The Price You See is Not Always the Price that is Relevant: The Housing Bubble

by Mario Rizzo  

To argue successfully that a low Fed interest rate policy was the fundamental cause of the housing boom-bubble is not a slam dunk. A relatively small reduction in the mortgage rates available at the time should not alone have a generated so much of a boom.  

Casey Mulligan has a very interesting post at his blog, supply and demand (in that order). [I must say I have never liked the neo-Ricardian implication of the title: supply – real factors – is more important than demand. But let that pass. I like his blog anyway.] The immediately relevant posts are here and here.  

In true Beckerian fashion, Mulligan asks the question: How is housing (the ultimate good) supplied? It is supplied not only by the physical inputs but also by all of the financial services that go along with it.  

A mortgage contract has a certain “put option.” The owner can give up the house and walk away owing nothing. (Yes, there are costs involved.) Now the put option is worth something. It is worth more in expected value when there is an increased likelihood of a price crash. Now as prices in the housing market go up, the probability of the fall increases. Suppose the put option is not subsidized. In that cases, mortgage rates or some other cost of buying the house will rise.  

Now suppose the put option is subsidized, say by the explicit and implicit guarantees of government sponsored agencies or by the fear of systemic risk problems (“they can’t let all this fail”). Then this valuable option becomes increasingly valuable as the boom goes on. However, because of the subsidy the new homeowners do have to pay more by the amount of this increased value.  

(The reader should note that there is an asymmetry here. The subsidy does not turn into a tax when the probability that housing prices will rise increases.)  

Therefore when we see the mortgage rate only somewhat below the normal mortgage rate we are not making the correct comparison. The effective mortgage rate should have been higher than the normal rate. This means that the relevant price of houses was actually going lower even as the observed mortgage rate did not move much.  

This makes sense to me. Nevertheless, I should add that I do not rule out other factors playing a role too (and neither does Professor Mulligan).

18 thoughts on “The Price You See is Not Always the Price that is Relevant: The Housing Bubble

  1. This boils down to the banks lending into a bubble because they expected to be bailed out.

    Stockholders have had little bailout. They too a lot of loss. Of course rather 100 percent losses, the bailouts mean 95% losses. And that counts for something.

    But, perhaps the expected returns were enough. It was the lenders to the banks insured and uninsured depositors at commercial banks and those holding various short term liabilities of investment banks that were lending into the bubble.

    Well, we know the insured depositors had nothing to worry about. And so, the moral hazard was the correct expectation by uninsured depositors and other short term lenders that they would be bailed out.


  2. I disagree with Casey Mulligan’s assertion that the value of a put built into a mortgage increases as home prices rise. On the contrary, it should fall (maybe not by much), and for the same reason that a put option falls as the price of the underlying stock increases. (And here we can ignore the fact that a stock option is a wasting asset, the value of which falls to zero at expiration.)
    The fact is that most people buying homes at the top of the housing bubble (the Csse Schiller Index peaked in July 2006) expected them to increase in value, or at least not fall. Housing bears shorted shares of homebuilders (or the XHB), or various structured finance instruments, possibly including mortgage derivatives. Some of them bought puts on home building stocks, for example; but they were a small and brave band, and not cut from the same cloth as typical new home owners, contrary to Mr. Mulligan’s supposition.
    I submit that he is looking at the market through a (distorted) set of rational expectations lenses.
    Mario points to mortgage rate levels, and, if I understand him correctly (please correct me if I don’t), expresses skeptism that they were low enough to fuel the housing boom.
    But if we consider an alternative measure of valuing house prices, namely the price to rent ratio (the house price analogue of a stock price’s price/earnings ratio), we see that, consistent with the Case-Schiller story, home prices rose in lockstep with the rents they could have earned.
    That brings us to another point, argued by Alfred Rappaport in his great but neglected book _Creating Shareholder Value_ (2nd ed.), namely that using p/e ratios has certain problems, including accounting issues, and that it should be supplanted by a discounted cash flow analysis (see examples and discussion at, and there are other sites too).
    When the Fed under Greenspan pushed interest rates to very low levels for over a year starting in 2003, that put downward pressure on the discout rates investors used to value long-dated cash flows of many different classes of assets, including stocks and bonds, private equity, land, residential and commercial real estate, and then structured finance vehicles and derivatives. The prices of commodities and art also boomed in concert with other asset markets.
    It is the Fed-fueled (lower) discount rates home buyers used to value expected cash flows (based on rents), not the (somewhat) lower mortgage rates they paid, that caused the housing boom.

    Over time adaptive expectations developed, and and many, perhaps most, investors who were long believed that the prices of assets they owned would continue to rise or at least not decline. (The naysayers shorted them and were eventually proved right when the bust came. But they were a minority.)
    I’m in the camp that sees lower interest rates as the cause of the boom, and not just in real estate. Jeff Hummel has been defending the alternative view, most recently at the Liberty and Power blog. I don’t see how what The Economist called the biggest credit boom in history could have been caused by anything else other than sub-market interest rates. Would supra-market rates have caused it? Don’t demand curves slop downward?

