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.
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