PrefBlog

The Federal Reserve Bank of Boston has released a discussion paper by Kristopher S. Gerardi, Christopher L. Foote, and Paul S. Willen titled Reasonable People Did Disagree: Optimism and Pessimism About the U.S. Housing Market Before the Crash:

Understanding the evolution of real-time beliefs about house price appreciation is central to understanding the U.S. housing crisis. At the peak of the recent housing cycle, both borrowers and lenders appealed to optimistic house price forecasts to justify undertaking increasingly risky loans. Many observers have argued that these rosy forecasts ignored basic theoretical and empirical evidence that pointed to a massive overvaluation of housing and thus to an inevitable and severe price decline. We revisit the boom years and show that the economics profession provided little such countervailing evidence at the time. Many economists, skeptical that a bubble existed, attempted to justify the historic run-up in housing prices based on housing fundamentals. Other economists were more uncertain, pointing to some evidence of bubble-like behavior in certain regional housing markets. Even these more skeptical economists, however, refused to take a conclusive position on whether a bubble existed. The small number of economists who argued forcefully for a bubble often did so years before the housing market peak, and thus lost a fair amount of credibility, or they make arguments fundamentally at odds with the data even ex post. For example, some economists suggested that cities where new construction was limited by zoning regulations or geography were particularly “bubble-prone,” yet the data shows that the cities with the biggest gyrations in house prices were often those at the epicenter of the new construction boom. We conclude by arguing that economic theory provides little guidance as to what should be the “correct” level of asset prices —including housing prices. Thus, while optimistic forecasts held by many market participants in 2005 turned out to be inaccurate, they were not ex ante unreasonable.

I’ll admit I was undecided about whether to highlight this paper in its own post, or simply to mention it in today’s market update … until I read the following:

It is instructive to read the logic of non-economists who looked at house price data in the same period. Paolo Pellegrini and John Paulson, whose wildly successful 2006 bet against subprime mortgages is now the stuff of Wall Street legend, made the following argument, as chronicled in Zuckerman (2009). First, they noted that house prices had deviated from trend:
…
Those facts are indisputable, but the logic that followed would have earned the two investors a zero on an undergraduate finance exam:

Ha-ha! I hope this gets quoted extensively by Fabulous Fabio and Alan Greenspan as they defend themselves against the charges that they bear personal responsibility for the Panic of 2007.

The authors don’t spare Krugman:

Krugman’s thesis seems to hinge on the idea that scarce coastal land is valuable and bubbles can only happen when assets are in short supply, but the whole point about bubbles is that the fundamentals of supply and demand do not matter. Thus, there is no reason why land in places where it is easy to build could not experience bubbles. Ex post, as we will explore at length, the places in the United States where the housing market most resembled a bubble were Phoenix and Las Vegas. According to recent research, both locations are characterized by relatively high housing-supply elasticities; unlike certain coastal areas, the two cities have an abundance of surrounding land on which to accommodate new construction.

The authors’ purpose is clear:

Ultimately, our paper argues that the academic research available in 2006 was basically inconclusive and could not convincingly support or refute any hypothesis about the future path of asset prices. Thus, investors who believed that house prices were going to fall could find evidence to support their position, while those who wanted to believe that house prices would continue to rise could not be dissuaded either. There were reasonable arguments on both sides.

One of the bubbleistas was Baker:

In addition to the divergence between rents and prices in the U.S. housing market, Baker also called attention to changes in demographic trends that could put additional downward pressure on house prices. He noted that during the 1970s and early 1980s, housing grew from about 17 percent of consumption to more than 25 percent, in large part due to increased demand for housing from the first baby boom cohorts, who were then entering adulthood. From the early 1980s to the mid-1990s, the housing share of consumption remained relatively constant, consistent with the modest demographic changes taking place in the United States at that time. In the future, Baker argued, as the baby boomers entered retirement, housing demand—and hence prices—would likely fall.

This argument has been taken up by some researchers at BIS, as discussed on August 4.

Baker also supplied contemporary arguments against the Greenspan-dunnit thesis:

As we will
discuss in more detail below, many economists pointed to low interest rates as justifying higher housing prices, but Baker was skeptical of this claim. Nominal interest rates were indeed low in the early 2000s, as the Federal Reserve had adopted a loose monetary policy to combat the effects of the 2001 recession. However, Baker pointed out that nominal rates could not explain the divergence of housing prices from fundamentals, as it is the real interest rate (the difference between the nominal rate and expected inflation) that should influence prices.

Another very interesting point is:

The evolving landscape of mortgage lending is also relevant to an ongoing debate in the literature about the direction of causality between reduced underwriting standards and higher house prices. Did lax lending standards shift out the demand curve for new homes and raise house prices, or did higher house prices reduce the chance of future loan losses, thereby encouraging lenders to relax their standards? Economists will debate this issue for some time. For our part, we simply point out that an in-depth study of lending standards would have been of little help to an economist trying to learn whether the early-to-mid 2000s increase in house prices was sustainable. If one economist argued that lax standards were fueling an unsustainable surge in house prices, another could have responded that reducing credit constraints generally brings asset prices closer to fundamental values, not farther away.

Another good point is:

If we have learned anything from this crisis, it is that large declines in house prices are always a possibility, so regulators and policymakers must take them into account when making decisions. A 30 percent fall in house prices over three years may be very difficult, if not impossible, to generate in any plausible econometric model, but a truly robust financial institution must be able to withstand one. The fact that so many professional investors as well as individual households ignored this possibility, even in 2006, suggests that we cannot allow investors to try to time market collapses.

All in all, most interesting and well balanced. Related posts on PrefBlog include:

• Hull & White on AAA Tranches of Subprime
• Bernanke: Monetary Policy and the Housing Bubble
• Subprime! Problems forseeable in 2005?

As for me … I’ve always disclaimed any ability or interest in forecasting macroeconomic trends. But what I have said is … bad investments will hurt you. Concentration will kill you.

The Panic of 2007 wasn’t caused by Merrill Lynch et al. buying sub-prime paper. It was caused by the fact that they levered it up big time.

This entry was posted on Monday, August 16th, 2010 at 3:59 pm and is filed under Interesting External Papers. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.