In this post , I suggested that the spike in housing prices starting in 1997
was due more to government housing policy and less to animal spirits or a self-fulfilling bubble that somehow got started out of the blue.
The picture is from Barry Ritholtz’s blog, The Big Picture.
Barry responds in the comments:
Be wary of squishy thinking.
While its easy to blame Uncle Sam, you need to show the data that supports that argument — so far, no one has successfully done that. NO ONE.
The much more persuasive case has been made that the combination of ultra low rates, shadow banking system, corrupt rating agencies, foolish lenders, irresponsible borrowers and dumb bond fund managers were the primary causes.
The DATA provides an overwhelming viewpoint of where the Housing boom and bust came from
Barry, I think you’re confusing the subprime crisis with the housing boom. They are related but they’re not the same thing. The Fed’s low interest rates between 2002 and 2004, for example, did have something to do with the subprime crisis. And artificially low interest rates did inflate the housing market generally. I don’t think they had
much anything to do with housing prices in 1997. And yes, the shadow banking system had a lot to do with the run-up in prices after 2003 or s0. And yes, there were a lot of dumb, myopic lenders, borrowers and bond-fund managers. But why did they start getting dumb in 1997.
My other thought is that we don’t have particularly good models of bubbles, by definition. So when you say there no one has produced the data, I’m not sure what standard to use to evaluate it. What I think you really meant when you wrote that was that Fannie and Freddie and the CRA can’t explain why Bear Stearns and Lehman and a bunch of other cowboy waa-hoos went crazy on MBS. And you’re right. But that’s not all that I meant by government housing policy.
Here’s the outline of my narrative. Sure, it’s squishy in parts. All narratives are. Yours, too, I suspect, but I’ll let you make the call on that one.
The role of government in the housing market goes back decades to the deductibility of mortgage interest, FDIC insurance, and the creation of Fannie Mae. But those interventions were done a long time ago and they stayed in place with minor variations. They weren’t the cause of the crisis. You have to find a change in government policy. My narrative starts in the early 1990’s. Check out this article  from 1992. (And don’t worry, even though I’m going to use the letters “CRA” in consecutive order in what follows, I don’t think the CRA is the main cause of the subprime crisis. I, like you, blame most of that on shadow banking. But the CRA has something to do with it…)
It’s about how ACORN and others used provisions of the CRA to get urban banks to make loans in neighborhoods that hadn’t been receiving loans:
The Philadelphia banks in the program, Mellon, Continental and Fidelity,, say their experience shows that a well-structured program can break even in the short run and promises intangible and financial gains over the long haul. The banks charge sufficient fees to cover costs and work hard to keep delinquencies and foreclosures low.
“These are not conventional loans and we make sure that we don’t lose money,” Mr. Desiderio said. “But they are totally beneficial to us because they improve our trade area. In the long run this will drop to the bottom line.”
Bankers believe that as poor neighborhoods stabilize, the entire region benefits, which affects a bank’s future profitability.
What is more, these mortgages help banks fulfill somewhat vague obligations of the Community Reinvestment Act of 1977, which requires banks to invest in communities that provide them with deposits.
It also talks about the role of Fannie and Freddie. Remember, this is 1992, right around the time HUD starts pushing Fannie and Freddie to buy more loans than they had bought before in poor neighborhoods.
But the mergers that have helped create the lending programs are also a cause of concern for some. LaVerne Butts, a Philadelphia Acorn official, fears that mega-mergers may leave the poor in the dust. “Where’s the accountability?” she asked. “We’re doing wonderful things, but we’re still swimming against the tide. Many of these banks still don’t view low- and moderate-income people as people. When they get so big, who do you lean on?” Aiming at Secondary Market
Yet at present, the three Philadelphia banks seem responsive. They have lobbied with Acorn in Washington to find ways to make it easier to package these mortgages and sell them in the secondary market. This would reduce the banks’ risk and free up more money to lend.
