Where did the housing bubble come from?

In today’s Wall Street Journal, Andy Laperrière, a managing director of the Washington office of the ISI Group, wrote a piece on the crisis in the mortgage industry, I wrote to the Journal’s editor, the following letter:

In his “Mortgage Meltdown” (Wall Street Journal, March 21, 2007), Andy Laperrière assigns the residential real estate bubble to the boost to home prices that the subprime market has provided “at the margin.” By that he ignores that housing is segmented and although easier access to the lower part of the market has no doubt contributed at raising prices at that particular end of the range, it is unlikely to have had any impact on housing higher up on the ladder where Alt-A and prime borrowers do shop for a home.

If this is so, what are then the factors that contributed to lifting the price of housing? The Agencies, Fannie Mae and Freddie Mac, have claimed part of the responsibility, saying that their active securitization of individual loans into Mortgage-Backed Securities has resulted in lowering the interest rates charged to borrowers. Wayne Passmore, a researcher at the Federal Reserve, has shown convincingly that this was not the case and that the Agencies’ favorable impact for the borrower amounts to a negligible 7 basis points (0.07 %) (1). Fannie and Freddie come out thus clean in that respect.

Governor Alan Greenspan had a different culprit in mind when he was assigning the blame to new construction: the lower progress in productivity in that sector compared to the rest of the economy, he explained, meant that the price of new construction would necessarily rise, forcing that of existing homes to align on them (2). But the 1% yearly increment credited to that cause was a far cry from the 28% rise in home prices observed over the period 1997 to 2002.

Tax deductibility of interest payments is another likely candidate as the government subsidy may erase up to a third of the amount of a mortgage’s monthly payment. It is reckoned that in 2004 borrowers saved 61.5 billion dollars through tax-deductibility of interest. In the first years of an amortizing mortgage, the best part of a monthly payment is interest, with only a small part of principal being repaid. On a typical 30 year fixed rate mortgage, it takes nearly twenty years before the monthly payment contains a larger portion of principal than of interest due. Laperrière reminds us also that in 2006, Interest Only loans represented about one third of all mortgages, with here of course, tax deductibility applying to the entire payment.

The “causes of the current housing bust” may not be that mysterious after all.

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(1) Passmore, Wayne, The GSE Implicit Subsidy and the Value of Government Ambiguity, Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C., 2003 et 2005.

(2) Alan Greenspan, Home Mortgage Market, Remarks by Chairman Alan Greenspan At the annual convention of the Independent Community Bankers of America, Orlando, Florida, , 4 mars 2003.