Wednesday, October 24, 2007

Housing Bubble or Credit Bubble

The Big Picture notes that what we're seeing here is not the result of a bubble in housing prices, but of a bubble in credit:

We can define a bubble as a “trade in high volumes at prices that are considerably at variance from intrinsic values." By that definition, I'm not so sure Housing was a true bubble -- the run up in prices, a doubling over the course of about 7 years, was actually a rational market response to interest rates being dropped to generational (46 year) lows. Trading volumes moved up, but proportionately so. Compare that with the Nasdaq, which doubled from October 1999 to March 2000 on a dynamic of a new paradigm. Trading volumes skyrocketed. When it was over, the Nazz had plummeted 78%.

House prices normally fluctuate in response to interest rate changes due to how they are financed. An example I used a few years ago: The first house I owned had a $300,000 mortgage. Back when interest rates were over 9%, the monthly payment would equal $2,632.71 (30 year fixed 10% mortgage). When mortgage rates plummeted, a buyer could finance a $500,000 purchase with a 6% fixed mortgage for a monthly payment of $2,997.75.

That easy credit resulted in part because lenders no longer worried about whether the loans would be repayed. Instead, they repackaged and sold off their loans through mortgage backed securities:

This drop in lending standards and absurdly easy credit is where things truly went awry: Despite the incredibly accommodative interest rates, lenders simply stopped being concerned about the borrowers' ability to repay loans. My favorite example: California strawberry picker Alberto Ramirez, who despite earning just $14,000 a year, was able to obtain a mortgage to buy a home for $720,000.

The assumption appeared to be that lenders could simply sell the mortgages to Wall Street to be securitized, without worries about delinquencies, defaults and foreclosures.

At the end of the day, it's the investors who purchased CDOs consisting of mortgages owed by strawberry pickers who are going to feel the bubble pop.

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