The Housing Bubble Reaches the Breaking Point

Starting to Face the Possibility of Losses

The very large flows of mortgage funds over the past two years have been described by some analysts as possibly symptomatic of an emerging housing bubble, not unlike the stock market bubble whose bursting wreaked considerable distress in recent years. Existing home prices (as measured by the repeat-sales index) rose by 7 percent during 2002, and by a third during the past four years. Such a pace cannot reasonably be expected to be maintained. And recently, price increases have clearly slowed.. .. But any analogy to stock market pricing behavior and bubbles is a rather large stretch.

Remarks by Federal Reserve Chairman Alan Greenspan Annual Convention of the Independent Community Bankers of America, Orlando, Florida March 4, 2003

(Continued)

These loans (subprime) represent roughly $370 billion in outstandings, or 4.3 percent of all mortgages, and may ultimately result in just $110 billion in net loan losses for the mortgage industry. In addition, it is likely that any foreclosures associated with these troubled mortgages will be spread over a number of years, and losses will be borne not just by banks, but also by investors in privately-issued mortgage-backed securities. Economic Conditions and Emerging Risks in Banking Report to the FDIC Board of Directors, p. 14 Federal Deposit Insurance Corporation May 9, 2006

We know from data ... that a significant share of new loans used to purchase homes in 2005 were nonprime (subprime or near-prime), ... [and] the share of securitized mortgages that are subprime climbed in 2005 and in the first half of 2006. [But] we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. Remarks by Federal Reserve Chairman Ben S. Bernanke Federal Reserve Bank of Chicago's 43rd Annual Conference on Bank Structure and Competition Chicago, Illinois May 17, 2007

Now that we are in a crisis, it is instructive to look back and examine whether there were ample signs of a housing bubble—and whether heeding these warning signs could have mitigated the damage.

As discussed earlier, the Federal Reserve created a low-interest rate environment, which was further fueled by an inflow of funds from investors based in other countries with savings gluts. Low interest rates set off a surge in home sales, prices, and housing starts, and the whole system was kept well oiled with liquidity by investors searching far and wide for higher yields. There were plenty of telling indicators along

Figure 3.13 The Recent Run-up of Nominal Home Prices Was Extraordinary (1890-Q2 2008) Index, 2000 = 100

Figure 3.13 The Recent Run-up of Nominal Home Prices Was Extraordinary (1890-Q2 2008) Index, 2000 = 100

Sources: Shiller (2002), Milken Institute.

Note: The annualized growth rate is the geometric mean.

Sources: Shiller (2002), Milken Institute.

Note: The annualized growth rate is the geometric mean.

the way that these trends had converged to produce a bubble that was reaching dangerous proportions.

It is useful to begin by placing recent housing prices in a broader context. Figures 3.13 to 3.16 show what happened to both nominal and real (adjusted for inflation) home prices from 1890 to the second quarter of 2008. Over this long period, nominal home prices rose at an annualized rate of 3.4 percent (just 0.57 percent in real terms). It is clear from these figures that the recent run-up in prices quickly outstripped historical norms. Figures 3.14 and 3.16, moreover, contain another important lesson: they show that home prices do not just rise in a steady trajectory—they can undergo fairly wide swings, both positive and negative. But amid the heady days of the housing boom, many market participants chose to ignore the fact that housing prices can drop and that booms are often followed by busts. Taken together, these figures make a compelling case that the recent home price bubble was simply not sustainable as it continued to grow with each passing day.

Table 3.6 shows the real returns on U.S. stocks, bonds, and homes from 1890 to 2007—and as it happens, stocks and bonds have been

Figure 3.14 Home Prices Don't Go up Forever: Change in Nominal Home Prices in 100-Plus Years (1890-Q2 2008)

Percentage change in nominal home prices from preceding year

Figure 3.14 Home Prices Don't Go up Forever: Change in Nominal Home Prices in 100-Plus Years (1890-Q2 2008)

Percentage change in nominal home prices from preceding year

Sources: Shiller (2002), Milken Institute.

Note: The average growth rate is the arithmetic mean.

Sources: Shiller (2002), Milken Institute.

Note: The average growth rate is the arithmetic mean.

