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What Led to the U.S. Real Estate Bubble?

By: Elite Legacy Education, January 6, 2017

What Led to the U.S. Real Estate Bubble?

Whether or not you fully understand what led to the U.S. real estate bubble, it’s likely that you were impacted by it one way or another. After all, the effects of it rippled through the global economy, so there was no way of avoiding the devastation. This led to a Global Financial Crisis that was felt around the world from 2007 to 2009. The U.S. in particular was hard hit and there were obvious consequences which could best be told by those most affected.

Released in 2015, a movie by the name of The Big Short was inspired by a book written by Michael Lewis. The story reflected the events leading up to the housing crash in the United States of America and those that followed. However, if you haven’t had a chance to see it or read it yet, here’s the gist of what happened.

 

How it all began: The creation of the mortgage-backed security.

It all started one day when a trader by the name of Lewis Ranieri created a new financial instrument that was referred to as a mortgage-backed security (MBS). Basically, these securities were comprised of a bundle of claims on various mortgage payments. Initially, these bundles were made up of high quality mortgages with low chances of default. This positioned MBSs as very safe assets with sizable returns. Needless to say, Wall Street got excited as these new securities caught the attention of many investors.

 

The MBS starts spiraling out of control.

In fact, mortgage-backed securities became so popular that supply couldn’t keep up with demand. This is where the disillusion set in as traders had a desire to keep creating them. By bundling lower rated mortgages (i.e., ones with a higher risk of default)with many other mortgages they were passed off as being rated better than they really were. Specifically, it was thought that the risk could be diversified by including a larger number of mortgages. Basically, traders were making them appear to be more reliable than these assets really were. In hindsight, this should have been one sign of caution, but it doesn’t end there.

 

Mortgage lenders adopt lax lending policies.

With the housing markets providing excellent returns, everyone wanted in on the action. Mortgage lenders started adopting lax lending policies. This led to unqualified individuals being able to receive a mortgage and essentially magnified the problem. So while the quality of the loans themselves continued to decline, more MBSs were being created. And what do you think they were being made of? If you guessed these extremely low rated mortgages, you’re right. Claims on these mortgages were continuing to be bundled into MBSs, creating a recipe for disaster.

 

And so the default begins.

Once the people who were granted these mortgages couldn’t make payment, there was a sharp increase in the rate of mortgage defaults. These defaults were occurring on the very mortgages that laid the foundation for a significant amount of MBSs on the market. Thus, when all of these mortgages started defaulting, these MBSs became “very expensive pieces of paper.” Nobody wanted them, but everybody had them. This onslaught of supply with negligible demand drove their prices down even further.

 

The financial aftermath.

Some firms were so highly leveraged and reliant upon these securities that they took massive blows to their portfolio values and in some cases, blows that they couldn’t live through. In fact, this housing bubble was the center of so much trading on Wall Street that when it finally popped, many large US banks and financial institutions went down with it. Some were lucky enough to be bailed out by the government, but many were not. The Salomon Brothers in particular was one of the US institutions that saw its demise in the wake of this crisis.

Even though there were many warning signs along the way, the crisis had unprecedented consequences on all who suffered from its effects.

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