A Decade of Despair

The catalyst for much of what happened to the residential real estate market in this decade-about-to-end was a mind-bending tragedy: the attacks of Sept. 11, 2001.

"The boom happened, in large part, because interest rates began to decline after 9/11, and that juiced up housing demand," said Mark Zandi, chief economist for Moody's Economy.com in West Chester.

But much also preceded that date, and it is helpful to track it all to appreciate why the U.S. housing market collapsed, taking homes from millions of families and shattering the American illusion that real estate values always rise and you can leverage that value to live beyond your means.

When this decade dawned, all the stars necessary for a residential real estate boom began moving into alignment.

The dot-com bust of April 2000 stalled the surging, technology-driven economy of the previous five years. Fixed rates for 30-year mortgages were 8.20 percent that month, and they never dropped below 7 percent for the next two years, data kept by Freddie Mac show.

Although higher than they are today, those interest rates were half what they had been in the 1980s, and adjustable-rate mortgages provided an ever-more-popular alternative for home buyers.

Prices had been falling since residential real estate hit a wall in the aftermath of the October 1987 stock-market crash, the collapse of the commercial market, and the resulting savings-and-loan debacle.

All those forces suppressed home buying, even in the relatively prosperous second half of the 1990s.

Then came life-altering 9/11.

The Federal Reserve lowered the short-term federal funds rate to 1 percent, and the rest of the world fell in line, said Nigel Gault, an economist with IHS Global Insight in Lexington, Mass.

"The rate was low, inflation was low, and long-term rates followed suit," Gault said.

The decline in interest rates was accelerated by extensive securitization of mortgages and the proliferation of new loan products to make home buying easier, Zandi said.

Although Freddie Mac and Fannie Mae had long been buying back mortgages from lenders and repackaging them as securities for sale to investors on the secondary market to create a greater pool of home-buying capital, this was going to be a different time.

"There was a push by both Congress and the White House to promote greater home ownership," said Econsult Corp. vice president and economist Kevin Gillen in Philadelphia. "So government agencies like Fannie, Freddie, and the FHA turned on the credit spigots.

"On the private side," Gillen said, "there was the perception that there was an exceptional return to investing in housing, so subprime mortgage lending began to proliferate, which was also encouraged by the federal agencies."

The world - individual investors, pension funds, and governments such as China - was desperate for a safe place to put its money. And what appeared to be the most secure harbor was the American home, Zandi said.

"There was a lot of surplus savings in other countries, especially in Asia and specifically China," Gault said. "They lent the money back to the United States, which kept long-term rates low, and even when the Fed began raising short-term rates, long-term ones remained low."

The sputtering stock market wasn't a sure thing for investors foreign and domestic, and interest rates on savings, including long-term CDs, were very low.

That made trillions of dollars available for housing loans. And that, combined with a stagnating economy, sliced interest rates for qualified buyers to the neighborhood of 5.5 percent by the second quarter of 2002, and even lower thereafter.

The unprecedented volume of securitization severed the traditional link between those who originated the loans and those who serviced them, Gault said.

Not only that, but in an effort to spread the risk as a way to reduce it, "there was no way of telling if whoever was holding the loans could handle the risk," he said.

With access to seemingly unlimited funds, borrowers confronted a limited supply of houses for sale, however - leading to bidding wars and even uncontested offers that propelled real estate prices, as it turned out, to heights far beyond sustainability.

"The feeling was that if I don't buy today, the price would only go up," said Peter Buchsbaum of Arlington Capital Mortgage in Jenkintown.

"Home prices were reflective of the frenzy," said Philadelphia mortgage broker Fred Glick.

Another response to the terror attacks of 9/11 was in play, too.

"There was a lot of 'nesting' going on," Zandi said, and "consumer need for bigger and better homes became an important factor," especially as the rest of the economy softened in 2002 and 2003 and continued to bleed jobs.

To pay for it all, millions of homeowners began tapping into real or perceived home equity, "cashing out . . . and taking on larger loans, expecting their homes to continue to appreciate," he said.

As home values continued to soar, growing numbers of potential buyers were being shut out of the market.

The solution was "alternative" mortgage products that went light-years past the simple adjustable-rate loans that had given marginal 1980s borrowers a choice.

These products - "option" adjustable rates, negative amortization, pick-and-pay, no documentation, stated income (without evidence) - accelerated the trip on the road to ruin, the experts said.

Federal regulators could have stepped in at any time to put the brakes on this throttle-wide-open lending, but didn't until it was too late - just as in the savings-and-loan crisis of the late 1980s.

"These innovations were based on an assumption that housing prices would never go down, and had the blessing of the ratings agency based on past performance," Gault said.

"The belief was that some mortgages may fail, but they couldn't all fail at the same time."

Said Glick: "When the economy is rolling or the economy needs to be pushed along, there is usually a softening of regulation and credit in order to get people jobs and get buyers buying."

The situation worsened as speculators took control of markets such as Miami, Las Vegas, Phoenix, and California.

"Housing was the only thing appreciating," Zandi said, helped by "people forecasting with a ruler."

Though lenders were to blame "for allowing 100 percent financing and interest-only loans, they were simply satisfying what the borrowing community requested," Buchsbaum said.

The pendulum, said Glick, "swung too far to the left."

Unlike the 1929 stock-market crash, no one event signaled the bursting of the housing bubble.

"Housing prices certainly reached a point beyond most people's ability to pay," Gault said. "In addition, delinquencies started to increase, especially on some of the crazier mortgages where the buyers had no chance of even making the initial payment."

"Double-digit returns in perpetuity are only possible if credit is limitless," said Philadelphia economist Gillen. "And, on the supply side, both home builders and flippers were steadily adding to the inventory of homes available for sale.

"As yields on mortgage-backed securities began to decline, so did the availability of credit," he said. "As borrowers began to have more trouble qualifying for a mortgage at then-sky-high prices, sales began to decline. Declining sales and ballooning inventories finally began to exert downward pressure on house prices in 2006, and by 2007 the collapse was under way."

While the experts agree unanimously that the real estate market is cyclical, Zandi is certain that it won't come roaring back, even though prices are close to bottoming.

"The key reason is credit," he said. "Investors are cautious, and unwilling to invest in loans that aren't safe."

Said Buchsbaum: "Instead of credit scores and automated systems, we need to return to simple real-time decisions by people trained to measure the borrowers' ability to repay the debt, and a history that shows a propensity to repay it."