Over at Economix, Harvard economics professor Ed Glaeser looks at the ultra-low interest rates of the aughts, and does not find them to be much to blame for the US Housing boom and bust:

“The most common explanation for the great surge in prices is the availability of easy credit, which took the form of low interest rates, high loan-to-value ratios and permissive approval of mortgages. These variables certainly affect housing prices, but they don’t seem to have moved nearly enough to explain the great price fluctuations of the past decade.”

Professor Glaeser fails to see many of the causal and exacerbating factors of the housing boom and bust, including those directly attributable to ultra low rates. Why don’t we review these factors, for the benefit of both the Professor as well as those laypeople those who may have missed them.

We have reviewed these in the past, but given the prof’s 30 year chart, I would like to walk through the broader context of what took place historically. (Note: I exhaustively detailed this in Bailout Nation).

Here are 20 steps to a Housing boom & bust:

1. A medium Housing boom and bust began circa 1988-89, following the Fed’s rate reaction to the ’87 market crash. Nationally, residential RE did not get back to break even until about 1996-97 (although recovery did vary by region).

2. The 1990s saw the build out of numerous technology industries: Mobile, Software, Semi-Conductors, Internet, Storage, Telecom, Networks, etc. Huge amounts of wealth was created: Employment was running near capacity, wage gains were substantial, employee stock options did extremely well.

3. Stock markets had been making enormous gains since the Bull began in 1982. I worked as a Wall Street trader mid-1990s, and witnessed first hand numerous investors cashing out huge equity gains. Much of this cash was rotated into Real Estate. This included major trade ups of primary residences, and purchases of second homes/vacation/investment properties.

4.  All good things must come to an end: The dot coms and tech crashed (March 2,000); Enron, WorldCom, Tyco, collapsed; the analyst banking scandal, took place, etc. The equity party appeared to be over.

5. Starting in January 2001, the FOMC began lowering rates, eventually taking them all the way down to 1% by June 2003. Rates were kept below 2% for 36 months, and at 1% for over a year. This was unprecedented.

6. Even with a 30% down payment, Homes are a leveraged credit purchase, and lowering the cost of that credit has an inverse effect on prices — i.e., cheaper mortgages = more expensive houses.

7. Most people budget their home expenses monthly. Their carrying costs are more important to them than the actual purchase prices. This is why an outsized drop in interest rates — from 5.5% to 1% — can cause a spike in home prices, and yet still keep monthly payments fairly similar.

Bottom line: Ultra low rates were the initial fuel sending home prices higher.

8. Professor Glaeser (and others) have focused on interest rate impact on Housing, but missed the impact rates had on global bond managers. The ultra low rates forced the fixed income managers into a mad scramble for yield. Pension funds, trusts, foundations require 5% annual gains (for tax and other reasons), and without it, they have major issues.

9. Nearly all of these Bond managers cannot purchase junk by fund charter; They are required buy only investment grade paper. This becomes a very important factor, as we learned later in the timeline, because of their purchases of hi yielding RMBS — essentially junk stamped AAA.

10. Wall Street had been securitizing collateralized debt for years. They turned credit cards, student loans, auto financing, and mortgages into CDOs.

But in the era of ultra-low rates, the search was on for higher yields. Making loans to sub-prime borrowers –people with weaker credit scores, lower incomes, or more debt — generated higher yields at a higher risk. This is why collateralizing these subprime mortgages allowed securitizers to generate higher yielding paper for the managers of bond funds. There is nothing wrong with creating this junk paper, so long as it was rated appropriately.

11. The Rating Agencies — Moody’s, S&P, and Fitch — were corrupted by the enormous fees on this securitized junk, paper. This Rating Agency payola allowed the underwriters of RMBS securities to essentially purchase their AAA ratings for a fee.

Hence, the higher yielding, higher risk junk paper received an investment grade rating. Without it, it could not have been sold to the vat majority of these funds that were only permitted to buy investment grade paper.

NOTE: Here is the first point where lack of oversight comes in (vis-à-vis the ratings agencies) comes in. But it is important to note that we never would have gotten to that issue BUT FOR the ultra low rates.

12. Triple AAA rated junk paper sells well, increasing demand for more of it. Wall Street responds to this demand, and scooped up all of the legitimate higher yielding sub-prime mortgages they could find.

13. After exhausting all of legitimate subprime paper supply, the Street begins acquiring weaker and crappier mortgages to feed into the maw of the securitization beast. They consumed the output of all the non-bank sub-prime lenders, who made worse and worse loans. Their  business model became lend-to-sell-to-securitizers; then reload and do it again and again.

