Home prices have skyrocketed over the last few months. The dream of owning a home, once a possibility for many families, is evaporating. As demand increases, so have the prices, and thus, people's dreams and livelihoods are at risk. So, is this a housing bubble? Is the current real estate market a warning of what happened in 2008?
I'm one of those millennials who entered this game of mortgages and real estate and had to come out alive. In one of the worst moments in the pandemic, I bought my first condo around September last year, so I had to learn. In this article, I'm going to share some of the lessons I learned with you.
Let's cover some of the basics to understand why the 2008 Housing Crisis happened. Of course, the first step for a housing crisis to happen is buying one.
Most people don't have the money to buy a house upfront. Instead, they need to borrow from a lender. To get a loan, a buyer needs to put a down payment, a percentage of the total value. The lender then provides the funding for the rest. Finally, it pays the previous owner and charges you a monthly interest rate on the money you owe them.
In exchange for that loan, the lender gets a mortgage. It's a deed that says the owner agrees to give the house to the lender if they fail to pay them. Executing a mortgage means the lender sells the asset to collect the missing debt. So, since the down payment already covers a percentage of the debt (20% to 30%) from day one, it's easy to liquidate the asset.
For institutional investors, mortgages are a safe bet in relative terms. Not paying a mortgage means losing the property, so the risk is too high for the owner. For the lender, taking ownership of the property is easy.
Sometimes, the market requires changes. These changes can impact the economy for decades to come, as we'll describe in this section.
In the 70s, new legislation allowed lenders to bundle the mortgages together. Legislators named it a Mortgage-Backed Security, and it was a very cool investment.
Mortgage-backed securities pay better interest than a single mortgage and are safer. After all, an investor like you is betting on thousands of mortgages that dilute the risk. If one or two individuals fail to pay, the rest covers for them.
This structure led to immense popularity for the next couple of decades. Mortgage-backed securities fueled profits for banks and Wall Street investors, and they got greedy. It was a vicious cycle. More investors want to put money into these securities. So there was more money available to lend. But there are only so many families or individuals who wish to buy a house and have a perfect credit record.
So, to have more people to lend money to, the investors loosened the requirements. This was both a good and a bad thing. Let's look at how these changed.
There were many changes. First, your credit score no longer had to be perfect, and you could still get a loan. Second, required down-payments decreased as well. Still, the investors had to find a way to make up for the risk, so a new kind of loan appeared.
Lenders offered sub-prime loans. These have a low, fixed interest rate for a few years, and then it spikes up to a much higher interest rate. It's adjustable, so it changes based on different market indicators.
Many house buyers didn't look that far into the future. They were more motivated by the fact that it was now easier to buy a house. The buyers also wanted fancier homes, and with all the money flowing in, builders obliged. Fancier houses in more extensive residential complexes started popping up all over the country.
Not only that, but houses themselves increased in value. Buying a home became a shorter-term investment because its value could rise 20% or 30% within a few months. It made perfect sense to take advantage of these conditions. So, people bought not one, but more, each with a different mortgage.
While this happened, Wall Street investors doubled down on their bets, starting a vicious gambling cycle. Let's see how:
Banks took bets on investors' bets. First, they packaged mortgage-backed securities into bundles called CDOs. Next, they took loans to buy more of these assets.
Then, they insured the securities using an instrument called a credit-default swap. As its name states, this allowed some investors to make money if the security failed. In short, if people didn't pay, investors would make money because the mortgage failed.
From the eyes of an investor, this was a motivating scenario. So, they bet on bets on bets. But, the first bet was a mortgage that someone took on a house with an inflated price. Plus, it happened with a low down-payment, on a subprime loan, on a salary that wasn't enough to pay the loan. So, all the ingredients added up.
What happens when you can't pay a loan? The owner of the mortgage needs to sell it to recoup their capital. When this happens to many people at once, many houses reenter the market at the same time. This creates a big problem.
First of all, nobody is buying. More supply and less demand mean that prices drop. In an instance, the asset was not enough to cover the mortgage. Still, you had to pay for the mortgage; the original value doesn't change. So, interest rates were still high.
Since people couldn't pay for them, they started walking away from the mortgages. Lenders repossessed even more houses, but the market kept getting saturated. So they went bankrupt.
The banks had insured the mortgage-backed securities with credit-default swaps. Now, they didn't have enough money to pay either. So, they went bankrupt as well.
These banks and investors belonged to Wall Street, the stock market also plummeted. The consequences were vast. People lost their jobs, which meant they couldn't afford other mortgages. The vicious cycle of financial chaos only grew and grew.
We are still reeling from the effects of the 2008 Housing bubble, and that means that we should be cautious.
The median home price in the US reached an all-time high earlier this year. That is higher than 2008, right before that bubble burst. There are other signs as well, as things got pretty crazy in early 2021.
Homebuyers got into aggressive bidding wars. They even threw punches over the few houses on sale in the market. So, the signs are there for many to say that there's a new bubble approaching.
The fact of the matter is that today's reality is quite different: it's not Wall Street gambling or speculating. The world learned a lesson and regulated this aspect after 2009.
First, you need to look at mortgage rates. They're lower because of the various stimulus packages the government has approved to keep the economy active. In March 2020, the average interest rate for a mortgage was 3.45% on a 30-year loan. That dropped to 2.9% by July 2021, which means getting a mortgage on your new house is now cheaper.
For example, this interest rate on a $400,000 house means that you pay $1,827 vs. $1,935. So that's $100/mo that you can use towards a bigger house.
There's another interesting factor. Various studies show that the US has underbuilt houses over the last 20 years, by 5.5 million homes. This means that there's a smaller supply of houses, combined with higher demand.
And this higher demand comes from various factors also associated with the pandemic. Many people choose to move to a bigger house because they now work from home and want the extra space. They also spent a year stuck at home. If they kept their jobs, that meant fewer expenses, less travel, and a couple of thousand dollars in stimulus checks.
These are people who might have considered buying a house in the next few years. Now, they're moving faster because they have the cash.
So many experts have called what's happening now a housing boom rather than a bubble. Prices drive up by higher demand and lower supply. It's a magic combination to increase the pricing on something. Time will tell if it's also a needle to burst a bubble.