Tuesday, April 7, 2009

Some observations on the US housing bubble

Vernon Smith and Steven Gjerstad chronicles the lead up to the housing bubble, the events that precipitated its deflation, and the contagion on the financial markets. They have some interesting observations about the the crisis

1. By excluding home ownership costs (it instead contained rental values, at 23% of the CPI), the CPI based inflation index underestimated the rise in house prices. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3. In 2004 alone, when the price-rent ratio increased by 12.3%, inflation should have been 6.2% instead of 3.3%. As measured by the Case-Shiller 10 city index, the accumulated inflation in home-ownership costs between January 1999 and June 2006 was 151%, but the CPI measured a mere 23% increase. With home price increases outside the inflation scanner, monetary policy was allowed a free run. It appears that India is not alone in having problems with its inflation index!

2. During the previous housing bubbles in 1976-79 and 1986-89, the Fed had raised rates as the bubble was getting inflated, thereby probably contributing to its slow deflation. The present bubble, which started in 1997, was interestingly accompanied by lowering of rates, relaxed lending standards, and tax-free capital gains. When the Federal funds rate finally started rising in May 2004, the housing prices had taken a momentum of its own.

3. The equity markets tracked the housing market with a small lag, as indicated in the graph below. Housing peaked in early 2006. Losses from the mortgage market began to infect the financial system in 2006; asset prices in that sector began to decline at the end of 2006.

4. The most definitive signs of a bubble bursting came by the middle of 2007, as the cost of insuring new mortgage-backed securities skyrocketed, leading to steep declines in issuance of mortage backed securities and squeezing of the mortgage financing market. Sub-prime originations almost dried up, plummeting from $160 billion in the third quarter of 2006 to $28 billion in the third quarter of 2007 and mortgage-backed security issuance fell comparably, from $483 billion in all of 2006 to only $30.7 billion in the third quarter of 2007. The liquidity generated by housing had dried up.

5. Though the dot com bubble wiped out $10 trillion in assets, the effects of the mortgage bubble which wiped out more than $3 trillion, has been much more devastating. In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners.

In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. As millions of homes became worth less than the loans on them (it was estimated that 10.5 million homes had negative equity), huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury. The interest-only adjustable-rate mortgage (ARM), and the negative-equity option ARMs, mortgages at teaser rates etc, coupled with securitization and leverage meant that the scale of penetration of the bubble was spectacularly deep and all-pervasive in the financial system. As Smith and Gjerstad write,

"Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash (first being the Great Depression), the end of a massive consumption binge."

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