Wednesday, December 15, 2010

Did cheap credit and easy lending cause the housing bubble? No!

Research by Edward L. Glaeser and Joshua D. Gottlieb of Harvard University, and Joseph Gyourko of the University of Pennsylvania argues that the housing bubble was not primarily caused by cheap credit and easy lending.

Between 1996 and 2006, real housing prices rose by 53 percent according to the Federal Housing Finance Agency price index. One explanation of this boom is that it was caused by easy credit in the form of low real interest rates, high loan-to-value levels and permissive mortgage approvals. We revisit the standard user cost model of housing prices and conclude that the predicted impact of interest rates on prices is much lower once the model is generalized to include mean-reverting interest rates, mobility, prepayment, elastic housing supply, and credit-constrained home buyers. The modest predicted impact of interest rates on prices is in line with empirical estimates, and it suggests that lower real rates can explain only one-fifth of the rise in prices from 1996 to 2006. We also find no convincing evidence that changes in approval rates or loan-to-value levels can explain the bulk of the changes in house prices, but definitive judgments on those mechanisms cannot be made without better corrections for the endogeneity of borrowers’ decisions to apply for mortgages.
Interest rates do influence house prices, but they cannot provide anything close to a complete explanation of the great housing market gyrations between 1996 and 2010. Over the long 1996-2006 boom, they cannot account for more than one-fifth of the rise in house prices. Their biggest predictive influence is during the 2000-2005 period, when long rates fell by almost 200 basis points. That can account for about 45% of the run-up in home values nationally during that half-decade span. However, if one is going to cherry-pick time periods, it also must be noted that falling real rates during the 2006-2008 price bust simply cannot account for the 10% decline in FHFA indexes those years.

There is no convincing evidence from the data that approval rates or down payment requirements can explain most or all of the movement in house prices either. The aggregate data on these variables show no trend increase in approval rates or trend decrease in down payment requirements during the long boom in prices from 1996-2006. However, the number of applications and actual borrowers did trend up over this period (and fall sharply during the bust), which raises the possibility that the nature of the marginal buyer was changing over time. Carefully controlling for that requires better and different data, so our results need not be the final word on these two credit market traits.

This leaves us in the uncomfortable position of claiming that one plausible explanation for the house price boom and bust, the rise and fall of easy credit, cannot account for the majority of the price changes, without being able to offer a compelling alternative hypothesis. The work of Case and Shiller (2003) suggests that home buyers had wildly unrealistic expectations about future price appreciation during the boom. They report that 83 to 95 percent of purchasers in 2003 thought that prices would rise by an average of around 9 percent per year over the next decade. It is easy to imagine that such exuberance played a significant role in fueling the boom.

Yet, even if Case and Shiller are correct, and over-optimism was critical, this merely pushes the puzzle back a step. Why were buyers so overly optimistic about prices? Why did that optimism show up during the early years of the past decade and why did it show up in some markets but not others? Irrational expectations are clearly not exogenous, so what explains them? This seems like a pressing topic for future research.

Moreover, since we do not understand the process that creates and sustains irrational beliefs, we cannot be confident that a different interest rate policy wouldn’t have stopped the bubble at some earlier stage. It is certainly conceivable that a sharp rise in interest rates in 2004 would have let the air out of the bubble. But this is mere speculation that only highlights the need for further research focusing on the interplay between bubbles, beliefs and credit market conditions.
This is essentially what I've been arguing from the beginning: The bubble was primarily the fault of home buyers who saw real estate as a way to get rich quick. Some fundamental factor in the late 1990s caused the initial rise in home prices, but then psychology (greed) took over and home buyers were willing to pay any price for a home because "real estate is the best investment you can make" and "home prices never go down." (If something is the best investment you can make and the price will never go down, then the price you pay doesn't matter.)

