In Part 1, I asked why the mortgage mess happened, and why did it happen when it did.
Part 2 explains the role of the Great Moderation and the mild housing cycle in the 2001 recession.
Part 3 explains the role played by securitization of mortgages.
Now I explain how the last recession set in place the triggers for the present mortgage mess.
Let's remind ourselves of the strength of the housing market thanks to the Great Moderation and the mild housing cycle of 2001. If a mortgagee could not make payments, there was no problem for the mortgage-backed investor. Home appreciation meant that borrowers could simply sell at a profit if unable to make payments--or they might refinance and use the cash for another year's payments. Or in a worst case, the mortgage servicer foreclosed, but there was no loss because the house sold for more than the principal due on the loan.
These were to two main ingredients of the mortgage mess. Now let's talk about how they came together in the early 2000s.
The recession of 2001 brought interest rates down. The Federal Reserve began cutting short-term interest rates in early 2001, and mortgage rates also fell. Mortgages had been running in the sevens in 1999, then hit eight and a half percent in 2000. With the recession, though, demand for credit fell. That, combined with falling short-term interest rates, brought mortgage rates way down. By the end of 2002, 30-year fixed rate mortgages were available at six percent, an interest rate not seen since 1965.
Low mortgage rates brought first-time homebuyers into the market earlier than normal. There was also a great deal of shuffling around of existing home owners, as they moved from one home to another. Keep in mind that transactions of existing homeowners just push the peas around on the plate: when a family buys a new home, it is typically selling an old home, so net demand is zero. Not so with first-time homebuyers.
There's a normal life-cycle for first-time homebuyers. Young families get their finances in shape, show that they can handle debt, and accumulate a little bit of down payment. Then they buy. Well, starting in 2002, first-time homebuyers were able to buy ahead of schedule. Mortgage rates were so low that families who had expected to wait until 2004 were able to buy their first home in 2002. This trend accelerated when mortgage rates hit their low point, five and a quarter percent, in mid 2003. This interest rate was even lower than the lowest rates of the 1960s.
So housing demand was stimulated by low mortgage rates, pushing home prices up. Builders started to meet the increased demand, but it took them a while to gear up construction schedules. In the meantime, home prices accelerated. In the prior decade, the 1990s, home price appreciation had averaged a mere three percent per year. Three percent per year! But low mortgage rates changed all that. National average price measures showed six to eight percent gains in the early years of the new century. Those price gains brought out investors.
Stock prices had peaked in 2002 and fell through 2002. Even after stock prices began to rise, the levels of stock prices failed to match the earlier peaks, so stock investors were disappointed. They looked around and said, "Gee, houses sure do well. They never seem to go down, they just go up." The three percent gains of the 1990s seem puny by Wall Street standards, but stock investments are mostly unleveraged; at most, they have a 50 percent loan to value ratio. Houses can be leveraged, with 90 percent or even higher loan-to-value ratios. Here's a bit of arithmetic: if you pay 10 percent down on a house that appreciates by three percent, your equity grows by 30 percent!
Investors constituted net new demand, along with first-time homebuyers. In response to the strong demand, prices appreciated at an even faster rate. Homebuilders took this as a challenge, and housing starts rose from 1.5 million - a typical pace - to 2.3 million units, a fifty percent gain.
The growth of net new demand from first-time buyers and from investors was helped by carefree attitudes engendered by the Great Moderation, along with mortgage securitization. Mortgage investors tested the waters with lower down payments, less documentation of loans, borrowers with lower credit scores - and the tests looked good. A more conservative sort of person would have continued the tests through a real downturn, but that sort of person lost business to the mortgage investors who went full bore ahead.
Our economic history includes periods of low mortgage rates that did not lead to a disaster like we are experiencing today. No disaster occurred in those earlier eras because they pre-date the Great Moderation and mortgage securitization. The 1990s had the critical elements of the crisis, but not the trigger: low interest rates and a weak stock market.
Everything came together in the perfect storm that we now call the mortgage crisis.
Given what we've learned so far, what does the future hold for economic cycles, mortgages and the housing market? We'll address that in our final segment.