The terms supply and demand usually are what cause prices to vary whether it be real estate or any other freely traded commodity. This is true but to go beyond this simplistic answer one must look to what factors enter into establishing the supply and the demand.
Let's start first with supply. Before Developers decide to initiate the construction of housing they obtain as much information as possible relating to the potential demand for specific types of housing so that they feel assured that there will be buyers for them when they come to market. Thus demand is the initiating factor.
Then what affects the demand for housing? The obvious primary answer is the ability for buyer's to have sufficient assets and monthly income to qualify for mortgage loans. What follows is the availability of these loans at an affordable cost, along with the funds to which buyer's have access necessary to complement the loan amount so that the purchase can be effected.
Factors that effect the cost of a loan include credit score, loan fees, term of loan, fixed or adjustable interest rate amount, interest rate change triggers and possible prepayment fee. The availability of funds from lenders that affect these factors is related to the nation's money supply that is controlled by the actions of the Federal Reserve Board (FRB). The expansion or contraction of the money supply acts to change the Federal Funds Rate that is the interest rate paid by one bank to another to borrow funds in other to meet their reserve requirement. The financial markets use this interest rate as an indicator that other interest rates should move accordingly including mortgage rates. In addition, there is a relatively long period of time between the time the FRB makes a change in the money supply and the market reacts to it. This can be viewed in Figure 3 on the M1 Money Stock graph for the period 1975-2007 comparing it to Figures 1 and 2).
With this basic knowledge now again view Figure 1, the graph California Median Home Prices and Population 1968-2003. The graph shows that population has grown steadily at a linear rate over this period of time. However, the median prices show periods of moderate growth, rapid growth and decline. A period of decline occurred between 1989 and 1998 preceded by and followed by a period of relatively rapid growth. The period from 1998 to the fourth quarter of 2005, where one might say "the price bubble burst", is especially marked by an inordinate rapid increase.
A rational explanation for what occurred can be made. A recession in our economy developed in 1990-91 that had started the reduction in the number of potential buyers of homes that lasted until circa 1998. To counteract the recession, the FRB had already begun to incrementally increase the money supply (see figure 3) and correspondingly lower interest rates. When home prices started to erode due to the decreased demand, investors speculating in real estate moved their money into stocks and the stock market began its run up. The FRB began to react circa 1994-95 and the money stock leveled off for a bit before starting to decline. Lenders in reaction to the increase in the money supply creatively found new ways to lend their money out and buyers reacted accordingly.
Hence, although the FRB reacted to the decrease in demand, increasing the money supply incrementally over time, it wasn't until 1998 that the increased money supply, that already had exacerbated the increase in stock prices, took hold. Figure 3 graph shows that the money supply started its downward trend in 1995 but the stock market didn't fully react until 1998 when the decrease in the money supply effected the beginning of a subsequent recession in 2001. The financial indicators of a pending recession caused the stock mark bubble to burst. This in turn caused investors to turn to other investment vehicles and some returned to Real Estate.
Much can be learned by again viewing the Figure 3 graph that shows a leveling of the Money Stock growth starting in 1998 and then starting its rise up again in 2001 to counteract the recession. This increase was exacerbated due to an inordinate increase in the money stock as a reaction by the FRB to the terrorist attack on 9/11. The money that was generated in the economy had to be loaned out by the various lending institutions since that is where their profits are derived. A most important contributing factor was the acceptance of Credit Scoring during the 1990's. This aided and abetted the movement to substitute the rating of buyers on their ability to pay off their loans for the previous widely used requirement for adequate collateral to back their loan.
The loan industry was quick to adapt to this and, in fact, created loan vehicles that were able to circumvent the need for mortgage insurance that had for many years been required for loans exceeding 80% of property value. The flood of available money to be loaned exacerbated by this factor led to truly creative mortgage terms that allowed many to qualify for loans that would not have under previous rules. Loans were packaged into securities where by that virtue appeared to normalize relative risk and could be sold to investors. This allowed lenders, although still servicing them, to pass on to securities investors loans they might not normally make if they had to continue to own them.
Thus new home construction boomed to satisfy the demand created by the many people taking advantage of the opportunity to own a home of their own or to buy up to a more spacious and higher priced one with the every increasing equity being built up in their previous home. The increasing price spiral attracted more speculative investors away from the stock market. Buying with high leverage, having put very little down with prices increasing at an annual rate of 20 to 30% resulted in an extremely high return on invested capital. As seen in Figure 1 and then Figure 2 the price rise starting in 1998 rose virtually asymptotically until the bubble burst in the third quarter of 2005 as shown in Figure 2.
The foregoing clearly shows the causal factors for the recent collapse of housing prices and is available to everyone. The obvious question that arises is "will those having the means to implement correct measures utilize them? Future events in the housing and securities markets will answer that question.
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