 Recent news has been littered with stories about the housing crisis. Troubled borrowers here, devious lenders there, foreclosures everywhere; the housing market is an absolute mess. But how did the market get into such turmoil, such disarray, that even McCain, Clinton, and Obama are discussing their bailout strategies? The answer is simple economics and a market bubble. Let's take a closer look into the anatomy of a housing bubble and just how the housing market got into this mess.
Overview The central ingredients of a hot housing market are high demand, widely available credit, and the expectation of rising home prices. Between 1995 and 2005, these key ingredients were abundant in many major metro areas, thereby causing home prices to rise much faster than overall inflation. With subprime lending thrown into the mix, a housing bubble was formed. Bubbles form as a result of people buying on the expectation that prices will rise faster than their ability to afford the product later, causing people to buy now. Home prices bubbled because demand was sustained on the expectation of rising equity. At the same time, lending practices became looser and more reckless, thus inflating the bubble to its maximum capacity. And then, pop went the bubble, the housing market, and the overall economy. Basic Economics of Housing To understand the anatomy of a housing bubble it is essential to understand the fundamental economics of the housing market. First, it is important to analyze home values and what factors determine what a home is fundamentally worth. While there are many factors that determine a home's value, the most essential are: Location, Opportunity Costs, and most importantly, the Characteristics of the Home itself (44-2). Speaking in terms of location, a three bedroom, 2 bathroom, 3,000 square foot home, would be worth more in New York City than it would in Iowa. Logically, this is mainly because land and materials cost significantly more in New York City than they would it Iowa. Another important factor in determining home value is the demand side of the housing market. Many factors of demand affect home prices, most importantly the income of buyers and the population growth of the community. In terms of buyers' income, housing prices in Manhattan can be priced higher, essentially because people in Manhattan make more money then other areas of the country. Speaking in terms of population growth, an increase in population amounts to higher demand and a decrease in population decreases demand. Housing prices, therefore, will respond according to the laws of supply and demand. Mortgages A mortgage is a loan designed around a payment scheme to bring the original debt to zero over a period of time. A traditional mortgage refers to a loan structured around a 20% down payment, an 80% loan, and a consistent payment of x amount, for x number of years, at a given interest rate. For example, Mr. and Mrs. Jones want to buy a home worth $250,000. They agree to a traditional mortgage in which they will put down $25,000 up front, and then pay the remaining balance off in thirty years at a 5% interest rate. Therefore, Mr. and Mrs. Jones will pay $1,342 the first month, the last month, and every month in between. (continued in part two...) -written by: K. Skowronski
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