The housing bubble was inflated by a massive expansion of credit and the influx of capital into residential mortgages. The expansion of credit took four forms: lower interest rates, lowering or eliminating qualification requirements, different amortization methods, and higher allowable debt-to-income ratios.

Lower interest rates expand credit by allowing larger sums to be borrowed with the same payment amount. In 2000, the interest rate on a 30-year mortgage was 8.05%, and in 2003, it was 5.83%. This reduction in interest rates accounts for 20% to 50% of the increase in house prices experienced during the bubble. Subprime lending is an oft-cited example of lowering qualification requirements, but many loan programs included limited documentation that also allowed people with good credit to purchase multiple properties with little or no money down and no real ability to make the payments.

Credit was also expanded by borrowers utilizing risky financing options including interest-only and negative amortization. Interest-only loans artificially "add" affordability to the market because it allows for larger sums of money to be borrowed with lower payments. The final component of credit expansion was a willingness of borrowers to take on larger debt-service payments as evidenced by increasing debt-to-income ratios. All of these factors also helped speculators. The acquisition and carrying costs of a speculative flip was greatly reduced. More people were eligible to speculate, and with rapidly rising prices, more people wanted to do so.

Nationally, prices during the bubble rally increased by 45%. About half of this increase was due to lower interest rates. However, in the markets most prone to irrational exuberance, prices increased much more than the change in interest rates can explain. These markets also saw a large increases in the use of exotic financing and major increases in debt-to-income ratios utilized by many borrowers.

For example, the median household income in Irvine in 2006 was $83,891. Applying a 28% DTI leaves a payment of $1,957. Interest rates at the time were about 6.5%; a payment of $1,957 on a fixed-rate 30-year mortgage at 6.5% would finance $309,691. Short-term adjustable rate mortgages carry lower interest rates than long-term fixed rate mortgages because the lenders have less interest rate risk exposure. The same $1,957 payment on a 5-year ARM at 5.5% would finance $427,081. The interest-only loan terms allows borrowers to increase their loans by 25% thus artificially increasing prices by 25%.

The most important single factor in the expansion of credit was the negative amortization loan, also known as the Option ARM. The payment rates on Option ARMs differ widely, but for the sake of this calculation, assume a 3.8% teaser rate (they were as low as 1 %). The $1,957 payment finances $309,691 with a Conventional mortgage, $427,081 with an Interest-Only mortgage, and a whopping $618,144 with Negative Amortization. Stop for a moment and ponder the math: the same payment now finances 100% more money. Is it any wonder the real estate in bubble markets like Irvine, California, were 100% overvalued at the top?

People purchasing with Option ARMs were buying at the rental equivalent monthly cashflow, at least for a while. From a financing perspective, the market was not overvalued. People were paying exactly what they should have been paying. They were just doing it with loan terms which were going to destroy them, hence the terms "toxic financing" and "suicide loan." This point cannot be overemphasized, Negative Amortization loans inflated the housing bubble. If this loan product had not been offered and aggressively pushed by lenders, the bubble would not have inflated to the degree that it did.

Most financial manias are associated with an uncontrolled expansion of credit. The housing bubble was no different. In the end, all Ponzi Schemes collapse as the flow of credit is shut down. The credit crunch which began in August of 2007 was triggered by homeowners defaulting on their toxic mortgages. The near elimination of credit caused the Ponzi Scheme to collapse, and it lead to the deflation of the housing bubble.

Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
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