Oct012008

Preventing the Next Housing Bubble – Part 1

Preventing the Next Housing Bubble

The pain of the deflation of a housing bubble cannot be avoided by trying to keep the bubble inflated, or by trying to deflate it slowly. The only way to avoid these problems is to prevent the bubble from inflating in the first place through some form of intervention in the mortgage market. Intervention can take the form of a market-based intervention demanded by investors and ratings agencies, and it can also come about through direct government regulation.Home Page Image

Necessary Intervention

The regulated free-market system in place at the turn of the millennium allowed the creation of the Great Housing Bubble. Some combination of market-based and regulatory reforms is necessary to prevent the same circumstances that created the bubble from creating another one; it is imperative to prevent the next bubble in order to avoid the problems from the bubble’s deflation. [iii] The kind of intervention proposed here is not a bailout plan. A substantive bailout plan to rescue homeowners would be fraught with problems and unintended consequences. In September of 2008, the banking system neared collapse due to the problems of the fallout, and a banking system bailout became necessary. This outcome argues more forcefully for an intervention to prevent future bubbles from occurring in the housing market.

Economic Problems

The foremost problem resulting from the deflation of the Great Housing Bubble was the imperilment of our banking and financial system. The Great Depression was precipitated by the collapse of margin trading and the subsequent decline of the stock market beginning in 1929; however, this decline is not what made the Great Depression so severe. The policies responding to the upheaval caused many banks to fail, and it was the failure of banks that led to the dramatic decline in business activity and asset deflation of the Great Depression. To prevent a repeat of those problems, Congress passed a number of banking reforms granting the Federal Reserve broad powers over our currency and effectively abandoned the gold standard. One of the most successful of these policies was the establishment of the Federal Deposit Insurance Corporation (FDIC) to guarantee the safety of deposits in banking institutions and prevent panic-induced, mass depositor withdrawals (aka “bank runs”) from decimating our banking system. Since the FDIC has been in effect, mass depositor withdrawals at American banks have been relatively uncommon. Just as the deflation of the stock market asset bubble of the Great Depression imperiled the banking system, the deflation of the Great Housing Bubble endangered the banking system because the bank losses were so severe that most became insolvent and many went bankrupt or were taken over by other lenders. Whenever the banking system is put in jeopardy, economic growth is curtailed, and other major economic problems develop.

Another source of economic problems caused by housing market bubbles is the immobility of workers. These problems were witnessed in the deflation of the coastal bubble during the early 1990s, and they occurred again in the deflation of the Great Housing Bubble. When people owe more on their mortgage than their house is worth, they could not move freely to accept promotions or work in other areas. In such circumstances the borrower had limited options. The borrower could have tried to rent the property, but those who bought at bubble prices paid in excess of its rental value so renting the property did not cover the costs of ownership. They were losing money each month trying to keep the house. If they tried to sell the house to avoid the monthly loss, they could not get enough money in the sale to pay off the debt. The borrower would either pay the lender the difference or accept the negative consequences of a short sale or foreclosure. Most often they chose the latter option. Since none of the options available to borrowers were very palatable, many passed on promotions or other opportunities because they were trapped in their homes. Employers also faced difficulties when house prices were much higher than local incomes. When an employer wanted to expand and hire new people, the potential new employee was repelled by the high house prices and either demanded a higher wage or refused to accept employment. Both circumstances were detrimental to the economy when an employee was trapped in their home and could not move and when an employer could not attract new employees because local house prices were very high.

Like all financial bubbles, the bubble in residential real estate caused the inefficient use of capital resources. When prices rose, it signified an increase in demand, and the supply chain went to work to deliver more supply to meet this demand and capture the profits from increased prices. When the demand was artificial, as was the case in a bubble, the market became oversupplied, and this supply was not of the type or quantity the market really needed. For instance, in the NASDAQ stock market bubble, billions of dollars of investment capital flowed into internet companies. This money went into all forms of unproductive uses which ultimately provided little or no return on the investment capital. In the Great Housing Bubble, the inflated prices prompted builders to construct many large houses known as McMansions. The economics favored this because the largest homes had the lowest cost per-square-foot to construct, and these houses obtained some of the highest revenues per-square-foot on the market. The result was entire neighborhoods of homes that were very resource wasteful. If the construction resources had been allocated based on true market need, which would have happened in the absence of price bubble distortions, fewer construction resources would have gone into each home, the ongoing cost of maintenance would have been reduced, and fewer total homes would have been built. The temporary demand of construction resources in a financial bubble also impacted human resources. There was a nationwide increase in construction employment to meet the bubble demand. When the bubble burst, many of these people were laid off causing both economic and personal turmoil.

