The Housing Boom and Bust

Who or what caused the housing boom and bust?

There was no single cause of the housing crisis, and there is certainly plenty of blame to go around, especially among Washington politicians of both parties, who have been strenuously looking for villains outside of Washington. During the housing boom there were some voices of sanity that warned against the risky way things were being done, both in Washington and in Wall Street. However, during that boom, warnings were brushed aside with clever phrases or with pious statements about the benefits of increased home ownership.

When trying to get at the causes of any major social phenomenon, we are likely to find that these causes range across a wide spectrum. The causes of the housing boom and bust have been as general as the flaws and shortcomings of human beings and as specific as the effects of Federal Reserve System policy on interest rates or a change in mortgage loan eligibility standards by the Federal National Mortgage Association (“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”). The housing market is greatly affected by interest rates and credit eligibility rules, but there is much more to the story than that.

The record-breaking housing price rises that preceded the record-breaking housing market collapse were not evenly spread across the United States but were heavily concentrated in a relatively few places. Much confusion between local trends and national trends in housing markets contributed to counterproductive government policies. We need to understand what led to both kinds of home price trends during the boom before examining the causes and consequences of the housing bust—and the repercussions that spread, not only across the nation but internationally.

In order to follow the story of the housing boom and bust more easily, it may be worth pausing to briefly note the main cast of characters in the housing markets. While the individual home buyer may deal solely with a bank that provides the money to buy the house, in exchange for a mortgage to be paid off in monthly installments, behind that bank and over that bank are all sorts of other institutions, whose actions affect or control the housing markets.

Among the government agencies regulating various aspects of banking is the Federal Reserve System, which also has powers to take actions which affect interest rates and the money supply. Given the great importance of the level of interest rates in the home mortgage markets, the Federal Reserve is a major player in that market, even though that is just one of the markets in which its influence is felt.

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are two government-created, but privately owned, profit-making enterprises that buy mortgages from banks. By selling these mortgages, banks get money from a 30-year mortgage without having to wait 30 years for monthly payments from home buyers to pay off their debts. With the proceeds from these sales to Fannie Mae or Freddie Mac, or to other financial institutions, the banks then have money to lend again to create more mortgages from which to profit.

More than two-thirds of the mortgages made in 2004, for example, were resold to some other financial institution, including Fannie Mae and Freddie Mac. These two government-sponsored enterprises bought more than one-third of all the mortgages in the nation that were resold by the original lenders. In order to qualify to sell their mortgages to Fannie Mae or Freddie Mac, banks must conform to the rules and standards prescribed by these mortgage market giants, including rules and standards that banks must in turn apply to people who seek loans to buy houses. One of the consequences, however, of reselling mortgages on a large scale is that the initial lender has fewer incentives to be meticulous about the financial qualifications of the people to whom mortgage loans are made.

The U.S. Department of Housing and Urban Development (HUD) is another major institution in the housing market. HUD exercises authority over Fannie Mae and Freddie Mac, and therefore indirectly over banks and home buyers, as well as directly influencing mortgage lending practices.

Other important players—and relatively new players in recent years—are Wall Street firms which buy mortgages, bundle thousands of them together and issue securities based on the value of the anticipated income from monthly mortgage payments. Wall Street firms have sold these bundles to investors across the country and around the world.

These and other organizations affecting the housing market are very different from one another and are responsible to very different constituencies. The Department of Housing and Urban Development (HUD) is a Cabinet-level agency directly responsible to whatever administration is in power in Washington. Although the Federal Reserve System is also a government agency, it is led by a board whose members’ staggered terms in office overlap different administrations, in order to make them independent of any particular administration.

Fannie Mae and Freddie Mac are responsible to their stockholders, as Wall Street firms are. But Fannie Mae and Freddie Mac are also what are called “government-sponsored enterprises”—meaning that they were created by the federal government, which has some continuing involvement in their policies. More important, that government involvement leads other financial institutions to lend to these two hybrid institutions at lower interest rates than they would to completely private enterprises, because of the implicit assumption that, in the event of a crisis, the federal government would not let Fannie Mae and Freddie Mac fail.

Investors also buy securities issued by these two government-sponsored enterprises with the same reliance on a federal guarantee that is nowhere explicit but is widely assumed to exist de facto anyway. Therefore, when Fannie Mae and Freddie Mac take bigger risks in pursuit of bigger profits, the market may continue to buy their securities because the federal treasury seems likely to make up losses that might result from these risks. As the Wall Street Journal put it: “Their profit is privatized but their risk is socialized.”

What all this means is that, with such very different organizations having a major influence on the housing markets, there is no inherent reason to expect them to coordinate their actions, so as to produce some consistent policy in those markets. They each have their own incentives, their own agendas and their own constituencies.

Other organizations of various sorts can also play a role in the housing markets, including in some cases the U.S. Department of Justice, as we shall see in Chapter 4. But, for now, the organizations just described can be considered the main players.