The biggest buyer of mortgages is the Federal National Mortgage Association, known as Fannie Mae, which resells them to investors. But Fannie Mae has been reluctant to buy such unconventional mortgages. Acorn hopes that large commitments like that of Nationsbank will help bring pressure on Fannie Mae. Already, Nationsbank is talking about joining with Acorn’s Washington lobby.
Fannie was reluctant, but they got over it. They made an enormous amount of money when they were “forced” to lower their standards. They weren’t really forced. They liked being thrown into the briar patch.
Remember, this is 1992. In 1995, the CRA got revised and was made tougher. Fannie and Freddie’s were required to buy more mortgages made to low-income buyers. In 1995, President Clinton announced the 1996 Home Ownership Strategy. Read about it here . Go to the end of the document. It details all the activities that would increase home ownership.
And it worked. Or something did. Correlation is not causation. The fact that home ownership rates started to rise in 1995 doesn’t mean the policy worked. But that was the goal of the policy and the stated activities related to that goal (Making Financing More Available, Affordable, and Flexible) would increase home ownership. Of course, you have to look at the data. You have to show that financing did become more available, affordable, and flexible. This 2001 paper by Josh Rosner  makes the case pretty convincingly. But maybe I’m biased. You tell me where Rosner goes wrong. He does have a lot of data. Remember, this is 2001. Long before the important part of the subprime crisis.
I summarize the role of Fannie and Freddie’s increased willigness to buy mortgages they wouldn’t have bought before, here . I’m agnostic about their direct role in subprime. I don’t think they bought very much of it. They bought a lot of subprime MBS. But maybe someone else would have bought that anyway. It was awfully profitable for a while.
So my claim is that between 1995 (and maybe a little earlier) and 2001, there was a lot of government policy that pushed up the demand for housing. Increases in demand usually increase prices. There are exceptions. If supply is sufficiently elastic, the price increase can be minimal. But I think it’s pretty clear that in some cities, supply was quite inelastic, for both geographic reasons and zoning restrictions. So the push in demand helped create the rise in prices you see in the graph.
It probably didn’t create the subprime crisis directly. But it doesn’t have to in my story. In my story, the increase in demand (driven by housing policy, somewhat well-intended (getting people into homes who couldn’t afford them before), somewhat very nasty self-interested cronyism (NAR, NAHB, Fannie and Freddie) pushed up the price of housing between 1995 and 2001.
Once the price of housing started rising dramatically, it became profitable to bet on the rise continuing. So a lot of people, smart and stupid, tried to ride that meteor as it shot upward. And that’s where the shadow banking system and the low interest rates come in. The shadow bankers pumped trillions into that market via all those innovative new assets (CDO’s, CDO squared etc). They use borrowed money because they could. The lenders lent the money because the government had signaled  that lenders would get made whole even when the bets their loans financed were worthless. I learned part of that story from a fine book called Bailout Nation . I think you’ve heard of it. So moral hazard had something and maybe a lot to do with the last part of the housing bubble and especially the subprime part. But why did the moral hazard spend itself in the housing market rather than somewhere else? That was because that market was rising nicely. But why was it rising nicely. Animal spirits or government policy that kicked off the madness? I think the government had a lot to do with it.
Here’s where my story is squishy. It’s not enough to say that demand went up, so prices went up. You have to show that the magnitudes are reasonable. You have to show the areas where Fannie and Freddie were most active between 1995 and 2001 were the areas where price rose. I’ve seen one paper  that argues that Fannie and Freddie’s affordable housing goals had a limited impact on providing liquidity. Could be. But it is hard to tease out independent effects. I suspect this debate and empirical evidence will keep going for a while. But it’s a reasonable debate. It’s not silly.
And yes, I know other countries had housing bubbles but didn’t have a CRA or Fannie or Freddie. You can increase subsidies to home ownership without having the same named entities. Again, it’s an empirical question. And I certainly agree that monetary policy and the coddling of cronies in the shadow banking system made the whole thing many times worse than it otherwise would have been.
I responded to Brad DeLong’s claims that Fannie and Freddie had nothing to do with the crisis, here .
I responded to Erik Hurst’s claims about animal spirits, interest rates and foreign capital flows, here .