Financial bubbles also witnessed the birth, growth and death of unsustainable financial models. The NASDAQ bubble had internet companies, and the Great Housing Bubble had subprime lending. The subprime lending model was profitable despite a 10% to 15% default rate among its customers. The industry was able to sustain this rate of default because the default losses they sustained were small as long as prices were rising. As soon as prices stopped rising, their loan default rates increased, and their default losses drove the entire industry into oblivion. [iv]

In the aftermath of the coastal housing bubble of the early 90s, the economy experienced a period of diminished consumer spending because many homeowners who bought during the bubble and did not go into foreclosure were making payments that represent a high percentage of their income. The extra money going toward their mortgage payment, the money in excess of normal debt-to-income guidelines was money the borrower did not have available to spend on other things. The diminished discretionary spending income from this population of borrowers slowed economic growth in an economy heavily dependent upon consumer spending such as the United States. [v] Many borrowers during the Great Housing Bubble became accustomed to supplementing their income through mortgage equity withdrawal. When house prices fell, mortgage equity withdrawal was curtailed. This forced many to adjust their lifestyles to live within the money provided by their wage incomes after paying the large debt-service payments. This loss of spending power was not just a difficult economic problem, it was a deeply personal problem for those who wished to spend freely.

Personal Problems

The economic problems caused by asset price bubbles often lead to personal problems in the wake of the deflating bubble. Statistics about unemployment, foreclosure and bankruptcy are impersonal. The events that result in any one of these outcomes was anything but impersonal: these things happened to real people who had very real emotional responses. Many people during the fallout of the Great Housing Bubble experienced all three. Any one of these outcomes can lead to depression, suicide, divorce and a whole host of traumatic personal problems. All of it was preventable if the bubble was not allowed to inflate in the first place.

The volatility of price action during a bubble had a profound and capricious impact on people’s financial lives. Many people became enriched by fortuitous timing. Some of these people were market savvy individuals who knew when to buy and sell in a volatile market; however, since the mindset of a successful trader was rare, and since most housing market participants were amateurs with emotional responses almost guaranteed to produce a loss, the majority of bubble participants lost a great deal of money. Some were lucky. Some people bought and sold at the right time due to life circumstances beyond their control. Those who transferred out of bubble markets for their careers and sold their houses at the peak reaped huge windfalls. Of course, for every seller who reaped a windfall, there was a buyer who faced major financial difficulties. The unequal distribution of gains and losses from bubble market volatility is not a positive feature.

Another group of people deeply impacted by bubble market volatility are those who chose not to participate. Some of these people recognized the bubble for what it was, and some could not set aside common sense to accept the fallacious beliefs of bubble mentality. This group was forced to rent during the bubble and subsequent decline. Many of these people would have preferred ownership, preferred to have the freedom to customize a property to their liking, and preferred to obtain the intangible benefits of ownership such as a feeling of community and belonging. These people had to endure the patient “waiting game” and feelings of groundlessness renting can entail.

Addressing the Cause

Before a doctor prescribes a treatment, the patient must first be evaluated and a disease must be diagnosed. Similarly, implementing a new policy in either the public sector or private sector to prevent future housing bubbles can only take place after the causes of the housing bubble are accurately identified. If the root causes are not identified correctly, policy initiatives may not have the desired effect. The Great Housing Bubble was a credit bubble, and some form of restriction of credit must be part of any policy initiative. A common criticism of past initiatives restricting credit availability to homeowners is that these initiatives tended to limit opportunities for home ownership without properly addressing problems with lending practices. [vi] The goal of any policy initiative with regards to preventing future housing bubbles is to limit or constrain irrational exuberance without impacting the smooth operation of the financial market. It is no easy task.

Before a policy can be formulated, there needs to be an open discussion of the goal of maximizing home ownership. Owning a home has become synonymous with the American Dream. Every Presidential administration has had the expansion of home ownership as one of its goals. The tax code is structured to give tax breaks to home owners to encourage home ownership. The idea of home ownership is deeply embedded in our culture.

Managing the rate of home ownership is analogous to managing the rate of economic growth. It is not the policy of our government or the Federal Reserve to maximize economic growth. Instead, the Federal Reserve balances economic growth with inflation and tries to manage economic growth to keep it on a sustainable path. This policy grew out of our painful history of economic cycles of boom and bust. It was realized that economic growth must be tempered to a sustainable level to minimize the damage of economic downturns. Similarly, the rate of home ownership should not be maximized. Home ownership will never reach 100%, and this should not be the goal of housing policy. Just as economic growth is tempered by the rate of inflation, home ownership rates are tempered by the rate of default of mortgage loan programs.

