The House Folds: The Housing Market and Irrational Exuberance
"If wishes were houses," observed sociologist John Dean in 1945, at the outset of the great postwar housing boom, "a clear majority of Americans would be home owners." Sure enough, between 1940 and 1960 the portion of the country that owned a home would jump from 44 to 62 percent, by far the most rapid increase in the ownership rate in any period of American history. Returning soldiers and families of modest means drove the surge in purchases, thanks largely to government-backed loans that made affordable mortgages widely available for the first time. The affluent society was taking shape. As Americans flocked to burgeoning suburbs, homeownership fast became the most coveted item in the inventory of the new consumer economy.
But Dean was a skeptic, an unlikely bear in a bull market. Most Americans might wish for a home to call their own--but that didn't mean it was feasible for them all to purchase one. Homes were still the biggest of big-ticket expenses, involving large initial outlays, long-term indebtedness, hidden future costs and unpredictable price fluctuations that might plunge a family into default if the housing market collapsed (as it had a decade earlier). Furthermore, Dean warned, "the whole complex problem [of] whether a specific family should buy and what is or is not a wise buy for it is an area of acute illiteracy" among the public. The decision to buy involved far too many risks to be taken so lightly by a political culture prone "to assume that for all families home ownership is desirable financially, morally, psychologically, and from a housing angle." Dean's book Home Ownership: Is It Sound? was one of very few at the time to challenge the pro-ownership consensus. "For some families some houses represent wise buys," Dean wrote, "but a culture and real estate industry that give blanket endorsement to ownership fail to indicate which families and which houses."
Robert Shiller is also something of a skeptic. An economist at Yale, Shiller is a prominent figure in the modish field of behavioral economics, which draws on the study of human psychology and social behavior to understand how people make economic decisions. His bestselling book Irrational Exuberance (2000) foretold the dot-com bust while tech stocks were at their peak and investors remained convinced that stock prices would continue to rise indefinitely. For an updated second edition published in 2005, he added a chapter on the dangerously inflated bubble in house prices, a year before that market began to unravel, too. As prices skyrocketed by more than 50 percent between 1997 and 2004, far outpacing homebuyer incomes, Shiller cautioned that "irrational exuberance really is still with us." By 2008 prices had tumbled 18 percent nationally and plunged even more in the worst local markets, in south Florida and the Sun Belt. Around 12 million homeowners owed more on their homes than they were worth, and mortgage defaults had tripled, driving the American economy into recession and crippling financial markets around the world.
Irrational exuberance, or the "social contagion of boom thinking," is also the subject of Shiller's new book, The Subprime Solution, a slim but valuable addition to the growing literature on the ongoing collapse of the housing market. Shiller argues that "the ultimate cause of the global financial crisis is the psychology of the real estate bubble," the misguided idea that the market could sustain the unprecedented rate of expansion that began in the late 1990s. Dazzled by record prices and surging home purchases, Americans came to believe we had entered a "new era" of limitless growth, a story mostly endorsed by credulous news media and trumpeted by political leaders, mortgage lenders and Wall Street banks all eager to reap the benefits of the "ownership society." Millions of homeowners cashed in on rising property values with second mortgages or took out home equity loans to finance home improvements and other consumer expenditures. In 2005 the personal savings rate--the percent of disposable income that is not spent--was negative for the first time in nearly three-quarters of a century, as house-rich Americans forswore saving and turned their homes into ATMs.
Because a market slowdown seemed unlikely and a crash unthinkable, risky loans proliferated, particularly loans made to low-income or credit-poor "subprime" borrowers. Many were first-time homebuyers who flocked to low down payments with only a vague understanding of ballooning interest rates to come; at the same time, mortgage lenders like Countrywide ignored obvious long-term repayment risks to collect outlandish lending fees in the very short term. Besides, the housing windfall could be turned into an even greater bonanza on the international securities market, creating an added incentive to keep the faucet gushing. In 2006 lenders generated $615 billion in subprime mortgages, and when these loans began defaulting in droves a year later, sales of mortgage-backed securities were running at about $1 trillion annually.
