Professor Glaeser unfortunately overlooks many of the causal and exacerbating factors of the housing boom and bust. Let us go over some of these factors for the benefit of those who may somehow have missed them.
I have reviewed this in the past, but given the prof’s 30 year chart, why don’t we walk him through the entire context of what took place historically. (Note: this is exhaustively detailed in Bailout Nation)
1. A medium Housing boom and bust began in 1989, following the Fed’s rate reaction to the ‘87 crash. Nationally, residential RE did not get back to break even until about 1996-97 (it varied by region).
2. The mid-1990s also saw the build out of numerous 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, and employee stock options did extremely well.
3. Stock markets had been making enormous gains. As someone who worked on Wall Street then, I witnessed first hand investors taking partial cash outs of huge equity gains and rotating them into Real Estate. This included major upgrades to primary residences, and purchases of vacation/investment properties.
4. Then came Enron, WorldCom, Tyco, the dot com crash, analyst banking scandal, etc. The Equity party appeared to be over.
5. Starting in January 2001, the FOMC began lowering rates, eventually to 1%. Rates were below 2% for 36 months, and at 1% for over a year. This was unprecedented.
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. People budget monthly, and those carrying costs are more important than actual purchase prices. An outsized drop in interest rates can cause a spike in home prices, with monthly payments remaining fairly similar.
Bottom line: Ultra low rates were the initial fuel sending home prices higher.
7. Professor Glaeser focused on the interest rate impact on Housing missed the impact these rates had on global bond managers. The 1% rates forced them into a mad scramble for yield. Pension funds, trusts, foundations require a certain annual gain, and without it, they have major issues.
8. Most of these managers by their own charters cannot purchase junk, they can only buy investment grade paper. This becomes a very important factor.
9. Wall Street had been securitizing collateralized debt for years. They turned credit cards, student loans, auto financing, and of course, mortgages into paper. In an era of ultra-low rates, the search was on for higher yields. Making loans to people with weaker credit scores, lower incomes, or more debt generated those higher yields (but at a higher risk).
10. Collateralizing these subprime mortgages allowed Securitizers to generate higher yielding paper for the managers of bond funds.
11. The Rating Agencies — Moody’s, S&P, and Fitch were corrupted by the big fees on this paper, and allowed the securitizers to essentially purchase AAA ratings. Hence, the higher yielding, higher risk junk paper received an investment grade rating. Without it, it could not have been sold to these funds that could only purchase 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 knows how to respond to demand, and they scooped up all the higher yielding sun-prime mortgages they could to feed all of the demand.
13. After exhausting all of supply of legitimate subprime paper, they started acquiring weaker and weaker mortgages to feed into the maw of the securitization beast. They consumed the output of all the non-bank sub-prime lenders, who made weaker and weaker loans. Their business model was lend-to-sell-to-securitizers.
14. Since there is only a finite supply of people who can afford mortgages, these lend-to-securitize mortgage originators got creative with ways to make mortgages even cheaper. They made ever shadier loans to even less qualified borrowers.
15. 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.” And, 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.
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.
20. The Fed began raising interest rates, and the party was over. The entire housing edifice of the 2002-07 era was based on ever rising prices, supported by cheap credit, and a greater number of buyers than there was Household formation.
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
Originally published at The Big Picture and reproduced here with the author’s permission.