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THE REAL ESTATE BUBBLE

The U.S. economy this decade experienced a dramatic real estate bubble – the inflation of both home values far in excess of historic norms and of reasonable estimates of the growth of fundamental determinants of home value. One salient feature of the bubble psychology was the expectation on the part of home-buyers of a continuation of this supra-normal trend in home price appreciation. This expectation fueled demand by first-time home-buyers fearful of being priced out of the market or of missing out on the phenomenal equity gains to be realized. It also fueled demand by existing home-owners, who could now realize enormous capital gains on previous home purchases and trade up in the market, or buy second, or vacation, homes. And it stoked the demand of investors, who could realize a quick profit by 'flipping' a home.

Another critical feature of the bubble was very favorable credit market conditions. Mortgage interest rates were low, decreasing the monthly re-payment amounts required to finance a home purchase and boosting affordability. In addition, as low long-term interest rates re- sulted in high valuations of existing assets, homes appeared more attractive as an invest- ment. The financial market innovation of mortgage-backed securities also dramatically increased the secondary market for mortgages, injecting credit and encouraging the mort- gage lenders to supply easy credit terms.

Each of these factors contributed to the explosive growth in 2004 and 2005 of sub-prime mortgages, and of exotic mortgage instruments which were sold to numerous buyers who otherwise would not have qualified for mortgage lending and whose ability to pay was cru- cially dependent upon the continuation of the bubble in home prices. The most notable of these were 2/28 adjustable rate mortgages under which buyers were qualified by the ability to pay, for the first two years of the mortgage, very low 'teaser' interest rates, but for which monthly payments would reset at much higher market rates two years later. It was the sharp increase in this lending in 2004 and 2005, with rate resets in 2006 and 2007, which has led to the mortgage mess in 2007. Suddenly, buyers who would not have qualified for mortgages at the reset rates have found themselves with a home they are unable to pay for or to sell. Moreover, with mortgages divided and resold in secondary bond markets there is often no mortgage-holder left with whom to renegotiate the payments. Foreclosures are the result.

It is important to note that the sub-prime mortgage and foreclosure crisis was not confined to metro areas where home prices had escalated rapidly. The ease of obtaining home lend- ing credit had extended to slower growth regions, especially in the Midwest, where borrow- ers had long had difficulty meeting credit standards. Home purchases and the exploitation of home equity lines of credit became dramatically easier there as well. Indeed, foreclosure rates in 2006 skyrocketed first in Ohio, Michigan, and Indiana. Then California and Florida metro areas, among others, began to see escalating delinquencies and foreclosures as well.

Global Insight, along with most economists, realized early on that home prices could not keep appreciating at the rates experienced up until 2005. We also realized that the growing use of adjustable rate mortgages (ARMs) would create affordability problems as rates were reset. But then the perfect storm occurred. Home price appreciation ground to a halt, and home sales plummeted. This happened just as the ARM rate resets were beginning in large

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