In Housing, Even Hindsight Isn’t 20-20

Today's Economist

Edward L. Glaeser is an economist at Harvard.

Last week’s dismal job figures understandably overshadowed the relatively bright news from the housing markets.

From March to April, the seasonally adjusted Case-Shiller housing index for 20 major markets had its best performance since August 2007, reporting a decline of only 0.89 percent. Four metropolitan areas — Cleveland, Dallas, Denver and Washington — actually experienced price increases. Four other markets — Atlanta, Boston, Chicago and San Francisco — had price declines of less than one half of a percentage point.

Does this mean that the housing market is starting to hit bottom?

Next week, I’ll try to say something about the future. But I wanted first to acknowledge the limits of our knowledge before plunging into perilous prognostication.

One major point of economics is that predicting asset prices is extremely hard, and that goes for housing as well as stocks. Moreover, the last seven years should make everyone wary about predicting housing price changes.

At this point, not only is our foresight limited but our hindsight isn’t exactly 20-20 either. The housing price volatility of the last six years has been so extreme that it confounds conventional economic explanations. Over a four-year period — from February 2002 to February 2006 — the Case-Shiller index increased 68 percent in nominal terms or about 50 percent in constant dollars.

Certainly, those price increases cannot be explained by increases in average income. Income growth was quite modest from 2002 to 2006. Nor can the boom be explained by a dearth of new housing supply. Construction rose dramatically during the boom, and we built hundreds of thousands of additional homes. Our current low levels of construction will continue until we work through all of this extra housing stock.

A number of pundits place the blame for the bubble on the shoulders of the former Federal Reserve chairman, Alan Greenspan. They argue that loose monetary policy caused housing prices to rise.

While lower interest rates are correlated with higher prices, the relationship is far too weak to explain the price explosion that America experienced. A 100-basis point (1 percentage point) reduction in the inflation-adjusted rate of interest is typically associated with a price increase of less than 5 percent. To get a 50 percent real increase in housing prices, real interest rates would have had to decline by more than 1,000 basis points (10 percentage points), which is not what happened.

Mr. Greenspan’s loose monetary policy may have been a mistake, but low interest rates cannot readily explain what happened to housing prices. Real rates actually rose slightly between 2002 and 2006.

While low interest rates, on their own, cannot make sense of the bubble, perhaps the increased availability of credit to subprime borrowers has more explanatory power.

Certainly, there was more subprime lending in markets, like Las Vegas, that had the highest housing price appreciation. Yet the correlation between housing price growth and subprime lending across markets is as likely to indicate that lenders took more risks in booming markets as that those risks caused markets to boom. After all, subprime mortgages represented a modest share of national mortgages, and prices were also rising quickly for homes bought by low-risk borrowers.

The most plausible explanations of the bubble require levels of irrationality that are difficult for economists either to accept or explain.

For many years, the creators of the housing index, Chip Case and Robert Shiller, have argued that housing bubbles were fueled by irrationally optimistic beliefs about future housing price appreciation. More recently, Monika Piazzesi and Martin Schneider have documented the rise in optimistic beliefs about housing price appreciation over the recent boom. Using some elegant algebra, they suggest that overly optimistic beliefs could cause a boom even if those beliefs were held by only a small share of the population.

It is hard to argue with this view. The only way that anyone could justify spending bubble-level prices in Las Vegas was by having the incorrect belief that those prices would increase.

I once thought that the Las Vegas housing market was so straightforward (vast amounts of land, no significant regulation) that no one could be deluded into thinking that prices could long diverge from construction costs, but I was wrong. I underestimated the human capacity to think rosy thoughts about the value of a house.

Yet even if ridiculously rosy beliefs are a major part of bubbles, we cannot say that we understand those bubbles until we understand the sources of such beliefs. Economists like to link beliefs to reality, but these views weren’t grounded in sound statistics. The housing boom was a great wildfire that spread from market to market, but it is hard to make sense of its flames.

It is proving equally hard to predict where the markets will land. I will return to that topic next week.

Comments are no longer being accepted.

I think you are too quick to dismiss the theory that the bubble was caused by the relaxation of credit standards.

You cite the fact that only a small percentage of loans were subprime, but I don’t think that fact is really telling. Prices are set by supply and demand, and the relaxation of credit standards caused a sudden pop in demand by increasing the number of households that were able to buy a house. Simultaneously, relaxed lending standards made it possible for non-subprime borrowers to borrow more with less down and/or with a smaller monthly payment, effectively giving ordinary borrowers more money to spend on housing. Combine a modest excess of demand over supply with an increase in the money available to spend on housing and what would you expect to see?