Unlike most people (including politicians and journalists who dare not blame the voters/viewers), I remember the home owners during the bubble who insisted I should buy a home because real estate is such a great investment. I remember them telling me how much their home had gone up in value. I remember them telling me I was throwing money out the window by renting. I remember being kicked out of my home because of a (failed) condo conversion by real estate investors chasing the rising prices. This is the psychology that causes bubbles! Since the collapse of the bubble, however, home buyers cannot be blamed. THEY WERE DECEIVED! THEY WERE CHEATED! Instead, they look for a scapegoat (greedy bankers) to blame for their own greedy decisions. This paper essentially says the banksters ain't to blame.

As for the initial fundamental cause of the rise in home prices, I've been going with the Bernanke explanation of a global savings glut, but this paper seems to throw a monkey wrench into that one.


  1. Really? Rates can't explain it?

    Hold a $2000 mortgage payment constant.

    @10% 30 year FRM you can buy a $227,900 house in 1990
    @3.5% 1year ARM you can buy a $445,390 house in 2004

    Add a reduction in downpayment requirements, and easy credit, and you can explain the upswing pretty well.

    Harvard and Wharton? Wow, we're screwed. I didn't even account for increasing the $2000 mortgage payment for inflation. Add 2.5% a year inflation to the 2k in 1990, and now we're at $2825 payment which gives a house value of $629k.

    So with some inflation adjusting on the payment we can get a tripling in the value of a house, never mind the psychology of "it'll only go up, might as well leverage yourself as much as possible"

  2. I had thought that the thing that started the rise in prices was the collapse of the tech bubble. As investors pulled their money out of the stock market, they looked for a place to put it, and housing was what a lot of them picked.

  3. Alpha Check,

    The paper's authors were looking at real interest rates. You're quoting nominal ones. There's a big difference.

    I think one thing that fooled home buyers in the early 2000's was that they were looking at the "historically low" nominal mortgage rates. Real mortgage rates at the time were not spectacularly low. This error in thinking is called "money illusion."

  4. These academics are always looking for some hidden explanation when the obvious is quite evident. Alpha provides a simple example of why home values deviated from historical appreciation rates. Lower mortgage rates create affordability. The inverse is also true. Next subject?

  5. James,

    So then when rates where high in the 1980s were homes undervalued during that period of high inflation?

  6. Now I am 100$ certain the owner of this blog is a paid-for provocateur/disinformation agent.

    Thanks but no thanks. You have been deleted from my bookmarks.

  7. James,

    I was looking at rates that you pay. You want to mince words, fine. When the rates shifted from 10% 30 year to a 3-4% ARM, it changed home values. People buy homes like they buy cars. They have xx $ per month, if that can buy them a 600k home instead of a 200k home, they're thrilled. If you'd like to explain why nominal mortgage rates aren't real, that'd be great. Banks were really offering me lower rates in 2004 than they were in 1980, nominal or not.

  8. James is right. Keynes called this 'animal spirits', a herd mentality that besets people and moves markets.

    I've been around long enough to have witnessed several real estate cycles. Each one is different for various reasons, but the chants are the same.
    "Real estate never goes down. Real estate HERE never goes down. Real estate prices HERE will rise even if it falls elsewhere because of A, B, C."

    But somehow it does.


  9. James is not right. Most people don't care about inflation when they're looking at mortgage rates. The dropping of rates is what caused the inflation in home prices. Conveniently inflation of home prices wasn't baked into CPI, so the lovely economists didn't see it as inflation and kept rates low.

  10. Rates were a huge part, but zero lending standards did the deed, though you cannot divorce that from easy FED money policies.

    Quick lesson, free money with no (percieved risk) finds a home that may not be a good place to live. Good thing easy money is not out there now.......oh wait!

  11. Let me clarify things a little here. Let's say you live in one of two possible time periods. In the first, inflation is 2% per year and mortgage interest rates are 5% per year. In the second, inflation is 7% per year and mortgage interest rates are 10% per year.

    Are you better off buying a home in the low inflation time period than in the high inflation one? Mathematically, no. Your real cost of borrowing in both time periods is 3%.

