Did cheap credit and easy lending cause the housing bubble? No!

Research by Edward L. Glaeser and Joshua D. Gottlieb of Harvard University, and Joseph Gyourko of the University of Pennsylvania argues that the housing bubble was not primarily caused by cheap credit and easy lending.

Abstract:

Between 1996 and 2006, real housing prices rose by 53 percent according to the Federal Housing Finance Agency price index. One explanation of this boom is that it was caused by easy credit in the form of low real interest rates, high loan-to-value levels and permissive mortgage approvals. We revisit the standard user cost model of housing prices and conclude that the predicted impact of interest rates on prices is much lower once the model is generalized to include mean-reverting interest rates, mobility, prepayment, elastic housing supply, and credit-constrained home buyers. The modest predicted impact of interest rates on prices is in line with empirical estimates, and it suggests that lower real rates can explain only one-fifth of the rise in prices from 1996 to 2006. We also find no convincing evidence that changes in approval rates or loan-to-value levels can explain the bulk of the changes in house prices, but definitive judgments on those mechanisms cannot be made without better corrections for the endogeneity of borrowers’ decisions to apply for mortgages.

Conclusion:

Interest rates do influence house prices, but they cannot provide anything close to a complete explanation of the great housing market gyrations between 1996 and 2010. Over the long 1996-2006 boom, they cannot account for more than one-fifth of the rise in house prices. Their biggest predictive influence is during the 2000-2005 period, when long rates fell by almost 200 basis points. That can account for about 45% of the run-up in home values nationally during that half-decade span. However, if one is going to cherry-pick time periods, it also must be noted that falling real rates during the 2006-2008 price bust simply cannot account for the 10% decline in FHFA indexes those years.

There is no convincing evidence from the data that approval rates or down payment requirements can explain most or all of the movement in house prices either. The aggregate data on these variables show no trend increase in approval rates or trend decrease in down payment requirements during the long boom in prices from 1996-2006. However, the number of applications and actual borrowers did trend up over this period (and fall sharply during the bust), which raises the possibility that the nature of the marginal buyer was changing over time. Carefully controlling for that requires better and different data, so our results need not be the final word on these two credit market traits.

This leaves us in the uncomfortable position of claiming that one plausible explanation for the house price boom and bust, the rise and fall of easy credit, cannot account for the majority of the price changes, without being able to offer a compelling alternative hypothesis. The work of Case and Shiller (2003) suggests that home buyers had wildly unrealistic expectations about future price appreciation during the boom. They report that 83 to 95 percent of purchasers in 2003 thought that prices would rise by an average of around 9 percent per year over the next decade. It is easy to imagine that such exuberance played a significant role in fueling the boom.

Yet, even if Case and Shiller are correct, and over-optimism was critical, this merely pushes the puzzle back a step. Why were buyers so overly optimistic about prices? Why did that optimism show up during the early years of the past decade and why did it show up in some markets but not others? Irrational expectations are clearly not exogenous, so what explains them? This seems like a pressing topic for future research.

Moreover, since we do not understand the process that creates and sustains irrational beliefs, we cannot be confident that a different interest rate policy wouldn’t have stopped the bubble at some earlier stage. It is certainly conceivable that a sharp rise in interest rates in 2004 would have let the air out of the bubble. But this is mere speculation that only highlights the need for further research focusing on the interplay between bubbles, beliefs and credit market conditions.

This is essentially what I've been arguing from the beginning: The bubble was primarily the fault of home buyers who saw real estate as a way to get rich quick. Some fundamental factor in the late 1990s caused the initial rise in home prices, but then psychology (greed) took over and home buyers were willing to pay any price for a home because "real estate is the best investment you can make" and "home prices never go down." (If something is the best investment you can make and the price will never go down, then the price you pay doesn't matter.)

Unlike most people (including politicians and journalists who dare not blame the voters/viewers), I remember the home owners during the bubble who insisted I should buy a home because real estate is such a great investment. I remember them telling me how much their home had gone up in value. I remember them telling me I was throwing money out the window by renting. I remember being kicked out of my home because of a (failed) condo conversion by real estate investors chasing the rising prices. This is the psychology that causes bubbles! Since the collapse of the bubble, however, home buyers cannot be blamed. THEY WERE DECEIVED! THEY WERE CHEATED! Instead, they look for a scapegoat (greedy bankers) to blame for their own greedy decisions. This paper essentially says the banksters ain't to blame.

As for the initial fundamental cause of the rise in home prices, I've been going with the Bernanke explanation of a global savings glut, but this paper seems to throw a monkey wrench into that one.