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Deluded buyers to blame?

Posted by Scott Van Voorhis May 16, 2012 07:15 AM

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That's the latest theory on what caused the housing bubble - and it makes a certain sense.

A new Boston Fed paper takes aim at the profusion of studies and documentaries that try to pin the blame for the housing bubble on the machinations of a few greedy Wall Street types. (Thanks gmbc for pointing this one out.)

Instead, it was the average buyer, borrowing to the hilt and beyond to grab a house in the belief that prices would just keep on going up, who drove the runaway prices of the bubble years, the Fed paper suggests.

It's certainly a provocative theory - and one very current now as the real estate market starts to recover and prices in some of Greater Boston's more affluent suburbs head up again.

In fact, for all those who are feeling a bit optimistic again - including me - the Fed researchers offer a very timely warning at the end.

First, financial institutions must be able to withstand a serious house price shock ... For example, just because house prices have already fallen 20 percent does not mean they cannot fall another 20 percent. As Table 3 illustrates, some analysts were convinced that a bottom had been reached for house prices in 2006.

Here, the Fed researchers lay out the idea that overly optimistic buyers/borrowers played the key role in inflating the bubble.

In contrast to these these explanations for the credit expansion, the facts suggest that the expansion occurred simply because people believed that housing prices would keep going up- the defining characteristic of an asset bubble. Bubbles do not need securitization, government involvement, or nontraditional lending products to get started. Bubbles in many other assets have occurred without any of these things - not only tulips in seventeenth-century Holland, but also shares of the South Sea Company in eighteenth-century England, U.S. equities and Florida land in the 1920s, even Beanie Babies and technology stocks in the 1990s.2 As the housing bubble inflated it encouraged lenders to extend credit to borrowers who had been constrained in the past, since higher house prices would ensure repayment of the loans. Much of this credit was channeled to subprime borrowers by securitized credit markets, but this does not mean that securitization "caused" the crisis. Instead, expectations of higher house prices made investors more willing to use both securitized markets and nontraditional mortgage products because those markets and products delivered the biggest profits to investors as housing prices rose.

And if the the problem was not misaligned market incentives, but rather mistaken optimism on part of average home buyers, then economists and policy makers will need to refocus their efforts, the paper suggest.

From tulips to tech stocks, outbreaks of optimism have appeared repeatedly, but no robust theory has emerged to explain these episodes. As a telling example, at the peak of the housing boom economic theory could not provide academic researchers with clear predictions of where prices were going or if they were poised to fall. Scientific ignorance about what causes asset bubbles implies that policymakers should focus on making the housing finance system as robust as possible to significant price volatility, rather than trying to correct potentially misaligned incentives.

Certainly provocative. What's your take?

This blog is not written or edited by Boston.com or the Boston Globe.
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About boston real estate now
Scott Van Voorhis is a freelance writer who specializes in real estate and business issues.

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