  3. It is the Fed-fueled (lower) discount rates home buyers used to value expected cash flows (based on rents), not the (somewhat) lower mortgage rates they paid, that caused the housing boom.

    Just to be clear, I am asserting that the cash flow discount rates were lower than the mortgage rates.

  4. I’m sorry that Mario inadvertantly perpetuates a myth. He should not have taken the facts as presented for granted.

    Whether someone can “walk away” from a house under water depends on state law. In California and Nevada, there is “one action” — you can foreclose or you can sue (not both). In Texas and many other states, the lender can foreclose and sue for the unpaid balance (both). In Texas, you can obtain a judgment lien and go after the deadbeat for 10 years.

    No one was worried about falling prices. That was the problem. If there is some theoretical put in a mortgage, it was underpriced.

    Subprime loans (e.g., 2/28s and 3/27s) were structured to make it costless to walk away. Read Gary Gorton’s “The Panic of 2007.” Mortgage rates reacted only after the crisis hit.

    If one starts with Becker rationality and efficient markets, you can quickly prove that the housing boom never happened. That is why Jim Buchanan wrote his apper, “Economists Have No Clothes.”

  5. I’m not sure that moral hazard is only relevant because of deposit insurance: it is relevant whenever costs are socialized.

    If I invest too much now, together with everybody else, in a private-costs world I would expect high interest rates in the future when there will be a scramble for credit, i.e., investment that raises the demand for capital, as Hayek put it.

    When there is the central bank with a countercyclical monetary policy, during the scramble for capital, normally, interest rates never rise in the short run, and probably also in the long run (the policy intervention will be at least as persistence as the crisis, i.e., the scramble for credit).

    Counterfactually, an interest rate that in a private-cost world would have risen to 7-8% at the onset of the crisis, becomes a 0% interest rate because of the central bank. This may be a great cost socialization… as the counterfactual market interest rate is not observable, it is difficult to evaluate if the phenomeon is relevant.

    When costs are socialized, the market system is uncapable of retrieving and spreading correct information and forcing correct incentives. All the coordination process goes astray.

    Competitive market agents will take moral hazard into account and “optimize” taking the cost socialization technology into account, i.e., they won’t “optimize” to find a “social optimum”, whatever it means.

    Systemic risk cannot be avoided because noone has private incentives to avoid it. Only monetary authorities can stop socializing risks, but countercyclical policies work on the opposite principle.

  6. Pietro is correct. It is not that banks expected to need bailouts. Rather, the safety net led to an expectation of stable funding and the well-established “Fed put” assured low interest rates.

  7. I admit to being somewhat out of my depth here. I was impressed with Mulligan’s argument. Perhaps I should not have “endorsed” it. In any event I have a few questions/points.

    1. I find it difficult to believe that as housing pricing rose and rose that the market did not assess a rising probability of a fall (not a certainty but a rising probability). That alone would have raised the value of the so-called put to the buyers.

    2.Even if the put was not costless to use, it did mean that some kind of escape was possible — which surely had value.

    3. Yes, Mulligan is looking at things through a RE perspective (at least to some extent)but I do not think that is always incorrect.

    4. Jerry, you say:
    “Subprime loans (e.g., 2/28s and 3/27s) were structured to make it costless to walk away.” Isn’t that consistent with Mulligan’s point?

    5. I will read Gorton’s piece which I printed but just put in a pile.

    Overall, I am simply trying to puzzle through the prima facie difficulty in connecting such a huge housing bubble with mortgage rates that were only somewhat below normal. (This is what Krugman and DeLong have argued.)

  8. Mario,

    I’m taking your summary of Mulligan at face value. If we live in the world he constructs, bubbles can’t happen. But they do happen.

    The characteristic of bubbles is that they engender expectations of further rises in prices — not falling prices. The moment those expectations shift, the bubble bursts. Only then does pricing catch up to reality.

    “Costless to walk away” = Put priced at $0. Most of the case studies I’ve read dealt with the bubbles in CA and NV. (Most of the outsized gain in home prices occurred in 5-6 states.)

    If mortgage markets were rational, then interest rates in single action states would have been higher than in other states (e.g., CA compared to TX). But they weren’t because no one was pricing the risks. I take that to be Pietro’s point.

    There has been lots of confusion on the correct rate of interest for mortgage costs. The bubble deniers want to look at 30-year fixed-rates. If those were the relevant rates, we probably wouldn’t have had a housing bubble.

    5-year money became long-term, and ARMs were being offered at 1-year rates. Meanwhile, the funders were borrowing at overnight interest rates. Read the story about Lehman’s collapse and its use of overnight money to fund long-term assets.

  9. I should just add why the Gorton paper is so important. His thesis is that information about the riskiness of loans was lost in the process of securtizing them. And he goes into great detail to prove that point.

    Whatever one thinks about how risk is priced normally, the needed information was lost in the sceutization of subprime loans. That begs the question, of course, of why such a product could ever have been marketed.

  10. Jerry,

    “If there is some theoretical put in a mortgage, it was underpriced.”

    Isn’t that point more or less what Mulligan was getting at?

