Understanding The Current Housing Market Part 1, The Foundation Of The Bubble

For most Americans, the current housing market is both depressing and intimidating. People often ask me, “Why does the price of my home keep going down?” Another question I frequently receive is, “I don’t know if I should buy a house right now, what if it loses value after I buy it?” These are great questions and I have decided to write a multi-part series on the current housing market. This is an area that I am very up to date on because I am the age where I would normally be a first time home owner. I have researched all aspects of the problems in the housing market and will break them down in a way that will be both informative and easy to understand.

I think the best place to start is with a brief summary of what started this mess to begin with. You need to understand how banks set the stage for the housing bubble. Politicians and investors often claim that nobody really saw this disaster coming; I think that’s a load of bull and you will see why.

Banking is one of the oldest and most perfected professions in the human history. In its simplest form, banking is relatively strait forward. Banks loan money to people for items that would normally be too expensive for them to buy with their savings, and in return the banks receive interest from the borrowers to make a profit. The primary responsibility of a bank is the ability to reliably judge if the person borrowing will be able to pay the money back. This is basically the whole reason we have credit scores.

A person earns a good credit score by paying bills or loans reliably on time and being a responsible borrower. If banks lend money to people who have proven they are responsible at paying their debts, the bank will almost certainly make a profit under normal circumstances. If the borrower has a less than perfect credit score, they are penalized with a higher interest rate because they are statistically less likely to pay the loan back. Banks charge borrowers with lack luster credit scores a higher interest rate because individuals in this pool have higher default rates and the bank needs to make a profit.

Now that we covered the basics, let us look at how the banks deviated from this sound model and you will see that they must have known they were being negligent. As the housing market took off, banks threw almost all sound practices out the window. Borrowers with very poor credit scores were given loans. Borrowers were not required to show proof of a job or income. Finally borrowers were not even required to put a down payment on the property. A down payment has always been an important banking tool because borrowers are less likely to walk away from a house if they already put 5 years of savings into it up front.

To wrap up part one of my housing market series, I want you to take away one basic idea. Banks have no excuse for being so negligent in their lending practices. They threw all common sense banking rules out the window and this laid the foundation for the bubble. In the end, it is the responsibility of the lender to determine how likely they are to be paid back. For example, lets say I loaned some money to one of my friends that I know is very irresponsible and they do not pay me back. My wife is going to be pissed at me for being stupid because she would say that I should have known what the result was going to be before I lent the money.

In part two, I will show you how the bubble began to form and I suggest you stay with this because I will get to where we currently are very quickly.