From a talk by Erik Hurst of the University of Chicago’s Booth School:
Starting around 1997, there was a massive run-up in housing prices that we haven’t seen at least in the measured country’s history. We had this big run up in prices. Now why was that? There are lots of stories. Interest rates were really low. Cheap capital from the world. People had expectations about the housing market. Maybe a bubble-type story, people wanted to get in on the bubble. Whatever was going on, people started re-allocating a lot of resources to the purchases of housing.
If you watch the talk or even read the words I’ve transcribed above, you can tell that Hurst isn’t particularly interested in the reason for the run-up in housing prices. He’s more interested in the effects and the after-shocks from the run-up. And these are the standard stories you hear–low interest rates, capital inflows, and animal spirits–if people think housing prices are going to go up, then there is a self-fulfilling prophecy as people bid to get access to an appreciating asset.
But are these good answers? Are they reasonable? Do they pass the sniff test? Again, I’m agnostic about whether Hurst really believes these answers as plausible or whether he just wanted to get on to the rest of his talk. But I think it’s important to consider whether these are good answers. If housing markets are prone to crazy behavior because of these three things on their own or in tandem, there are important implications for public policy toward housing and the Fed.
First, lets look at a measure of housing prices and how they changed over time:
So yes, housing prices did start to accelerate around 1997. And then around 2001 or 2002, they seem to start increasing at an even faster rate.
Now let’s look at the three explanations that Hurst mentions–low interest rates, capital flows, and animal spirits.
First interest rates. Here is a picture of different mortgage rates from 1992 to the present.
Reproduced with the permission of Mortgage-X.com
The first thing to note is that nothing apparently happens before 1997 that might explain the launching point of housing prices then. There is a drop in interest rates starting around 2000 that might help explain the acceleration in housing prices starting around then. But the path of interest rates cannot easily explain the take-off that began in 1997.
What about foreign capital flows? To be honest, I have never really understood this argument. There’s always lots of capital in the world looking for yield and facing the trade-off between risk and reward. Even if capital flows surged during this time period, why did they flow into housing? What is the underlying cause? After all, foreigners weren’t buying houses–they were at best financing them. Why would foreigners find it suddenly profitable to invest in financing houses?
One answer is that there were suddenly more investment vehicles for investing in houses such as mortgage-backed securities. Again, let’s look at the data:
Click on this picture to make it bigger. Look at it. Then look at it again. Ignore the Ginnie Mae line. Look at the red line, which is Fannie and Freddie, and the lime green line, which is private. The private category is mortgage backed securities issued by Bear Stearns and Lehman Brothers and other investment banks. The Fannie and Freddie line is Fannie and Freddie–mortgage backed securities issued by Fannie and Freddie with the implicit backing of the US government. That implicit backing became explicit in fall 2008.
There is an increase in Fannie and Freddie’s activity between 1997 and 2000. It’s hard to notice because the vertical scale is so stretched to accommodate the even bigger increase after 2000. But between 1995 and 1998, Freddie and Fannie’s issuance of MBS more than doubled. There is also a big percentage increase in the private label MBS between 1995 and 1998, but it is dwarfed by Fannie and Freddie. Also note that in 2004, Fannie and Freddie’s issuance fell sharply. But don’t get fooled when Krugman and DeLong tell you that Fannie and Freddie were “small players” after 2003 or that they withdrew from the market. As you can see, they were still massively large by any historical standard and still almost as large as the private label MBS. Between 2004 and 2006, they still issued over two TRILLION dollars worth of MBS. That’s not withdrawing. That’s not small. That’s not insignificant. They also bought a lot of that private MBS which was subprime.
So again, most of the action is in the post-2000 period. But there is some action between 1997 and 2000. Is it enough to get housing prices to take off as they did? Perhaps. But my point is that foreign capital flows are at best a proximate cause. The underlying cause is whatever made it possible for Fannie and Freddie to issue increasing amounts of MBS post-1995.
So what allowed Fannie and Freddie to expand? One answer, and it might be the only answer you need, is that starting in the mid-1990s, Fannie and Freddie were encouraged by the President and Congress to relax their previous standards for which mortgages they could buy. They were encouraged to buy loans from low-income individuals and the percentage of their business accounted for by such borrowers was required to grow steadily. See the two charts at the end of this HUD paper, written in 2001. Fannie and Freddie started buying loans with low down payments and loans with incomplete documentation. Is this enough to explain what happened? I don’t know, but it’s a good place to start. More details in the first half of my essay on the crisis. Here.
The other thing that happened in 1997 was the government made it a lot easier for people to avoid capital gains taxes on homes. Before 1997, you had to buy another house of equal or greater value. After 1997, you didn’t have to roll the gain over. Did this increase the demand for housing? I haven’t seen a careful analysis of this but there is an unambiguous effect of the 1997 tax change: you could avoid the capital gains on a second home as long as you lived in it for three of the previous five years. This encouraged the purchase of second homes.
And what about those animal spirits? What do you need them for? What got them started? Why did people all of a sudden in 1997 start thinking housing was a better investment than they had thought before? Certainly once prices began appreciating people might buy houses for the investment return. But what gets them started? The animal spirit theory isn’t much of a theory.
So if you want to know why housing prices accelerated in 1997 and then racheted upward once more in the early 2000s, I would focus on government’s bipartisan attempt to engineer an increase in home ownership that ratcheted upward in the 1990’s and extended through the 2000’s. Then add the implicit backstopping of the creditors from large financial institutions. Large financial institutions that lent money to others to buy AAA-rated MBS were very leveraged. This leveraging allowed enormous sums of money to flow into MBS. Those creditors should have been wiped out in 2008. But almost none of them were. Just as they had been protected in the past, they anticipated being protected again. So they lent money recklessly and allowed the funneling of trillions of dollars into housing. Bad idea. Bad allocation of capital. Bad result for the taxpayer. Bad effects on future incentives. Again, the whole story is here. But the point I want to emphasize here is that when we talk about why the housing went crazy between 1997 and 2007, let’s not stick with interest rates, capital flows, and animal spirits. Let’s remember the role of bad economic policy in the housing market and the financial sector.