14. Since there is only a finite supply of people who can afford prime alt-a, or even sub-prime mortgages, these lend-to-securitize originators got creative with their financing. They came up with ways to make mortgages even cheaper. They made ever shadier loans to ever less qualified borrowers.

15. The progression: Start with 2/28 variable loans, with a cheap teaser rate the first two years. Then write Interest Only (I/O), where there was no principal repayment. Lastly, underwrite Negative Amortization (Neg/Am) mortgages, where the borrower paid less than the monthly interest charges, with the difference added to the principal owed (each passing month, the mortgagee actually owed more on the house than the month before).

Most of these loans could be described as “Rent with an option to default.”  In fact, these loans defaulted in enormous numbers.

16. The lack of regulation of these non bank lenders by the Fed was another key factor. Ironic, perhaps, since the Fed started the spiral via rates, they also allowed it become a conflagration through their nonfeasance — their failure to fulfill their regulatory duties. Greenspan called these lenders “Financial innovators.”

17 . Numerous states had on their books anti-predatory lending laws. These made it illegal to make loans to people who could reasonably not afford them (nor could they charge usurious rates or excessive fees that would make defaults much more likely).

18. John Dugan, head of the Office of the Comptroller of the Currency (OCC),  (with the blessing of the Bush White House) issued its doctrine of “Federal Pre-emption.” This orderd the States to step out of the way of these lenders. The data shows that states with anti-predatory lending laws had much lower defaults and foreclosures than states that did not; the Federal Pre-emption significantly raised default rates in these states. This did not cause the housing problem, but allowed it to spread further.

19. The lack of regulatory enforcement was a huge factor in allowing the credit bubble to inflate, and set the stage for the entire credit crisis. But it was intricately interwoven with the ultra low rates the FOMC set. The complexity and intricacy of the mortgage factories’ many parts are often overlooked.

20. A housing market based on ever rising prices, cheap credit, and a greater number of buyers than there was Household formation was unsustainable.

The Fed began raising interest rates in June 2004. By June 2006, they had rates back up to 5.25% — and the beginning of the end of RE party was in sight. A year later, the entire housing edifice of the 2002-07 era was in collapse.

Too many people are looking for a single explanation for a highly complex set of circumstances. There were myriad causes of the Boom & Bust, and it is far more complex and nuanced than the over-simplifications we typically see.

While low interest rates were the initial factor that began the spiral — it could not have gone as far or as fast as it did without them — the rate regime is far from the only factor.

Professor Glaeser has set up a straw man, and tried to knock it down, but his analysis misses much of the reality of what occurred.

>

Source:
Did Low Interest Rates Cause the Great Housing Convulsion?
Edward L. Glaeser
Economix, August 3, 2010
http://economix.blogs.nytimes.com/2010/08/03/did-low-interest-rates-cause-the-great-housing-convulsion/

Category: Bailout Nation, Credit, Real Estate, Really, really bad calls, Regulation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

41 Responses to “Understanding Context: The Housing Boom & Bust”

  1. Dennis says:

    Great stuff.

    You must really enjoy tilting at windmills — you cannot educate the people who sincerely desire to stay ignorant.

  2. NoKidding says:

    “The lack of regulatory enforcement was a huge factor”

    Thanks for using precise words. Lack of regulation was not the problem. Every rule, law and accepted practice required to avoid this crisis was in place long before it started.

    Our government has reacted to poor judgement of the policy makers and regulators by adding redundant policy makers and regulators, and writing thousands of pages of redundant or ineffectual regulation.

  3. DonF says:

    I don’t know how many times I have sent the link out of yours of these reasons. I do it every time my bipartisan friends want to blame the other side. Although the cause is not simple, it is not THAT complicated, and I continue to be bewildered at the lack of understanding and amount of misinformation flowing about. Thank you for having a nice succinct summary to shine on people.

  4. constantnormal says:

    And today, even lower rates are fueling an on-going equities bubble …

  5. constantnormal says:

    And while I agree completely with everything BR has said here, the obvious question is to apply the same logic that BR has used so effectively when debunking the “it’s all the fault of the CRA” meme … there was a global housing boom, not just a domestic one. How’d that happen?

    Are we to believe that the extended low rates from the world’s strongest economy (and also the global reserve currency) fueled not just a domestic housing bubble, but also sparked a global housing bubble?

