Over at Economix, Harvard economics professor Ed Glaeser looks at the ultra-low interest rates of the aughts, and does not find them to be much to blame for the US Housing boom and bust:
“The most common explanation for the great surge in prices is the availability of easy credit, which took the form of low interest rates, high loan-to-value ratios and permissive approval of mortgages. These variables certainly affect housing prices, but they don’t seem to have moved nearly enough to explain the great price fluctuations of the past decade.”
Professor Glaeser fails to see many of the causal and exacerbating factors of the housing boom and bust, including those directly attributable to ultra low rates. Why don’t we review these factors, for the benefit of both the Professor as well as those laypeople those who may have missed them.
We have reviewed these in the past, but given the prof’s 30 year chart, I would like to walk through the broader context of what took place historically. (Note: I exhaustively detailed this in Bailout Nation).
Here are 20 steps to a Housing boom & bust:
1. A medium Housing boom and bust began circa 1988-89, following the Fed’s rate reaction to the ’87 market crash. Nationally, residential RE did not get back to break even until about 1996-97 (although recovery did vary by region).
2. The 1990s saw the build out of numerous technology industries: Mobile, Software, Semi-Conductors, Internet, Storage, Telecom, Networks, etc. Huge amounts of wealth was created: Employment was running near capacity, wage gains were substantial, employee stock options did extremely well.
3. Stock markets had been making enormous gains since the Bull began in 1982. I worked as a Wall Street trader mid-1990s, and witnessed first hand numerous investors cashing out huge equity gains. Much of this cash was rotated into Real Estate. This included major trade ups of primary residences, and purchases of second homes/vacation/investment properties.
4. All good things must come to an end: The dot coms and tech crashed (March 2,000); Enron, WorldCom, Tyco, collapsed; the analyst banking scandal, took place, etc. The equity party appeared to be over.
5. Starting in January 2001, the FOMC began lowering rates, eventually taking them all the way down to 1% by June 2003. Rates were kept below 2% for 36 months, and at 1% for over a year. This was unprecedented.
6. Even with a 30% down payment, Homes are a leveraged credit purchase, and lowering the cost of that credit has an inverse effect on prices — i.e., cheaper mortgages = more expensive houses.
7. Most people budget their home expenses monthly. Their carrying costs are more important to them than the actual purchase prices. This is why an outsized drop in interest rates — from 5.5% to 1% — can cause a spike in home prices, and yet still keep monthly payments fairly similar.
Bottom line: Ultra low rates were the initial fuel sending home prices higher.
8. Professor Glaeser (and others) have focused on interest rate impact on Housing, but missed the impact rates had on global bond managers. The ultra low rates forced the fixed income managers into a mad scramble for yield. Pension funds, trusts, foundations require 5% annual gains (for tax and other reasons), and without it, they have major issues.
9. Nearly all of these Bond managers cannot purchase junk by fund charter; They are required buy only investment grade paper. This becomes a very important factor, as we learned later in the timeline, because of their purchases of hi yielding RMBS — essentially junk stamped AAA.
10. Wall Street had been securitizing collateralized debt for years. They turned credit cards, student loans, auto financing, and mortgages into CDOs.
But in the era of ultra-low rates, the search was on for higher yields. Making loans to sub-prime borrowers –people with weaker credit scores, lower incomes, or more debt — generated higher yields at a higher risk. This is why collateralizing these subprime mortgages allowed securitizers to generate higher yielding paper for the managers of bond funds. There is nothing wrong with creating this junk paper, so long as it was rated appropriately.
11. The Rating Agencies — Moody’s, S&P, and Fitch — were corrupted by the enormous fees on this securitized junk, paper. This Rating Agency payola allowed the underwriters of RMBS securities to essentially purchase their AAA ratings for a fee.
Hence, the higher yielding, higher risk junk paper received an investment grade rating. Without it, it could not have been sold to the vat majority of these funds that were only permitted to buy investment grade paper.
NOTE: Here is the first point where lack of oversight comes in (vis-à-vis the ratings agencies) comes in. But it is important to note that we never would have gotten to that issue BUT FOR the ultra low rates.
12. Triple AAA rated junk paper sells well, increasing demand for more of it. Wall Street responds to this demand, and scooped up all of the legitimate higher yielding sub-prime mortgages they could find.
13. After exhausting all of legitimate subprime paper supply, the Street begins acquiring weaker and crappier mortgages to feed into the maw of the securitization beast. They consumed the output of all the non-bank sub-prime lenders, who made worse and worse loans. Their business model became lend-to-sell-to-securitizers; then reload and do it again and again.
14. Since there is only a finite supply of people who can afford prime alt-a, or even sub-prime mortgages, these lend-to-securitize originators got creative with their financing. They came up with ways to make mortgages even cheaper. They made ever shadier loans to ever less qualified borrowers.
15. The progression: Start with 2/28 variable loans, with a cheap teaser rate the first two years. Then write Interest Only (I/O), where there was no principal repayment. Lastly, underwrite Negative Amortization (Neg/Am) mortgages, where the borrower paid less than the monthly interest charges, with the difference added to the principal owed (each passing month, the mortgagee actually owed more on the house than the month before).
Most of these loans could be described as “Rent with an option to default.” In fact, these loans defaulted in enormous numbers.
16. The lack of regulation of these non bank lenders by the Fed was another key factor. Ironic, perhaps, since the Fed started the spiral via rates, they also allowed it become a conflagration through their nonfeasance — their failure to fulfill their regulatory duties. Greenspan called these lenders “Financial innovators.”
17 . Numerous states had on their books anti-predatory lending laws. These made it illegal to make loans to people who could reasonably not afford them (nor could they charge usurious rates or excessive fees that would make defaults much more likely).
18. John Dugan, head of the Office of the Comptroller of the Currency (OCC), (with the blessing of the Bush White House) issued its doctrine of “Federal Pre-emption.” This orderd the States to step out of the way of these lenders. The data shows that states with anti-predatory lending laws had much lower defaults and foreclosures than states that did not; the Federal Pre-emption significantly raised default rates in these states. This did not cause the housing problem, but allowed it to spread further.
19. The lack of regulatory enforcement was a huge factor in allowing the credit bubble to inflate, and set the stage for the entire credit crisis. But it was intricately interwoven with the ultra low rates the FOMC set. The complexity and intricacy of the mortgage factories’ many parts are often overlooked.
20. A housing market based on ever rising prices, cheap credit, and a greater number of buyers than there was Household formation was unsustainable.
The Fed began raising interest rates in June 2004. By June 2006, they had rates back up to 5.25% — and the beginning of the end of RE party was in sight. A year later, the entire housing edifice of the 2002-07 era was in collapse.
Too many people are looking for a single explanation for a highly complex set of circumstances. There were myriad causes of the Boom & Bust, and it is far more complex and nuanced than the over-simplifications we typically see.
While low interest rates were the initial factor that began the spiral — it could not have gone as far or as fast as it did without them — the rate regime is far from the only factor.
Professor Glaeser has set up a straw man, and tried to knock it down, but his analysis misses much of the reality of what occurred.
Did Low Interest Rates Cause the Great Housing Convulsion?
Edward L. Glaeser
Economix, August 3, 2010