U.S. Housing Market Boom to Bust: Causes Explained

House Prices Rose at Unprecedented Levels

U.S. housing prices rose at an unprecedented level for nearly a decade, ending dramatically in 2007. According to Leonard, housing appreciation climbed from the 1983–2006 average of 7.4% to the staggering 12.7% appreciation that was nationally common just prior to the current decline. Leonard also stresses that individuals took full advantage of these boom-era appreciation percentages for the first time as home equity loan products came onto the market in record numbers — something that was unheard of until after 1981. The relative illiquidity of real property prior to 1981 kept consumers reasonably safe from declines and kept their equity safe from overspending. Once home equity loan products became widely available, homeowners not only risked carrying a loan that exceeded the current value of their property, but could also be repaying a second mortgage that further exceeded that value — even as housing appreciation rates slowed, stalled, and, after 2007, actually began to decline for the first time since the early 1990s and in a far more substantial manner. (Leonard, 2010, p. 87)

Though some analysts were early in their assessment of the potential for a rapid decline — calling the record appreciation of 8% in 2005, the highest recorded growth since 1975, an unsustainable bubble — consumers and banks alike sought ways to maintain this artificial curve by changing how they lent and borrowed. Institutions and individuals with a financial interest in rising home assessments simply altered their borrowing and lending strategies to offset any potential downturn, and it was precisely this action that created deeper instability. (Weller, 2006)

Had consumers of home equity loans and new mortgages been required by national lending standards to simply hold their appreciated-value homes in a state of illiquidity — as they had in the past — both the economy and those individuals would have been riding a much smaller wave downward as housing prices declined during a normal economic correction. (Schiller, 2006) Sadly, that did not happen. Many consumers were fundamentally preyed upon by unscrupulous lenders seeking to keep new mortgage and equity loan sales high, and they now hold mortgages that in some cases far exceed the value of their homes. (Reich, 2006) In the wake of the broader economic downturn, many of these individuals have also experienced an inability to make their mortgage payments as real job losses and other economic factors compound the problem.

Reich stresses that most banks at the regional level remained relatively healthy due to their ability to contain costs during the emerging crisis (writing from a 2006 perspective), but that at least four factors contributed to the housing boom: "a growing economy, interest rates that have remained near 40-year lows and general home price appreciation that has risen to extraordinary levels in some markets. And some would add a fourth factor, innovative mortgage loan products." (Reich, 2006, p. 4) Writing from the perspective of a banking professional affiliated with the Office of Thrift Supervision, Reich is notably charitable toward banks and bankers. Many observers have since reframed that fourth factor — "innovative mortgage loan products" — as predatory lending practices.

The unprecedented growth of U.S. house prices can also be examined through the lens of rental rates, which serve as a foundational indicator of the overall health of that growth. The ratio of house prices to rents grew at an unprecedented rate of 78%, despite the fact that these two figures normally rise together at a nominal rate, keeping renting only slightly less expensive than buying and allowing rental income to remain at least marginally profitable. (Killelea, 2010)

Aggressive Sale of Subprime Mortgages

Normally when house prices rise, demand moderates because fewer people can afford mortgage payments on increasingly expensive properties. Historically, banks lent responsibly to avoid overextending homeowners. In the U.S. housing market, however, mortgage lenders were desperate to maintain sales volume and simply found new ways to sell more expensive houses. The "innovative mortgage loan products" referenced by Reich (2006, p. 4) are more broadly known as subprime lending practices — and more recently as predatory lending practices — as consumers became increasingly outraged by the aggression with which banks and brokers marketed them into loan products that would have been considered unacceptable just ten years earlier. The underlying false promise was that the economy would continue to rise, and that at some point in the future consumers would be able to manage their escalating mortgage rates, premised on reduced down-payment requirements and inflated housing assessments.

To understand why these products were problematic, it helps to first understand how a traditional, or prime, mortgage works. Applicants are evaluated on their actual income (not income potential), their existing credit history, and the amount they have saved for a down payment. They are prequalified for a loan amount that fits their budget and then seek a home within that price range. The down payment on a traditional prime mortgage is between 10% and 15%, with a few narrowly defined exceptions such as loans for first-time buyers or veterans. Without exception, this has been standard practice in mortgage lending for more than a century, because banks had no real interest in lending to borrowers who would default and leave the bank carrying the debt. If an individual had marginal or poor credit, a low income, or insufficient savings for a down payment, they were simply ineligible for a mortgage until their personal finances improved.