Who was to blame for all this? Shiller rejects the conventional wisdom, which tends to overlook the excessive speculation at the market's core and focus instead on specific components of the boom-and-bust cycle in real estate: irresponsible borrowing, lax regulation of predatory lending practices and the inflationary monetary policy of former Federal Reserve chair Alan Greenspan. "These other factors were themselves substantially a product of the bubble," Shiller argues, "not exogenous factors that caused the bubble." Succumbing to the irrational belief that previous gains would guarantee future profits, various parties ignored obvious warning signs. House prices, historically very stable, had come completely unglued from economic fundamentals like building costs, population growth and incomes, suggesting that something anomalous was at work in the real estate market. And yet "even intelligent, well-informed people," to say nothing of the rest of us, "typically did not comprehend" what was happening in the run-up to the subprime crisis. Shiller offers that "understanding such a social contagion is a lot like understanding a disease epidemic"; by the time the housing bubble finally burst, we had all been infected.
The prevalence of the hallelujah gospel of speculative thinking is the key difference between the housing boom at the beginning of the twenty-first century and the one John Dean surveyed with such trepidation in the middle of the twentieth. A robust manufacturing economy, steadily rising incomes and the expansion of the middle class prevented an unsustainable price bubble from developing during the postwar period, and the wave of home foreclosures that had swept the country during the Depression years was a recent and grim reminder that the market for houses could go up and down. But the high of the '90s stock boom left investors and buyers feeling invincible. All kinds of people poured money into real estate because they were certain of a lucrative flip. "The idea developed that we ought to expect to make a lot of money," Shiller writes. "It is the change in thinking about ourselves that is the deepest cause of the bubble, and may be slowest to unravel after the bubble comes to an end."
Shiller's analogy of a social epidemic is useful for conveying people's susceptibility to contamination by irrational exuberance, but it risks obscuring essential differences of degree. Nobody expected to make as much money in the housing market as the financiers--lenders, investment banks, private equity firms, hedge funds and global investors--whose voluminous capital inflated the bubble to its giddy heights. This is the other major difference between the two periods: while individual consumers and the state subsidized the postwar boom, the recent bubble was largely the work of a vastly expanded financial sector, freed to speculate wildly in real estate by the deregulatory regime ushered in during the Reagan presidency and reinforced by Clinton-era economic reforms like the repeal of the Glass-Steagall Act. Overconfidence may have kicked off the speculative housing bubble, but overreaching capital kept it growing.
The American real estate market's appetite for greater risk, in other words, was stimulated by financialization, the rising dominance of financial markets and institutions in the world economy. "Residential mortgage lending was previously a very staid business," writes economist Mark Zandi in his first book, Financial Shock, a methodical and densely packed tour through the housing crash. Thirty-year fixed-rate mortgages--so-called "plain vanilla" loans--had been standard issue in the wake of the Great Depression, minimizing risk through the postwar housing boom and preventing another major outbreak of loan defaults and foreclosures, even during periods of economic downturn. But in recent decades a dizzying array of new lending and financing practices changed the rules of the game, eventually turning the housing market into what Zandi calls the "financial Wild West," which precipitated the current crisis.
"Wall Street drove the changes in the mortgage lending business," according to Zandi, by creating a market for home loans to be pooled and sold to investors as securities. Securitization, in turn, altered the basic economic calculus behind lending. "Making a loan and maintaining ownership of it was no longer as profitable as making the loan and selling it to an investment bank," where financial engineers were devising complex derivatives like collateralized debt obligations and credit default swaps to reap even greater dividends (which redounded to them in the form of hefty stock options and lavish bonuses). "There seemed to be no limit to what the securitization machine could produce," and ever more mortgages were needed to keep it humming. "Lenders now made their money solely on volume; the more loans they originated, the greater their profits."
