Despite the "irrational exuberance" that drove the housing market over the past few years, few envisioned such spectacular fallout on the down side. Frankly, had it not been for two factors poor decision-making that created the sub-prime financial crisis and a dramatic decline in household formations the housing market would have slumped, but not plunged.

The sub-prime crisis

In the early 2000s, mortgage rates fell to more than 40-year lows as the Federal Reserve lowered borrowing rates to stave off the recession. With these low rates also came new, unconventional (but also riskier) mortgage options that allowed a larger share of households to become homeowners. Homeownership rates rose to a peak of 69.4 percent in the second quarter of 2004 up from 63.9 percent a decade earlier and 66.7 percent five years earlier.

Unfortunately, the means by which many of these new homeowners were placed into their homes was not based on solid lending practices. Down payment requirements were minimal or nil, some (no documentation) loans did not have income verification requirements, and others had deeply discounted initial rates that were subject to sharp increases once the initial rate period was over. Although these creative lending practices were originally designed to enable a larger share of the population to afford home ownership, as the number of sub-prime loans rose, delinquency rates, default rates and foreclosures soared.

Foreclosures increasing

According to RealtyTrac of Irvine, Calif., foreclosures were up 55 percent in the first half of 2007 compared to the same period of 2006. Even compared to the second half of 2006, foreclosures were up 30 percent. A total of 925,986 default notices, auction sale notices, and bank repossessions were issued in the first half of this year and RealtyTrac sees no sign that the trend will abate. They estimate that foreclosures could increase to 2 million in the second half of 2007, which would represent a 65 percent increase from the same period last year. Nevada, Colorado, and California posted the highest foreclosure rates, although the largest number of foreclosures came from California, Florida and Texas.

The dramatic upswing in foreclosures along with significant prodding from regulators and Congress has encouraged the financial community to tighten lending standards.

While these changes will not help those who are already in the process of default, they will serve to protect future buyers. At the same time, however, these stricter lending standards will significantly reduce the number of households eligible for a mortgage loan. Thus, the demand for new homes will be curtailed and the downturn in the housing market is likely to last much longer than previously estimated as the excess inventory of unsold homes takes longer to work off.

Slower household formations

Even with the finance crisis, the housing market would be in much better shape today if the rate of household formation had not sharply slowed over the past 12 months. In the year that ended with June 2006, the Census Bureau estimates that 1.6 million households were formed higher than the 1.1 to 1.2 million households that were formed over the previous five years but not unprecedented demographic growth. In late 2006, however, household formations suddenly and dramatically slowed. In the most recent year (July 2006-June 2007), just 891,000 new households were formed almost halving the previous year's rate.

This trend reversal significantly slowed the demand for housing and exacerbated the already tenuous inventory situation. According toBusiness Week, if Americans had continued to form households at the same rapid rate of the previous year, 700,000 more homes would have been occupied and vacancies would have risen by a much more subdued 300,000 units. The lesson to be learned: because demographics ultimately drive housing, watch out when activity strays too far from the trend.