Real Estate Bubble
A real estate bubble is an increase in the price of housing which occurs uncorrelated to factors such as wages, employment, construction costs, land value and interest rates. This paper will explore the forces that converge to create a real estate bubble and the effects it has on the housing market in which it occurs. Such an analysis will help the reader better understand the elements that contributed to the global economic crisis of 2008-2010 and how those elements can adversely impact the marketplace.
Keywords: Community Reinvestment Act; Housing Bubble; Mortgage Rates; Negative Amortization; Real Estate; Recession; Shadow Banking; Subprime Lending
The 1920s were one of the most important decades in modern U.S. history. As the nation began to transition from the wartime economy of World War I to a peacetime economy, it entered a period of major prosperity. The introduction of new technologies, combined with a growing entrepreneurial spirit, charged the stock markets and spawned many "rags-to-riches" stories. However, the wealth of the "Roaring 20s" was not distributed evenly, and the economy had become dependent on the stock market. In 1929, the very source of America's wealth in the 1920s collapsed and the era of the Great Depression began. The famed American industrialist J. Paul Getty later reflected on the 1920s, saying that the "Roaring Twenties were the period of that Great American Prosperity which was built on shaky foundations" (www.brainyquote.com).
In many cases throughout history, the promise of a significant return has usually outweighed the potential risks, at least in the minds of those who engage in such activities. Such a mentality has fueled the stock market for decades, even after the cautionary example set by the infamous market crash that ended the Roaring 20s and ushered in the Great Depression. Since that era, stock market booms powered by speculative investing have been quickly reversed in recessions of varying severity. In some cases, such economic boom times have immediately followed recessions.
As the United States attempted to return to economic strength following the recession of 2001-2002, the federal government began strongly encouraging Americans to engage in a particular type of extremely risky investment. The government understood that an increased volume of real estate purchases meant more jobs (for construction workers and real estate professionals), more local and state tax revenues and greater financial assets for the new homeowner. It set out to prod more lower-income residents to take advantage of so-called "subprime" mortgages and record-low interest rates. The result was a surge in the real estate marketplace.
Unfortunately, this increase also fostered an unexpected increase in the price of real estate. Government and lenders alike turned a blind eye to this housing "bubble," allowing it to grow larger and, like a child's balloon, more fragile as it expanded. When the bubble collapsed, it led to one of the worst recessions since the Great Depression. This paper will explore the forces that converge to create a real estate bubble and the effects this concept has on the market in which it occurs. Such an analysis will help the reader better understand the elements that contributed to the global economic crisis of 2008-2010 and how those elements can adversely impact the marketplace.
The Basis for the Bubble
Put simply, a real estate bubble is an uncorrelated increase in the price of housing. Housing price increases and decreases can usually be correlated to a number of factors, such as wages, employment, construction costs, property value and, as mentioned earlier, interest rates (Bourassa, Hendershott & Murphy, 2001). When housing prices increase, but that upward trend cannot be attributed to any of these factors (or any combination thereof), a real estate bubble may be occurring. This paper will explore the most recent housing bubble, whose collapse led to the 2007-2010 global economic crisis.
It has long been accepted that home ownership is the American dream. In fact, many world leaders have stressed to their societies the virtues of home ownership. The National Association of Realtors has written that President Franklin Delano Roosevelt once said that a nation of homeowners is "unconquerable." Several decades later, British Prime Minister Margaret Thatcher moved nearly two million families living in public housing into their own homes, saying that homeowners become responsible citizens (cited in Pisillo, 2010). Indeed, for most people, the idea of owning a home is a dream worth pursuing.
However, there are many people for whom home ownership is an unattainable dream. Those with low income, poor credit or other financial issues are not typically in a position to make a sizable down payment and/or enter into a long-term mortgage as well as keep up with their other bills. Still, governments emphasize the value of owning a home, which brings with it tax credits, assets that increase in value, more flexibility in obtaining loans to reduce bills and, of course, the pride that goes with ownership. Naturally, the potential benefits of increased home ownership volumes to the local, state and the national economies are also contributors to the government's endorsement of real estate transactions.
The Community Reinvestment Act
To bridge the gulf between less affluent residents and the pursuit of home ownership, the U.S. government introduced the Community Reinvestment Act (CRA) in 1977. Part of an effort to eliminate discrimination in lending, the CRA required that banks target a portion of their loans toward low-income and racially concentrated communities (Holyoke, 2004). Some observers see the CRA as the catalyst for the growth of low-income-oriented mortgages, a highly risky venture for lenders. Others shy away from blaming the CRA for contributing to that trend, citing its value as a piece of public policy that levels the playing field (Aalbers, 2009). Regardless of the veracity of either argument, what is clear is that the CRA was significant for the fact that it helped cast a light on low-income residents as potential homeowners.
The Recession of 2007-2010
In December of 2008, the National Bureau of Economic Research, a private group of leading economists, announced that the United States had been in a recession for one year. The main culprit, experts argued, was a decline in housing prices that had begun in 2006 (Isidore, 2008). This sudden drop in prices had an immediate impact on the stock markets, nearly leveled the financial industry and spread throughout the world. The recession was one of the worst in U.S. history since the Depression. Political leaders would eventually react with efforts to prop up the financial industry and restore growth, but the root of the recession — the housing bubble and its collapse — would launch an international debate.
Put simply, a real estate bubble is an increase in housing prices that is not connected to other signs of economic growth. As its name suggests, such a phenomenon is not a persistent, long-term condition. The bubble will ultimately collapse upon itself unless another element of the economy takes place to support it, such as an increase in jobs or a significant reduction in the federal deficit. The real estate bubble that led to the recession of 2007-2010 is complex in terms of the myriad of factors that drove it, some of which date back to the 2001-2002 recession and the economic slowdown it created.
The first of these factors was interest rates. While other elements of the economy, such as the stock market and other interest-bearing investment activities became stagnant in the 2001 recession, housing prices continued on an upward trend, demonstrating a shift of...
(The entire section is 3485 words.)