Thursday, November 29, 2018

Housing: Part 334 - Credit supply and the housing bubble.

Tyler Cowen links to a new paper today, with this note: "Credit conditions really did matter for the housing bubble." (HT: Tyler)

I haven't looked at the paper yet, but I have looked at a set of slides, here.

My basic point of view here is:

1) Of course credit conditions matter.  This is standard finance.  Credit provides liquidity, and less liquid securities sell at a discount.  But, this is an asymmetric relationship in standard finance.  Liquidity doesn't lead to over-priced assets.  It just leads to asset prices that reflect the market rate of return with a lower liquidity discount.  One reason that homes are a good investment for many households is that liquidity is very constrained.  Transactions costs are high and they must be purchased as a whole, not piecemeal.  Returns on homeownership are highly correlated with the length of tenure, where these costs can be amortized over longer periods.  Developments that reduce the costs associated with those problems should increase home prices.

2) The outcome of the housing bubble and bust matches standard financial expectations.  Prices during the boom were as sensitive to long term real interest rates as we should expect them to be, highly sensitive to local rent inflation trends that were the result of a supply shortage, and sensitive to credit supply where the supply shortage had pushed prices high enough to create obstacles to conventional funding.  Credit supply is an ingredient here, but it is secondary to supply constraints.

3) The problem with analysis of the housing bubble and the financial crisis is that the notion that there was an unsustainable bubble that was destined to collapse was canonized before it was established empirically.  So, evidence that explains the bust is taken as evidence that explains the boom, and vice versa.  But, if the bust was not inevitable, then correlations during the bust don't tell us anything about the boom.  This goes back to points 1 and 2.  The bust is certainly explained largely by a negative credit shock, but this is an asymmetric relationship.  From that, it doesn't necessarily follow that a boom had been created by a positive credit shock.

If I get a chance to see the full paper, I will be happy to retract my comments here.  But, these slides associated with the paper do not appear to avoid these issues.

Here is a graph of credit standards from the slides.

Not only is the relationship between liquidity and yields or prices asymmetrical, but in this particular case, the scale of the negative shock was far greater than the scale of any other shift in lending standards.  The relationship between credit standards and home prices from 2006-2010 will dominate any statistical analysis here.

So, given my priors, what I would like to see from an analysis like this is the relationship for the period up to 2005 or 2006 and the relationship for the period after 2006 or 2007.

Here is a table of results from the slides.  They run regressions from 1991-2017, 2005-2013, and 2007-2017.  Elsewhere, they use 2000-2010.  This is unsatisfying.  There is a clear trend break to a negative shock that starts in 2006.  There is no analysis of the relationship during the boom that doesn't include that period.  For someone who looks at this with the standard presumption that the boom and bust are necessarily related, this might seem like more evidence that a bubble was largely due to loose credit.  I would like to see the regression from 1991-2005.

Here is a chart comparing the one year change in real home prices to the trend in credit standards.  The asymmetrical relationship is clear here.  I have not precisely replicated the regressions shown in the slide.  I have simply done regressions of the two measures shown in my chart.  For the periods analyzed in the slide, I find similar, strong correlations as the authors do over the periods they use.  For the period from 1991-2005, I find no correlation.

When I see the paper, I will update regarding whether this is addressed there.  In the meantime, this seems like another paper that found that collapsing credit markets were highly correlated with the housing bust and concluded that loose credit caused the boom...which is a shame, because the conclusion that does clearly follow from this data - that a negative credit shock led to a housing bust and a financial crisis - is the conclusion that should be motivating current public policy and retrospectives about the crisis.


  1. Interesting to note the decline in home prices began well before the tightening of credit standards.

    1. Yes. I think it is reasonable to say that, first, there was a flight to safety out of home equity and the decline in lending was only triggered when that flight became strong enough to push sentiment on valuations to negative expectations, after which, lenders didn't want to make loans without some cushion, and existing loans lost value based on expectations of future price declines.


    Kotlikoff gets half of it right. He still does not address housing supply, but I guess that's too much to ask for.

  3. I like your thoughts here. I'd add that if 2006 was a bubble, then prices today shouldn't be where they are. And why aren't all the people who called 2004 to 2006 (or even started in 2002) a bubble, why aren't they calling today a bubble?