In order to generate mortgages fast enough, lenders like Countrywide and Washington Mutual came to rely heavily on the most dubious of loans. Between 2004 and 2007, "the market was flooded with the riskiest varieties of subprime, alt-A, and jumbo ARM loans, the types of loans lenders would have been too nervous to make even a few years before." "As if by magic," but really thanks to super-low down payments and increasingly lax underwriting standards, "the average first-timer now had just enough income to afford to purchase a median-priced starter home." In 1990 only 4 percent of home loans allowed down payments of 5 percent or less; in 2007 a study by the National Association of Realtors found that the median down payment for first-time buyers was just 2 percent. By 2006 nine out of every ten new subprime mortgages came with adjustable interest rates that typically jumped upward after two years--the riskiest loans for the riskiest borrowers. But the securitization machine pushed the added risk off lenders' books and onto those of global investors, who saw the soaring real estate market as a sure bet and pumped in new capital to keep the cycle going. "As the housing bubble expanded, mortgage lending moved from merely aggressive to increasingly reckless and, in some cases, disingenuous and predatory," while "the most aggressive lenders forced the rest--even the more cautious among them--to either lower their standards or lose their market share."
Financial Shock devotes a chapter each to various other factors that contributed to the collapse of the subprime market. New construction went into overdrive during the boom but glutted the market when demand slowed and foreclosures mounted. More than 2 million unsold homes sat vacant by early 2007, and the home-building industry, which had accounted for as much as a third of growth in the overall economy in the first half of the decade, tanked. Federal regulators first turned a blind eye to the mortgage frenzy, instead placing their faith in the market's ability to regulate itself; then they intervened to address only the most egregious lending practices. It was "too little and too late," Zandi writes; although "regulators didn't create the subprime financial shock...they did nothing to prevent it." Until October, when, backs to the wall, they passed a heavily modified version of Treasury Secretary Henry Paulson's $700 billion bailout plan, members of Congress had also "dithered" as the fallout from the subprime market spread throughout the rest of the economy--unsure of how to respond, unwilling to intervene quickly and unprepared for the extent of the crisis.
But none of them played the decisive role. "Of the places you can point the finger for the housing bubble and subprime financial shock," Zandi argues, "the most deserving is the removal of responsibility from the financial system. Lost in the rapid, wholesale rush to securitization...was the notion that someone--anyone--should ensure that individual loans are made responsibly, to responsible borrowers." The windfall profits were simply too great for anyone to risk betting against the house. Decades of deregulation and free-market orthodoxy had bred a fatal sense of self-confidence, a "belief that the ordinary rules of economics and finance no longer applied" and innovative methods for managing risk and maximizing profits could forestall the inevitable. At the peak of the housing bubble, "America's financial ingenuity seemed without parallel."
Needless to say, America's financial ingenuity turned out to be a chimera. With the first wave of defaults in 2007, the securitization machine went into reverse. Nobody knew which securities contained faulty loans, and so trading dried up altogether. Lenders stopped issuing new loans, and home sales plummeted. Prices, which had stumbled in 2006, crashed--more than 30 percent in cities like San Diego, Miami and Las Vegas--and home equity evaporated. Global investors began to doubt the entire American residential mortgage market, which at $11 trillion accounted for nearly 10 percent of outstanding bank loans and securities internationally. Major banks and investment houses that had bet heavily on mortgage-backed securities found themselves overleveraged and began posting record losses, their balance sheets crumbling under the weight of so much worthless paper. The endless supply of credit that had kept the bubble inflated suddenly disappeared. On the Richter scale of economic disasters, Zandi tells us, "the subprime shock was as serious a financial earthquake as any the nation had seen since World War II."
