The housing boom and bust

by Russ Roberts on April 13, 2011

in Government Intervention, Housing

Here is an updated version of Case-Shiller’s housing index for the country. (The source for the updating and the image is The Big Picture and TBP reader Steve Barry.) It is of course somewhat misleading because there is not a national housing market. But it does capture factors that affect all housing markets.

Some people explain the recent 15 years as being caused by “animal spirits” arguing that if you think prices of an asset will go up, then that belief can be sufficient to cause a bubble. True, no doubt. But what causes that belief to take hold. Some people say it’s just random. A fad. The madness of crowds. Could be. I suspect that the systematic attempt by federal government policy that began in earnest in 1995 and ran through the Clinton and Bush II administrations had a lot to do with it.

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Barry Ritholtz April 13, 2011 at 11:23 am

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

Slappy McPhee April 13, 2011 at 11:53 am

From listening to his podcasts, Russ seems hesitant to place all the blame within government. Though sometimes, I have trouble telling the difference where government ends and banking begins.

Brian Bedient April 13, 2011 at 12:09 pm

Ultra low rates were the Fed’s responsibility. As for the rest, as Pete Boettke would say, who was passing out the crazy juice?

Who was making it in all those folks’ self-interest to be “corrupt, foolish, irresponsible, and dumb?” They weren’t being dumb – they knew the government was backstopping the market. They bought extremely risky assets because on the upside they made a lot of money and on the downside, they’d be made whole by the taxpayer. Their getting bailed out proved they were the smart money. Why should they do the hard work of real investing if they can just give away billions to anyone with a pulse and sell their overvalued assets to Fannie and Freddie or TARP?

The data here prove that the housing market has never gone nearly as crazy as it did in the last decade. If market participants being stupid is wholly to blame, why did they suddenly drop in intelligence? The evidence is if anything in the other direction – they’ve gotten much more sophisticated. What made them ‘stupid’ is a change in incentives, fostered by Uncle Sam and the Fed.

GP Hanner April 14, 2011 at 3:33 pm

Speaking of DATA, I will also suggest these as data sources: look at the number of fines imposed on mortgage lenders, especially banks, who failed to lend to the federally mandated standards. I would also suggest studying the the groups of recipients of “federally guaranteed” or “federally back” mortgages. Both of the policies contribute to moral hazard on the part of mortgage lenders and reinforce each other. Lenders make risky loans to meet federal standards and to avoid being penalize by the federal government; having the federal government (the tax payers) guaranteeing risky mortgages simply encourages poor underwriting standards.

For those who might be too young to remember, some twenty years ago the Democrats waxed highly indignant over the practice of “redlining;” they claimed that certain racial groups were being denied loans because of who they were rather than their credit worthiness. We are seeing the result of the policies installed to correct what was claimed to be racial discrimination.

Lionel from France April 13, 2011 at 11:41 am

Some talk about “animal spirits” when they can not explain human behavior.

frank April 13, 2011 at 11:56 am

Isn’t it interesting that the peak of the housing boom and its subsequent bust occur much earlier than the following financial crisis?

To me, this looks like evidence that the housing bubble was a rather minor factor in causing the financial crisis. Something else must have been going on that caused the big economic crash so much later than peak housing in late 2008. Or can this big lag be explained by factors I am not aware of?

geckonomist April 13, 2011 at 12:37 pm

Prof. Roberts, how does your narrative explain (much more mad) housing booms (still going on) in places where there is little or no government support (and/or no change in such support) for housing whatsoever?

In nations as different as – to name just two of many- Kenya and Belgium.

Talking to investors & bankers from such nations invariably yields the same premise/paradigm : “In our country, property values have never gone down and never will” , followed by a list of narratives as to why their country is a special case, why their country or situation is different from the USA/UK/… and how much money they’ve made by trading property.

Darren April 13, 2011 at 12:38 pm

The credit crunch lagged the housing bust because it takes time for falling prices to be factored into the prices of mortgage-backed assets. Homeowners don’t immediately start defaulting on loans, they only do so when their ARMs reset at high rates and they cannot refinance. And then it takes times for bankers to realize that their RMBSs and correlated assets are worthless. Only when everyone starts selling them all at the same time do you get a credit crunch.

