Thread by @calculatedrisk

There have been a few posts recently about the housing bubble not being a “bubble”. This is incorrect, and this long thread (with a few detours) will explain why that view is incorrect.

First, what is a bubble? There is no formal definition, however …
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https://twitter.com/pmarca/status/1512599671629234179

In early 2005 I defined a bubble as follows:
calculatedriskblog.com/2005/04/housin…

“A bubble requires both overvaluation based on fundamentals and speculation. It is natural to focus on an asset’s fundamental value, but the real key for detecting a bubble is speculation.”
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The tulip mania in the 1600s meets my definition of a bubble, however the “bust” didn’t seriously impact the economy (although fortunes were made and lost). Most “bubbles” are irrelevant, it depends on the size and the amount of leverage.
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Since the housing bust, there have been several incorrect explanations of what happened. Some say it was the fault of the CRA, or Fannie and Freddie, or Fed policy. All are incorrect. Let’s start with someone I’ll call person zero.
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Person zero earned $40,000 a year and bought a $400,000 condo with no money down in 2004. My reaction was: How does that work?

According to Freddie, the average 30-year fixed rate in 2004 was 5.8%. But person zero obtained a loan with a 2 year “teaser” rate of 1%.
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The lender qualified person zero at the teaser rate! Principal & interest on their loan was $1,287 per month, or about 39% debt-to-income (DTI). Add in taxes, insurance, and HOA, and DTI was over 50% at the teaser rate. I asked: What happens when the teaser rate expires?

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Person zero said when the teaser expired, they'd do one of the following: 1) their income would increase, or 2) they’d refinance or 3) sell the property for a profit.

Uh, right.
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At a 5.8% interest rate, P&I would be $2,347 per month or about 70% DTI, add in taxes, insurance, HOA, maintenance, and person zero couldn’t eat, drive or do anything else. And there were far worse products (NINJA: no income, no job, no assets), Alt-A, and much more.

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All of these terrible products were private label (PLS), and not GSE (Fannie and Freddie).

There were millions of these loans that were clearly going to go bad, and any explanation of what happened has to explain why these loans were made.
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My analysis during the bubble led me to make some bold calls. Like expecting 40% price declines in some areas, and financial losses of over $1 trillion for the financial institutions. See: blogs.wsj.com/economics/2007…
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And a detour: Before you think I’ve just been a “housing perma-bear”, I correctly called the bottom in prices in early 2012. calculatedriskblog.com/2012/02/housin…
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And early last year I argued I wouldn’t call the current boom a “bubble”. calculatedriskblog.com/2021/04/is-the…
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Now some economists are saying that the housing bust didn’t cause the recession, rather the Fed’s policies led to a recession that caused a much more severe downturn in housing and led to the financial crisis.

Does this explain person zero above? No. Not even close.
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The real causes of the housing bubble were rapid changes in the mortgage lending industry, rating agencies that didn't account for those changes, combined with a lack of regulatory oversight.
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As an example, the lenders used to use the three Cs: Credit, Capacity, and Collateral. Instead of using the three Cs, the private lenders innovated and just used FICO scores, and then eventually little or nothing to underwrite the loan. There were other "innovative changes"
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The rating agencies models were based on prior lending methods, and weren't adjusted sufficiently to account for the new (non-existent) underwriting standards. This meant the private label MBS were rated too highly (junk rated AAA).
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The regulators turned a blind eye to the loose lending and excessive concentrations. I was talking with field regulators in 2005 and 2006, and they were all terrified. I was told the appointees at the top of the agencies were blocking any effort to tighten standards.
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It was apparent, by the end of 2005, that there would be a large number of distressed sales, pushing down house prices (leading to cascading price declines) and huge losses at the financial institutions.
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This housing bust caused the recession, and the subsequent financial crisis. People arguing otherwise are like those math problems that show 1 = 2 and challenge the reader to find the divide or multiply by zero.
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The good news is underwriting has been pretty solid during the current boom. I have other concerns, for example I'd be concerned about unregulated or poorly regulated areas of finance. Last time unregulated shadow banking played a key role.
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Recently I argued: Don't Compare the Current Housing Boom to the Bubble and Bust
Look instead at the 1978 to 1982 period for lessons
calculatedrisk.substack.com/p/housing-dont…
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Finally, I started a newsletter last year to discuss the current housing market, with data and analysis.
You can subscribe here (no guarantee I’ll get it right again):
calculatedrisk.substack.com
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