Good Wall Street Journal Op-ed on the Bubble’s Advent

The Wall Street Journal’s editorial page runs a must-read today on why the housing bubble has caused so much more damage than the tech bubble did earlier this decade.

It’s interesting that the two economists, Steven Gjerstad and Vernon Smith, put a ton of blame on (without explicitly mentioning) Alan Greenspan, who in the same space just three weeks ago pleaded not-guilty to bubble blowing in an unconvincing op-ed.

One of the most interesting points Gjerstad and Smith make is how the Fed was lulled into complacency by low-balled inflation numbers, which if calculated correctly would have thrown up red flags much earlier:

By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.

How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since “owners’ equivalent rent” is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.

And the Federal Reserve would have been under much more pressure to raise rates earlier than its disastrously late 2003 increases, as Gjerstad and Smith point out:

As the Federal Reserve monitored inflation in the early part of this decade, home-price increases were no longer visible in the CPI, so the lax monetary policy continued. Even after the Fed began to slowly raise the fed-funds rate in May 2004, the average rate remained low and the bubble continued to inflate for two more years.

A question that immediately raises for me, but which the piece doesn’t address: Doesn’t that mean we’re likely in deflation already (or closer than CPI says)? That same CPI measure is surely overestimating housing prices even as home values tumble nationwide.

It’s long been theorized that Greenspan, worried about deflation after the tech bust in 2000, simply caused the second bubble in real estate to goose the economy. Here are some numbers that show how that worked:

Mortgage loan originations increased an average of 56% per year for three years — from $1.05 trillion in 2000 to $3.95 trillion in 2003!

Another fascinating data point that seems to show where subprime really hit hard (emphasis mine):

The price index graphs for Los Angeles, San Francisco, San Diego and Miami show that in all of these cities, prices in the low-price tier have fallen between 50% and 57%

That’s quite a bit higher than the Case-Shiller averages of all houses in those markets: LA is “only” down 39 percent from its peak in September 2006, while San Diego is down 41 percent, while San Fran and Miami are off 43 percent each. Remember that huge number above, showing mortgage originations nearly quadrupling from 2000 to 2003? Most of these markets are still only back down to autumn 2003 prices, when the bubble was well under way.

But Gjerstad and Smith have yet more interesting stuff. Here they explain why this bust, which so far has resulted in $3 trillion in lost home value, is so much worse than the tech crash, which wiped out $10 billion in equities.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

The big bad leverage monster. Remember how the 1929 stock crash was caused in large part by investors speculating on stocks using margin (borrowing) to leverage their bets? See if this sounds familiar::

In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury.

That’s a clear, succinct explanation of the magnitude of the crisis and why it’s grievously wounded the financial system.

But the economists try to poke through that theory of the Depression’s cause, as well as Milton Friedman’s and Anna Schwartz’s famous monetary theory of the cause:

The Great Depression has been attributed to excessive speculation on Wall Street, especially between the spring of 1927 and the fall of 1929. Had the difficulties of the banking system been caused by losses on brokers’ loans for margin purchases in 1929, the results should have been felt in the banks immediately after the stock market crash. But the banking system did not show serious strains until the fall of 1930.
Bank earnings reached a record $729 million in 1929. Yet bank exposures to real estate were substantial; as the decline in real estate prices accelerated, foreclosures wiped out banks by the thousands. Had the mounting difficulties of the banks and the final collapse of the banking system in the “Bank Holiday” in March 1933 been caused by contraction of the money supply, as Milton Friedman and Anna Schwartz argued, then the massive injections of liquidity over the past 18 months should have averted the collapse of the financial market during this current crisis.

And they make a parallel between the Depression:

The events of the past 10 years have an eerie similarity to the period leading up to the Great Depression. Total mortgage debt outstanding increased from $9.35 billion in 1920 to $29.44 billion in 1929. In 1920, residential mortgage debt was 10.2% of household wealth; by 1929, it was 27.2% of household wealth.

They blame the Great Depression on a great consumer-debt washout similar to what we’re going through now.

The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we’re witnessing the second great consumer debt crash, the end of a massive consumption binge.

We have a long, hard slog ahead of us.

The problem I have with this consumer-debt theory is that they don’t mention how levered the banking system is, too. One follows the other. If the banks hadn’t been able to lever themselves so much, consumers wouldn’t be in so much debt, but it’s turned out it didn’t have the capital to make those loans.

Still, it’s a worthy piece.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.