Figure 3.15 The Recent Run-up of Real Home Prices Was Extraordinary (1890-Q2 2008) Index, 1890 = 100

Figure 3.15 The Recent Run-up of Real Home Prices Was Extraordinary (1890-Q2 2008) Index, 1890 = 100

Sources: Shiller (2002), Milken Institute.

Note: The annualized growth rate is the geometric mean.

Sources: Shiller (2002), Milken Institute.

Note: The annualized growth rate is the geometric mean.

Figure 3.16 Home Prices Don't Go up Forever: Change in Real Home Prices in 100-Plus Years (1890-Q2 2008)

Percentage change in real home prices from preceding year

Figure 3.16 Home Prices Don't Go up Forever: Change in Real Home Prices in 100-Plus Years (1890-Q2 2008)

Percentage change in real home prices from preceding year

Sources: Shiller (2002), Milken Institute.

Note: The average growth rate is the arithmetic mean. voffset="-5pt"

Sources: Shiller (2002), Milken Institute.

Note: The average growth rate is the arithmetic mean. voffset="-5pt"

better investments than homes over time (providing real returns of 6.3 and 4.7 percentage points, respectively, while the real return on homes totaled only 0.6 percent over this long period). Only from 1997 to 2007, a period that encompasses a collapse in stock prices due to the dot-com implosion and the growth of a major housing price bubble in its place, did homes deliver higher real returns than stocks and bonds.

Table 3.6 Real Returns on Stocks, Bonds, and Homes

Average Return (%)

Stocks

Bonds

Homes

1890-1925

5.4

3.8

-0.7

1926-1945

6.8

2.8

1.0

1946-1970

9.5

3.7

0.2

1971-1996

6.5

8.5

0.0

1997-2007

1.5

4.9

6.0

1890-2007

6.3

4.7

0.6

Sources: Robert Shiller, Milken Institute.

Note: The percentages are based on geometric means and the real return for homes is based on home price appreciation.

Sources: Robert Shiller, Milken Institute.

Note: The percentages are based on geometric means and the real return for homes is based on home price appreciation.

The fact that homes have typically produced low returns over long periods underscores why lenders traditionally made mortgage loans to individuals with "skin in the game" (i.e., a down payment that gave them a significant equity stake from the outset). Borrowers with equity have more cushion against financial stress and will fight to stay in their homes and protect their initial investment. Those with very little (or even negative) equity are not as well positioned to maneuver when times are tough and are more likely to lose (or walk away from) their homes if their personal circumstances deteriorate.

For many years, a 20 percent down payment was considered standard, and regarded as some evidence of the borrower's financial stability. In other words, lenders preferred to grant mortgages with a loan-to-value ratio (the outstanding mortgage balance as a percentage of the price of the home) closer to 80 percent than to 90 percent or higher. Maintaining that ratio was also considered in applications for second mortgages and home equity loans. (See Appendix Figure A.11 for information on bank home loans, including the breakdown of those secured by first liens, junior liens, and home equity loans, as well as those that are financed with ARMs.)

Lenders traditionally took these steps to manage risk because in most cases they have no recourse to the borrower's other assets or income in the event of default and because they frequently get no more than 50 percent to 75 percent out of foreclosures. But at the height of the boom, these standards were abandoned. Lenders were churning out mortgages that required little or no money down—knowing they could pass that increased risk on to investors.

A comparison of the nominal return on homes to other selected assets is provided in Figure 3.17. It shows what $1 invested in each of the assets in 1890 was worth at year-end 2007. Homes slightly outperformed gold after 1988 but distantly trailed the returns on stocks, bonds, and CDs.

Figure 3.18 provides a much shorter but equally revealing look at what was happening to home prices both nationwide and in California from 1979 to September 2008. The peak median home price nationwide was about 90 percent higher than the average median price over that period, while California's peak exceeded its average by more than 150 percent. The peak price nationwide was $229,093 (virtually the

Figure 3.17 Nominal Returns on Selected Assets (1890-2007) US$

December 31, 2007 value of a $1 investment in 1890:

Stocks /

Stocks: $848

Bonds: $228

CDs: $197

Homes: $52

CDs

Gold: $39

Bonds

Homes

Gold v \

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