The harsh reality is that a certain percentage of the population lacks the desire, discipline or responsibility requisite to be a homeowner. There is a percentage of the population who do not want to be homeowners. Many people require mobility to pursue career opportunities or other goals. Some people like the freedom of renting and do not want the responsibilities of home ownership that go beyond monthly payments. There are some people who simply do not make housing payments consistently. This group is not capable of sustaining home ownership. There may be opportunities for policy initiatives to increase education to make this group smaller, but there will always be some people who cannot or will not do what is necessary to keep a house: make their payments. There is a percentage of the general population who should be renters.

There is a natural, sustainable level of home ownership. Home ownership rates in the United States increased markedly at the end of World War Two as the 30-year fixed-rate mortgage became the commonly accepted vehicle of home finance. In the 60 years that followed, home ownership rates stabilized between 60% and 65% through good economic times and recessions and interest rates ranging from below 6% to above 18%. Subprime lending demonstrated that increasing the home ownership rate through the widespread use of lending programs with high default rates is inherently unstable. Managing the home ownership rate is not a subject of governmental policy. Any legislative initiative to specifically limit home ownership rates would be politically unpalatable; however, either a market-based initiative or a legislative initiative that prevents the widespread use of loan programs subject to high rates of default rates would effectively manage the home ownership rate and prevent painful declines in that rate. Home ownership rates decline as homeowners become renters, a painful process known as foreclosure.

What did not cause the bubble?

There are a wide variety of ideas for preventing future housing bubbles, and all the ideas in the public forum are not discussed here. Some of the more popular are examined to demonstrate why they would not be successful. Most of the ideas that will not work are some form of direct regulation of interest rates, secondary mortgage market activities, price-to-income ratios or investment of equity capital. All regulatory initiatives carry a common problem: there is little enforcement once a bubble starts inflating. When times are good, there is immense political pressure for regulators to look the other way. When there is no apparent, immediate harm from a given practice, there is only a vague memory of a time long ago when circumstances were quite different and some restrictive law was passed. The law may seem quaint and old-fashioned or simply an obstruction to the wheels of progress. The rationalizations and justifications for ignoring laws are many, and the pressure to do so is intense when powerful lobbying interests are pressuring Congressmen who subsequently pressure government regulators.

Many believe that lower interest rates created the Great Housing Bubble, and the regulation of interest rates would prevent future bubbles. This is wrong on both counts. The lowering of interest rates did help precipitate the bubble by reducing borrowing costs and increasing home prices; however, once house prices started to rise, prices went much higher than the lower interest rates alone can account for. At most, one-third to one-half of the national price increase was due to lower interest rates, and less than 10% of the increase in coastal areas can be attributed to these lower rates. The direct regulation of mortgage interest rates would disrupt the free flow of capital in the mortgage market. If the regulated rate was too low, no money would be made available, and if the rate was too high, excess money would flow into real estate working to create another bubble. No form of mortgage interest rate regulation would prevent a future bubble because interest rates were not responsible for the Great Housing Bubble.

Much of the responsibility for the bubble can be attributed to the flow of funds into the market from hedge funds through collateralized debt obligations. There have also been calls for greater regulation of hedge funds and the secondary mortgage market. Any kind of regulation would likely restrict the flow of money to all mortgages and disrupt the secondary market. Also, regulating hedge funds themselves will prove problematic, if for no other reason, it is difficult to define exactly what a hedge fund is. Also, hedge funds are simply investment vehicles, and it is unclear exactly what they do that other investment entities do not do that causes problems resulting in financial bubbles. Much of the demonization of hedge funds is demagoguery and looking for someone to blame.  Many of the problems with the secondary markets will correct themselves as investors stop investing in products that lose money. In fact, one of the greatest challenges in the aftermath of the Great Housing Bubble is going to be getting investors back into the secondary market. One of the market-based solutions proposed herein addresses these issues. Direct legislative intervention to hedge funds and collateralized debt obligations would be more disruptive than productive.

Another proposed solution is to regulate the loan-to-income ratio of the borrower. When 30-year fixed-rate mortgages first came out, mortgage debt was limited to two and one-half times a borrower’s yearly income. It was an artificial limit that made sense when interest rates were higher and people were accustomed to putting less money toward housing payments. A legislative cap on the loan-to-income ratio would prevent future housing bubbles, if it was enforced. This would not work for the same reason lenders went away from the two-and-one-half-times-income standard years ago: it does not reflect changes in borrowing power due to changes in interest rates. This idea of regulating loan-to-income ratios is actually an evolution of the idea of regulating interest rates. If the total loan-to-income ratio is limited, very low interest rates do not cause dramatic price increases, but since low interest rates were not really the cause of the bubble, limiting the loan-to-income ratio is not addressing the real cause of the bubble. Plus, there are ways to get around a cap on home loan borrowing by obtaining other loans not secured by real estate. It would be relatively easy for a borrower to obtain bridge financing to acquire a property and then obtain a HELOC to pay off the bridge financing. In the end, the borrower would have borrowed more than the cap amount thus rendering any cap meaningless. To close the various loopholes, more regulations would be required, and a regulatory nightmare would ensue.  A better and more effective method of limiting borrowing is to regulate the debt-to-income ratio. This idea is explored in the next section.