Housing is special in a number of ways. It is special to homeowners, for most of whom their house is their largest financial asset and, at the same time, their greatest financial liability. Census data show that home equity—the value of the home, over and above what is owed on the mortgage—is by far the largest single asset in the average household, accounting for 42 percent of the household’s total net worth. Meanwhile, a study by the Federal Reserve System found that mortgage debt was 82 percent of the total debt of homeowners.

Whether people are buying or renting, monthly housing costs are often also the largest single item in their current budgets. In some places with especially high housing prices, such as parts of coastal California, either rent or monthly mortgage payments have taken one-half of the average person’s income. An extreme example is Salinas, California, where the monthly mortgage payment on a median priced house has taken 60 percent of new home buyers’ median income. That of course severely limits what kind of standard of living home buyers can afford with what is left.

Housing is also special because a house is something that can seldom be bought and paid for immediately in cash. Because borrowed money is what usually pays for houses, the interest rate on that borrowed money is crucial—and that interest rate varies greatly with circumstances in the economy as a whole, in addition to varying considerably over time and from one borrower to another. While some factors affect housing prices in local areas, other factors operate nationwide. Interest rates are set nationwide by the Federal Reserve System, through the interest rate it charges to lenders, who in turn lend to the general public, including people buying homes.

The interest rate on a conventional 30-year mortgage was about 8 percent in 1973, 18 percent in 1981 and 6 percent in 2005. At any given time, the interest rate also varies from person to person, depending on the financial condition and credit record of each individual. Those individuals whose credit ratings are below par may be denied loans at the prevailing interest rates, but granted “subprime” loans, which charge higher interest rates to offset the greater risk of lending to people who have lower incomes or a history of credit problems.

In general, not only are people with lower credit scores charged higher interest rates for mortgage loans, people charged higher interest have higher rates of late payments, defaults or foreclosures, suggesting that the market has accurately assessed the risks. All this means that the cost of buying a given house can vary greatly with the times, with the individual and with the various “creative”—and risky—ways of trying to make the monthly mortgage payments affordable, especially in markets with high home prices.

Just a difference of a percentage point or two can significantly change the cost of buying a home. When buying a house by taking out a 30-year mortgage for $400,000, the monthly payment will be less than $2,200 when the interest rate is 5 percent, but more than $2,600 when the interest rate is 7 percent. That is a difference of more than $5,000 a year.

Another way of saying the same thing is that a monthly mortgage payment that would cover the cost of a 30-year mortgage for $400,000 when the interest rate is 7 percent would cover a 30-year mortgage of nearly $500,000 when the interest rate is 5 percent. In short, declining interest rates not only enable more people to be able to afford to buy a house, they enable the same person to buy a more expensive house without a higher monthly mortgage payment. In both cases, lower interest rates increase the demand for housing and thereby drive up home prices.

During the early years of the twenty-first century, the interest rates that the Federal Reserve System charged financial institutions were brought down to extremely low levels. Between the beginning of 2001 and the spring of 2003, the Federal Reserve System brought down its interest rate from 6.5 percent to one percent. Moreover, these rates were not only lower than they had been in decades, they remained at these low rates for years. Competition among financial institutions in turn brought down the interest rates they charged, including interest rates on mortgage loans. Mortgage interest rates fell to their lowest level in decades. Not surprisingly, housing prices rose to record high levels. This helped set the stage for the housing boom.

One of the biggest hurdles to becoming a homeowner has been the traditional substantial down payment required—often 20 percent of the price of a home. That has been an especially large hurdle where home prices are highest. People who already have a home can often sell that home, even if it is not yet paid for, paying off the mortgage from the sale price and using the money left over—their equity in the house—as a down payment for a new house. That has usually been the primary source of a down payment for California homeowners buying another home, their savings usually being secondary. But, after the housing boom turned to bust, savings became the primary source of down payments in California, as homes no longer sold as fast or for as much money as before.

People who are buying a home for the first time, however, have had to come up with the hard cash, which many found difficult or impossible—again, especially in places with very expensive housing. While first-time home buyers were about half of all home buyers in California in the mid-1990s, that proportion fell to about a third during the housing boom in the early years of the twenty-first century. Down payments from first-time buyers in California were much less than down payments from repeat buyers—less than $30,000 compared to more than $100,000 for repeat buyers in 2008, for example.

Lenders are, of course, well aware that requiring substantial down payments limits the number of people who can afford mortgage loans—and therefore limits the total amount of business they can do and the profit to be made from making mortgage loans. Obviously, there must be some offsetting advantage to having such a requirement for it to continue, despite its restriction on the number of business transactions to be made. That advantage is reducing the risk of default. A home buyer with a substantial investment in the home from the outset is less likely to someday simply walk away from the mortgage and the house, leaving the lender in the lurch.

In exceptionally expensive housing markets, first-time buyers have had to pay an especially high proportion of their incomes for monthly mortgage payments, since they have often made the minimum down payment possible. First-time buyers have also more often than others resorted to various “creative”—and risky—methods of financing the purchase of a home.

