Before I go into an explanation of why housing prices skyrocketed from 2000 to 2006, I think it’s a good idea to give a little history of what the housing market and the mortgage market used to be like before things got out of control.
Let’s go back to the mid-70s when my parents bought a house. We lived in New Orleans and the house if I remember correctly, cost roughly $60K.
Back then, and until more recently, in order to buy a house, you had to put 25% down. So 25% of $60K is a fourth of it. So you have to save up $15K and then you’re going to get a mortgage on $45K, right?
I forget the exact interest rates then, but I’m just going to throw out a number, because this is just really for instructive purposes. Interest rates back then were higher. They were like 9% I think. So 9% on $45K, how much interest am I going to pay?
45 times .09. So I’m going to pay a little over $4K a year in interest. And if I divide by 12, it comes to about $340 a month in interest.
At the time, we actually moved out of our house, and we rented it out because we needed cash. We rented out the exact same house, and this was in the late ‘70s or early ‘80s. It went for $900 a month.
This raises a couple of questions
First of all, the big question is, why did those people rent our house? I mean, they paid $900 a month. They must have had a good income for that time. Why were they willing to pay rent, when they could have bought a house with a mortgage for no more than $400 a month?
Why would you just throw away money?
This is the classic rent versus buy argument. Why would you throw away $900 when you could actually build equity paying $400 a month for the exact same place?
You can think about that for a little bit, but there’s a bunch of reasons. What was necessary to buy a house then? Well one, you needed $15K down payment. Maybe these people had really good cash flow every month, but they just never had the right circumstances or maybe the discipline to save up $15K.
You also needed a really steady job. Maybe the people who were renting they were working odd jobs, or they didn’t have a steady income. I don’t think we would have actually leased the house to them had that been the case.
The last thing you needed to get a mortgage was good credit. And maybe these people didn’t have that. Maybe they didn’t pay some bills in the past, and they couldn’t find a bank that was willing to give them a loan despite having a steady job and the $15K down.
If you had to ask me, I would think the biggest barrier for this family at that time was probably the $15K down payment. And frankly, they probably had trouble saving $15K because they were busy paying $900 a month in rent. So that was the circumstance throughout most of modern history.
You had this barrier to buying a house. It did make sense, the conventional wisdom that it is better to buy than rent held. It’s just everyone knew that. But a lot of people couldn’t buy even though they wanted to since they didn’t have the down payment, they didn’t have the steady job, or they didn’t have the good credit. That was the circumstance then, and that lasted for some time.
What happened in the early 2000s, and it actually happened in California in the mid-1990s is that people started lowering the standards. It got more and more; I guess we could say flagrant, as we went through the decade.
Let’s say that in 1980, you needed 25% down. You needed a steady job. And you needed a 700 credit score. And that was true from 1980 to 2000. I’m exaggerating a bit, but this is just to give you a broad sense of what actually happened.
In 2001, if you wanted to buy a house, all of a sudden, you could actually find someone who was willing to give you a house for 10% down. Maybe you just need a job. And maybe you had a 600 credit rating.
So what happens when the standards on the mortgage go from this to this?
Let’s go back to these people who used to rent that house from us for $900. Maybe they didn’t have $15K, right?
Maybe they had $6K, they just couldn’t get up to $15K in savings. So back when they were doing this in the ‘80s, if the standards got a little bit freer, like they did in the 2000s, those people would have bought a house. They would have said, we don’t have to rent anymore. We saved up the 10% down payment.
It’s gotten a little bit easier. Our job now meets the requirements. Our credit now meets the requirements. We can go buy that house.
So that would have increased the aggregate demand for housing even if no one’s income increased and even if the population didn’t increase?
All of a sudden there’s a new person who could get financing to buy a house. Then if we go to 2003, they say, you know what? You don’t need any down payment. No money down.
So you can imagine there’s a whole set of people who maybe have a decent income but they couldn’t save any money. Now all of a sudden, there is no down payment barrier to buying a house. Maybe you still needed a job and maybe just needed a 500 credit. So all of a sudden without people’s incomes going up, without more jobs being available, without the population increase, there were more people who could get financing, or more people who could bid up homes.
And this situation got pretty bad. By 2004, 2005, you had a situation where they had these things called liar loans. These were essentially no down payment. If you had a job, you could make it up. Just say, I had a job. They wouldn’t validate it. So even though the mortgage might require an income of $10K a month, and your income is only $2K a month, you could say your income is $10K a month.
Stated income, no down payment, maybe a job. And they didn’t even do a credit check. So what happened from 2000 to 2004 is that credit just got easier and easier to get. And every time credit got easier, there were more people who despite the fact that they weren’t making any more money were able to get financing.
So the pool of people, who were able to bid on homes, or the demand for homes because there was this pool for financing, became larger and larger. And that’s what increased the prices of homes.
Now, the obvious question is, why did this happen?
First of all, why did they get easier in 2001, and on as we went to 2004? And why did they get to this unbelievably absurd level where by 2004 and 2005, you hear stories, especially in California and Florida of people who are making $40K a year buying houses with no money down?
Some of these people were migrant laborers and they were able to buy houses for a million dollars. Why were people willing to give their cash to people to buy a house that had a very low likelihood of getting paid back and for a house that had a very low likelihood of being able to retain its value?
I’ll see you in the next presentation.
