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Your Guide to the Housing Crisis

From the May/June 2008 Issue

With the financial world in turmoil, here’s a handy guide to the bursting of the housing market bubble.

Q. The term “bubble” is used frequently in discussing the housing market—did we have a bubble, and what does that really mean?
A. Yes, we did. A “bubble” is created when many people believe that an asset’s price, which has already greatly increased, must keep on rising, and that it therefore makes sense to borrow in order to buy it—for example, to buy a house with no down payment. Speculators acquire loans that can be repaid only if the asset is sold for a higher price, temporarily driving up prices and debt; lenders grow confident that it is attractive to make such loans. As long as the prices rise, borrowers, lenders, and investors all make money. But bubbles, by definition, come to a sad end, with defaults, failures, dispossessions, scandals, and late-cycle political and regulatory reactions and often overreactions.

Q. How big was the recent bubble in the U.S. housing market?
A. This time we had the greatest house price inflation in U.S. history. The value of U.S. residential real estate almost doubled between 1999 and 2006. The U.S. residential mortgage market was already the biggest credit market in the world, and it grew to have total loans of over $10 trillion. Securitized prime and subprime mortgages were purchased by investors around the world.

A financial crisis occurs about once a decade, with markets relearning the same lessons and then forgetting them.

Q. Are bubbles just caused by stupidity?
A. No. They look stupid in retrospect, but when a bubble collapses many intelligent people get caught. Brilliant model builders and articulate Wall Street bankers helped create the most recent bubble. Economist Walter Bagehot’s 1873 observation remains true: “The period of rising prices…naturally excites the sanguine and the ardent…and the ablest and the cleverest the most…. Every great crisis reveals the excessive speculations of many houses which no one before suspected.” Isaac Newton, possibly the greatest genius in history, invested in the bubble of the early 1700s, the South Sea Company, selling at a large profit. But when the price continued to rise, he bought back in—and then was stuck with a large loss when the bubble turned to panic. Disgusted, Newton wrote, “I can calculate the motions of the heavenly bodies, but not the madness of people.”

Q. Why is a bubble so hard to control?
A. Bubbles are notoriously difficult to control because so many people are making money from them while they last. Also, this one made politicians of both parties happy because it was increasing home ownership.

Q. What does a “credit crunch” mean and how is it tied to falling house prices?
A. When lenders experience high delinquencies and defaults, they always become more conservative about extending new credit, as is happening now. They also are typically under regulatory pressure to keep up their ratio of capital to assets—and if the capital has been reduced by losses, their loans have to be constrained. In addition, lenders who have failed or gone out of business, such as about 200 former subprime mortgage lenders that have closed since early 2007, are obviously not making any loans. A credit contraction or “crunch” results. The reduction in available mortgage credit reduces the demand for houses, just when there is an excess supply of houses for sale. The combination of reduced demand and excess supply causes house prices to fall.

PollockQ-A_Affordability.jpgQ. How much can house prices fall?
A. Of course no one knows for sure what future prices will be, but some credible analysts estimate that the price drop from peak to trough will be about 20 percent to 25 percent. This is a huge fall—especially if you bought at the peak with no down payment! At the peak, the aggregate value of U.S. residential real estate was about $22 trillion. It has now fallen about 10 percent. With a total 20 percent or 25 percent decrease, household wealth would be reduced about $4.4 trillion or $5.5 trillion. Millions of borrowers would owe more on their mortgage than their house is worth. This is called being “upside down” and it creates the temptation—some would say a rational economic decision—to default on the mortgage and simply walk away from the house, accepting the blot on your credit record as a trade-off. Typical estimates are that the mortgage market is facing as many as 2 million foreclosures, which represent about 4 percent of mortgages but a lot of people and voters. Of course, for buyers, lower house prices are an advantage—especially for those buying a house for the first time.

Q. Will the drop in house prices depend on where you live?
A. Yes. There are always local and regional differences in house prices. While house prices are falling nationally on average, they are more likely to fall in areas where price gains were previously high and where new construction was excessive—in California, Florida, and Las Vegas, for example.