    In a time of high inflation, as soon a you buy the house, your monthly "rent" starts dropping at an inflation-adjusted rate of 7% per year. That is, if you continue renting during a period of high inflation, your nominal rents will increase at a rate of 7% annually, but as soon as you buy a house, your nominal "rent" stops going up. Sure, your initial mortgage payments are high, but inflation eats away at them pretty quickly.

    However, it is the people during the time of low inflation who trick themselves into thinking they're getting a great deal because "mortgage rates are at historic lows." This is money illusion. People are getting fooled by inflation (or the lack thereof).

    In fact, if you look at Robert Shiller's 120-year graph of home prices, you'll see that prior to the bubble, changing interest rates have not caused massive changes in home prices.

    So, did low interest rates encourage people to pay up for houses during the bubble? Yes. But it was not a mathematically sound decision. "Historically low interest rates" was just another of those myths that people used to rationalize their irrational behavior.

  12. The housing bubble wasn't caused by standard interest rates, it was caused by teaser rates combined with banks approving anyone who breathed.

    Yes, people were greedy, but the banks were the enablers -- the greed couldn't have gotten anywhere without the banks' complicity.

    This academic paper is crap.

  13. James,
    Please stop comparing past periods of time to the bubble period. I think it is fair to say that the circumstances present during the most recent bubble did not resemble the normal conditions of past periods. There has always been a fundamental relationship between home prices and household incomes. I believe what many people overlook is the higher percentage of income now being attributed to mortgage payments. No one talks about this when offering an explanation for the country's lower savings compared to historical statistics. The rule that you should on buy a home valued at 2.5 times your income was ignored. Real estate agents and mortgage brokers couldn't resist assisting buyers from breaking the rule.

  14. While I fully support the idea that psychological factors (like greed/gullibility/irrational belief in stability) were the strongest, i don't think that the paper is exonerating banks entirely. obviously i haven't read the whole thing, but saying that the banks weren't entirely to blame isn't the same as saying that they were entirely blameless.

  15. I think you've got it backwards, james. When borrowing money, you want inflation as high as possible. When lending money you want inflation low. If you have a fixed mortgage rate, high inflation drecreases the real value of your payment and the value of the debt you owe. The lender is making less in real terms. This is why inflation expectations drive long term interest rates. Lenders won't lend if they know inflation will eat away all their interest value.

  16. I read this paper when it came out and while I like Ed's work, this one misses the mark. It's not about rates alone, nor was it about some sort of change in mindset that is causing our society to go to hell in a handbasket. It was a credit boom, not a housing boom and lending standards fell to keep the pipeline full. The net was cast to a broader range of people who couldn't afford what they were buying. As appraisers, we saw it first hand.

    It is folly to apply interest rates to price trends and nix the idea that easy credit defined the bubble. That's why the NAR affordability index is fairly meaningless. The variable here NOT being measured is underwriting standards.

    4Q 01 - the fed pushes rates to the floor
    2002-2003 demand rises and prices soon follow
    2004-2007 affordability falls as prices rise sharply and the fed starts raising rates in June-04

    To keep the pipeline full and everyone making money in the process, mortgage underwriting stands became non-existent and borrowers only needed a pulse to quality for a mortgage. People bought based on payment qualification only and did't look at pricing.

    Within short order, the house of cards collapsed as marginally qualified borrowers started to default.

    I know writers often like to be contrarian to get attention for their work, however this one was not up to their usual high standards. Just because an academic writes a paper, doesn't mean it is grounded in reality.

  17. kahner said...
    "I think you've got it backwards, james. When borrowing money, you want inflation as high as possible. When lending money you want inflation low."

    I don't know what I got backwards, since I didn't suggest it's better to borrow when inflation is low.

    Inflation at the time of lending doesn't matter because lenders know what the inflation rate is and will set mortgage interest rates high enough to cover them. What you're talking about only applies to unexpected changes in the inflation rate AFTER the money has been lent.

    kahner said...
    "Lenders won't lend if they know inflation will eat away all their interest value."

