Causes of the 2000s United States housing bubble
Risky mortgage products and lax lending standards
Risky mortgage products and lax lending standards
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[thumb\|300px\|Common indexes used for Adjustable Rate Mortgages (1996–2006\).](/wiki/File:ARMs_Indexes_1996-2006.svg "ARMs Indexes 1996-2006.svg")

Excessive consumer housing debt was in turn caused by the [mortgage\-backed security](/wiki/Mortgage-backed_security "Mortgage-backed security"), [credit default swap](/wiki/Credit_default_swap "Credit default swap"), and [collateralized debt obligation](/wiki/Collateralized_debt_obligation "Collateralized debt obligation") sub\-sectors of the [finance industry](/wiki/Finance_industry "Finance industry"), which were offering irrationally low interest rates and irrationally high levels of approval to [subprime mortgage](/wiki/Subprime_mortgage "Subprime mortgage") consumers because they were calculating aggregate risk using [gaussian copula](/wiki/Gaussian_copula "Gaussian copula") formulas that strictly assumed the independence of individual component mortgages, when in fact the credit\-worthiness almost every new subprime mortgage was highly correlated with that of any other because of linkages through consumer spending levels which fell sharply when property values began to fall during the initial wave of mortgage defaults. Debt consumers were acting in their rational self\-interest, because they were unable to audit the finance industry's opaque faulty risk pricing methodology.

### Expansion of subprime lending

Low interest rates, high home prices, and [flipping](/wiki/Flipping "Flipping") (or reselling homes to make a profit), effectively created an almost risk\-free environment for lenders because risky or defaulted loans could be paid back by flipping homes.

Private lenders pushed subprime mortgages to capitalize on this, aided by greater market power for mortgage originators and less market power for mortgage securitizers. Subprime mortgages amounted to $35 billion (5% of total originations) in 1994, 9% in 1996, $160 billion (13%) in 1999, and $600 billion (20%) in 2006\.

### Risky products

The recent use of [subprime mortgages](/wiki/Subprime_lending "Subprime lending"), [adjustable rate mortgages](/wiki/Adjustable_rate_mortgage "Adjustable rate mortgage"), [interest\-only mortgages](/wiki/Interest-only_loan "Interest-only loan"), [Credit default swaps](/wiki/Credit_default_swaps "Credit default swaps"), [Collateralized debt obligations](/wiki/Collateralized_debt_obligations "Collateralized debt obligations"), [Frozen credit markets](/wiki/Frozen_credit_markets "Frozen credit markets") and [stated income loans](/wiki/Stated_income_loan "Stated income loan") (a subset of "[Alt\-A](/wiki/Alt-A "Alt-A")" loans, where the borrower did not have to provide documentation to substantiate the income stated on the application; these loans were also called "no doc" (no documentation) loans and, somewhat pejoratively, as "liar loans") to finance home purchases described above have raised concerns about the quality of these loans should interest rates rise again or the borrower is unable to pay the mortgage.

In many areas, particularly in those with most appreciation, non\-standard loans went from almost unheard of to prevalent. For example, 80% of all mortgages initiated in San Diego region in 2004 were adjustable\-rate, and 47% were interest only.

In 1995, [Fannie Mae](/wiki/Fannie_Mae "Fannie Mae") and [Freddie Mac](/wiki/Freddie_Mac "Freddie Mac") began receiving affordable housing credit for buying Alt\-A securities Academic opinion is divided on how much this contributed to GSE purchases of nonprime MBS and to growth of nonprime mortgage origination.

Some borrowers got around downpayment requirements by using seller\-funded downpayment assistance programs (DPA), in which a seller gives money to a charitable organizations that then give the money to them. From 2000 through 2006, more than 650,000 buyers got their down payments through nonprofits.
According to a [Government Accountability Office](/wiki/Government_Accountability_Office "Government Accountability Office") study, there are higher default and foreclosure rates for these mortgages. The study also showed that sellers inflated home prices to recoup their contributions to the nonprofits.

On May 4, 2006, the IRS ruled that such plans are no longer eligible for non\-profit status due to the circular nature of the cash flow, in which the seller pays the charity a "fee" after closing. On October 31, 2007, the Department of
Housing and Urban Development adopted new regulations banning so\-called "seller\-funded" downpayment programs. Most must cease providing grants on FHA loans immediately; one can operate until March 31, 2008\.

Mortgage standards became lax because of a [moral hazard](/wiki/Moral_hazard "Moral hazard"), where each link in the mortgage chain collected profits while believing it was passing on risk. Mortgage denial rates for conventional home purchase loans, reported under the Home Mortgage Disclosure Act, have dropped noticeably, from 29 percent in 1998, to 14 percent in 2002 and 2003\. Traditional gatekeepers such as mortgage securitizers and credit rating agencies lost their ability to maintain high standards because of competitive pressures.

Mortgage risks were underestimated by every institution in the chain from originator to investor by underweighting the possibility of falling housing prices given historical trends of rising prices. These authors argue that misplaced confidence in innovation and excessive optimism led to miscalculations by both public and private institutions.

In March 2007, the United States' [subprime](/wiki/Subprime_lending "Subprime lending") mortgage industry [collapsed](/wiki/Subprime_mortgage_crisis "Subprime mortgage crisis") due to higher\-than\-expected home [foreclosure](/wiki/Foreclosure "Foreclosure") rates, with more than 25 subprime lenders declaring bankruptcy, announcing significant losses, or putting themselves up for sale. *[Harper's Magazine](/wiki/Harper%27s_Magazine "Harper's Magazine")* warned of the danger of rising interest rates for recent homebuyers holding such mortgages, as well as the [U.S. economy](/wiki/Economy_of_the_United_States "Economy of the United States") as a whole: "The problem \[is] that prices are falling even as the buyers' total mortgage remains the same or even increases. ... Rising debt\-service payments will further divert income from new consumer spending. Taken together, these factors will further shrink the "real" economy, drive down those already declining real wages, and push our debt\-ridden economy into Japan\-style stagnation or worse."

Factors that could contribute to rising rates are the [U.S. national debt](/wiki/U.S._public_debt "U.S. public debt"), inflationary pressure caused by such factors as increased fuel and housing costs, and changes in foreign investments in the U.S. economy. The Fed raised rates 17 times, increasing them from 1% to 5\.25%, between 2004 and 2006\. *[BusinessWeek](/wiki/BusinessWeek "BusinessWeek")* magazine called the option ARM (which might permit a minimum monthly payment less than an interest\-only payment) "the riskiest and most complicated home loan product ever created" and warned that over one million borrowers took out $466 billion in option ARMs in 2004 through the second quarter of 2006, citing concerns that these financial products could hurt individual borrowers the most and "worsen the \[housing] bust".

To address the problems arising from "liar loans", the [Internal Revenue Service](/wiki/Internal_Revenue_Service "Internal Revenue Service") updated an income verification tool used by lenders to make confirmation of borrower's claimed income faster and easier. In April 2007, financial problems similar to the subprime mortgages began to appear with Alt\-A loans made to homeowners who were thought to be less risky; the delinquency rate for Alt\-A mortgages rose in 2007\. The manager of the world's largest bond fund [PIMCO](/wiki/PIMCO "PIMCO"), warned in June 2007 that the subprime mortgage crisis was not an isolated event and will eventually take a toll on the economy and whose ultimate impact will be on the impaired prices of homes. 


What were the consequences of rising interest rates on recent homebuyers and the US economy?