Dean Baker: The Housing Bubble Starts to Burst

Is there anything as beautiful as the sound of surprised economists in the springtime? I haven't had this much fun since the NASDAQ started to deflate seven years ago.

Okay, enough of the gloating; while the collapse of the housing bubble was both predictable and inevitable, it is not pretty. Tens of millions of people will be hurt as they see much of the equity in their homes - money that most had counted on to support their retirement - disappear. Millions more will be forced out of their homes as they find that they are unable to meet the payments on adjustable rate mortgages that reset at higher rates. People who had worked hard and saved in order to become homeowners will see their dream disappear.

The timing and process of the unwinding of the bubble cannot be known, but the basic story is clear. Investors are finally realizing that the high-risk mortgages they have been holding are high-risk.

Mortgage brokers, who make their money on issuing mortgages, not holding them, had been anxious to get as many people as possible to buy mortgages. While old-fashioned bankers would demand large down payments and good credit histories, many mortgage brokers were happy to issue mortgages that they knew buyers could not pay off. Since the brokers dump their mortgages in the secondary market almost immediately after they are issued, they have little reason to be concerned about whether the buyer can actually meet the payments.

Mortgage brokers were able to entice more people into the housing market with low "teaser rates" that were often several percentage points below the market rate to which the loan would eventually reset. Many homebuyers who could meet their monthly payment on a mortgage with a 1.5 percent interest rate would be hopelessly over their heads when the mortgage reset to a 6.5 percent rate.

But, everything was fine, as long as home prices continued their rapid appreciation. If a homebuyer's income wasn't high enough to make the mortgage payment, the homebuyer could draw on the new equity created by a rising home price. As a result, delinquency and foreclosure rates remained low through 2004 and 2005, even as the number of high-risk mortgages soared.

However, the party began to end last year as house prices started to fall. The fall thus far has been relatively modest (around 3 percent nationwide), but with prices going in the wrong direction, most new homebuyers have no equity that they could rely upon to meet their monthly payments. As a result, delinquency rates began to soar in 2006. More than 10 percent of the subprime adjustable rate mortgages issued last year (the most risky category) were already seriously delinquent or foreclosed within 10 months of issuance. This is even before any of these mortgages reset to a higher interest rate.

With foreclosure rates soaring, the music is about to stop. The investors who bought up these mortgages in the secondary market are now refusing to lend more money. Credit is drying up for both the subprime and the Alt-A market, which is a notch above subprime in creditworthiness. These two segments of the housing market together accounted for 40 percent of the mortgages issued in the last two years.

If 40 percent of potential homebuyers suddenly have problems getting credit, it has to have a large impact on the housing market. Throw into the mix that the inventory of unsold homes is 25 percent higher than at the same time last year. And, the number of vacant units up for sale (normally an indication of a highly motivated seller) is up more than 40 percent compared to last year. Since house prices fell by three percent last year (six percent in real terms), it looks like we have the beginnings of a serious slide in house prices. And, a sharp fall in house prices will lead to more problems in the mortgage market.

That is the story of a collapsing housing bubble. It is not pretty. It was predictable. However, the experts either looked the other way or said everything was fine. And, the politicians pushed policies that persuaded many moderate-income families to buy overvalued homes that they could not afford. And the mortgage brokers made a fortune selling bad mortgages.

That is the way the US economy works these days. Those who mess up the economy do well, while their victims - in this case millions of moderate-income homebuyers who will lose their homes - pay the price for the experts' mistakes.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.

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