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Low interest rates didn't cause the bubble, economists say

Everybody knows what caused the housing bubble, with its breathtaking, though ephemeral, increase in prices, right? A long run of low mortgage interest rates, loose lending and low (to nonexistent) downpayment requirements are the usual culprits cited by experts.

But those factors can be blamed for only a small part of the bubble, according to research published this week by economists Edward L. Glaeser and Joshua Gottlieb of Harvard University and Joseph Gyourko of the Wharton School at the University of Pennsylvania.

They write: "It isn't that low interest rates don't boost housing prices. They do. It isn't that higher mortgage approval rates aren't associated with rising home values. They are. But the impact of these variables, as predicted by economic theory and as estimated empirically over many years, is too small to explain much of the housing market event that we have just experienced."

Glaeser, Gottlieb and Gyourko say those factors can explain only about a 10 percent increase in home prices between 2000 and 2006. That's only one-third of the 30 percent increase in prices (adjusted for inflation) during that period, as measured by the Federal Housing Finance Agency, or the 74 percent increase measured by the Case-Shiller/Standard and Poor's index of prices in 20 large metro areas.

So what is to blame for the bubble? Well, they're not sure. "Using the standard toolkit of the empirical economist, we are unable to offer much of an explanation for what happened," they write.

They don't know what caused the bubble. But they are convinced that low interest rates and loose lending didn't do it. So, they conclude that there's little reason to worry about rising mortgage interest rates. And they feel more secure in suggesting that government policymakers back away from popular programs aimed at reducing the cost of homeownership.

"The relatively modest link between interest rates and housing prices makes us more confident about rethinking those federal housing policies that act primarily by lowering the cost of credit to home buyers, most notably the home mortgage interest deduction," they write.

In particular, they suggest that the current $1 million cap on the amount of debt that qualifies for the mortgage interest tax-deduction could be lowered to $300,000, which would direct that tax benefit to people in lower income-tax brackets. It "would not dramatically affect most households," they say. (They don't mention it, but that's really a $1.1 million cap on mortgage debt that qualifies for the tax deduction, if you include home equity loans.)

Of course in markets like the Washington metro area, such a limit would affect quite a few households. The median price for homes sold so far this year in the District (not counting the suburbs) was $354,000. Half of the homes sold for higher prices. Shrinking the mortgage-interest deduction may or may not be your idea of a fair and reasonable policy change. Plenty of people argue that the subsidy disproportionately rewards the more affluent and favors owners over renters. But lowering it would certainly lighten the wallets of many Washington-area homeowners.

The three economists also wonder if state governments might want to smooth-out home-price volatility by overriding local restrictions on development. They found that home prices were much more volatile in areas like Boston that have "particularly restrictive" land-use policies compared to areas like Houston that have fewer restrictions. But local governments hardly stifled development in Las Vegas, where housing developments sprouted as fast as they could be built, and the housing bust has been among the worst in the country.

Economists have spent the past 70-plus years trying to figure out what caused the Great Depression. They're likely to spend the next 70 analyzing the causes and lessons of this decade's devastating boom and bust.

By Elizabeth Razzi  |  May 7, 2010; 6:00 AM ET
Categories:  Mortgages , Statistics , Taxes , The economy  
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Elizabeth: you mention downpayments, but did the study look at that? There are two things that affect affordability: (1) monthly payment; and (2) downpayment. Interest rates, lower approval standards, etc. affect only the first; my gut says that the second is a much, much bigger deal. Did they assess that?

It's funny how quickly our frame of reference changes. When I bought my first place in 1991, the only option was to put 20% down. How quickly we forget what a HUGE barrier to entry that is! If you want a $250K "starter" condo in DC, that's $50-70K for downpayment and closing costs! How long will that take to save? 10 years? 20? And we all know that Americans in general [are bad] at saving. How many more people were out there who could afford the monthly payments, but didn't think they could ever own a home because they couldn't conceive of saving that much?

That barrier was dismanted, piece by piece, in the 2000s. First came 5% down and piggyback loans (which we used in 2001, btw). Then came 3% down. Then 0% down. Then 0% down and no closing costs. So: how many people can afford a $250K condo that costs $65K up front? How many more can afford it when it doesn't cost once red cent?

Here's the thing that strikes me: you're not just talking about one age group. It's not just that today's 25-year-olds can afford a home that yesterday's 25-year-olds can't. Because now all of yesterday's 25-year-olds are in the market, too -- and all of the paycheck-to-paycheck crowd who never thought they'd be able to buy. By removing the barrier to entry, you have opened the market to hordes of people of all ages who had been shut out of it for literally all their lives.

Now, normally, if the demand for something increases, you ramp up supply to absorb it. And early on, that's what happened; as the lenders started cutting back to 10% and 5% down, builders started getting busier, prices started to rise, etc. But housing supply can't adjust as quickly as lenders can develop new loan products -- there's only so much land, builders can build only so many houses per year, it takes time and money for new builders to get established, etc. So demand kept increasing faster than supply, and ultimately supply couldn't keep up. And we all know what happens then (heck, I never even took Econ, and I can figure that one out!).

So to me, it seems entirely logical that removing the downpayment -- the big barrier to entry -- would have had a much larger impact than mortgage rates. Saving $100/month will open up the market to a few more people; going from $65K up front to nothing opens it up to a whole bunch more.

Posted by: laura33 | May 7, 2010 9:52 AM | Report abuse

They did address downpayments, but not very convincingly. They said the amount of downpayment did not change significantly during the period, based on their review of federal data. That's a bit of a shocker, as I remember the boom differently. I would love to link to the actual report, but Harvard hasn't made it available online yet.

Posted by: Erazzi | May 7, 2010 3:14 PM | Report abuse

Hi Elizabeth,
I hope we can figure out the cause of the bubble so it won't happen again. I havent' heard much about the $250k/$500k capital gains waiver being a motivation for people to sell so they can claim an exemption for the capital gains they've accumulated over the years. It was also an incentive for people reaching the limit to move and reset their cost basis. Perhaps a small factor, maybe it was the combination of many small factors (low interest, easy qualifying, no/low down payment) which caused the mentality of "buy more, have more, bigger is better, have it all now"...then the fire fueled itself. It's good to see more caution used by the banks today, unfortunately, one banker told me that this will all be forgotten and the banks will do it again in 20 years. I hope that's not true!
Thanks for an interesting topic in your column.

Posted by: dianne_hansen | May 8, 2010 12:28 PM | Report abuse

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