Although the financial repercussions of the housing boom and bust have been national and even international in their scope, many of the problems that provided the impetus for these economic disasters were local in origin. The national and even international market for local mortgages has meant that the repercussions of housing crises in various localities can spread far beyond those localities. Moreover, a confusion between the local and the nationwide availability of “affordable housing” has contributed to government policies that led to the boom and bust. To understand all this, we need to start at square one, the scattered localities around the country where housing prices have been some multiple of the national average, and were rising much faster than the national average, during the housing boom.

California—and especially coastal California—has been the largest of these exceptionally expensive housing markets. It has also been the most expensive and with the fastest rising home prices. At the height of the housing boom in 2005, the top ten areas with the biggest home price increases over the previous five years were all in California. Yet California home prices were once very similar to home prices in the rest of the nation. It was only after the decade of the 1970s that home prices in much of coastal California became far higher than home prices in the country as a whole.

In the San Francisco Bay Area, for example, the median-priced home in 2005 cost more than three times the national average. In the city of San Francisco, the median home sales price that year was $765,000. In March of the same year, home prices in San Mateo County (adjacent to San Francisco) rose at a rate of $2,000 a day and later peaked at just over one million dollars in 2007. This price was paid for homes averaging less than 2,000 square feet.

San Mateo was by no means unique among California communities in having modest-sized houses that were selling for what would be charged for large luxury homes elsewhere. For the state as a whole, including its interior valleys where housing prices were lower, the median sales price of homes peaked at $561,000 in 2006, when the median size of the houses sold was 1,600 square feet. Most Californians were not living in mansions, but many were paying what would be mansion prices, in some other places, for modest middle class homes.

Although the housing boom and bust is a national problem in terms of its repercussions, its origins tended to be concentrated in particular places with unusually high housing prices and unusually volatile changes in those prices. For example, while home prices rose 13 percent nationwide in a single year, from 2004 to 2005, the range was from a 4 percent rise in Michigan to a 35 percent rise in Arizona. As already noted, California housing prices have long been some multiple of prices in the country as a whole.

What is different about such places?

Certainly the cost of building a house does not vary anywhere nearly as drastically as the prices of houses in different places. Nor does the quality of the houses vary that much between the high-priced states and the lower-priced states. Although San Francisco has some of the highest home prices and apartment rents in the country, the houses are often rather modest and built close together. As for apartments, the San Francisco Chronicle reported a graduate student looking for a place to rent in San Francisco, who was “visiting one exorbitantly priced hovel after another.”

Conceivably, rising incomes or rising populations might explain why some places have higher or faster rising housing prices than others. But, in fact, incomes were rising less in California than in the rest of the country during the decade of the 1970s, when California housing prices became a multiple of the national average. Nor have population increases usually been what has driven home prices up in some places so much faster than the national average. Population increase on the San Francisco peninsula during the 1970s was virtually identical with population increases nationally—11.9 percent versus 11.5 percent, respectively. Housing prices in Palo Alto, California (near Stanford University), nearly quadrupled during the decade of the 1970s, when that community’s population actually declined by 8 percent.

What then does distinguish the places with skyrocketing housing prices from other places?

Studies of housing prices across the country show that what varies drastically from one place to another is the price of the land on which houses are built. Economists at the National Bureau of Economic Research estimated that the cost of a quarter-acre lot added about $140,000 to the price of a house in Chicago, over and above the cost of constructing the house itself. In San Diego, a quarter-acre lot added about $285,000 to the cost of the house itself, in New York City the same size lot added about $350,000, and in San Francisco nearly $700,000. The extraordinary cost of the land in San Francisco helps explain why modest but very expensive homes in that city are often jammed close together.¹

While great variations in the price of land from one place to another help answer some questions, these variations raise other questions. Why are there such great variations in the price of land from one place to another, in the first place? Moreover, why did the price of housing suddenly become radically more expensive in California in the 1970s, when it was not before? Surely the amount of land in California did not change radically during that decade.

In a sense it did. It changed politically.

The decade of the 1970s saw a rapid spread of laws and policies in California severely restricting the use of land.² Often these laws and policies forbade the building of anything on vast areas of land, in the name of preserving “open space,” “saving farmland,” “protecting the environment,” “historical preservation” and other politically attractive slogans. Moreover, these restrictions were extended to more and more land over the years.

The normal transfer of land from one use to another over time was often stopped by such laws and policies, so that a farmer who quit farming was not allowed to sell the land to someone who might build houses on the site. Instead, the former farmland could be forced to become “open space” by various restrictions placed on its use. In this and other ways, large and growing amounts of land in many coastal California communities became “open space”—more than half of all the land in San Mateo County, for example. This artificial scarcity of land of course drove up the price of the remaining land in the county, creating the conditions in which modest-sized homes became literally million-dollar homes in that county.

While California was different from most of the rest of the country in the extent and severity of its land use restrictions, it was not unique. The same kinds of land-use restrictions which spread through many coastal California communities during the 1970s spread through various other places around the country, either during that decade or in other years. But, in whatever years building restrictions were tightened in various localities, those were usually the same years in which housing prices skyrocketed.