Why a Housing Bubble?

Why did we have a housing bubble in the 00s? Why not Tulips or something else?

Kevin Drum:

The real difference seems to lie not in housing becoming a better target for investment, but in real goods and services becoming less attractive ones. Why? Surely this is something that deserves considerably greater scrutiny than it’s gotten. Why did investors no longer think that the returns from investing in the real world portion of the American economy looked very compelling? Why was demand for real world goods and services not high enough to provide ample investment opportunity? This seems like a core question of the past decade that hasn’t gotten enough attention.

Yglesias:

I’m not sure the distinction between “real estate got more attractive as an investment” and “other investments got less attractive as an investment” is all that conceptually rigorous. But I think there is, in fact, reason to believe that the causation involves real estate starting to look more attractive. In particular, we had a lot of “innovation” in mortgage finance that both expanded the number of people who could (apparently) afford to own a home and expanded the number of people who could viably engage in real estate speculation. I don’t think it’s all that surprising that this entrance of new market participants could have started a bubble scenario or that once the bubble was underway it kept attracting more and more money. We’re herd animals and there’s always a preference for getting in on the latest investment fad than for whatever else is on the table.

One answer to Kevin’s question is because of the terrorist attacks on 9/11, and the financial scandals of Enron and Worldcom, bond markets were scared out of their minds that they might be lending to the next Worldcom. Noah Millman has an excellent description of that situation on the ground related to the beginning of the wave of structured finance. Worldcom is early 2002; people are spooked about the next landmine, and housing always seemed like a safe bet for both consumers, and because of some financial innovations and excellent ratings, for investors.

To go deeper, I think it’s useful to distinguish between supply and demand here. Many financial institutions, because of all kinds of financial innovation, deregulation, ratings agency’s behavior and changes in the repo markets, wanted to give out more housing loans than before. That’s supply. Where did demand come from? Why did consumers buy so much real estate? The quick answer is that supply creates its own demand, or that demand stayed still while supply moved enough to cause what we’ve seen.

Another answer is behavioral-style herd behavior. Now mind you, as opposed to me stockpiling tulips, which doesn’t effect you unless you envy my tulips or feel status externalities to my tulips etc., me bidding up housing in a neighborhood does effect you if you are my neighbor, as neighborhood value drives a part of housing value. And with early 1980s banking deregulations, my ability to bid on housing is unconstrained by law.

Though it may be a rounding error, or it may have some interesting stories in it, I’ve written before on the idea that demand for housing intersects with a dismantling of the social safety net. To deal with rising health insurance premiums you get a credit card, and to deal with the debt you can borrow against your home – housing equity as the new social contract. In Massachusetts, 60% of all subprime defaults were mortgages that started with a prime mortgage, terms that usually imply something other than consumption smoothing. As for all the talk about the embedded option of getting a tax refund in a mortgage (as your interest can be written off), which is something that should be phased out, the real embedded option in housing is schooling – the option to send your kids to the local public school. As the robustness of educational meritocracy became a hot button issue in the 00s, the value of this embedded option must have skyrocketed. Not to mention gentrification issues, as well as exurbs that were implicitly dependent on cheap gas prices. That’s not the whole story of what was going on, but I think it’s worth some empirical research.

This entry was posted in Uncategorized. Bookmark the permalink.

12 Responses to Why a Housing Bubble?

  1. -g says:

    Mike,

    Thanks for this. As a reader without any background at all in the areas you write about (but one who read the Yglesias ) post, the added context and analysis helps.

    Keep on trucking, brother.

    -g

  2. Petey says:

    “One answer to Kevin’s question is because of the terrorist attacks on 9/11, and the financial scandals of Enron and Worldcom, bond markets were scared out of their minds that they might be lending to the next Worldcom. Noah Millman has an excellent description of that situation on the ground related to the beginning of the wave of structured finance. Worldcom is early 2002; people are spooked about the next landmine, and housing always seemed like a safe bet for both consumers, and because of some financial innovations and excellent ratings, for investors.”

    I’ll add in a couple of additions details to answer “why housing?”

    - Capital was already in dollars to play in the NASDAQ boom.

    - Capital couldn’t move into emerging markets because the disarray in the aftermath of the Russia/Asia panics.

    - Capital couldn’t move into Europe because of the disruption of the Euro transition.

    So capital didn’t want to leave the US, didn’t want to be in US equities, and didn’t want to be in cash since Treasury rates were too low.

    US real estate was the only place for capital left to move.

  3. JeffreyY says:

    Why “Why a housing bubble”? My core understanding of bubbles is that they’re positive feedback loops triggered by random fluctuations in the economy. When one sector “bubbles”, it could be that there’s something special about that sector, but it’s more likely that several sectors were ripe for a bubble, and the one happened to randomly hook into the feedback loop before the others. Once one bubble starts, it suppresses other concurrent bubbles by depriving them of “fuel” (attention and funding). So when we see a bubble, that doesn’t constitute evidence that other sectors _weren’t_ ripe for a bubble.
    Am I missing something?

  4. Nate says:

    I want hedonic house price analysis with year-dummy-dist-to-nearest-school variables. I was crunching a hedonic model of a busy housing market just recently and the variable that was the distance the house was to the central business district paled in comparison to the variable that tracked the local gasoline cpi over time in terms of predicted negative impact on house value.

    Don’t forget about the implementation of school of choice – it must have pretty seriously effected implicit prices in the sense that the housing stock associated with any given school rose significantly.

