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What Did Not Cause the Housing Bubble?

Posted: 26-12-2008 | Views: 239

To fully understand what caused the housing bubble, one needs to examine some of the purported causes that are not valid because these often lead to incorrect policy initiatives. Bad policy initiatives include interest rate regulation, hedge fund regulation, and loan-to-income regulation.

There are a wide variety of ideas for preventing future housing bubbles, and all the ideas in the public forum are not discussed here. Some of the more popular are examined to demonstrate why they would not be successful. Most of the ideas that will not work are some form of direct regulation of interest rates, secondary mortgage market activities, price-to-income ratios or investment of equity capital. All regulatory initiatives carry a common problem: there is little enforcement once a bubble starts inflating. When times are good, there is immense political pressure for regulators to look the other way. When there is no apparent, immediate harm from a given practice, there is only a vague memory of a time long ago when circumstances were quite different and some restrictive law was passed. The law may seem quaint and old-fashioned or simply an obstruction to the wheels of progress. The rationalizations and justifications for ignoring laws are many, and the pressure to do so is intense when powerful lobbying interests are pressuring Congressmen who subsequently pressure government regulators.

Many believe that lower interest rates created the Great Housing Bubble, and the regulation of interest rates would prevent future bubbles. This is wrong on both counts. The lowering of interest rates did help precipitate the bubble by reducing borrowing costs and increasing home prices; however, once house prices started to rise, prices went much higher than the lower interest rates alone can account for. At most, one-third to one-half of the national price increase was due to lower interest rates, and less than 10% of the increase in coastal areas can be attributed to these lower rates. The direct regulation of mortgage interest rates would disrupt the free flow of capital in the mortgage market. If the regulated rate was too low, no money would be made available, and if the rate was too high, excess money would flow into real estate working to create another bubble. No form of mortgage interest rate regulation would prevent a future bubble because interest rates were not responsible for the Great Housing Bubble.

Much of the responsibility for the bubble can be attributed to the flow of funds into the market from hedge funds through collateralized debt obligations. There have also been calls for greater regulation of hedge funds and the secondary mortgage market. Any kind of regulation would likely restrict the flow of money to all mortgages and disrupt the secondary market. Also, regulating hedge funds themselves will prove problematic, if for no other reason, it is difficult to define exactly what a hedge fund is. Also, hedge funds are simply investment vehicles, and it is unclear exactly what they do that other investment entities do not do that causes problems resulting in financial bubbles. Much of the demonization of hedge funds is demagoguery and looking for someone to blame. Many of the problems with the secondary markets will correct themselves as investors stop investing in products that lose money. In fact, one of the greatest challenges in the aftermath of the Great Housing Bubble is going to be getting investors back into the secondary market. One of the market-based solutions proposed herein addresses these issues. Direct legislative intervention to hedge funds and collateralized debt obligations would be more disruptive than productive.

Another proposed solution is to regulate the loan-to-income ratio of the borrower. When 30-year fixed-rate mortgages first came out, mortgage debt was limited to two and one-half times a borrower's yearly income. It was an artificial limit that made sense when interest rates were higher and people were accustomed to putting less money toward housing payments. A legislative cap on the loan-to-income ratio would prevent future housing bubbles, if it was enforced. This would not work for the same reason lenders went away from the two-and-one-half-times-income standard years ago: it does not reflect changes in borrowing power due to changes in interest rates. This idea of regulating loan-to-income ratios is actually an evolution of the idea of regulating interest rates. If the total loan-to-income ratio is limited, very low interest rates do not cause dramatic price increases, but since low interest rates were not really the cause of the bubble, limiting the loan-to-income ratio is not addressing the real cause of the bubble. Plus, there are ways to get around a cap on home loan borrowing by obtaining other loans not secured by real estate. It would be relatively easy for a borrower to obtain bridge financing to acquire a property and then obtain a HELOC to pay off the bridge financing. In the end, the borrower would have borrowed more than the cap amount thus rendering any cap meaningless. To close the various loopholes, more regulations would be required, and a regulatory nightmare would ensue. A better and more effective method of limiting borrowing is to regulate the debt-to-income ratio.

The Great Housing Bubble was not caused by low interest rates or the activity of hedge funds. Any interest rate regulation, hedge fund regulation, and loan-to-income regulation would not have prevented the bubble, and such policies would likely have unintended consequences going forward.

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