Economic bubbles start with a shining story and end with a tragedy, which keeps reminding people that nothing can be overdone. Surprisingly, bubbles are built on top of solid fundamentals. Once people believe in them, people start to over-leverage them until, of course, the situation becomes so extreme that everything is afloat, detached from their roots. This real estate bubble is no difference.
It is normal that low interest rate will energize house purchases, and consequently, jack up the price. However, it should be bound by debt-to-income ratio. Further, it is also bound by available liquidity. Creatively, “smart” people in financial system built up models based on historic data analysis, proving that house price will keep going up in the foreseeable future.
Thus, the risk of sub-prime loans becomes acceptable and it is safe to hedge a booming housing market. Now, the only issue is to find ways of borrowing money for lending. Thanks to these smart guys, we landed up with tons of SIV (Structured Investment Vehicles), CDO (Collateralized Debt Obligations), CMO (Collateralized Mortgage Obligation) and other toxic papers, and a shaky economy. This is exactly what has been repeated many times in other bubbles. The bubble model is built on the assumption that there would never be any liquidity issues. In this case, the combination of over-leveraged home buyers, over-leveraged mortgage lenders, relatively high mortgage rate, and increasing inflation rate eventually weighted in. Subprime loans triggered the downward spiral.
Now, let’s look at what the Fed is doing. Given the fact that the position of hedging a booming real estate market is so enormous, it is not an option for the government to bail out the whole system. What Fed plans to do is to reduce the damage from the first wave of this real estate recession as much as possible, which is exactly Federal Reserve Committee’s responsibility. The first wave will happen this year with about 60%~75% of the $1.2trillion ARM reset. Until now, Fed still has the leverage for this year with relatively modest inflation rate, relatively strong employment, and nearly $1 trillion cash to save the system. It is the next year that we might start to see things out of control. The bottom line is that this country needs to maintain the current employment rate for a while to help heal the real estate bubble burst.