Q. What is “jingle mail”?
A. This is what the lender receives when an “upside down” borrower walks away and mails in the keys to the house.

Q. Has a bust like this ever happened before?
A. Yes, many times. Financial history shows that a financial crisis occurs about once every decade on average, with financial markets relearning the same lessons and subsequently forgetting them. The bust, like the bubble, won’t last forever, and in the intermediate term house prices will again begin rising and mortgage markets will resume normal functioning.

Q. Was fraud involved?
A. Yes. Throughout history, bubbles have induced fraud: “The propensity to swindle grows parallel with the propensity to speculate during a boom,” wrote the eminent economic historian Charles Kindleberger. “The implosion of an asset price bubble always leads to the discovery of frauds and swindles,” he added. Said Bagehot, “The good times of too high price almost always engender much fraud.”

Our most recent bubble was no different. Some borrowers lied about their income to get loans; some mortgage brokers misled borrowers or falsified documents; and there were various schemes to defraud lenders. The euphoria about rising prices characteristic of bubbles also induces carelessness, which makes fraud easier.

Q. What is the “financial accelerator” or “adverse feedback loop” the Federal Reserve talks about?
A. In other words, financial problems make a recession worse, and a recession makes the financial problems worse. This also does not last forever, and the financial and economic cycle will turn back up, as it always does, though we cannot know exactly when.

Q. Didn’t financial experts have computer models to analyze the risk?
A. Smart people, including investment bankers, rating agencies, and bond investors, had complex models and lots of data. This is the most recent expensive lesson that computers and data do not make us wise—especially in that fascinating form of group behavior known as financial markets. The models greatly underestimated how loan origination behavior was changing and how bad defaults on mortgage loans could become.

They all used as a key factor “House Price Appreciation,” but what we have now is house price depreciation.

PollockQ-A_Bubble burst.jpgQ. What can be done to improve the mortgage market in the future?
A. The most obvious and important reform is to make sure the borrowers know what they are getting into with their mortgage loan. Borrowers are understandably overwhelmed by the huge stack of confusing documents with small print presented at a mortgage closing.

The solution is a straightforward one-page form stating the essentials of the loan, provided to every borrower as long as possible before the closing, which shows in particular how much of the household’s income the loan payments will require. I have proposed to Congress such a one-page form, which is available on the American Enterprise Institute’s website.

Should people be free to take a risk in order to own a house, if they want to? Yes, provided they really understand the commitments they are making. And should lenders be permitted to give loans to borrowers with poor credit records, if they want to? Yes, if they clearly tell borrowers about the loan’s obligations.

Q. What about all the proposals for the government to support borrowers and the mortgage market in the short term?
A. One thing we know for certain is that governments always intervene when the bust leads to spreading panic and the risk of an out-of-control financial meltdown—just as was done to prevent the impending Bear Stearns bankruptcy. Both Congress and the administration are already promoting the further expansion of government financing through Fannie Mae, Freddie Mac, and the Federal Housing Administration. The risks of doing nothing in the crisis are simply too great and are never taken.

Governments also typically intervene when there are very widespread mortgage defaults and foreclosures. The harsh moneylender enforcing contractual rights against the struggling borrowers is never a popular figure. Since 1970, we have had four “emergency housing acts,” and Congress is working on what could be the next one. All such programs use the government’s credit in one way or another. A key argument against them is that they put the taxpayers at risk; the counterargument is that a financial collapse puts everybody at even more risk.

Are these interventions a good idea? Once the bubble has inflated and then collapsed, there are no good choices, including doing nothing. The problem becomes looking for the least bad choice. The least bad interventions are focused and, above all, temporary. When the crisis is over, they are thanked and closed down.

Alex J. Pollock is a resident fellow at the American Enterprise Institute and past president of the Federal Home Loan Bank of Chicago.

Photograph by Getty Images.

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