If anything, he underestimates the extent of the damage. More recent aftershocks at mortgage-industry giants Fannie Mae and Freddie Mac, mega-insurer AIG, savings-and-loan mainstay Washington Mutual, megabank Citigroup and leading brokerage firms Lehman Brothers and Merrill Lynch all occurred after Shiller and Zandi finished writing, but these events only confirmed how extensively the subprime crackup had demolished the financial system. When two of the country's oldest investment banks waved a white flag in a single weekend in September--Lehman was forced into Chapter 11; Merrill, a buyout by Bank of America--even Greenspan had to acknowledge the unprecedented scale of the meltdown. "This is a once-in-a-half-century, probably once-in-a-century type of event," he told an interviewer, "by far" the worst crisis of his career.
As Ben Bernanke, Greenspan's successor at the Fed, and Paulson scrambled to stanch the bleeding, much was made of the government's decision to rescue Wall Street from its ruinous excess. Like the Fed-backed buyout of Bear Stearns in March or the $150 billion in loans made to keep AIG solvent, the $200 billion of taxpayer money propping up Fannie Mae and Freddie Mac is surely indicative of the Bush administration's willingness to deviate from its laissez-faire dogmatism at the behest of financial interests. Such policies have been skewered as "Wall Street socialism," but in this case the complaints overlook the systemic problem in the American model of homeownership brought into relief by the bailout of the two government-sponsored but publicly traded firms, which together own or guarantee half of all home loans and are the engines of the US mortgage industry.
Before they were put under explicit national control, Fannie and Freddie enjoyed implicit government backing because of their mandate to finance affordable loans by funneling money into the private mortgage industry. They functioned as quasi-public agencies fulfilling a social duty, a market-based alternative to historically deficient public or federally subsidized housing reserved largely for the ghetto poor; and as such their role in the residential mortgage market grew significantly during the last two decades. The Clinton and George W. Bush administrations identified expanding homeownership, particularly among low-income and minority households, as a key domestic policy objective, and pushed the two firms to finance mortgages for millions of first-time buyers. During these years, the ownership rates for black and Latino households--who benefited particularly from the availability of subprime loans and have suffered disproportionately in the ensuing foreclosure crisis--grew by at least twice the rate for whites.
But Fannie and Freddie were pulled in another direction as well, because as publicly traded companies they were also beholden to their shareholders. Although they were far from the most reckless actors in the subprime saga, the two firms were buying billions of dollars' worth of increasingly risky loans from commercial lenders every month--Fannie's purchases of loans with down payments of less than 10 percent grew threefold between 2005 and 2007. Reselling them to investors around the world as overvalued mortgage-backed securities earned the companies outsized profits during these years while encouraging the deterioration of lending standards and adding to the inflationary pressure that ultimately sank the real estate market.
Fannie and Freddie clearly could have benefited from more effective regulation during the recent bubble, but in their twin and conflicting identities they embodied a core contradiction in the country's singular reliance on the private market to fill its housing needs. More than the self-destructive greed of financial institutions or the irresponsibility of individual borrowers, the subprime collapse has demonstrated the market's intrinsic failure to equitably distribute the benefits of homeownership across society. Subprime loans enjoyed government approval and the blessings of the federal regulatory apparatus because they seemed to broaden access to the mortgage market and promised to satisfy what Zandi rightly identifies as "America's fierce and long-standing devotion to the ideal of home ownership for all."
And yet with incomes mostly stagnant for the bottom half of the labor market since the early 1980s, and job growth weak or negative in recent years, increasing the ownership rate among subprime households necessarily entailed the assumption of significant debt burdens for families struggling even to keep up with inflation. At the bubble's peak, subprime borrowers were devoting an astonishing 35 percent of their after-tax income to paying off mortgages and other debt, a recipe for disaster once house prices began to fall and homes could no longer be used as collateral for more borrowing. In retrospect, it is obvious that these borrowers should not have bought such overpriced homes in the first place. But as John Dean understood half a century ago, the dominant "ideology of home ownership" cannot account for the reality that, except in times of robust growth and widespread prosperity, homeownership just isn't feasible for many families. "To say that such families 'ought to have more foresight' is not to recognize that lack of foresight...may be heavily culturally encouraged," Dean wrote, and "the home owner, by being 'unwisely susceptible' to the urge to own, may overburden himself financially." Presented as a means of leveling the playing field in the private housing market, the subprime solution was a debacle waiting to happen--the more open the market became, the more likely it was to collapse under the weight of added risk.
