Research Upsets “Housing Bubble” Conventional Wisdom

Press Release by Aaron Pressman:

BOSTON, May 5 (Reuters) – Low interest rates and loose lending policies were not to blame for the nationwide boom and subsequent crash in U.S. home prices over the past decade, according to a new paper by three university researchers released on Wednesday.

Contrary to conventional wisdom blaming the Federal Reserve for keeping rates too low or failing to enforce tighter mortgage standards, the paper blames “faulty expectations” of buyers and lenders who believed home prices would rise indefinitely.

“If economists are going to better understand housing bubbles, we will surely need to accept that home buyers often have very exuberant beliefs about housing prices,” the authors concluded.

The study was written by Edward Glaeser, a professor of economics at Harvard University’s Kennedy School of Government; Joseph Gyourko, a University of Pennsylvannia professor of real estate; and Harvard graduate student Joshua Gottlieb.

Presented on Wednesday at a conference on the roots of the housing crisis at the Federal Reserve Bank of Boston, the paper analyzed a variety of nationwide housing market data from 1980 through 2008.

The researchers found a 1.0 percent decline in real interest rates typically led to an 8.0 percent increase in home prices. Real rates on 10-year Treasury bonds used to set mortgage rates declined by 1.3 percent from 2000 to 2006, accounting for only about a 10 percent increase in prices.

Similarly, lending standards eased during the bubble years but not enough to explain the huge price moves, the paper found. Mortgage loans were made at an average of 84 percent of the value of homes in 1998, suggesting a 16 percent down payment, compared to a loan-to-value ratio of 88 percent, or a 12 percent down payment, by 2006.

“We found no statistically meaningful relationship between house value and the down payment size,” the authors concluded.

NO DRAMATIC IMPACT

Boston Fed president Eric Rosenberg opened the conference by noting that more research was needed on the role of the Fed’s monetary policies in the real estate bubble and other financial run-ups.

“Many have contended that the short term interest rates that were very low in the middle of this decade was a significant contributor,” Rosenberg said in a brief speech. “I’ve always been a little bit skeptical that a 100 basis point movement in the Fed funds rate was likely to have a dramatic effect on asset prices.”

Dean Baker, a leading critic of the Fed over the housing bubble, agreed that the central bank should not simply have raised rates. But, Fed chairmen Alan Greenspan and Ben Bernanke still should have been more active, he said.

“Greenspan and Bernanke should have been alert for the risk of bubbles,” Baker, co-director of the Center for Economic and Policy Research, said in an email. The bankers should have initially issued frequent warnings and cracked down hard on lending abuses, he said.

“If this didn’t work, then they should have raised interest rates as a last resort, but with an explicit target of deflating the bubble,” Baker said.

Co-author Glaeser said that a complete understanding of the causes of the bubble might not be known for decades. “We’re in the awkward position of having experienced an extraordinary housing market without any comfortable explanation,” he said after presenting the results.

Still, government policy can help mitigate the effects of bubbles, Glaeser said, such as by curtailing home ownership tax incentives and relaxing land-use restrictions.

In general, price appreciation was much higher in areas with strict land use controls than in areas where contructing new homes was easy. Prices after accounting for inflation rose 88 percent between 1996 and 2006 in areas with the most limited new supply of homes compared to a 23 percent gain in areas that were the least restrictive.

However, two areas that saw the biggest jumps and subsequent steepest declines — Las Vegas and Phoenix — were also among the easiest markets in the country to allow new construction.

Paul Willen, a senior economist at the Boston Fed, presented similar research he said debunked other conventional wisdom about the real estate bubble.

So-called toxic mortgages, or loans with low initial rates that could reset much higher after two years, have gotten far too much blame, Willen said.

Examining data for subprime loans made in 2005, 2006 and 2007, Willen found no evidence of an increase in defaults when rates reset after two years. In fact, all three groups of loans exhibited significant default rates from the start.

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