On the subject of what caused the bubble I think it’s just fingerpointing to try and figure out how much was government and how much was the private sector. I think everyone can agree it was both to some degree. Trying to figure out exactly who deserves how much of the blame is impossible.

Brian Bedient April 13, 2011 at 12:43 pm

It’s not the peak that hurts, it’s the slide downwards. Foreclosures started going up in 2006 but it didn’t reach the full-on panic stage until later.

I remember taking a class for the Series 7 (stockbroker) exam in 2005 and asking the teacher, an older, experienced broker, what would happen to mortgage-backed securities if we had mass foreclosures for some reason? I thought it extremely strange that some of these things were considered AAA investments up there with Treasury securities in safety. I’ll never forget what he said: “that’s never happened before.” It’d be fine as long as housing prices keep going up, and well, they’re not making any more land… He told me to try not to think about it because it wouldn’t help me on the exam.

All through the crisis we had people telling us that this was just the smaller subprime mortgage market that had problems and housing was going to start going back up any minute now and the government’s going to fix everything, etc. It seems clear in hindsight (indeed, it was clear to many of us at the time) that there was a serious crisis, but the verdict wasn’t really in for sure until around that September when Hank Paulson threatened Congress with martial law and chaos in the streets if they didn’t give him $900 billion to hand out to his buddies, with no strings, pronto.

Properal April 13, 2011 at 1:07 pm

I came across this speech by Ellen Seidman who was Director of the Office of Thrift Supervision from October 1997 to December 2001. In this speech she bragged about how the CRA created the subprime market. Something banks were reluctant to get into.

“CRA has generated a fair amount of innovation, in an industry that is—or certainly was— not especially known for innovation, especially with respect to entry into new markets [sub-prime]. … In lending, expanded underwriting for both prime and non-prime [sub-prime] loans was encouraged by the opportunity for CRA credit. Recently, CRA service credit has probably had an impact in encouraging banks to explore better ways to serve “underbanked” [sub-prime] consumers. CRA changed the hurdle rate for new products, services and markets, encouraging banks and thrifts to look for investments and products for which a part of the return was in CRA credit, rather than dollars [don’t expect to get your money back]. Once these initiatives were started, many have proven to be sustainable in purely financial terms.”

Sam Grove April 13, 2011 at 1:27 pm

Government policies never, ever, ever, ever, have unforeseen consequences, as long as they are fomented by progressive sentiments.

BintheD April 13, 2011 at 2:15 pm

The old Political-class axiom:

Judge our program not by its results, but by its good intentions

vikingvista April 13, 2011 at 3:51 pm

The actual effect of any political intervention is known with absolute certainty, merely by looking at its ostensible intent. It’s just that sometimes those effects are obscured by market failures.