    In the absence of any better story, I think we are. But that answer is not really a satisfying one.

    But it is possible that there are better explanations, as the Japanese housing boom-and-bust preceded ours by at least a decade, and some (China, Canada, Australia) lagged the housing booms in the rest of the world by sufficient time as to render them “probably unrelated”.

    But questions remain regarding the causal factors in pretty-much-coincident housing booms around the planet.

    I don’t have an answer, or an axe to grind, I only raise the awkward question.

    Credible answers with supporting data are welcomed.

  6. rayy says:

    Well, maybe it’s an oversimplified explanation, but like any bubble, this was caused by the expectation of ever-increasing prices. i.e. “if you don’t get in now, you’re going to miss out”. I don’t think low rates alone explain that–it’s a psychological thing, and probably unpreventable.

  7. dead hobo says:

    I just read the NYT article and I think you might have over reacted a tad. Most of the article was econo-bla-bla.

    His main point was that low interest rates were not the sole cause of the housing bubble, although they were a part of the problem.

    Note his concluding paragraph …

    “I am not claiming that interest rates weren’t important, or that they didn’t play a role in creating the cocktail that led to a housing price bubble. I suspect that they did. I am not defending the wisdom of monetary policy. I am only dismissing the notion that we really understand what caused the bubble, where really understanding means – to me – that we have a well-specified theory that has been tested in many different ways and not rejected by the data.”

    I can easily support his assertion. Compare current housing prices and interest rates today. If low interest rates manufacture housing bubbles, then where is it? We should have the mother of all bubbles right now. If prices are in a bubble right now, then free houses are coming soon.

    Wall Street, greater fool theory, shadow capital markets, criminally incompetent rating agencies, a new financial markets mania that convinced everyone that free money was available if you only give what you have to Wall Street now, which evolved into a world wide ponzi scheme all helped. Today, the machine that created the last financial bubble appears to be trying hard to make a new one.

    Frankly, his blog article seemed quite innocuous. I didn’t read the paper it was based on and maybe there’s an issue or two there. Anybody read it?

  8. dead hobo says:

    Also, in his concluding paragraph, where he said

    “I am only dismissing the notion that we really understand what caused the bubble, where really understanding means – to me – that we have a well-specified theory that has been tested in many different ways and not rejected by the data.”

    I’m going out on a limb here and suggest he forgot to add something like “We should be able to use that theory to see these bad things coming and stop them before they get out of control.” As opposed to the autopsy approach used above.

  9. “18. John Dugan, head of the Office of the Comptroller of the Currency (OCC), (with the blessing of the Bush White House) issued its doctrine of “Federal Pre-emption.” This orderd the States to step out of the way of these lenders. The data shows that states with anti-predatory lending laws had much lower defaults and foreclosures than states that did not; the Federal Pre-emption significantly raised default rates in these states. This did not cause the housing problem, but allowed it to spread further. ”

    ~Not to quibble, nor to be seen deflecting blame away from the Bush Administration, but it is a well-settled principle of law that Federal law always preempt state law when in conflict and concerning the same subject matter. The abolishment of any meaning afforded the commerce clause limitations in Wickard v Filburn and Katzenbach v. McClung, etc., ensures that the commerce clause will almost never save a state law from Federal supremacy.

    For an example of how these things get resolved, in my home state’s laws regarding residential mortgage lending, there was a law on the books that prohibited prepayment penalties on first mortgages. This conflicted with Federal law, which allowed them. For a lender to charge prepayment penalties, all it need do was get certified with local HUD office as a nationally-certified lender and it was free to ignore state law and charge prepayment penalties. This was true even as far back as 1996 when I first got in the business. I had a client then–new to the state–that was charging prepayment penalties. I checked for their certification and they didn’t have any. So I told them they couldn’t charge prepayment penalties. They stopped for a couple of months until they got certified, and then went right back to it.

    State laws that limited federal law in the area of residential mortgage lending was always bound to yield to federal law as the market became ever more federalized, what w/ Fannie Mae/Freddie Mac/Ginnie Mae, etc, setting the lending standards with their gargantuan funding of mortgages, and RESPA, inter alia, setting the standard for residential real estate transactions.

    ~~~

    BR: Ahhh, but here was no conflict between laws. This was about a philosophical disagreement against regulation.

    The Fed legislation is silent on issues of usuary and predatory lending, and there is a long history of allowing the states to set their own limits (or additional limits) on interest rate ceilings, fees, and qualifications for mortgages.

