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Manage episode 222714412 series 2467225
The U.S. Federal Reserve cut its key rate, the federal funds rate, to 1% in mid- 2003 and held it there until mid-2004, roughly the period of most rapid home-price increase. Moreover, the real inflation-corrected federal funds rate was negative for thirty-one months, from October 2002 to April 2005, an interval again centered on the most rapid rise in home prices. Since 1950 the only other period of low rates as long as this one was the thirty-seven-month interval from September 1974 to September 1977.
This loose policy would not have been implemented if Alan Greenspan and others involved with monetary policy had comprehended that we were going through a housing bubble that would burst. Thus the monetary policy appears to have been driven at least in part by the same lack of understanding that produced the bubble itself. The Fed was excessively focused on preventing recession and deflation because they honestly saw the home-price increases as continuing, if at a reduced pace, indefinitely, even if they were to implement a monetary policy that would feed the bubble.
The impact of the loose monetary policy was amplified by the large number of adjustable-rate mortgages issued after 2000, particularly to subprime borrowers. These mortgages were more responsive than fixed-rate mortgages to the interest rate cuts that the Fed had made. So the rate cuts might have had the effect of boosting the boom, more than would otherwise have been the case, during its time of most rapid ascent, around 2004.
The demand for loans made with more flexible standards was accommodated by lenders because they themselves (as well as the investors in the mortgages that they sold off) believed in the bubble. That is why the period of soaring real estate prices corresponded to a time when no-documentation loans became common and when option ARMs and other questionable new mortgage types proliferated.
ARM refers to adjustable rate mortgage. Option ARM loans have four major types of payment options:
Fully Amortizing 15-Year Payment
Fully Amortizing 30-Year Payment
Moreover, the rating agencies that pass judgment on securitized mortgages persisted in giving AAA ratings to mortgage securities that ultimately were vulnerable because they too believed that there would be no bursting of the bubble. Even if they did harbor some doubts about the continuation of the boom, they were not about to take the drastic step of cutting ratings on securitized mortgage products on the basis of the theory, not widely held, that home prices might actually fall. That would have been an unusually courageous step, and one that was all too easily postponed in favor of other business decisions that were easier to make, until it was too late.
Another factor often mentioned as a cause of the housing bubble is the failure of regulators to rein in aggressive lending. Ever since the Depository Institutions Deregulatory and Monetary Control Act of 1980 effectively ended state usury laws, and made it possible for originators to make a profit with subprime lending by charging a high enough interest rate to offset the costs of the inevitable defaults and foreclosures, there had been a need for expanding the scope of regulation. Yet the expanded regulation never came, and over time during the 1990s and into the 2000s, a "shadow banking system" of nonbank mortgage originators was allowed to develop without anything like the regulation to which banks are subject.
But the lack of urgency among regulators in doing their job must ultimately have originated in their inability to believe that there could ever be a housing crisis of the proportions we are seeing today.
When I gave talks near the peak of the bubble in 2005 at the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation, both major bank regulators in the United States, I found staff members there in disagreement about what to do about the lending boom. I urged them to take prompt action to stop the excess of mortgage lending that was feeding an unsustainable bubble. The reaction I got was that, yes, they understood that maybe they should, and that indeed some among them thought so, but that it was just taking time, and negotiation, to arrive at any strong consensus. I had the feeling that many of them viewed me, with my argument that the bubble would burst, as an extremist who deserved a skeptical response.
When in October 2006 I participated in a panel sponsored by the Yale Investment Club, I shared the dais with Frank Nothaft, chief economist at Freddie Mac, a major securitizer of home mortgages. As I recall the event now, I asked him if Freddie Mac had stress-tested the impact on itself of a possible housing price decline. He answered that they had, and they had even considered the possibility of a 13.4% national drop in home prices. I protested: "What about the possibility of a drop that is bigger than that?" He answered that such a drop had never happened, at least not since the Great Depression.
Ultimately an important reason why all these factors fed the bubble has to be that the very people responsible for oversight were caught up in the same high expectations for future home-price increases that the general public had. In many cases they may not have believed as zealously in the housing boom, but they nevertheless accepted the received wisdom that it could not end badly. And that was the end of the story.
Then why did so many get caught by the bubble? They stopped seeing the bubble as a case of simple momentum that one could ride for a while but that must be exited before the market reversed course. Instead they came to believe the story that the boom would never end.