Almost 3 percent of American home loans now face foreclosure, the highest rate since the Mortgage Bankers Association began keeping such records in the 1970s, and more than four times the foreclosure rate during the last extended economic recession, in the early 1980s, when unemployment reached 10 percent. Shiller and Zandi end their books with the appropriate remarks about helping people keep their homes, but they quickly move on to what should be done to prevent a recurrence of the mortgage crisis (they are economists, after all). They agree on the need for stronger regulation to eliminate predatory lending practices and rein in the shadow banking system that turned the mortgage industry into a giant game of roulette in recent years. Both call for comprehensive, government-provided financial literacy training to steer people away from risky loans, particularly low-income Americans less likely to avail themselves of costly financial counseling services.
Shiller speaks more broadly of "democratizing finance--extending the application of sound financial principles to a larger and larger segment of the population," through the more effective implementation of information technology and "revolutionary" economic disciplines like behavioral finance. He even proposes a new currency unit called baskets, which, unlike dollars, would be tied directly to the widely misunderstood inflation rate. A better grasp of how inflation skews asset prices, Shiller argues, would discourage a resurgence of the irrational exuberance that produces speculative bubbles. "If we had been accustomed to quoting home prices in baskets since 1890, then people would generally have known that home prices haven't basically changed in a hundred years (until the recent bubble), and they would never have gotten the idea--as they did in the early 2000s--that home prices always go up."
More sensible is Shiller's proposal for "continuous-workout mortgages" (an idea he returned to recently in the New York Times Business section), which would allow homeowners to routinely renegotiate the terms of their mortgages based on current market conditions and their varying ability to make payments. Like "regular checkups and preventive care rather than a sudden trip to the emergency room," continuous-workout mortgages would function as a self-correcting device to better manage changing levels of risk and prevent another pandemic of loan defaults and foreclosures. "The key to long-term economic success is rightly placed confidence in markets," Shiller says in no uncertain terms, and flexible mortgages, greater regulation, more responsible derivatives trading and more prudent borrowing will help the housing market act more rationally in the future.
Nevertheless, it's unlikely that such market reforms will do nearly as much to fulfill the fundamental social need for decent, affordable housing as would substantial investment in improving and expanding public housing; a reversal of the thirty-year decline in federal subsidies for low-income housing; or more muscular legal rights and income support for renters in overpriced urban markets. Nor can Shiller's and Zandi's proposals remedy the fact that for millions of poor people, buying a home and realizing a core component of the American dream will remain permanently beyond their reach, and that millions more will turn to long-term indebtedness for an only tenuous claim to ownership. Shiller and Zandi are rightly bearish on a real estate market overrun by speculation--but as Dean understood, the problem lies in the private market itself and, by extension, in the very notion of the "ownership society," which transforms social goods into commodities and abandons the most vulnerable to the whims of the marketplace.
As it is, the private housing market divides the country along the most basic of class lines--owners and nonowners. The range of material advantages that benefit the propertied (from the starkly regressive mortgage interest deduction in the tax code to a home's equity-building potential) only deepens an already profound wealth gap. A more stable market will not repair this basic inequality on its own. Without a comprehensive federal commitment to guarantee affordable housing for all, the ownership society will remain nothing more than a myth, a house of cards for too many working- and middle-class families forced to borrow beyond their means to subsidize a diminished standard of living. If the growth and bursting of the subprime bubble teaches us anything, it should be that most Americans still wish they owned a home but too many of them still can't afford one.