I wonder why knowing pundits pass over what is probably the most significant bubble blower in the current mess, TAXES! After the tech bubble burst people were looking for a safe haven to put money and the extremely low interest rate made saving money a losing game. With no capital gains tax on housing it made the perfect vehicle for large numbers of investors to profit. Two years to wait for your return, even a low 5% tax free return was better than anything else on the market, and after all EVERYONE knows housing never goes down. And now all the experts wonder what caused the rapid rise in housing prices. Scarcity and demand just like most market prices only this time it was a lack of good investment alternatives which drove home prices through the roof.
DUH!

An interesting viewpoint but the banks have no culpability in this “rosy view of housing values that eventually went bust?” Loose lending practices and the giant banks ran happily ripshod over middle-class America and the Feds were content to turn away from any reasonable mortgage regulation for years. The writer infers the banks were a player in the real estate disaster but it is only an inference. Sure subprime is only a portion of the market, but that’s the point — the USA _middle class_ was phenomenally lied to by the banks. I have to wonder why an economist would quickly glide over the issue of wildly risky bank practices.

Retired in the Big Apple July 7, 2009 · 9:09 am

Basic problem here is that economists are as useless as real estate agents — they’re ingrained in in today’s culture but provide little or no real benefits to society.

Professor Glaesor’s major contribution in this article is his recognition that, ………”The most plausible explanations of the bubble require levels of irrationality that are difficult for economists either to accept or explain”.

In other worrds, economists, especially leaders at the Fed, have no idea of what happened or what will happen in today’s housing, jobs, inflation and credit areas.

How did it happen; just follow the money.

With interest rates on savings accounts so low, it is not unreasonable to expect people to move their money to the higher yield investment: housing. With the rapidly rising house values at the time, any home loan, subprime or not, was a low risk. And with Wall Street safely making billions leveraged 50 to 1, why should the Main Street folks not follow their lead?

That’s why we have unregulated free markets, so everyone, not just Wall Street, can make money the capitalist way.

I don’t know why you say that hidsight is not clear enough:
A ponzi scheme fueled by the easy availability of credit. That is all it was. Greenspan provided the credit. People always look for a place to park their money and what is better than an asset whose value “always” increases?

Don the libertarian Democrat July 7, 2009 · 9:29 am

I see fear more than optimism at work in the housing bubble. Let’s begin with interest rates. How would this work? Mortgage rates come down, say. Now, for some people, it will indeed be prudent and wise to buy a house when mortgage rates come down. However, it will not take long for this prudent investment to become dicey if home prices rise faster than other prices.

So, at the beginning of a bubble, there will exist a certain amount of prudent and sensible investing. Can we really call that the cause of a bubble? It certainly comes first in time, and often leads to home prices going up. But I can’t, in good conscience, call this prudent behavior a cause of the bubble.

I think that Angelo Mozilo, yes, that Angelo Mozilo, gave my view of the bubble when he testified before congress:

//oversight.house.gov/documents/20080307121803.pdf

“In June 2004, however, the Fed commenced what turned out to be 17 consecutive
interest rate increases. The combination of increasing interest rates and higher
home prices initially prompted a still higher spike in demand, as many borrowers
rushed to buy homes for fear of getting priced out of the market.”

There’s no way to make this prudent. In fact, it takes a cock and bull story to justify it. In my view, the story went like this:

1. You cannot count on the govt for retirement.
2. You cannot seem to save for retirement.
3. You can buy rather than rent, and turn a cost into an investment.
4. Housing prices are not coming down, so, if you don’t but now, then you never will.

It’s a story of fear and panic, the fertile grounds where fraud and foolishness can plant themselves. Oddly, Mozilo gets closer to the truth than most economists.

When you retire from the Ivory Tower world, I’ll sell you a nifty condo in Miami. Hurry, prices will be back up again soon!

I don’t think you have to be an economist to see that it was credit–easy credit–that made the housing bubble. Call it sub-prime if you like but that is only one variant of the explosion of easy credit that fueled the bubble. There was easy credit for builders (even true in a place like China where credit is highly regulated–the Chinese government especially favored residential real estate as a sector of the economy to grow and so easy credit was available to both builders and buyers), for non-credit worthy buyers (sub-prime) and for credit worthy borrowers who were extending beyond their means. The real explosion was not just in lending to sub-prime borrowers but also in the making of loans with “special features” that allowed borrowers to get in over their heads–like interest only loans, or ARM loans, all of which were underwritten based on the first payments, not where payments might go over the life of the loan. This of course lead to the ability of people to get into houses they could not otherwise afford because the thinking went that when the adjustments came, the overextended borrowers could “always” refinance or sell–or so the theory went. But of course as soon as the music stopped–that is housing prices stopped increasing–then the exit from the unaffordable loans was gone. This phenomenon of easy credit of course was not limited to housing–it was available in the form of credit cards and autos also. I remember looking at cars and not being asked by the salesperson how much car I could afford, but what I was looking to spend on a monthly basis. That type of thinking (or salesmanship) changes the calculus of what someone can “afford” drastically. And for those who refuse to participate in that type of crazy borrowing strategy-recognizing what they can truly afford–they may soon be priced out of the housing market. Put all of that together on a large enough scale and sooner or later, you have a crisis.