  10. Deborah says:

    “6. Homes are a leveraged credit purchase, and lowering the cost of that credit has an inverse effect on prices — i.e., cheaper mortgages = more expensive houses.”

    Policy that allows homes to be a leveraged credit purchase is a bigger problem then the actual interest rate. Allowing people to borrow to the same percentage of income regardless of rate is the problem with the policy.

    Low interest debt is a much different animal then high interest debt. Borrowers of low interest debt have very low empowerment to get out of debt compared to borrowers of high interest debt when debt servicing is the same percentage of income, as current policy dictates, and this is why the policy is so mathematically insane.

    I wrote a piece, Low interest rates as destructive as usury just over 3 years ago, http://makingsenseofmyworld.blogspot.com/2007/05/low-interest-rates-as-destructive-as.html.

    30-year mortgages should not be allowed with low interest rates. Mortgage qualifications should be a fixed standard with some fudge factor room based on lower rates and greater equity. For example, 30 years at 10% with 30% of income should be the baseline qualifying standard. As rates go down “leverage” of how much more a person can borrow should be somewhere between 25-50% of the difference between the baseline qualifying standard and 30% of income at the current rate. If you only have 5% down, then a max of 25% of difference, but with 25% then 50% of the difference.

    The mortgage term should be adjusted to 30% of income, so as rates are lower, mortgage terms are shorter. It insane to have 30 year mortgages at low interest rates, as the US is finding out.

    If you have appropriate lending standards with low rates then the debt servicing money it frees up truly goes back into the economy.

    ~~~

    BR: But note that Homes have been a leveraged credit purchase for centuries, and in the post WW2 US, typyically required 20-30% down . . .

  11. craig k says:

    Always remember that low interest rates aren’t always good, savers and people who depend on bond yields are hurt badly by low interest rates, thus they stretch for yield and as is reported here, when WS needed to find more yield to supply to the “yield seekers” they did so with riskier paper but had the rating agencies tell everyone they were AAA. gulp.

  12. “but his analysis misses much of the reality of what occurred.”

    especially, The Fraud..as in ‘found in many flavors, throughout the Era being ‘discussed’.
    ~~

    “Now, my g-d damned Cat is Homeless!”

    ref: http://www.ritholtz.com/blog/2010/07/iphone4-vs-htc-evo/ vid. #1

  13. rallip3 says:

    Surely the real problem is that of mortgage finance: in most countries of the world for most of the 20th century this was not the preserve of commercial banks but of specialised savings institutions such as savings and loans. The US has gradually replaced these with MBS, and the problem was that a whiff of fraud entered that market (as TBP points out). This caused a sudden closure of that market in 2008, which has since been crowded out by the Government-backed agencies.

    This has opened up a gap between the politically desirable rate for mortgages and the high rate that a free investors would now insist upon for a new MBS when they plug in the known volatility of house prices and default rates. Currently you see that 15-year mortgages cost 4% and 30-year around 4.6%. On the other hand I see General Electric Credit Bonds of 2038 yielding just under 6%. Similarly Greek sovereign borrowing in USD are over 10% for 3-year money. I am not saying that the latter are too high but that mortgage rates are way below ‘free market’.

    What caused the housing crash was the sudden realisation that the free-market model for mortgage finance was broken. It will only be fixed when a new model for both savers and borrowers is in place (maybe via covered bonds). Meanwhile there is a reason for hope because in absolute international comparisons, US house prices are actually low. The reason they are low is that median wages have stagnated in real terms. But that’s another story!

    ~~~

    BR: RMBS was never a problem until the lending standards collapsed.

    At first, it was the non depository banks — the lend-to-securitize underwriters. Eventually, the big banks fell for the same foolishness; see for example, How to Get an “Iffy” loan approved at JPM Chase

  14. Morgan says:

    I think there was another factor at work that has been left out, which is the ability to shift risk onto others. I don’t fully understand the mechanisms at work (and would be happy to be enlightened), but it seems obvious that predatory lending would be self-punishing unless the risk of default could be shifted elsewhere. I mean, would you loan your money to someone on a no-doc basis?

  15. “The Fed legislation is silent on issues of usuary and predatory lending, and there is a long history of allowing the states to set their own limits (or additional limits) on interest rate ceilings, fees, and qualifications for mortgages.”

