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."