Friday, October 3, 2008

The housing bubble explained

Russell Roberts has an excellent article in today's WSJ which summarizes all the factors which combined to push housing prices to unsustainably high levels. In a nutshell: 1) relentless political pressure for banks and Freddie and Fannie to liberalize their lending activities so that more and more people could afford to buy a house, 2) expansion of the availability and size of the capital gains exclusion for real estate, and 3) easy money and low interest rates from the Fed. (I would add the deductibility of mortgage interest, non-recourse loans, and no prepayment penalties to the list.) All of this combined to dramatically increase the demand for housing, which naturally resulted in much higher housing prices. Home ownership rates rose to historic highs, but then the Law of Unintended Consequences kicked in with a vengeance, and here we are with hundreds of billions of dollars of losses to contend with. More people may own homes, but those homes are now worth less and less. As he concludes, "Beware of trying to do good with other people's money."

Update: My ex-colleague Don Plotsky notes that the Basel I and II Accords gave banks a tremendous incentive to buy AAA-rated assets, due to their lower capital requirements. Traditional AAA debt didn't yield very much, however, so the banks pushed for Wall Street to creatively package subprime debt into higher-yielding AAA securities. This helped fuel demand for subprime loans, and that in turn made it easier for lenders to offer them to homeowners.


Tin said...

I didn't know "the banks pushed for Wall Street to creatively package subprime debt into higher-yielding AAA securities" ... wow. Talk about a self-inflicted wound.

Scott Grannis said...

Indeed they did. The problem of course was that even though the securities were highly unlikely to experience any losses, in the end many turned toxic because the "impossible" happened.