When “hunger joins joins hands with “eagerness to eat”: Understanding the house price boom

That´s from a Brazilian popular saying but the meaning is clear in English: When two complementary “forces” join up, the effect is magnified.

Conventional wisdom has it that the house price boom was the consequence of “lax” monetary policy, with rates staying “too low for too long” in 2002-04. In a previous post I argued that monetary policy was in effect “too tight” up to mid-2003, and was correctly “loosened up” when forward guidance was introduced in the August 2003 FOMC meeting.

The chart indicates that from mid-97 to early 2006 house prices go up at a more or less steady rate irrespective of the behavior of interest rates.

So, what´s behind the house price rise (“boom”)?

“Hunger”

The Asia crisis, a negative AD shock, hit in mid-97 when Thailand went “belly-up” soon followed by Indonesia, Malaysia and in late 1997 South Korea. What these countries, and others, had to do was turn a large current account deficit around. For that, resources had to be diverted from non-tradable (“house”) production to tradable production. Currency depreciation (expenditure-switching) and expenditure-reducing policies were implemented, with all these countries experiencing large output falls.

Who would be the “counterparty” to this adjustment? At the time the only large economy going through a robust growth phase was the US. So the US had to travel the opposite road, diverting resources from the tradable to the non-tradable (“house”) sector. The dollar appreciated and expenditure-increasing policies were put in place. The US current account dived into deficit and output growth went up.

“Eagerness to eat”

In October 2008, Russell Roberts of George Mason University put up this “willingness to eat” list in a WSJ op-ed:

Beginning in 1992, Congress pushed Fannie and Freddie (F&F) to increase their purchases of mortgages going to low and moderate income borrowers.

For 1996, HUD gave F&F an explicit target – 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005

For 1996, HUD required that 12% of all mortgage purchases by F&F be “special affordable” loans, typically to borrowers with income less than 60% of their area´s median income. That number was increased to 20% in 2000 and 22% in 2005.

Between 2000 and 2005, F&F met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down.

F&F also purchased hundreds of billions of subprime securities for their own portfolios to make money and to help satisfy HUD affordable housing goals, making them important contributors to the demand for subprime securities.

The Community Reinvestment Act (CRA) did the same thing with traditional banks. CRA was “strengthened” in 1995, causing an increase of 80% in the number of bank loans going to low-and moderate-income families.

F&F were part of the CRA story, too. In 1997, Bear Sterns (!) did the first securitization of CRA loans, a $384 million offering guaranteed by Freddie Mac. Over the next 10 months, Bear Sterns issued $1.9 billion of CRA mortgages backed by F&F. Between 2000 and 2002 Fannie Mae securitized $394 billion in CRA loans.

While F&F and the CRA were pushing up the demand for low-priced property, the Taxpayer Relief Act of 1997 increased the demand for higher valued property by expanding the availability and size of the capital-gains exclusion to $500,000 from $125,000. It also made it easier to exclude capital gains from rental property, further pushing up the demand for housing.

Between 1997 and 2005 the average price of a house in the US more than doubled. It wasn´t simply a speculative bubble. Much of the rise in housing prices was the result of public policies that increased the demand for housing.

The consequence of all this: “On top of putting the entire financial system at risk, the hidden cost has been hundreds of billions of dollars funneled into the housing market instead of more productive assets”.

The chart illustrates the two “forces” joining hands!