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peyton_farquhar's avatar

What was the housing bubble and why did it burst?

Asked by peyton_farquhar (3741points) January 15th, 2009

In other words, I am now admitting to my profound ignorance of the current economic state.

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11 Answers

kevbo's avatar

Listen to “The Giant Pool of Money” episode of This American Life. That’s a really good starting point. They do a couple of follow up episodes within a few months of that first episode.

laureth's avatar

Remember when real estate was considered a good investment because the prices were going up and up and up some more? A lot of that was people buying houses because they were such a good investment. And people would buy houses that they couldn’t really afford, thinking that they’d just “flip” them soon and make a profit, because the price would go up. And these people, among others, would get mortgages that were too big, because it was such a good investment.

Well, the price of something can go higher than what the thing is really worth. And if a bunch of people think that the market is inflated, they no longer agree that the thing (houses, in this case) are worth that much. If you can’t get someone to buy the house, the price doesn’t go up, and that’s when the bubble “burst.”

Remember all those people getting mortgages to buy those houses? A lot of them were poor credit risks. They listened to those TV commercials that promised mortgages “for bad credit, no credit, no money down, we’ll put anyone in a house.” And everyone was very surprised when people defaulted on these mortgages. Then the bank comes in and takes the house, for people all over the country that default. Suddenly there are too many houses in foreclosure, and the bad debts that are probably never going to be repaid echo throughout the economy.

Then, with so many foreclosed houses sitting there, they cause the value of the other houses to go down. One reason is because there’s no one taking care of it anymore, and it becomes a blight in the neighborhood. Also, foreclosed houses sell for much cheaper, driving down the prices of other houses trying to compete in a buyer’s market. And when the value of all the houses everywhere go down, suddenly a lot of people owe more on their mortgage than the house is “worth.” Some walk away and let it be foreclosed at that point, beginning the cycle again, like a big row of dominoes falling over.

That’s pretty much the story in a nutshell. And when you realize that all those bad mortgages were sold as “good investments” to banks, retirement plans, and general investors (who now had their money sucked down a valueless black hole), that’s why the rest of the economy is collapsing, too.

SuperMouse's avatar

Laureth summed it up beautifully.

One other factor was the popularity of “hybrid loans.” These are loans that start with a rate that is fixed for approximately three or five years, and changes to an adjustable rate thereafter. Banks were qualifying borrowers for these loans based on the starting rate and often on an interest only payment. This was allowing people to get into more house then they could really afford. When the rates reset after the fixed period, the payments sometimes doubled or even tripled, and the borrowers could no longer keep up. This also led to foreclosures and the cycle Laureth describes. I remember hearing four or five years ago that this type of lending would lead to problems.

laureth's avatar

Thanks for bringing up that part too, Supermouse. That’s a huge part of what went wrong!

aprilsimnel's avatar

Why was it OK for investment banks to buy up these mortgages and turn them either into a CDO or an SIV? The Gramm-Leach-Bliley Act of 1999, where the finance industry was deregulated, and regular banks, mortgage houses, investment banks and other financial institutions were allowed to consolidate, among other things. I believe that the Act is one of the root causes of what happened. There’s a lot of opportunity to fudge electronic numbers around to create crap investment vehicles, boost “profits” and “cancel” debt if your financial institution owns insurance divisions, securities trading, investment banking, credit companies, mortgage houses, etc. And those opportunities were taken. I know President Clinton thinks the Act was swell stuff, but then he would want to stick up for a horrible piece of legislation passed under his watch. Otherwise, it tanishes the ol’ legacy. Bah!

That 1999 act cancelled out part of the Glass-Steagall Act of 1933 that was intended to put the brakes on speculation, which is the term for the events that both Laureth and SuperMouse have described.

critter1982's avatar

The housing bubble started by high end consumption (>$500,000 homes), and supplemented by deregulation of financial lending. This put more people in the market for homes and therefore higher demand for the same home which increased home prices. The problem was that this was an artificially created high demand because of the deregulation and therefore artificially generated home appreciation. Now with the credit freeze most people can no longer buy homes and many people are even losing their home because they can’t afford it. Now there is a much lower demand for homes with a large supply hence the bubble burst. The pendulum swung the opposite way from where it was 2 years ago. Like pendulums do though, it will swing back. Capitalism lends itself to these types of things, and it’s really only govt. regulation that tends to controls how much the pendulum actually swings.

SquirrelEStuff's avatar

Just wait til the dollar bubble bursts. Replace housing, in Laureths explanation, with dollars, and you have the same bubble with the good ol dollar bursting, just as the founding fathers said would happen with paper money.

How are we supposed to pay the 8.5 Trillion promised in the bailout after the dollar bubble bursts?

The explanations in this thread for the bubble were all great. However, no one mentioned the cause for the bubbles. It is the federal reserve’s ability to print money, injecting it into the economy, causing inflated bubbles, which eventually burst, screwing us, while funneling money to the top 1% who control everything.
If you think Obama will help us, his top two economic guys are both from the federal reserve, which is why he plans on injecting more money into the economy, which is what caused the problem to begin with. You can’t fight inflation, with more inflation.

If our whole society depends on credit, we will be constant wage slaves to the banks and corporations that “give” us the credit.

critter1982's avatar

@chris: I agree with you except for your statement that the cause of the housing bubble was the federal reserve printing money. The housing bubble was created by incredibly low interest rates, deregulation, and speculation.

SquirrelEStuff's avatar

Lowering interest rates is how the fed essentially prints money. When interest rates are lowered, lending tends to grow, which created new debt, which becomes new money.

aprilsimnel's avatar

::sigh:: Anybody have a wheelbarrow?

critter1982's avatar

@chris: Okay I see your point.

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