Housing bubble in US

Many economists feel that the current financial crisis started with the housing bubble in the US. Price of houses in the US increased without the right fundamentals. When price of an asset increases without right fundamentals it is bound to fall. This is what happened to the housing market in US. Housing prices increased by more than 100% in the period between 1997 and 2006. With housing prices so high, it became an asset which earned more than 100% return. US investors looked at housing as an investment which guaranteed a high rate of return. But from where did they get money to finance. With easy credit conditions banks were more than ready to provide loans. The model in the mind of investor was simple. Take a loan and buy a house. After some time with the prices increasing sell the house at a premium. With money received pay off the loan and the remaining amount is your profit.

Coinciding with this was also a huge growth of wealth thanks to emerging economies. This created a pool of investors worldwide who were always hunting for maximum return. That is a giant pool of money was created approximately $70 trillion in worldwide fixed income investments which was constantly looking for a high rate of return. This pool of money approximately doubled between 2000 and 2007. However there were not many income generating investments to satiate this pool of money. Understanding the market requirements investment banks came up with products like the  mortgage backed securities (MBS) and  collateralized debt obligations (CDO). These financial instruments were also given safe ratings by the credit rating agencies. Hence this pool of money was routed to the mortgage market in the U.S. Investment banks earned huge fees through these transactions from the mortgage supply chain.

These new financial instruments were immensely popular with the investors and with appreciating housing market demand for these instruments only increased. The CDO in particular enabled financial institutions to get investor funds to finance subprime and other lending. CDO places cash payment from different loans into a single investment from where cash is then put to specific securities in an order. The security to get cash first receives higher rating.

This was all rosy when the interest rates were low and the housing prices were high. However by September 2008 prices of houses declined by approximately 20%. With prices declining and interest rates increasing borrowers with adjustable rate mortgages were unable to refinance and started to default. With the value of houses less than the loan amount the amount of foreclosures increased. In 2007 alone there was a 79% increase in foreclosure from 2006 amounting to about 1.3 million properties. The foreclosures further increased by 81% to 2.3 million in 2008. As per estimates by August 2008 approximately 9.2% of all US loans were either bad or foreclosed. This increased to 14.4% by September 2009. Like any other speculative bubble this bubble became unsustainable and finally busted.

Read more at: Financial Crisis Of 2007-2009- Causes And Impact On Global Economy Part I