Learning About Household Leverage (no, not the popular TNT drama series)

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When asked to investigate the economic recession of 2007, I was really at a loss for inspiration.  The financial crisis was something that I really did not know much about.  However, one thing I did know is that the housing bubble burst and at least partially caused the recession.  So I began my educational journey by learning about household leverage and the housing bubble.

It turns out that “npr.org” is a very helpful source for those who are interested in the housing market’s role in the financial collapse.  To start, David Kestenbaum was able to enlighten me on the concept of a housing bubble with his podcast/article titled “Where Did The Money In The Housing Market Go?”.  Somewhat ironically I learned that the money invested in the housing market actually remained where it was; no money was lost nor gained in relation to the recession.  The housing bubble is all about perceived value expectations.  If the housing bubble reaches unrealistic levels based upon economic capabilities, it bursts, causing the housing market to stagnate and property values to drop below the valuations used to back  loans taken out for mortgages or other luxuries.  Money was never the problem along this roller coaster of property valuation.  The problem was with the generous expectations about the housing market’s continual growth.

“Going forward, policy-makers, regulators and researchers must recognize the central role of household financial health in causing economic turbulence if we are to avoid repeating this painful episode.”

-Atif Mian and Amir Sufi, Chicago Booth School of Business

After familiarizing myself with the necessary concepts and background information, I could focus more on the actual housing bubble that played a part in the recession.  From 2001 to 2007, research shows that household leverage increased dramatically in the U.S. market.  Cheap mortgage rates of the early 2000’s allowed more potential home buyers to afford owning a property.  This in sense stimulated market demand for housing, which then raised housing prices.  The higher prices then led to even cheaper mortgage rates.  As this housing bubble grew, the amount of money available did not; however, debt or leverage was growing rampantly.

For every dollar growth in expected property value, homeowners “extract $0.25 to $0.30 in cash“.  Homeowners were banking on the hope that their property values would become reality upon the future sale at the growing price,  because a price is not meaningful until someone pays it.  But the question arises, why did financial institutions continue to drop their mortgage rates in response to the housing bubble?

I would hope that someone within those institutions was slightly more informed than myself and considered the dangers of the growing amounts of debt.  I personally cannot blame the homeowners for wanting to invest in their lovely homes.  They had no reason to believe their properties would soon drop in value.  Also, if financial firms were willing to arrange such cheap loan and mortgage rates so easily, shouldn’t that only spur confidence in the homeowners to believe the housing market was stable?  Today I can’t turn on the television without seeing a credit report commercial with a catchy jingle.  So if everyone is so worried about credit scores, shouldn’t loans be somewhat difficult to come by?  Creditors irresponsibly handed out loans, which victimized the consumers.  People may complain about tight-belted creditors, but if loans are handed out like hot cakes, apparently an economic recession is around the corner.  Housing prices wouldn’t have spun out of control if people were not able to take on enough debt to pay for them.

There is plenty I still don’t understand about the recession, but I feel I have a decent grasp on the topic I want to pursue.  For now, I am convinced that the housing bubble collapse was a strong cause of the 2007 recession. Next I would like to investigate how the creditors were affected internally by the devaluation of housing, or basically how the bubble bursting led to a sudden crisis.  Did everyone sell their houses at the same time?  Did mortgages have to be restructured along with dropping housing prices?


3 Responses

  1. “Lessons From The Fall: Household Debt Got Us Into This Mess”


  2. E.J your post was very interesting. I found amazing that for many years people were getting into debt as well as the banks giving loans to many people. Why do you think that people wanted to buy knew homes all of the sudden? It surprises me that banks gave loans to that many people, did the naks know that this bubble could collapse?

  3. People began investing in real estate because of the decrease in interest rates and the excitement of the skyrocketing housing prices. If it cost less to borrow money and valuation growth seemed inevitable, then why not purchase new property?

    Most theories seem to debate over whether Greenspan and the Fed were to blame for decreasing interest rates or not.

    From one side, a national push toward home ownership has existed since the 1930’s, spurred by tax benefits. This push intensified in the early 2000’s based upon three factors. First, the Fed lowered interest rates, driving down the cost to borrow money. Second, there was a stress to provide home ownership to even those that could not afford it. Third, rating agencies understated risks associated with mortgages by assuming home prices would rise forever. (Source: http://online.wsj.com/article/SB124631486277570583.html?KEYWORDS=us+housing+bubble)

    From the other side of fence, certain evidence exists showing the Fed isn’t to blame for the lower interest rates. The housing bubble, which occurred world-wide, stemmed from an increase in savings across the world. This led to a decrease in interest rates, while the annual growth rate of the monetary base actually decreased from 2001 to 2006. (Source: http://online.wsj.com/article/SB123811225716453243.html?KEYWORDS=housing+bubble+cause)

    So whatever the cause, financial institutions seemed to get caught up in the excitement of the bubble as well and had lower interest rates to work with. They definitely faulted in assessing the risks of mortgages and requiring substantial collateral in return.

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