“Success breeds a disregard of the possibility of failure” (Hyman Minsky)

Causes of the US housing bubble:

From 1996 to 2006 the ratio of median house prices to median income rose from approximately 3 to 5 in the United States. Minsky’s “financial instability hypothesis” (an alternative view to the efficient market hypothesis) and Kindleberger’s seven stages of asset bubbles trace beautifully the events that unfolded. Minsky stages: displacement, boom, euphoria, profit taking and panic. Kindleberger stages*: displacement, credit expansion, new economy, swindles, overtrading, panic and aftermath.

Displacement: Fed fund rate goes from 6.5% mid-2000 to 1% mid-2003. By mid-2003 mortgage rates had fallen considerably from a peak in 2000, with 1 year ARMs as low as 3.45% (approximately a 50% drop in 3 years). The dot com crash means people view housing as a safer investment than stocks.

Boom: Massive growth in securitisation. Asset backed securities increased by approximately 360% to December 2007 from 10 years prior (fuelled by triple A credit ratings). Between the second quarter of 2002 to the third quarter of 2006, the monetary policy was overly accommodative compared to the Taylor rule. Asian countries especially China artificially weakened their currencies by buying US dollars. This kept the long run US interest rates artificially low. Alan Greenspan believes this rather than the short term fed fund rate is the most likely explanation for the housing bubble (blame shifting?!)

Euphoria: Growth of speculative and Ponzi borrowers (those who relied on housing price increases to refinance). A new economy: living the American dream; a push by the Clinton and Bush administrations to ensure every American could own a home. From March 1998 to March 2006, real house prices increased by 80%.

                                          Picture courtesy of predatorhaven

Swindles: some households lied to get a mortgage and mortgage brokers extended loans to unqualified households due to risk shifting with securitisation. 

Overtrading: both subprime borrowers and creditors were relying on house price increases; effectively a giant Ponzi scheme (although with limited fraud).

Profit taking: this is the time to get out; just before mid-2006 in the US housing market. Demand was slowing as ARM rates had shot up due to fed fund rate increases and when people came off their initial low interest rate period they could no longer afford the new higher payments. Delinquency and foreclosure rates on subprime mortgages started to soar from mid-2005 (subprime ARM foreclosure rates increasing by 370% over the next 3 years).  Then on 9 August 2007, according to Paul McCulley of PIMCO, the Minsky moment occurred; BNP Paribas prevents withdrawal from three investment funds which had specialised in US subprime mortgage debt. The market panics and the crisis begins. Next week’s post is on this panic and the aftermath.
*the paper originally accessed through the link, entitled The US housing bubble and the current financial crisis (US congress joint economic committee 2008) is currently unavailable online but was a great source of inspiration for writing this post.