    Umm. Sort of. Lenders will happily lend when inflation is high. They'll just make sure the interest rate they charge is high enough to cover the cost of inflation. See my 7%-10% example. Or if inflation is 12%, they'll set mortgage interest rates to perhaps 15%.

  18. I have to say that creative lending had much to do with the mess we are in -> Alpha pointed out that people look at monthly payments, not the size of the loan. Smart folks don't, but many many do. That isn't really fair, people tend to trust their bankers. The banker says that someone 'qualifies' for a loan, people believe them, that taking this loan will be a good thing. Well, for the banker who collected the fees and flipped the loan it was good.

    Of course to qualify the loan needs to be exotically structured as interest only with a tripling of payments in 3 to 10 years when it converts to work on the principle.

    When I first heard of interest only loans I thought it was a mistake. Nope. At one point in the boom over 80% of new loans in CA were interest only.

    The last time interest only loans were big was 1927 at the peak of America's first real estate bubble, which crashed, and preceded the Great Depression by two years.

    So OK -- rates could be 200%, but a lot of people would still buy if they could get a loan with a $300 payment, nothing down and no points.

    And the beat goes on. . .

  19. Remember when Crack made it cheap for coke-heads to get really high and really addicted. Without cheap product (Low rates = cheap money) and willing consumers (Greedy Americans who want to get rich quick) and dealers to supply product (Home Builders and Banksters) there is no boom.
    I really like your point James, but the bubble did not inflate and burst in an academic vacuum.

  20. Mmm...not to pile on too much, but...

    - I agree with other commenters that standard 30yr fixed rate mortgages do not really comprise a valid sample - teasers, I/O, Option ARMs and the rest need to be taken into account.

    - I disagree that DAP, 80/20 bundles and SISA/NINjA standards were negligible (as the authors contend. The statistically significant plunge in GSE marketshare in 2004(+/-) is evidence of the huge shift underway in the mortgage market (where the GSE qualification standards remained a constant). Though the GSEs eventually chased the private market in the race to the bottom (of underwriting standards), the massive shift in the market is revealed in the decline due to GSE hysteresis.

    Were buyers innocent bystanders taken advantage of by unscrupulous credit pushers? Hell no. Let's not create a false dilemma here..."greedy buyers" could not have created this kind of insane bubble were they not enabled by the credit industry. The demand for bigger and better(?) homes and for "the American Dream" (greed by another name) has been a constant for a century or longer. The limiting factor in the reaction/equation has been the ability to acquire credit that could actually be paid off, based on income (not asset appreciation).

  21. I can't believe all the commenters just rejecting the article en masse with just a "it's crap" comment. Welcome to the internet, when an "intuitive" explanation anybody can think of in five minutes is more popular than something where you have to check the numbers.

    The housing bubble has always been global. The number of countries that have all experienced it at the same is staggering. As such I'm pretty skeptical of any explanatio that relies on national factors (aka. teaser loans, ARMs, etc. etc.).

    I think the authors are on to something. In deciding whether to buy or rent, I've found the no. 1 most important factor tilting my analysis is shifting the rate of house appreciation/depreciation by a couple points. If rates are appreciating at 10%+ it's pretty clear the carry cost is actually negative. Whether you're getting a 4% or a 7% interest loan is pretty inconsequential if the IRR on the house itself is 10% (and really more like 50%+ when counting the leverage).

    The folly was in extrapolating similar increases in the far future (difficult to argue when a 10-year trend has already been established).

  22. Greed of homebuyers is to blame, however this greed WAS fueled by greedy bankers, lenders, rating agencies, etc. The bottom line is that many parties share a degree of cupability in the houstin boom/bust. However, the prevailing theme comes down to greed by everyone involved.

  23. And no one is mentioning the role of Wall Street in providing easy ways for lenders to originate and sell bad loans?