    I don’t care for the put metaphor, although I think I see how it works: I can sell my house to the bank for a price equal to the unpaid balance of my mortgage. The lower the price of my house, the more likely I am to exercise that option and, therefore, the higher the put price should be. Banks underpriced the put option because they, the banks, were subsidized; they were gambling with other people’s money.

    In other words (I think!) there was an inadequate risk premium built into many mortgages. As far as it goes, Jerry, isn’t that’s right?

    I think you have two criticisms of Mulligan’s analysis. First, from the numbers he uses you suspect Mulligan is looking at published rates for 30-year fixed mortgages, whereas the really crazy-low rates were from ARMs and such. Thus, Mulligan seems to have missed just how low mortgage rates really were. Second, he seems to assum rational expectations, which is an implausible assumption in the case at hand.

    Right on to both of your criticisms, Jerry. But Mulligan may nevertheless be right to say that risk premia were too low, which seems to be part of your point too. Am I missing something here?

  11. Risk premia were too low during the boom. Interest rates are determined by time preference (the supply and demand for present goods), and they have an variable entrepreneurial risk component built into them. In a boom the risk component falls, leading to sub-market discount rates used to value investments (those based on cash flows). This causes overvaluations and asset price booms. The process is reversed in a bust, as discount rates rise and asset prices fall.

    Here is an article from the Dec. 2008 McKinsey Quarterly pointing out that cash flows fell in the bust thanks to greater uncertainty.

    The flip side would have been that during the boom bullish expectations became adaptive, or self-fulfilling, as risk premia and uncertainty fell.

    I think the idea that interest rates have a variable risk component is the Austrian answer to mainsteam financial economists’ view that assets (such as stocks) have variable risk premia. I’ve only seen the latter idea applied to the stock market though.
    If the Austrians are correct, this would seem to be a strength of Austrian theory, as it implies that a risk premium is the result of an investor evaluating the riskiness of any investment, rather than a free floating theoretical abstraction finance profs graft on to their analysis of stcok valuation.

  12. I have two abstract theses regarding originate to distribute and other innovations gone astray.

    The first is probably only a truism: coordination prolems can only occur if there are exchanges and exchange prices, so the higher the intricacy of transactions the higher the scope for monetary distortions and for coordination problems, even of nonmonetary origin.

    The other is that lemons markets under the hypothesis of socialized costs can become sovramarginal. Akerlof’s fear was that some markets may not exist because of adverse selection: the problem in a bubble economy is that there are too many.

    Regarding maturity transformation, it’s appalling that 3-months ABCP was used to fund 30-years mortgages, but that’s exactly what I would do with a countercyclical ceiling on short rates and guaranteed market liquidity.

  13. Roger,

    I didn’t Mulligan, just Mario. I do think you, Pietro and I are on the same page. Government subsidies pushed down risk premia. If that is what Mulligan said, then no problem on that point. The other issues, as you note, remain a problem.

  14. Here in Texas we did not have a housing bubble, we haven’t had a lot of foreclosures, and we have been one of the least affected states when it comes to the recession. We also have laws that, as O’Driscoll observed, make people be responsible for the contracts they enter into, but we also have one of the most lax bank regulatory environments in the U.S. As a result, most of our state banks are small or medium-sized (no Bank of American monstrosities, except for Bank of America itself, and other national banks we have here) and, more, there was no pressure from our state government on banks to make subprime loans for political gain. The results speak for themselves. Or, at least, they would if we didn’t have people like Krugman obfuscating economics facts at every turn.

    Interest rates were one — big — reason for the bubble. But they are one of the reasons for all bubbles, so saying they are responsible is much like sayig that oxygen we the cause of your house burning down. It’s true and, if you think adding oxygen to the fire will help put it out, you need to be informed otherwise, but it’s only part of the reason. Next, we have to look to further contributing factors. A huge part of it was political pressure put on lenders to make bad loans to people who couldn’t pay because of some idealistic notion that everyone should own a house (of course, if our elected officials really thought that, they would eliminate property taxes, which make it so that nobody actually owns their property, but in fact rents it from the government — to the tune of $400 a month for me, which is 50% of my monthly mortgage, making it a real barrier for many home buyers).

  15. I agree that mortgage price changes weren’t the driver. The driver was the amount of leverage given to the buyers. Leverage in this case slowly but surely increased from 20% down plus closing costs to zero down, and sometimes help from the bank with closing costs. Not to mention deterioration of lending standards (ie, many more borrowers, and each borrower having more funds at their disposal). This was massively inflationary in the truest sense of the word – more effective buying power chasing the same amount of goods (housing).

    I don’t know if the agencies had anything to do with the actual bubble – there were also massive real estate bubbles in Spain, Britain, Ireland, Australia, and Canada, so, we can’t just blame it on Fannie Mae.

    In reality, I think it was a true Minsky expansion. The bankers were offering more and more generous loans to less and less qualified individuals because they truly believed that housing prices were going up, and even if the schulbs defaulted, the house would come back to the bank worth substantially more than the loan. And, of course, housing prices kept going up and up because bankers had become confident enough in ever rising housing prices to offer more and more generous loans to less and less qualifited individuals…

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