Housing Bubbles Past and Present

Occasionally light does shine forth from the op-ed page of the NY Times.   This time we are indebted to Peter J. Wallison, senior fellow at the American Enterprise Institute.

Wallison's contention is that valuable insight is to be had by examining the costs of renting a residence. The U.S. Bureau of Labor Statistics has been tracking these costs since 1983.  They show that a steady rise of about 3% over the last 30 years, which is pretty much as it should be.

Home prices should do the same.  If the cost of running a house runs appreciably over that of renting, then in theory people would begin to turn to renting.  A divergence of the two prices leads to a bubble.

Between '97 and '02, prices began to diverge.  The average compound rate of growth in houses was 6%.  The growth in rentals was 3.34%.  The 6% growth in houses continued until '07 when the bubble burst.

Today the bubble is beginning to grow again with a rate of growth in houses at 5.83 % between '11 and the third quarter of '13.  The increase in rental costs was only 2% for the same period.

According to Wallison, this bubble and the last one were caused by the government's housing policies which made it possible to now buy a house with little to no down-payment.  The earlier bubble began after Congress, in '92, adopted the "affordable housing" goals for Fannie Mae and Freddie Mac, the major players in the housing market then as now.  Under congressional directive, these institutions were to make mortgages available to borrowers who were at, or under, the median income where they lived.

The ratio of such "affordable" mortgages was raised by the Department of Housing and Urban Development seven times from the 1990's into the 2000's.  Such mortgages came to more than 50%.  To make such mortgages available to low-income borrowers, Fannie and Freddie reduced the down- payments on mortgages they would acquire.  By '94, Fannie was accepting down-payments of 3% and by 2000 they were accepting mortgages with zero down-payment.

While these low down-payments were intended for low income people, they couldn't be confined to those borrowers.  No down-payment mortgages also went to people who could have afforded to make a 10% or 20% down-payment.  By 2006, the National Association of Realtors reported that 45% of first time home buyers put down no money.

The bottom line was that it became a lot cheaper to own a home than to rent.  It also created tremendous pricing leverage.  Anyone could afford almost any home -- certainly a home far above one's traditional means.  Borrowing was constrained only by appraisals and these rose as "comparables" rose.  This produced a bubble in home prices.

The same thing is happening all over again.  The FHA is requiring down-payments of only 3.5 %.  Fannie and Freddie require only 5%.  According to the American Enterprise Institute's National Mortgage Risk Index, set for Oct '13, half of all mortgages for buying homes -- not refinancing -- have only 5% or less being put down as a down-payment.  Such low down-payments clearly increase the risk of default.

So why not raise the down-payment to the traditional 10 to 20 % ?  This has actually been suggested, but the response from the Congress, from brokers and from home builders is that people won't be able to buy homes if that were done.  Wallison maintains that what they really mean is that people wouldn't be able to buy such expensive homes.  This is a small price to pay for preventing another housing bust.

So what's the take-away?  For me it's that housing bubbles and consequent financial collapses don't come out of the blue.  They are caused by misguided government policies.  After all, who tells Fannie Mae and Freddie Mac what to do?  It's Congress.  And, in the case of the first of recent collapses the individuals responsible were Chris Dodd and Barney Frank.