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Housing Bubble Was Whose Fault? Not the Fed's, Says New Study

Originally published in Housing Watch

May 7, 2010
Lita Epstein (Housing Watch)

Don't blame the Federal Reserve for the country's housing troubles. At least that's what a controversial new study claims. Economic researchers from Harvard's Kennedy School and the Wharton School of the University of Pennsylvania believe they've proved that reduced interest rates and lax regulations were not the primary cause of the housing bubble.

The authors of the study instead point to the currently allowable mortgage interest tax deduction as the main culprit.

But before you get too panicky about losing your mortgage tax deduction or other government benefits for homeowners, let's take a closer look at their conclusions. Also note that Federal Reserve Chairman Ben Bernanke disagrees with them. In fact, he thinks lax regulations sent the housing market into a downward spiral.

So who's right?

Edward Glaeser and Joshua Gottlieb of Harvard University and Joseph Gyourko of the Wharton Business School presented their study (titled "Did Credit Market Policies Cause the Housing Bubble?") at the Federal Reserve of Boston on Wednesday. In it, they call for a reduction from the upper limit of $1 million worth of debt to just $300,000 and say that "the distortions and the regressive nature of the deduction would be reduced in ways that would not dramatically affect most households."

They conclude that "rethinking those Federal housing policies that act primarily by lowering the cost of credit to home buyers, most notably the Home Mortgage Interest Deduction" would reduce the risk of future bubbles.

Ben Bernanke, on the other hand, has cited the following as the probable causes of the bubble:

  • Alternative types of variable-rate mortgages. These include interest-only ARMs, long-amortization ARMs, negative-amortization ARMs (in which the initial payment does not cover even the interest costs) and pay-option ARMs (in which borrowers determine the payment amount in the early years of the mortgage). Such exotic loans came on the market in 2000, but rapidly increased in usage during 2005 and 2006.
  • A protracted deterioration of mortgage underwriting standards. This includes practices such as no-documentation loans, also known as "liar loans," because borrowers needed to provide no evidence of income.
  • Inflated home value expectations. Both lenders and borrowers became convinced that house prices would only go up. Borrowers chose -- and were extended -- mortgages they could not make payments on over the long term.Instead, they expected homes to keep appreciating so they could refinance into a more sustainable mortgage in the future. The expectation that prices would only go up provided the air that sustained the bubble.



In contrast, Glaeser, Gottlieb and Gyourko found that real interest rates fell about 1.3 percentage points and that a 1 percent swing in real rates was only associated with an 8 percent change in prices. They say their theoretical and empirical work suggests even a smaller connection.

Yet between 2000 and 2006, the Case Shiller Housing Price Index "increased by 74 percent in real terms." So an 8 percent increase would account for just a small portion of this swing.

Other housing markets jumped much more. For example, Los Angeles home prices increased by 130 percent between 2000 and 2006.

The researchers also found that by 2006, "one quarter of all home purchasers were borrowing 99 percent of the purchase price and in nearly two-thirds of the nation's metropolitan areas, one quarter of all purchasers were taking out loans at least equal to the full value of their homes." Yet the study's authors did not think this had a major impact on house prices.

Do you believe that one?

In fact, in 1998 their sample of 75 metropolitan areas found that median loan-to-value ratio was 84 percent. By 2006, it was only 4 percent higher, at 88 percent.

At least they agree there was significant differentiation in regions.

When people put so little skin in the game and quickly flip a home for a quick profit, that's a perfect formula for inflating a bubble. Investors were selling to other investors and jacking-up prices. The buyers who were purchasing a home for the long term got caught in the crossfire.

I'm sticking with Bernanke on this one: Lax regulations that allowed so many to buy with so little money were the primary culprit. Making loans easy to come by with lax regulations, such as no-documentation loans, interest-only ARMs, negative amortization ARMs and other types of exotic mortgage packages, made fueling the fire very easy.

The economists seem to have an agenda against the mortgage interest tax deduction, and their paper simply manipulates the numbers to support that belief. In my opinion, their conclusion is as full of as much air as the bubble itself.

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