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In the aftermath of the financial crisis of 2007-08 Soros provided explanations for the housing crash. But more than that, he pointed out that the housing problem was but a part of a much larger and more broadly based super-bubble that started in the early 1980s. The lessons learned in that period may help us understand what is going on now, and what is to come.
Housing bubble
The US housing bubble followed the course described by Soros in his boom/bust model (see last week’s newsletters). Lax lending standards were supported by a prevailing misconception that the value of the collateral for the loans was not affected by the willingness to lend.
Loans were packaged up into financial securities and sold on to unsuspecting investors around the world. Those securitised bonds issued in the early stages of the boom showed a low default rate on the underlying mortgages. Credit rating agencies based their estimates of future default rates on the recent benign past – another misconception.
As house prices rose the rating agencies became even more relaxed as they rated collateralised debt obligation (CDOs) – instruments that repackage securitised bonds. In trying to perceive future risks and returns all participants failed to recognize the impact that they, themselves, made.
While Wall Street was creating all these weird and obscure financial instruments – and getting fat fees for arranging them – mortgage originators became increasingly aggressive in encouraging ordinary people to take on the responsibilities of a mortgage.
The value of a loan as a proportion of the value of a house got higher and higher. Towards the end of the boom people who had no job and nothing to put down as a deposit on a house were being granted mortgages.
The attraction of fee income lies at the heart of this. The mortgage arrangers received a fee for arranging the mortgage regardless of what happened to the house owner thereafter; the banks received fees for arranging securitised bonds, and yet more fees for CDOs, and yet more fees for even more complex instruments.
But, all of this was okay, if you believed that the value of homes and thus collateral for the loans, was growing and would continue to grow. This belief, for a while, created its own fulfilment: faith in the housing market led to more loans; the additional demand for housing stimulated by the availability of cheap mortgages led to house prices rising, providing more collateral; confidence in the housing market rose due to the additional collateral; more loans were forthcoming; and so on.
People became dependent on double-digit house price rises to finance their lifestyles. As they withdrew housing ‘equity’ through remortgages the savings rate dropped below zero.
When home owners became over extended and house prices stopped rising they had to cut back on remortgaging. There was a reduction in demand from both people moving and from people staying put and remortgaging
The moment of truth came in the spring of 2007 when New Century Financial Corp. went into bankruptcy. People started to ask questions: Perhaps the value of the collateral for mortgages was not destined to rise forever and was artificially supported by the willingness of lenders to make fresh loans? If they stopped perhaps much of the ‘value’ in houses would prove to be an illusion?
A twilight period followed when house prices were falling but participants continued to play the game – new mortgages were signed and securitisations created. In August 2007 there was a significant acceleration in downward price movements. Over the next year contagion spread from one segment of financial markets to another, until Lehman’s collapse sparked a further downward lunge.
The super-bubble
The super-bubble also reached its tipping point in 2007-08. This reflexive process evolved over a period of a quarter of a century. The main prevailing trend was
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