The change in velocity and quantity of money flowing into the housing sector are all you need to know, the second derivative, the area under the curve.

The supply of money exceeded the demand so money was marketed. Houses were marketed, refinancing was marketed very aggressively. Buyers bid up housing. Never before had this happened except during the boom bust vacation properties scams in Florida. It was no different.

My work required me to travel between a small PA town and a large South Florida city. In PA, I was hounded by strangers calling in the night or sending me letters offering refinancing. Money was being pushed, driven by commissions. My local banker had cobwebs on his ears because he offered loans as a service. Wall Street was in a frenzy to push money, first to qualified and then to anyone that could fog a mirror.

My friends in PA simply refinanced and went to work. The people in Florida would line up the night before to put several deposits on condos that were not built; which was fine because the people had no intention of living in them. A Florida friend bought several rental properties and had to take the last owner to court to consumate the deal because appraisal was 25% higher than the selling price. The Realtors were screaming that you must buy now, today, or you would be priced out of the market. Lending was 120% of the selling price.

Mortgage rates were attractive but did not drive the frenzy, it was the inexhaustible supply of money and forceful selling that out stripped the qualified borrowers. It was the commission based sales. Even Real Estate brokers were buying housing in bunches. It was all a phenomenon of Wall Street where every product is sold aggressively on commission. Wall Street figured out how to make the venture risk free and everyone was conning everyone else. Plus, most of the market was being sold by newbie players that came out of the woodwork to grab a piece of the action. I remember veteran agents complaining on blogs about the division of the pie and how little they were getting. It was no different than the dot.com IPOs. Make the market and get out. But the market collapsed too quickly to get out. They couldn’t process the paperwork fast enough, so they eliminated it. They created teaser ARMs that would not blow up until the security was sold.

What the low interest Fed money did was fuel a huge trade imbalance. Greenspan was looking for inflation in the US while the market was being flooded with inexpensive goods from abroad.

If there is one lesson to be learned, you need to watch where money is going, how fast and how much. It is not a simple increase and decrease of interest rates. Money is like blood and the body remains healthy by controlling the volume and flow to each organ and cell. Get the micro right and the macro will take care of itself.

You missed one other point. There was no dot-com bubble to get rich quick on, so young bankers and traders decided to con people into buying houses they could not afford. Cases in point-Countrywide Financial and Washington Mutual and the banks that bought the loans-AIG, Goldman Sachs, Merrill Lynch, Wells Fargo, etc. In other words, greediness run amok. We are in for a long hard ride!!

#2

“I wonder why knowing pundits pass over what is probably the most significant bubble blower in the current mess, TAXES!
— JOHN SANDERS”

And I’ll see that and raise you one – I think all this madness started when Reagan and his cohorts disallowed tax deductions on credit cards and other unsecured debt way back in the 80s, which created a whole new market for home equity loans, which were low cost and tax deductible. Suddenly, what was once a shame for the depression generation, that is, to take out a second mortgage, was a ticket to ride to material wealth for their children, the profligate boomers. And, really, it was sort of a wise financial move, if you “had” to borrow for the new Range Rover and the Vail ski trip. Except, of course, for the reckoning at the end of life, when all that equity actually did stop appreciating.

You should check your math on the relationship between changes in interest rates and the effect on home prices. The relationship is not linear.
The fundamental question when financing a home is “how much is the monthly payment?” This central question defines what is affordable.

Let’s assume the monthly budget for housing is $1000 or $12,000 per year. The results can then be scaled for any budget.

For a traditional 30 year fixed mortgage at 10%, one could borrow $114,000. If the interest rate drops to 9%, you could increase your loan to $124,300, an increase of 9%.
If interest rates started at 5%, you could borrow $186,400 and if they dropped to 4% you could now borrow %209,600, an increase of 12.4%.

With interest-only loans, the math gets even easier.
If the interest rate is 10% per year and our loan is interest only, then we can borrow $120,000. If the interest rate drops to 9% then we can borrow $133,333 – an increase of 11.1%
If, on the other hand, the interest rate is 5%, we can borrow $240,000. If the interest rate drops 1% to 4%, then we can borrow $300,000 – an increase of 25%

As interest rates approach zero, the amount that can be borrowed skyrockets if we have an interest-only loan.

In all cases (very high starting interest rates are not under consideration), an interest rate drop of 100 basis points will cause far more than a 5% increase in house prices.

