Thursday, March 3, 2011

The Housing Boom And Bust

Thomas Sowell is an economic scholar in residence at the Hoover Institute, Stanford University and, for Noman's money, the most lucid and readable practitioner of the dismal science.  In 2009, while the economic crisis was in full blister, he wrote a slim but penetrating volume regarding the housing debacle underlying the great dislocation, entitled "The Housing Boom and Bust.  Noman proposes to rehearse some of the book's findings and arguments over a few posts.

In chapter 1, Sowell discusses the economics of the housing boom.  The important thing to note is that the boom, much like the bust that followed, was localized.  It's consequences were globalized for reasons to be explained; however, its genesis was an explosion of real estate prices in areas like coastal California.  While the median sales price of an American single-family home rose by a third in the first half of last decade ($143,600 to $219,600), the appreciation was 79% in New York, 110% in Los Angeles and 127% in San Diego.  When government obsessed about a need to intervene in order to preserve "affordable housing," then, it was  generalizing from what was primarily a localized problem.  When government acted, it did so primarily through the Federal Reserve System; the government sponsored entities (GSEs), Fannie Mae and Freddie Mac; and the US Department of Housing and Urban Development (HUD).  The GSE's special relationship to the federal government left them subject to some continuing political involvement in their operating policies, and importantly lowered their cost of capital.  Private markets lent to them at rates reserved for public entities, and their securities were dispersed far and wide throughout global capital markets.

The cost of housing depended upon a number of factors including interest rates and down payments. When rates fall, home buyers are able to pay less money monthly for the same house, or buy a more expensive house for the same monthly outlay.  The Federal Reserve System dropped interest rates in the early years of last decade to historically low levels, and kept them low for an extended period of time.  This had the effect of driving up housing prices to record levels.  Down payments for homes--the single most important safeguard for keeping buyers in the home--shrank, also making it easier for people to enter the housing market for speculative purposes, and likelier for them to abandon a home when price fell, or merely stagnated.

The areas experiencing the fastest appreciation, and most acute lack of "affordable housing," during the boom were those that imposed land use restrictions.  The greater the extent and severity of state growth-management law or restrictive local plans, the higher the price of land.  For instance, the cost that a quarter-acre plot of land added to the construction price of a house was $140,000 in Chicago, $285,000 in San Diego, $350,000 in New York, and $700,000 in San Francisco.  A former governor of the Reserve Bank of New Zealand wrote that "the affordability of housing is overwhelmingly a function of ... the extent to which governments place artificial restrictions on the supply of residential land."  Another study indicated that in cities without growth management planning, a 4 bedroom, 2.5 bath, 2,200 square foot home with a two car garage would cost between $150,000 and $200,000.  The price rose to between $300,000 and $400,000 in cities with growth management planning in place for between 10 and 15 years.  The figure jumped to between $500,000 and $1.5 million in cities with such policies for 25 years or more.  Besides open space laws, other restrictive weapons available to local government are zoning laws, height restrictions, minimum lot size laws, historical preservation laws, building permit limits and farmland preservation laws.  While most people agree that builders should not be able to pave every square foot of greenery, it is nevertheless the case that less than 10% of the US's land area has been developed, and that trees alone cover more than 6 times the area of all cities and towns combined.  Despite the fact that in most areas of the country, purchasers could buy a home for a smaller share of their income than previous generations could, politicians and media generalized conditions in New York, DC, Miami and the California coast to create the impression of a general affordable housing crisis.  Ironically, the misconception arose that the free market had failed to produce affordable  housing, and that it was up to the federal government to make home purchasing affordable for the average American.

Creative financing--including no-down-payment mortgages, interest only loans, and adjustable rate mortgages (ARMs)--evolved to enable people to enter high-priced homes more easily.  Thus, between 2002 ad 2005, the percentage of "interest only" mortgages grew in the US from 10% of new mortgages, to 31%.  In Denver, Washington, Phoenix and Seattle, the number grew to 40%.  In San Francisco, the percentages grew from 11% to 66% of new mortgages.  These creative ways of purchasing houses for little initial monthly outlay encouraged people to speculate, live beyond their means, or both.  Home equity loans turned houses into cash machines in the rising market.  Income tax rules favored substituting home equity debt (for which interest payments were deductible) for consumer debt (the interest on which was not deductible).  Home equity loans soared from $593 billion in 2003, to $1.13 trillion by 2007.  "Cash out" financing rose from $26 billion in 2000 to $318 billion in 2006, a year in which 86% of all home mortgage refinances were cash out.  The number of "reverse mortgages" rose from 8,000 in 2001 to 40,000 by 2005.  With all of the speculative fervor in the real estate market, prices bore little relation to anything other than people's hopes and beliefs.

Low rates (often with "teaser" provisions) and lowered mortgage eligibility standards enabled a variety of non-traditional buyers to enter into the market.  Ironically, many of the least sophisticated and credit-worthy purchasers used the most complex financing products.  In a market like 2004-2005's California, where the median time that a home remained in the Multiple Listing Service was 2 weeks, prices pushed ever higher, as did risk in the system.  The ratings agencies blessed these goings on by putting their imprimatur on increasingly complex securities.  The stage was set for a debacle that would be brought about by borrowers, lenders, government and financial markets.  Chapter 2 turns to the politics of the housing that made it all possible.

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