By mid-2005, it was apparent that a housing bubble had developed and that the risks of a severe mortgage downturn had increased dramatically. Fueled by historically low interest rates, the creation of mortgage products targeting less credit-worthy borrowers and abundant liquidity from a booming secondary market for securitized mortgages, home prices had virtually doubled over the previous five years.
Housing starts, which had increased every year since 2000, peaked in second quarter 2005. Mortgage interest rates began rising, with the average rate on a conventional 30-year fixed rate loan jumping from 5.6% to 6.7% between June 2005 and June 2006. And mortgage lenders were loosening their lending standards and increasingly using novel loan products, including interest-only mortgages, option adjustable-rate mortgages and no documentation loans.
But one need not have been the CFO or director of a bank to know that a national housing bubble had developed and could burst. One need only have read the news, where a growing number of economists, investment analysts and public policy experts were sounding the alarm:
A number of firms did take action to reduce their mortgage-related risk exposure. Goldman Sachs, for example, began aggressively reducing its mortgage-backed securities exposure in late 2006, both by reducing inventory and hedging. Morningstar recently named PIMCO’s Bill Gross the best fixed-income fund manager in 2007, lauding him for avoiding exposure to subprime securities and for anticipating the effect that the decline in home prices would have on the broader economy and corporate bonds.