vikingvista April 14, 2011 at 3:51 pm

/ sarcasm

dan April 13, 2011 at 1:55 pm

The rolling of the snowball down the hill that lead to the avalanche was Govt interventionism. Govt sought higher homeownership rates amongst groups of people who were high risk borrowers. Banks were and are shrewd with lending, as a necessity. And, by govt regulations must abide by particular standards in lending like a percentage of cash holdings on outstanding loans.
Under the CRA, govt sought more housing for LMI (low to moderate income) individuals. Govt pressured banks to make loans to LMI individuals. When banks cited their potential losses or current losses from high risk borrowers, govt found ways to alleviate banks losses. Fannie and Freddie would be the institutions to alleviate this problem. Still, banks cited the regulatory standards for not loanding to LMI candidates. Govt removed those barriers and incentivized banks to sell these loans to Fannie and Freddie. Banks would lose in the long term on LMI borrowers, as their credit rating and other standard practices often can predict, especially when a recession occurs (recessions and growth in an economy is the norm).
The standard of practice in lending, since Fannie and Freddie were buying most loans that came in, was lowered to the point of ‘no money down’. This assured that the borrower had little to no skin in the game should their be tight times.
Banks did not have to sit on these likely to default loans as Fannie and Freddie would purchase them, and banks could profit today on the sale of the loan rather than wait out the length of the loan and collection of interest to profit should the loan remain solvent.
Govt further pressured banks……
‘In 1995, New regulation were created for determinig whether banks were meeting CRA standards. Examiners had their discretion removed. Before 1995, banks had to prove that they were looking for qualified LMI borrowers. Now banks had to make a requisite number of loans to LMI borrowers. The new regulations required the use of “innovative and flexible” lending practices to ‘address the need’ of LMI borrowers. ‘ This is tantamount to quotas on LMI loans.
Further pressures mounted……. 1999, pending legislation to allow banks to diversify into selling investment securities………. The White House pushed “that banks given unsatisfactory ratings under the 1977 CRA be prohibited from enjoying the new diversification priviliges”.
2002, GWB pushed for the American Dream Downpayment Act. This would subsidize down payments of LMI borrowers. Then he pushed for Congress to pass legislation to allow FHA to make ZERO-DOWNPAYMENT loans at low interest rates to LMI borrowers.
Congress and the Attorney General in the 90′s held hearings about banks and their lack of lending to LMI borrowers. The Govt used part of a set of stats to accuse banks of discriminatory practices. As Dr. Sowell points out, the stats govt used was 44% and 22%. The first represented black applicants who were denied loans and the latter of the whites denied loans. Govt asserted the only possible reasoning of the disparity is RACISM. But, they fail to take note of 12%. This is the rate of Asian-Americans who were denied loans. Did ‘White-owned’ banks disriminate against whites in favor of Asians?
Further pressures……….. ACORN and other scam orgs. were assembled to get out and get on TV. I can remember the picketers in front of a BofA building in NY, accusing BofA as racists.
Banks were given the options of continued harassment/loss of revenue or making and selling of their BAD LOANS with no risk but to Taxpayers.
Then………… the public took the ball and ran……….acting rationally…….. to make money and raise their own standards of living.

Ironman April 13, 2011 at 2:05 pm

It’s pretty safe to say that housing and lending policies established during the 1990s were enabling factors. Barry is correct to observe however that they were not causal factors.

For those, you need to keep in mind that there were two major bubbles in the U.S. in the period from 1997 through today. The Dot-Com stock market bubble, which ran from April 1997 to June 2003, played a major role in launching the housing bubble, which is still in its collapsing phase.

Overall, it’s a pretty good example of how the unintended consequences of poor public policy choices can create considerable volatility over a period of decades in a national economy. The data certainly suggests that it’s quite possible that the real causal factors behind the housing bubble are not the public policies that either Barry or you might have thought they were!

WhiskeyJim April 13, 2011 at 3:43 pm

What is a bubble? No one has come up with a consistent way to define one, until they burst and look back in time. This fact alone should give economists managing the FED great pause; actually foundational policy-change pause, given the role of cheap money since 2000 and the havoc it helped cause.

And while regulation was driving housing demand from all sides, institutional economists and bankers actually believed they had tamed risk forever with their new CDOs. I remember Greenspan actually saying it. But risk is never ‘tamed.’ It is only passed to someone else.

And how can anyone say the risk is ‘tamed’ when they are not modeling the big picture despite the trillions involved and the hundreds of millions spent on research? For if they had, someone might have noticed that all those trillions and their risk were being held in a very incestuous little banking circle. Hardly an effective method of risk dissipation.

But I would bet that is not how the few that shorted the housing market figured it out. They just saw that housing was becoming hugely over-priced while the quality of the loans was terrible. So then we are back again to the fact that everyone is acting quite myopically.

And so it is arguable that attempting to shape macro arenas by regulation and interest rates is akin to meddling with the steering wheel by a very short-sighted man. It puts us in the ditch every time.

vikingvista April 13, 2011 at 4:08 pm

“What is a bubble?”

Part of the definition must be that it is not widely recognized until long after it is well underway. Otherwise, the bubble couldn’t exist. That means most market actors, being unaware, cannot be culpable. They must be considered victims of the bubble. Yet they routinely get blamed for them.

And yet bubbles must have a cause. It is not enough to simply refer to business cycles as though they are a fundamental force of nature. Even those who claim bubbles are a natural feature of free markets must have a theory to justify that claim.

But those who dismiss ABCT make no attempt to replace it with a theory of their own. Keynesiacs express their total absence of a theory with “animal spirits”. Moneterists (or at least Friedman) express their total absence of a theory with “plucking theory”.