    • Adam Ozimek says:

      Did you control for household income? I imagine shocks to income will translate into shocks to gas prices, as supply takes time to increase in response to demand shocks. Also, more dense areas will likely have lower CPIs since the markets will be thicker, and travel-time to gas-stations might allow some price discrimination in less dense, high income areas. Did you use changes in CPI or levels?

  5. Pingback: Demand Is Not An Externality «  Modeled Behavior

  6. financeguy says:

    Jeffrey has a good point about feedback loops, and I think he’s right: to some degree, there’s just an element of chance, in “why a bubble here but not elsewhere?” Once the bubble does start to take off in one particular asset class, it starves other nearby bubbles taking form (as a former storm chaser, I’d liken it to that monster storm that sucks up the fuel supply of other storms in the vicinity, helping kill them). Of course with the amount of money sloshing around at the time, you needed a major asset class to absorb that. So tulips and Pokemon cards are out. My pet theory was that, when the dot-com boom collapsed, the froth money just shifted to real estate with nary a pause. One puzzler to me in the early 00s: I couldn’t understand why the 1% interest rates persisted for so long; that was just asking for trouble. Crazy.

  7. john c. halasz says:

    Jesus! No mention of the trade deficit here? The “China price”? The de-industrialization of the U.S. economy and the poor level of (domestic) corporate cap-ex? The recycling of of trade surpluses to maintain under-valued currencies? The increasing upward tilt in income distribution, (as the wealth class benefited from increased foreign profits, and the working-class declined), which made debt-financing through leveraging household equity/collateral both increasingly attractive and increasingly available? The causal arrow from trade deficits and declining investment in tradeable goods sectors to inflating bubbles in non-tradeable sectors, especially given the recycling of trade-surpluses, should be obvious, since such housing bubbles occurred in a number of trade-deficit countries. And in the U.S. some part of the rapid inflation in health care costs no doubt could be attributed to the same source. Economies with declining real investment opportunities, excess supplies of investment capital and low rates of return from real investment will turn to the extraction of rents from the remaining stock of the previously developed economy. And what sectors are more ripe for such rent extractions than a patch-work health care system full of information asymmetries and a household sector chasing monetary illusions due to increase shifting of social risks onto it, losses and distrust remaining from the stock bubble and approaching retirement burdens? That Wall St. stood ready to provide the mechanisms of asset price inflation through levering up on cheap money/low returns, on top of the high profits extracted from the MNC/FX fiddle, and thereby effectively looted the household sector should come as no surprise. What part of this do you liberals not understand?

  8. jm says:

    I second all john c. halasz writes above.

    As to why the bubble occurred in housing, note that even with traditional 20% down payments, it was about the only asset class in which the general public could speculate with 5:1 leverage. When 10% and lower down payments were allowed, the leverage available rose to 10:1 and higher.

    While this was going on, mortgage rates were falling due to the influences Halasz cites, and economists interviewed by the media (especially those of Fed ilk), were saying it made perfect sense for housing prices to vary in inverse proportion to interest rates. That this meant that houses were in effect trading like bonds, with the general public allowed to join in the market with 10:1 leverage, seems not to have been as clear to them as it was to this non-economist. And the issue of what would happen if interest rates were ever to rise, or prices were to fall due to, e.g., builders creating a glut of supply, also seems never to have occurred to them.

    That Fed economists did not perceive that if houses were to trade like bonds, they would be unable to raise medium-term interest rates more than 20% — e.g., from 5% to 6% — without putting a significant fraction of the nation’s mortgagees underwater, is to me both extraordinary and seriously disturbing.

    As for another aspect of why it was housing that went into bubble mode, note that in 1993 the overall home ownership rate was about as low as it had gotten in recent times, and was particularly low among the younger age cohorts. So there was genuine pent-up demand to get things rolling. And there was no glut of supply to hold prices back. When we also got a burst of immigration by relatively well-paid software developers and electronic engineers, the market got an additional boost and just as the tech-stock bubble burst was beginning to lift off from early-90s lows, so it looked like a safe haven to refugees evacuating the stock market.

    When lending standards were then loosened with > 10:1 leverage allowed, housing prices were sent into orbit.

  9. Pingback: A House Is Not A Home, It’s An Investment « Around The Sphere

  10. Justin says:

    Regarding your old post at the baseline scenario, you say that people aren’t treating houses as investments (they’re struggling to keep a house where the mortgage is underwater, etc). You therefore draw the conclusion that it’s unlikely people were making the rational calculation that a zero money down loan is a risk free investment.

    However, you might also get the same observed behavior from a combination of the endowment effect and a failure to predict one’s own behavior. So a home-buyer might think that it’s a risk free investment, ignoring the fact that their own psychology will lead them to overvalue the house once they buy it, and therefore suffer a serious risk.

  11. Blissex says:

    Almost all of the above explanations suffer from a fatal flow: USA parochialism. There were housing bubbles in *many* countries at the same time. And they were often preceded or followed by other asset bubbles. Explain that…

    «with traditional 20% down payments, it was about the only asset class in which the general public could speculate with 5:1 leverage. When 10% and lower down payments were allowed, the leverage available rose to 10:1 and higher.»

    That applies to most countries, but it is more of an explanation of why the bust was so big than of why the bubble was so large.

    The explanation I prefer is politics: in several countries speculators got the impression that housing was backstopped by the government, that the bubble was a policy by conservative parties to enrich asset holders and create new conservative voters, and that house prices as a result could only go up — a one way winning bet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s