    With Fannie, Freddie and Ginnie (i.e., the federal government) setting the standards for lending (through FHA loans, and “conforming” Fannie and Freddie loans) at a gathering pace through the aughts, it’d be hard for me to imagine, even had a state wanted to set its own lending standards, it would have been successful. If I recall correctly, sometime around 2007 or so Georgia tried to adjust the liability chain for mortgage origination to make the ultimate purchaser liable for whatever hijinks took place at origination, but had to quickly rescind the law when it became clear it would lead to a collapse in mortgage fundings.

    My point is that federal preemption was a given even if it hadn’t been expressly required by the Bush Administration. No state could reasonably make the gravy train of securitization too difficult to ride if it wanted its citizens to have access to all the hot money flowing into mortgages–and I’m not aware of any state at the time that was so wise and insightful that it realized the great costs that loomed for such securitization. The Bush Administration’s express preemption of state law did like so much of law–it reflected the practices already in place more than it really changed anything.

  16. Morgan says:

    Mark E Hoffer:

    Thanks for the pointer. Links 6 and 9 were especially helpful.

  17. [...] of the Housing boom and bust should be able to explain why it was global in nature. Hence, our earlier focus on issues such as interest rates, lending standards, securitization, scramble for yield, [...]

  18. Morgan,

    definitely, YW.

    also, the nice thing about that ‘Search Engine’, are the ‘Clouds’, listed on the left-hand side, that provide an additional level of ‘granularity’–with that, one, often, sees ‘relations’ that are not, necessarily, immediately obvious..

  19. napster says:

    A Harvard Economics professor indeedy.

    Funny thing, if you did a two-variable correlation analysis of interest rates with housing prices, the correlation would be nil because interest rates stayed flat. Like … duh? Does this mean that low interest rates did not fuel the speculative urge to buy, sell, and re-sell? Of course not.

    This type of simplistic analysis is the backbone of the antiquated efficient market hypothesis. It is also how the Economics profession tends to operate. Although the irrationality of humans, the stresses of ego and the urgings of individual emotional needs cannot be modeled by a formula, the mighty statistical techniques of correlation, normalization, and fat-tail distributions are all used to somehow better “understand” the relations between economic entities.

    Caveat Emptor.

    As Barry shows, you cannot understand the relationship of economic entities by math alone. When you use mathematical tools, you are automatically making assumptions about relationships, and this will not give you a representation of the actual inter-relationships. If the assumptions are somewhat correct, the results will be a good approximations. However, assumptions are always based on a paradigm. Mathematical models are therefore not relevant without a historical knowledge of the context within which the inter-relationships occur.

  20. Casual Onlooker says:

    Excellent analysis.

    7. Most people budget their home expenses monthly. Their carrying costs are more important to them than the actual purchase prices. …

    I think it’s hard to overstate the significance of this statement. To many people a total purchase price 30 years out is an abstract concept. Those at the lower end of the economic spectrum are especially ill prepared to understand the significance of long term financing. All these people look at is how much am I going to have left at the end of my paycheck. It’s simply the way they have always lived.

    Couple that with a lot of magical thinking feed at them from all angles about how easy it would be to resell or refinance the house and you have a recipe for disaster. There were a lot of parties feeding on that magical thinking, and no one was seriously looking to establish some sane limits on the consequences of this thinking.

  21. [...] easing, something – to move higher from here.”  Also great on Barry’s site today is a very neat summation of the housing crisis and his take onTimmy G’s NY Times Op Ed column, which I need to add my own .02 [...]

  22. WFTA says:

    Please feel free to rip this proposition:

    The Fed left rates low because they were over occupied with guarding against wage inflation and consumer price inflation, the traditional boogiemen.

    After 2000, the increase in disposable income went to the already-very-wealthy; thus it was investable income. So instead of wage inflation, we had investment inflation and the demand for fixed income securities drove everything else.

  23. patient renter says:

    While there is no single factor that caused the bust, I tend to think that there is one factor without which the bust would not have occured, or at least not in such a terrible way – that factor being ultralow rates.

  24. mcnet says:

    FWIW I think the 20 point framework is pretty much spot on.

    However, I’d insert an aditional point at around 2a:

    The tech boom was fueled by the run up to the Euro. To bring gov’t debt ratios down the Euro states were selling off their airwaves. One result was the massive unsustainable investment in telecom, offset by apparently cleaner sovereign balance sheets,

    Telecom investors effectively paid off govt debts, and lost, but those losses (and then some) got shifted into the Real Estate bubble through the low rates, ratings abuses and regulatory ineptitude that followed.