Yet creative bankers and mortgage brokers began applying different standards as home prices climbed beyond the reach of new buyers. A particularly troubling trend was the mass application of a subprime lending mechanism previously reserved for wealthy investors — the optional adjustable-rate mortgage (ARM). In its original form, the ARM required a low initial payment for a short period, after which the payment adjusted upward. This product was designed for high-net-worth individuals or entities that held significant assets temporarily tied up in illiquid investments and expected to refinance or pay off the loan once those assets were realized. It was never designed for the general public. (Der Hovanesian, 2006)

When ARM mortgages were mass-marketed to ordinary borrowers who could not realistically meet their financial demands, they were paired with additional risk-amplifying features such as balloon payments — large lump-sum payments due at a later date to offset the initial low payments — and extremely low or zero down-payment requirements of 0–3%. The term "subprime mortgage" is a compact way of acknowledging that the product is not the best available and that the consumer faces serious potential risk in carrying it. These subprime lending practices became foundational when housing prices climbed so high that ordinary borrowers had no realistic way to qualify for a home under traditional mortgage standards. While many lending institutions have attempted to invoke a "buyer beware" defense, consumers do not purchase homes every day — lenders do. The marketing of subprime loan packages was so pervasive and sophisticated that it was genuinely difficult for an individual to see through the short-term incentives. Many observers therefore argue that these lending practices were always predatory — a deliberate attempt to override the natural demand correction that would have slowed unsustainable housing price growth. (Der Hovanesian, 2010)

Increased Promotion of Discounted Mortgages

The way subprime — and what many call predatory — lending practices affect the housing market had never been tested at such scale before, since these tactics had historically been carefully controlled by lending institutions with a long-range view of risk. Subprime lending is fundamentally a short-term tactic, and its consequences are now being confronted on a massive scale as foreclosures mount, more families face the loss of their homes, and more banks absorb debt on mortgages that far exceed the reduced market value of the properties securing them.

The marketing of subprime lending products was absolutely saturated. Nearly every consumer was urged to buy or refinance before extremely low interest rates began to rise and before housing prices climbed even further out of reach. Even large, established banks — in an effort to compete with less scrupulous agencies — adopted aggressive lending tactics, likely under significant internal pressure to produce volume in situations that would previously have been disqualifying. ARM mortgages, low down-payment loans, and introductory interest rate structures (previously reserved for smaller consumer loans like auto financing) became standard practice. Borrowers are now struggling to repay them, and banks are carrying enormous loads of bad debt offset only marginally by federal assistance.

From approximately 2000 onward, the marketing for subprime loan products was unrelenting, and lending institutions were not exaggerating their willingness to lend — they really were doing so at unprecedented levels. As Ornstein, Tallman, and Holahan (2006) define it, a predatory loan "generally refers to a loan that takes financial advantage of an unsophisticated borrower who has accumulated equity in his or her home, but who may be unable to repay the obligation" (p. 54). Many argue, however, that competitive pressure from unscrupulous lenders compelled traditional institutions to relax their standards — and that in doing so, those traditional lenders themselves became predatory.

Conclusion

This paper presents a brief but comprehensive account of how the boom-to-bust process in the U.S. housing market began and how it may eventually resolve. The market has shown some minimal signs of recovery, and it is hoped that this will continue. More importantly, it is hoped that the changes arising from this crisis will include regulations and consumer protections designed to prevent history from repeating itself. It is difficult, at the level of an individual homeowner, to see how personal financial decisions reverberate across a broader social and economic landscape. On the other hand, economists and lenders — who have a far more complete view of the whole picture — bear a particular responsibility. Lenders especially should be wary of revisiting this crisis by once again expanding subprime lending options for consumers who will be harmed in the long term. The greatest hope is that the institutional changes ahead will meaningfully strengthen consumer protection, substantially curtail predatory lending, and restore realistic standards of affordability to the mortgage market.

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