A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.
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How we could have contained the housing bubble
29 October 2008
Last week, Congress held hearings to figure out what caused the credit-crunch-turned-credit-crisis-turned-credit-obliteration. One cause that went unmentioned by former Federal Reserve chairman Alan Greenspan and others: American policymakers treated owning a home as a universal entitlement, just as houses were becoming yet another emergent investment class vulnerable to market excesses and crashes. This intersection of social policy and market forces resulted in disaster.
Until a decade ago, housing wasnt a spectacular investment opportunity. As Yales Robert Shiller has found, after a sharp spike following World War II, home prices in the United States stayed fairly flat, relative to inflation, between the 1950s and the late 1990s. Once in a while a short boom would feed on itself, but it would quickly go bust before it could do much more than local damage. Houses were good investments only in that they were an effective hedge against inflation.
In the late 1990s, though, housing stopped being a stable, inflation-protecting physical shelter and became an opportunity to make money fast. The average person who bought a single-family house in any of 20 sprawling metropolitan areas (including suburbs) in 2000 doubled his money by 2006. Home-price increases exceeded such measures as growth in personal income (which quantifies peoples ability to pay the debt holding up their house values). The reasons for this housing bubble included middle-class distrust of the stock market after tech stocks went bust, almost unimaginably bad financial-industry management, and cheap credit created by easy money and by ever more exotic financial instruments.
But if the government had acknowledged that housing had become an investment, not a basic consumer good, and had regulated housing as it regulates nearly all other investments, the bubble could never have grown to such proportions. Easy money and poor regulation could still have wreaked havoc with world markets, but millions of Americans wouldnt have found themselves owing a fixed amount of debt on an asset declining in value.
How could the government have kept Americans from excessively speculating on their homes, as it already protects them in the financial markets? First, with protection from speculative borrowing and its effects. Regulators prohibit average investors from borrowing on an unlimited basis to buy stock; those investors must put some cash down. If we had maintained a similar requirement for houseseven just 10 percentthe housing bubble would never have engorged itself so dangerously. Though borrowing would still have been cheap in an easy-money environment, working-class and middle-class buyers would have had to overcome the hurdle of saving, say, $20,000 for a $200,000 house. Marginal buyers at all price levelsthe poor person who couldnt afford a house at all, the middle-class person who couldnt afford a rich persons house, and the rich person who couldnt afford two houseswould have found themselves shut out. Prices could never have reached their 2006 heights.
Second, financial-market regulators arent supposed to let average people find their way into complex investments. For example, people without high-six-figure incomes and seven-figure savings arent allowed to invest in hedge funds, since regulators have determined that the average person doesnt have enough information to assess the funds true risks. But exotic mortgages were sophisticated investments, too. An adjustable-rate mortgage, for example, is nothing more than an unhedged bet on the direction of interest rates. If regulators had treated these mortgages as what they weresophisticated, wildly risky speculationswe wouldnt be where we are today.
Other regulations govern the marketing of financial instrumentsand should have governed the marketing of houses. Your broker is prohibited from telling you that you cant lose money on an investment in a particular stock or bond. In fact, he must warn you about the possibility of loss. But real-estate brokers operate under no such restriction. Agents telling unsophisticated investors that they couldnt lose money on a house were just as common as exotic mortgages a few years back.
Finally, policymakers tax policy actually encouraged speculation and a dangerous lack of investment diversification. Middle-class people have to pay complex capital-gains taxes when their stocks increase in value, but not when their homes do (provided the profit doesnt exceed $500,000 for a married couple). So five years ago, if you had a choice between putting $50,000 into the stock market or spending that money on a bigger house, tax policy would rationally push you toward the bigger house, since any eventual gain would be tax-free. That policy led too many Americans to get their entire net worth tangled up in the value of one highly leveraged investmenttheir home.
How did such a toxic brew of high borrowing and exotic risk-taking for undiversified asset speculation possibly escape the protections imposed on other investments? Regulators, policymakers, and most observers used history to blind themselves. Because housing had always been a safe purchase, they figured, it would continue to be so in the future, meaning that investment-type regulations werent necessary. They also blinded themselves with an ideal: that everyone should own a homeor a bigger, better homebefore saving enough money to do so. The government thus enabled dangerous speculation by treating it as the means to achieving a universal entitlement.
That entitlement cut across income classes. Poor people unable to make down payments shouldnt have taken on mortgages to buy quarter-million-dollar houses. But people earning in the low six figures shouldnt have taken on mortgages to buy three-quarters-of-a-million-dollar houses, either. The distinction between speculators who flipped houses and homeowners who lived in them is similarly artificial. Until 2006, people could and did speculate on the value of the houses in which they lived.
Today, the nation is dealing with the aftermath of its colossal mistake: bankrupt financial institutions, complex mortgage renegotiations, and mass foreclosures. Only by not recognizing housing for what it wasan investment class, with all of the attendant risks and rewardscould America have created such a bubble, whose remains cover such a breathtakingly huge debris field.
Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.