    It’s more than a little ironic that we’ve come full circle re the Euro, but this time there are no more assets (air) to sell and gov’ts (us) get to pick up the inflated tab anyway.

  25. MatthewD says:

    Barry…

    Insightful comments. Is there a reason you don’t include government mandates on low-income loans through Fannie and Freddie in your analysis? Do you not see that as a factor, or is it not pertinent in the analysis laid out here?

  26. After exhaustively researching the data of GSEs, I could not trace it to what occurred.

    The link from Congress to GSEs to bank loans was at best tenuous, the actual loans you describe as “mandated” were not significant, either in dollar amounts or total houses moved. Indeed, what little I could find was absolutely tiny, and had existed for decades without incident, so that made me very suspicious of the GSEs as a prime causitive factor.

    Once I saw the data showing how global the boom and bust was, the GSEs went away as a factor. Fannie and Freddie simply do not impact the housing markets in Spain, Ireland, Portugal, France, South Korea, New Zealand, etc.

    You have to be able to explain a simultaneous global phenomena with similar causation. It was hard to reconcile the FNM/FRE were major causes of the US housing boom and bust, but the rest of the world had the same or worse, w/o them. It just didn’t work…

  27. old gil says:

    “8. Professor Glaeser (and others) have focused on interest rate impact on Housing, but missed the impact rates had on global bond managers. The ultra low rates forced the fixed income managers into a mad scramble for yield. Pension funds, trusts, foundations require 5% annual gains (for tax and other reasons), and without it, they have major issues.”

    Can you elaborate on this point? Seems like this is a big link in the chain that I haven’t seen explained in detail. Are there THAT many funds requiring 5% annual appreciation from AAA-rated bonds? If so, what are they doing now?

    ~~~

    BR: Its Bailout Nation chapter 9: The Mad Scramble for Yield. That chapter discusses this in painful detail

  28. bbaez says:

    Low interest rates were the contributor to all types of consumer and commercial excessive leverage. It was not exclusive to housing.

    If you map out the defaults that started the economic downturn you will see that they were in the fixed income inner city and outer lying commuter suburbs. It stemmed from $5 a gallon gasoline and $3K electric utility bills.

    It was the proliferation of structured finance driven by Wall St. insatiable demand for subprime mortgages that created the home ownership growth. The defaults were exacerbated by the multiplier effect of the home ownership growth.

    You have to keep in mind subprime was not a bad word on Wall St until it exposed the naked credit default swaps and AAA rated bonds consisting of subprime mortgages.

    The exposure occurred because of the pump and dump of energy by large hedge funds and banks that do not produce or retail electricity or oil.

  29. Jonathan M says:

    Interesting – I personally could see the correlation with falling mortgage rates first hand on the front lines so I chalk this up to “macro analysis.” It wasn’t the only cause but it certainly was a key factor

    Its kind of like jumping in a pool and then explaining that the cause of getting wet had nothing to do with the water in the pool.

    jonathan

  30. [...] My favorite email today: Ritholtz puts a beat down on Harvard Professor Ed Glaesar; there were no [...]

  31. DeDude says:

    @constantnormal;

    Houses are sold on monthly payments, and I have seen adds in Europe that listed only the monthly payment, not the actual price of a house. The monthly payment is dependent on interest rates and “financial innovation”. In the US we combined the two by first lowering interest rates (that got the pump primed), and then when the rates could no longer be lowered to keep the same “affordable” monthly payments on increasingly more expensive houses, we increased financial innovation.*

    Many countries had trade reasons to follow the Fed and lower their rates. In other countries it was not the central bank rates but a lot of savings from boomers that drove rates down (particularly after people go scared of putting their money into stocks). In most countries the wonderful financial innovations of the US were also a factor. For each country you have to compare development in house prices to central bank rates, mortgage rates and prevalence of non-standard “innovative” mortgage products, to assign blame on each components. If the US Fed rate decrease comes before that countries central bank reducing its rate, then our Fed is in part to blame.

    *I will put the political analysis down here since some seems to find it disturbing to hear about the larger picture. Any successful economic policy in the past 40 years has required that consumer spending goes up, because that is the overwhelmingly dominant part of our GDP. Whereas democrats have no problem combining their ideology of wealth distribution with the associated growth in consumption and economic success – just hearing the words “wealth distribution” makes a republican explode. Therefore, the only way that republicans can “grow” the economy is by increasing debt. The housing bubble and the associated household consumption via mortgage equity withdrawal was a godsend gift to Bush because it allowed economic growth without wealth distribution. That is why Greenspan lowered rates and regulators blocked attempts to stop abusive mortgages. They knew that as soon as the housing bubble busted, the house of cards called republican economic policy, would also go bust, and the economy be in deep sh!t. They desperately tried to keep it all going long enough that the bust and economic downturn caused by their “policies” would come on democrats watch and could be blamed on democrats.

