THE PECULIAR ECONOMICS OF HOUSING BUBBLES

I. INTRODUCTION Housing differs from other consumption goods in important ways. Houses are extremely durable, changing houses involves large transactions costs so that households do not move very often, and in most cases, houses are financed through borrowing. Furthermore, houses represent status and allow access to other benefits, such as parks, schools, or desirable neighborhoods. Automobiles share most of these attributes, although to a lesser extent, but housing and automobiles differ in one key feature. Automobiles, except maybe collectibles, tend to diminish in value over time. However, during several periods in recent history house prices have appreciated significantly, providing an investment motive for homeownership in addition to its consumption benefits. Home values rise rapidly during housing bubbles, generating large capital gains. Households can take advantage of these capital gains in two ways: either by selling the house or borrowing against its increased value through home equity loans or new mortgages. If households are allowed to borrow against the current values of their homes, it is a small step to allow them to borrow against the expected future values of their homes, especially when both lenders and borrowers agree that house prices will keep rising. In fact, this has been happening. The Federal Reserve Act of 1913 limited the loan-to-value (LTV) ratio, that is, the fraction of the current price of a house one could borrow, to 50%. By 1970, that limit had grown to 90%, and in 1989 it rose to 100%. In 1997, the LTV limit increased to 125% allowing the mortgage loan to exceed the market value of the house, and these loans were aggressively marketed to consumers. (1) The purpose of this article is to explore the implications of these high LTV mortgage loans secured by expected future home values. The evidence regarding high LTV loans paints a bleak picture. Haughwout, Peach, and Tracy (2008) report that 30% of subprime mortgages originated in 2006 had LTVs of at least 100%. These new subprime mortgages were the primary contributors to the first increase in homeownership rates in three decades (Chambers, Garriga, and Schlagenhauf 2007). The high LTV originations led to high foreclosure rates during the recent housing bust. In 2007. 40% of the foreclosures in Massachusetts had origination LTVs of at least 100%. Fifteen years earlier, in contrast, fewer than 9% of foreclosures had such high origination LTVs (Foote et al. 2008). Haughwout and Okah (2009) note that roughly 10% of homes had negative equity in a December 2008 sample of 43 states that exclude boom and bust states. They report that the average origination LTV for the above-water homes was 83%, and that for below-water homes was 98%. Our analysis presumes a particular type of market failure. If markets are efficient, expected future prices are tied to current prices through the interest rate. Specifically, if markets expect the price of an asset to be $600,000 in 10 years and the 10-year interest rate is 50% (i.e., 50% over 10 years and not 50% per year), then the present value of the asset is $400,000. Conversely, if the current value of the asset, say a house, is $400,000 and the 10-year interest rate is 50%, then the expected future price of the house is $600,000. But what would happen if markets forecast home prices to grow faster than the interest rate? (2) For example, what would occur if current house prices are $400,000 and are expected to rise to $700,000, but the corresponding long-term interest rate is only 50%? This scenario could materialize if the recent house price growth rate has exceeded the interest rate and both borrowers and lenders expect such recent price trends to persist, thereby expecting the housing bubble to continue, not burst. (3) How do these beliefs coupled with access to high LTV loans impact behavior today? To answer this question, we use a simple, partial equilibrium, consumer theory framework. …