this, but many of the loan products today put the buyer in a position to heavily depend on property appreciation in order to build equity. This is why even 2-3 years of flat prices would put many current borrowers in a bind. It also amazes me that people are able to borrow up to 40% of their monthly income for a mortgage when the old standard was about 28%. Also, ten years ago the average person put down 10% on their house, today it is barely 3%. Banks don’t exist to counsel people on being responsible about their finances and many people are in a position where they will crush under their debt with any little bump in the road or when they run out of room to borrow against their property. This is exactly what is playing out in the business world for the formerly leveraged high flyers.

Banks keep making these loans, because they can turn around and sell them the next day and not worry about the risk. How many of these loans would they make if they had to hold onto them? I think it is the norm these days for couples to have two student loans, two car payments and a nice big mortgage. We are also in a situation where many people that have done cash out-refi’s at these very high valuations. Even a small dip could put a lot of homeowners in big trouble and potentially even owing more than their house is worth.

The internet bubble was famous for phrase such as “new paradigm”,” it’s different this time” and “there are new rules”. I think that the lending industry is reaching a similar bubble thanks to many of the new products I have read about lately including 40 year loans, 0 principal loans and even negative amortization loans (where you owe more as you go on). These are all billed by the banks as way to help you afford more house now, without having to pay until later when you will likely have a higher income. Doesn’t this describe 99% of all people in this country? It’s the difference between saving to buy a car and needing the car now, but paying for it for the next five years.

Something has to give. If the banks get gun-shy or Freddie Mac and Fannie Mae come under a lot of public pressure, we could quickly find that their aren’t enough chairs to go around when the music stops. I just read an article in which the author overlaid the last stock market crash against the last real estate crash. The real estate crash did not come until a few years later, after many people had blindly invested in real estate as a knee jerk reaction to having been burned in the stock market. If you listen around the water cooler these days, it is the same phenomenon, even in the face of the worst job market in 10 years. People don’t believe that real estate can go down, which is why it probably will. Rates won’t stay at 40 year lows forever and as they move up to fight off deflation and strengthen the dollar, I think some people are in for a world of hurt. And it affects us all, because in 20-30 years, the government will be picking up the tab with Medicare and Social Security because many individuals will not be able to save for their retirement due to most of their income going towards their home.

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