Why Buy a House?

This is the first of a 2-part series about the 2008 financial crisis

The heading might seem quite ambiguous but the way I see things this stood out to be the most fundamental factor which steered the whole 2008 financial crisis.

Buying a house is a significant financial decision. It requires notable clarity regarding the expectations one has in the long term perspective because chances are if you’re like most people, you won’t be paying for the house in total cash upfront. You would be relying on the mortgages, which tend to be ‘expensive’ and ‘long term’.

A Mortgage is an example of a secured loan (backed by underlying security) that makes it different from a loan that you might take out to buy a Car or by simply racking up credit card debt as those are unsecured. Suppose I want to borrow a Mortgage (secured loan) for my house of about 100k, then the bank would say, “That’s fine, but we’ll need the loan secured on the asset you plan to buy (the house)”. The benefit is that Secured loans tend to have a much lower interest rate (5–9%) than your typical credit card (~30% ), but that’s only the upside; if you fail to repay it or keep up with the repayments, the bank has the right to seize the property.

Until about 2006 if anybody asked a broker about the real estate prices they’d always tell people that on nationwide average, housing always went up in price.

There could be layoffs or shutting down of industries in certain parts of a country but on a nationwide scale, the prices always go up.

And that for the most part has been true as the housing prices have been growing at about 1% or so since the great depression, maybe a little less in real terms.

But something amazing happened at the beginning of the 2000s,

This is the Case-Shiller index; it roughly compares the price one would have to pay for the same property.

According to this, a house that cost about 100k in 2000 went up to 146k in 2004, i.e. in a span of 4 years, housing prices increased by 46% and by 2006 where they had peaked the prices increased by about 88%, almost doubling since 2000.

So an obvious question arises, “Why did this happen, what drove the price to increase so fast when in the history of the USA, the price has never increased as such (look at the slope of the graph)?”

This question is even more amusing considering what was happening in the global economy in general, since for the prices to increase, on a fundamental level the demand has to outpace the supply.

So let’s look at the possible demand drivers:

• Population goes up faster than new homes built
• Incomes go up

From 2000 to 2004 population increased by about ~1.5% But the average income per capita declined by about ~3% During the same period, the supply of homes went up by 6%

Reference: https://www.nytimes.com/2006/11/28/business/28tax.html

That is to say, the actual money out there to pay for the house went down at the same time as the number of houses increased yet over this same period the prices of houses shot up by 46% and continued to race up till 2006 where it increased by about 88% relative to 2000.

This is bizarre since basic economics tells us that if the supply is increasing and the demand is decreasing, prices if anything should come down, so what happened? They not only didn’t go down but increased faster than they ever did in the history of the United States !!!

But people seemed to not care much about questions such as “why is that even though the workers in California were getting laid off due to an increase in programming jobs being outsourced to countries like India thus essentially decreasing the demand for housing yet for some reason the housing prices keep going up? "

What went wrong?

Before I explain why the housing price skyrocketed in the early 2000s and eventually collapsed, we need to look at how the mortgage markets used to be before things got out of control.

But first, let us understand the asset-liability relationship with respect to the house purchase.

Suppose there is a house with a price tag of 100k; chances are, if we are in a sound economy, banks won’t be lending you the entire cost of the house. Let’s say they agree to grant you a mortgage of 70k, then the additional 30k down payment that you’ll put in towards the purchase of the house is your equity.

Thus, in case there is a fall in the housing value and even if you aren’t able to do the repayments due to various reasons like Layoffs, etc. then the bank would still be able to recover their principle if the house price doesn’t dip below the liability (Row 3).

In the case of row 2, it is only the owner of the house who’ll be taking the loss but if the price falls below the initial liability and the owner can’t repay the bank then it would not only wipe the owner’s equity but the bank would also end up taking a loss of 10k.

But if it’s the case of row 4 then both the bank and the owner are happy as the house turned out to be a good investment.

The Good Old Days

Let’s go back to the mid-80s, a house (say in New Orleans) cost roughly $60k. Back then, to buy a house, a family had to put a down payment of roughly 25%, i.e. about 15k in this case and then the banks gave them a mortgage of 45k. The interest rate used to be a lot higher back then and hovered around 9%. So a family would have to pay an interest of $4050 per year on this specific mortgage.

This is, by no means, a small sum. You would need a hefty down payment and then a ‘steady job’ to facilitate that mortgage which when coupled with the requirement of a good credit score made it very difficult for low-income families or families with less stable jobs to buy a house.

As we went through the decade, the stakeholders started lowering the lending standards.

The table is only to provide readers with a general sense of the situation

By 2004–2005 the situation got even worse, there were mortgages handed out on the basis of ‘stated income’ (called ‘liar loans’). These terms essentially mean “No down payment, no job verification”

With these freer standards suddenly a significant part of the population could buy a house and the aggregate demand increased even though nobody had any ‘real’ increase in their income.

This resulted in people with income as low as 35k (Including migrant labourers) taking on mortgages as huge as 1 million in hope that when the housing price would appreciate they would be able to make up for this humungous liability with the ‘Theoretically increased’ equity. This clearly didn’t happen and in such a situation, they lost not only their home to the banks after defaulting on mortgages but also their initial down payment capital.

‘But as the economy is in poor shape and as the banks have realized their mistake, they won’t be giving out new loans as easily, thus there would be fewer potential buyers.’ Consequently the auction price of the house might decline sufficiently below the risk tolerance level of banks (the mortgage initially handed out), and in the 2008 crisis, this decline not only wiped the ‘owners’ equity but also significantly reduced banks’ asset as the person couldn’t even pay back the principal.

But an obvious question arises here.

Why Did the financing kept getting easier and easier?

Wait for the 2nd part to find out : )