Bubbles are a central concern of the macro economy. Economic schools that take them as given but attempt no theory to explain them, such as keynesianism and moneterism cannot be taken seriously as ways to understand macroeconomics.

dan April 13, 2011 at 4:16 pm

Has there ever been huge valuation increases in an industry or a product, of sorts, that has held its value and then continued on the historical trend of slight up and downs? No dramatic decreases in valuation after peaking (in hindsight)?

vikingvista April 13, 2011 at 5:17 pm

Of course. By definition, few people know at the time if that is what is happening, or if it is merely a bubble.

And I’m not saying ABCT explains all ups and downs, but it at least attempts to explain some of them.

dan April 14, 2011 at 2:44 am

Of course? Help me out?
What market? What product?
I am, truly asking, for I do not know and wish to learn.
What market has had a huge valuation increase in a short amount of time, defying trends, without a fall or rapid decrease in valuation, to be more in line with historical trends of that particular market?

dan April 14, 2011 at 2:55 am

I think many, if not all, knew something was awry in the market on housing by 2005.
My spouse and I in line to join the masses of selling our property for a nice profit and moving into an upgrade of a home a little closer to our places of employment and in an area more centralized that had room for expansion, and of course increased valuation of property.
But, my gut, and logic, had been eating away at me that something was incorrect. The value of homes had increased, dramatically. Sounded good. But, having less knowledge of economics, even then, I recognized that the historical trends were off. I did not understand anything beyond that people were living above, what I thought, were their means. There is now way that the valuation of housing could maintain from their peak and continue on at historical trends of rising values. Thinking of what my, then 4yr old son, would be looking at for a mortgage on a starter home, when he would be in his mid to late twenties, seemed a bit high. I could not imagine a starter home in twenty plus years having a price tag of over $200,000, or more. Through much bickering, I won out on the argument to forgo the trade up.
But, surely, many knew something was not right.

vikingvista April 14, 2011 at 2:54 pm

It happens with successful new industries–semiconductors, locomotives, airplanes, automobiles, etc. The Case-Schiller data show that it happened with housing after WWII. And in each case, during the rise, some people may have been arguing that this can’t go on like this forever therefore something must be wrong. But they were wrong.

On any rise, people appropriately wonder if it is real or a transient asset bubble. But if there was truly widespread consensus that it was the latter, it would never amount to anything.

WhiskeyJim April 14, 2011 at 2:37 am

Exactly Viking. My long winded point was that it is hubris to believe you can manage or regulate an economy if you can not identify a bubble; you create it yourself since a bubble is misaligned capital and labor.

It is surely true that markets left alone will inevitably realign from time to time; I never believed the ‘rational market’ idea. I don’t think Smith did either.

But it is also true that government and rate interference exacerbate them. If anything, I hope that is the number one take-away for the Fed in all this.

Dr. T April 13, 2011 at 8:32 pm

The housing bubble is reported as a national phenomenon, but it was not. The worst bubbles were confined to large, southern, fast-growing metropolitan areas with restrictive zoning and not enough houses to meet demand. Tampa, Miami, San Diego, Los Angeles, Las Vegas, Phoenix, and Washington all had housing costs that rose by more than 80% (over inflation) from 2001 to 2006. In contrast, the fast-growing city of Dallas had less than a 10% housing cost increase because of its non-restrictive zoning.

The federal government was an enabler for the housing bubble. Without the easy credit from Fannie Mae and Freddie Mac, house prices could not have jumped by so much. The other enabling factor was the ability of mortgage lenders to sell mortgages individually and in bundles. The prevalence of mortgage securities was a main contributor to Paulson’s panic after the housing bubble burst.

dan April 14, 2011 at 2:57 am

Indeed, the easy credit. Without it, there is no housing run-up. Millions of people were know in the market for a mortgage and the spike in demand created prices to increase very rapidly.

Designer Wholesale Handbags April 13, 2011 at 11:56 pm

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.

willieblackmon jaskens April 14, 2011 at 4:50 am

Third quarter economic growth slowed to just 1.6% pushed down by the bust in the housing market.
Quick Detox

dan April 16, 2011 at 3:25 am

Ah-ha……….. innovation had huge valuation increases and then leveled off, but remained without a sharp decline? OK…..ok………. But, minus innovation on an existing product or service (in an industry) or a new piece of innovation, we have yet to see the rapid increase of valuation that leveled off and remain without a market correction? But, I believe when it comes to economics and behavior, it is possible for a run up on an existing product minus a change that increaed its value without a correction.

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