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How the Real Estate Market Got Here Today

With the second homebuyer’s tax credit set to expire today (April 30, 2010) and the Fed deciding to keep interest rates at historical lows this week, let me briefly recap how we got here.

A very large driver of the financial crisis was the out of control expansion of subprime mortgages.  While home prices played a central role, it was the widespread ignorance of the risks associated with the subprime mortgages and unsustainable home price appreciation laid the groundwork for the crisis.

Home price appreciation was first fueled by a historic drop in prime interest rates in response to the economic slowdown immediately following 9-11.  Low interest rates by themselves may not have caused such a large housing bubble.  With the introduction of various subprime mortgage vehicles and a relaxation of mortgage underwriting, this lead to an increase in housing demand that significantly increased home prices.

The securitization of mortgage back securities was on the rise because, historically, mortgages had been considered almost as safe and predictable as U.S. Treasuries but with higher returns.  When returns on U.S. Treasuries fell to historic lows, these higher returns caused the demand for mortgage backed securities to skyrocket.

For a while this looked like a good bet, because investors did not have the data needed to understand the true risks they were assuming.  In my opinion the causes of the subprime mortgage crisis were:

• Historically low interest rates for an extended period of time.

• Poor underwriting of subprime mortgage borrowers with respect to their ability to meet their mortgage obligation, due to the incentives to maximize product for the securitization market.

• No consideration regarding a correction in housing prices and the impact it would have on subprime borrowers.

• No single party responsible for the performance of the securitized portfolio.

• Investors not understanding the investment, only relying on the ratings of the securitized cash flows.

Once subprime mortgages influence home prices, the impact of this caused a false economic stimulus in employment growth from increasing housing demand fostered by record housing starts, which hid manufacturing employment weakness.  Home equity turned into an ATM for people.  This “newly created” money fueled the economy for several years.  But eventually the housing party came to an end…


April 30, 2010 - Posted by | Uncategorized |

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