  32. Fred Flintstone says:

    Compare current housing prices and interest rates today. If low interest rates manufacture housing bubbles, then where is it? We should have the mother of all bubbles right now. If prices are in a bubble right now, then free houses are coming soon.

    Effective rates were 0-3% for many borrowers gaining access to stated-income, stated-asset, negative-amortization, teaser rate loan products — products that are no longer with us since they killed their originators.

    The reason the economy boomed then and is in bust now is that there was a virtuous cycle of rising home valuations and rising cash-out refis.

    The 2003-2007 boom resulted in around a $4T household debt overhang that we are currently struggling with. Cash-out refis were around $500B/yr during the peak. That’s one heckuva stimulus that we’re really missing now.

  33. fxworks says:

    Your thesis seems to be “low interest rates did so cause the housing bubble and resulting financial panic/crash.” But in your entire analysis you only reference nominal rates, not real rates. I don’t know this for a fact, but I suspect in real terms the rates you reference in point 5 may not be so unprecedented- what was the core inflation rate during those times- Oh wait- I seem to remember you consider CPI a complete scam as well- (apologies if this is not the case…) But there must be some gauge of inflation you use to compare interest rates over various time periods- surely you agree that inflation was lower in the 90’s/2000’s than the 70s?

    In point number 6, It’s a good thing for the consumer to be able to buy more house and pay less interest to the lender- yes prices went up, but people got more house for their money. It would be interesting to look at the price increase of housing on a per square foot basis- that may well have gone up, but there is no way people weren’t buying much bigger houses in the 90s than in the 70s. Also building codes are more conservative, materials and construction are superior- after all, how many 70’s houses had granite countertops and stainless steel appliances :-) ??. (Yes, I know there are examples of bubble-built shoddy construction- spare me. Go talk to an architect- today’s houses are far superior on ever level when build by a reputable builder.)

    ~~~

    BR: 1) I consider CPI to understate inflation, not a “complete scam”

    2) Nominal vs Real rate of Inflation is not relevant for an asset bought via leverage.

    3) For future reference, “I don’t know this for a fact, but I suspect in real terms” is too damned lazy to take seriously. Rather than guess, why not actually do the work to prove or disprove it?

    4) buying “more house and pay less interest to the lender” is not a valid standard for whether or not rate are appropriate.

    And lastly, my thesis wasn’t written in the voice of a 14 year old girl. (did so)

  34. RC says:

    Informative, thorough yet concise list explaining the crisis !!!
    It reads like a powerpoint presentation that just goes to the point. Thanks for the education!!

    You have a minor typo in poiint #11
    “it could not have been sold to the vat majority of these funds that were only permitted”
    I think you meant
    “it could not have been sold to the VAST majority of these funds that were only permitted”

  35. JohnC says:

    To constantnormal,

    You bring up a good point because not enough work has been done on the transmission mechanisms between the countries. In the case of Real Estate, the predominance of the US Dollar as the reference currency and reference interest rate is a good starting point to explain most of the correlation between housing booms (and other financial movements). I don’t have a hard percentage figure but an overwhelming number of global financial contracts that I have reviewed are tied to US$ LIBOR in one way or another.

    Japan’s housing boom, as far as I can tell, had nothing to do with US interest rates. But that is a long story which traces its roots into the 50′s and 60′s.

    More recently, the lack of synchronization you see does not mean that there is no connection to US interest rates but rather that there are other factors in the mix. For Real Estate in particular, it should come as no surprise that there are significant local factors which impact price. China’s massive stimulus response to collapsing exports has pumped tremendous amounts of liquidity into a market where investment options (for middle class investors, not CITIC or CNOOC) are somewhat limited. It should come as no surprise that the Chinese might build a few extra apartments as a result (around 60m empty). And that same Chinese stimulus is what kept Australia out of recession for the duration of the Global Financial Crisis since a meaningful chunk of the stimulus money was spent on imports from Australia.