Rather than just broad statements, how about evaluating the individual and aggregated effects of each of the known major contributors to this cycle?
1) lowered interest rates
2) interest only loans
3) liar loans (no verification of income)
4) qualification based only on the initial (teaser) loan rate
5) inflation
6) Federal loan programs
7) change in capital gains treatment of homes
8) declining down payments
9) local job markets
All of this combined may not account for the entire rise in home prices, the remainder being buyer frenzy fostered by lender and seller irresponsibility, but it will account for most of the rise.

Low interest rates combined with the bank balance sheet liquidity driven by securitization may explain much of this boom.

Not for nothing, Greenspan sold a lot of treasuries and with the demand for strong credits, he could sell them real cheap. Why boost rates and pay more than you need to?

Derivatives were a response to low rates for savers. They offered security, regular income and paid more. Or at least that was the sales pitch. Not correct as it turned out, but investment bankers have been known to fudge the truth a bit.

Anyway, local originators had no problem selling into securitization, getting the funds and then repeating. It was cheap money and that fueled rising prices. Most home buyers had no clue why things were going up, they just were. And if they didn’t know that already, the realtor made sure they did.

Worked just fine until it didn’t.

One way to look at irrational optimism as a possible cause is: Would these people have had the opportunity or means to realize their dreams, despite them not being prepared or aware of what they were getting into, if it was not for easy credit? Dreamers and their dreams there will always be, but it requires work. People were basically being handed dreams on a silver platter.

I don’t think you can have this discussion of what happened without talking about the securitization of mortgages. That poured trillions of new dollars into mortgages. The demand for mortgages eliminated most of the traditional underwriting principals that limited the amount of money people could borrow for homes. The sub-prime mortgages brought many new borrowers into the market. But there was an even larger impact on how much people could borrow. Instead of 20% down and payments totaling 25% of their income, people were putting almost nothing down and spending as much as 40% of their income.

Γερώνυμος Αμάτι Nώνυμος July 7, 2009 · 9:26 pm


for a long hard ride!!
— boston girl

As we ride this one out, what will be next Ponzi? After all — better to get in at the bottom then back out half-way up. After Dot.com collapse basic materials started up. Then housing and construction led into home improvement. If this depression reaches 22% unemployment are we looking at 22 years before DOW is back up to 14,444? Not until 1954 did DOW reach new high above 1929 level. Will bonds be the only safe retirement play? But with bonds in some countries defaulting and US T-Bonds falling on inflation fear is only alternative simple savings account at our local bank? Real Estate is not much help with population slated to shrink.

What do you gals/guys suggest?

I think this is actually a pretty brave post by an economist and I appluad Dr. Glaeser for it. It’s especially difficult for an economist to admit that the behavior of economic agents is more difficult to predict than their models generally assume.

That said, I think the combination of easy credit and lending standards, which vary significantly across jurisdictions, needs to be examined along with the psychology of past non-real estate bubbles to draw a more complete picture.

The conservative Wall Street Journal had a good editorial last week on Friday, July 3rd about this issue.

In that article, they said that “Zero Money Down” not “Sub-prime” mortgages was the culprit in the mortgage meltdown.

It was written by an econ professor at the University of Texas. He studied loan data from McDash Analytics, a loan processor.

It seems that lax lending standards from banks for “prime” borrowers is the main problem.

That fits with my personal experience. I have friends on the West Coast that were prime, but because of the home prices, they took out these crazy loans with no money down just to get a decent house in a good area.

1) You’ve just said a bunch of nothing.

2) Your assertion that loose monetary policy hasn’t been a strong factor and your blaming subprime lending as the primary cultprit are supported by questionable assumptions.

The relationship between interest rate and asset valuation is hardly linear, and you failed to examine international factors that helped to inflate the bubble. The bubble was created by 1) the drive among investors seeking higher-yielding assets in a low yield environment, 2) the proliferation of securitized products in order to manufacture higher-yielding assets (including those using subprime mortgages as collateral), 3) the explosion of USD foreign reserves, particularly in China, who is one of the largest buyers of U.S. mortgage and government papers.

Subprime lending flourished in an environment of scant investment opportunities and massive liquidity. Crooks and ill-informed consumers have alway existed. It was the loose monetary policy that provided the macro backdrop that facilitated the rise of subprime lending.

You have contributed little in educating the American public about how the economic system functions, but continued to fuel sensationalist explanations to this country’s problems.

It pays the bills, I guess.

While there was plenty of land for development in Las Vegas, most of it (86 percent according to the Brookings Institution) was owned by the federal government, which was selling at such slow rates that prices exploded. Virtually the same effect occurred as if Las Vegas had established smart growth style land restrictions such as an urban growth boundary. In the early 2000s, federal auction prices per acre were $50,000. By 2007-8, the figure had jumped to over $550,000. Moreover, the Boulder City has banned development on 150 square miles of land that effectively stops urban fringe development to the south. See: //www.demographia.com/db-lvland.pdf for further information and references.