    As for the post, I thought it left out one issue which many do not talk about: tax policy. If one can make up to $500,000 tax free by flipping primary residences every two years (while getting a tax deduction on mortgage interest), is it really any surprise that a favorable interest rate environment, lax mortgage standards and government cheerleading led to a bubble? Tax policy was not the root cause but like many of the other factors mentioned in BR’s post, it was part of the enablement process.

  36. JohnC says:

    If you want to dig deeper into the China Real Estate issue (which may become an important issue down the road), there is an interesting article in Naked Capitalism (http://www.nakedcapitalism.com/2010/08/andy-xie-on-chinas-empty-apartments.html) by Andy Xie.

  37. Shadowfax says:

    This is a great overview! The hunt for yield issue is critical. We essentially connected the $70 trillion pool of global capital to the U.S. housing market via RMBS for the first time, rated AAA so Wall St. could make a fortune. This firehose pumped up the baloon to bursting and controls went out the window.

    The great article on this is NPR’s “The Giant Pool of Money” which won the Peabody Award and now was rated one of the top 10 pieces of journalism of the past decade:

    http://www.npr.org/blogs/money/2010/04/giant_pool_of_money_named_to_d.html

    Further, I think a big one omitted was the April 2004 decision by the SEC to relax the net capital rule. Investment bank leverage increased from around 20:1 to over 30:1 by 2007.

    http://www.nytimes.com/2008/10/03/business/03sec.html?_r=1&ref=the_reckoning

    A series of other articles from the NYT:
    http://topics.nytimes.com/topics/news/business/series/the_reckoning/index.html

  38. fxworks says:

    Barry- we have a very narrow disagreement here, so I’ll try to stay focused and not go off on tangents:

    I believe you are claiming the Fed made a policy mistake by setting rates too low for too long during the period in question. In support of your claim you offer the following:

    BR: Rates were kept below 2% for 36 months, and at 1% for over a year. This was unprecedented.

    My counter argument is:

    1) You can’t just look at the absolute level of level of rates to make the call that they are “unprecedented” you also have to take inflation into account (thus my comment about “real” rates.) Since inflation was lower in that period relative to other periods rates could be lower relative to other periods.
    2)With regard to interest rates the Fed has a dual mandate: price stability and as full employment as possible. Given that, when they make decisions about interest rates, they shouldn’t take into account that:
    a) “Pension funds, trusts, foundations require 5% annual gains (for tax and other reasons), and without it, they have major issues
    b)Executives of billion dollar companies might start doing things that are crazy, immoral and illegal.

    I believe that given their mandate the Fed acted appropriately. I also believe that low rates were not the major contributing factor to the astonishing bubble in housing; however, the above arguments do not make that case- It’s only an argument that they did the right thing, regardless. Since I noticed you edited my last post, presumably for brevity, I will save it for another time.

    BR: And lastly, my thesis wasn’t written in the voice of a 14 year old girl. (did so)
    Please except my apology- I offer no excuse- that was just uncalled for.

  39. fxworks says:

    BR: 3) For future reference, “I don’t know this for a fact, but I suspect in real terms” is too damned lazy to take seriously. Rather than guess, why not actually do the work to prove or disprove it?

    OK, point taken.

    This chart from calculated Risk shows the real Fed funds rate from 1969 through 2005. Real rates were actually negative from 2002-2004. But this period WAS NOT unprecedented. Real rates were negative from 1975-1978 and were more negative at the peak ( -3 vs. -1.75 ) for longer (4 years vs. 3 )

    http://photos1.blogger.com/photoInclude/img/243/2888/640/RealFED.jpg

    The Article is here:

    http://www.calculatedriskblog.com/2005/07/real-fed-funds-rate.html

  40. rudyf says:

    Decent article, but there’s one gaping hole in the “low interest rates was the catalyst” argument: we have exceptionally low rates right now and the same thing ain’t happening. Why? Because you have to do just about everything short of submitting to a cavity search to get a loan now. So the catalyst was more due to excessive sub-prime loans and lax oversight than the low rates. All of these things are factors, to be sure, but financial institution solvency and stability rests primarily on level of capitalization and the quality of the loans they are making more than on the rates they get from the Fed or other banks when they borrow. When you’re leveraged 20+:1, you’d better be loaning money you have a high probability of getting paid back.

    ~~~

    BR: The last time rates were this low, Houses were an appreciating asset class. Then we had the boom and bust. Now, they are a depreciating asset.

    That is the simple reason why today’s “exceptionally low rates” are not causing a housing boom — we already had the boom, and it is now working on a multi-year bust.