What did cause the bubble?

The Great Housing Bubble was caused by an expansion of credit that enabled irrational exuberance and wild speculation. The expansion of credit came in the form of relaxed loan underwriting terms including high debt-to-income ratios, lower FICO scores, high combined-loan-to-value lending including 100% financing, and loan terms permitting negative amortization. Addressing the conditions of expanding credit is a legitimate focus for intervention in the credit markets. Another major lending problem is unrelated to the terms: low documentation standards. The credit crunch that gripped the markets in late 2007 was exacerbated by the rampant fraud and misrepresentation in the loan documents underwriting the loans packaged and sold in the secondary mortgage market. It is essential to an evaluation of the viability of a mortgage note to know if the borrower actually has the income necessary to make the payments. When investors lost confidence in the underlying documents, the whole system seized up, and it was not going to work properly until the documentation improved to reflect the reality of the borrower’s financial situation. Any remedy for the housing bubble must address the issue of poor documentation in order to facilitate the smooth operation of the secondary market.

There are some factors that created the Great Housing Bubble that cannot be directly regulated. One of these is the lax enforcement of existing regulations as described previously. Even though lenders and investors lost a great deal of money during the price crash, their behavior during the bubble was still predatory. Lenders peddled unstable loan programs to borrowers who could not afford the payments. They did not do this to obtain the property as is ordinarily the case with predatory lending; they did it to obtain a fee through loan origination. Since they felt insulated from the losses to these loans being packaged and sold to investors, they were in a position to profit at the expense of borrowers–the definition of predatory lending. Another factor that cannot be regulated is the crazy behavior of borrowers caught up in a speculative mania. It is not possible to stop people from overpaying for real estate, but it is possible from preventing them from doing so with borrowed money. If people wish to risk their own equity in property speculation, it is their money to lose, but when lender money is part of the equation, the entire financial system can be put at risk, which it was during the Great Housing Bubble. The fickle nature of borrowers became apparent during the decline of the bubble when many borrowers behaved in a predatory manner refusing to make payments on loans they could have afforded to make because the property had declined in value. Borrowers who were grateful to receive 100% financing and what was perceived at the time to be favorable loan terms were not hesitant to betray the lenders when their speculative investment did not go as planned.

The 30-year fixed-rate conventionally-amortizing mortgage with a reasonable downpayment is the only loan program proven to provide stability in the housing market. Many of the “affordability” products used during the Great Housing Bubble and many of the deviations from traditional underwriting standards created the bubble. Mortgage debt-to-income ratios greater than 28% and total indebtedness greater than 36% have a proven history of default. Despite this fact, debt-to-income ratios greater than 50% were common in the most extreme bubble markets. [vii] Limiting debt-to-income ratios is critical to stopping loan defaults and foreclosures. Lower FICO scores was the hallmark of subprime lending. FICO scores provide a fairly accurate profile of a borrower’s willingness and ability to pay their debts as planned. Low FICO scores are synonymous with high default rates. Limiting availability of credit to those with low FICO scores was a historic barrier to home ownership because these people default too much. The free market solved this problem. Subprime was dead. High combined-loan-to-value (CLTV) lending including 100% financing is also prone to high default rates. In fact, it is more important than FICO score. FICO scores are very good at predicting who will default when downpayments are large, but when borrowers have very little of their own money in the transactions, both prime and subprime borrowers defaulted at high rates. Many prime borrowers are more sophisticated financially, and the unscrupulous recognized 100% financing as a perfect tool for speculating in the real estate market and passing the risk off to a lender. The primary culprits that inflated the housing bubble were the negative amortization loan and interest-only loans where lenders qualified buyers on their ability to make only the initial payment. As the Great Housing Bubble began to deflate, Minnesota and some other states passed laws restricting the use of negative amortization loans and required lenders to qualify borrowers based on their ability to make a fully amortized payment. The Minnesota law is a good template for the rest of the nation.

Any proposal to prevent bubbles from reoccurring in the residential real estate market must properly identify the cause, provide a solution that is enforceable, and allow for the unhindered working of the secondary mortgage market. The solutions outlined below are both market-based, meaning it does not require government regulation, and regulatory based, meaning it entails some form of civil or criminal penalties to prevent certain forms of behavior leading to market bubbles. All changes are difficult to implement and the solutions presented here would be no exception. Any policies which prevent future bubbles will be opposed by those who profit from these activities and homeowners who are in need of the next bubble to get out of the bad deals they entered during the Great Housing Bubble. Despite these difficulties, it is imperative that reform take place, or the country may experience another housing bubble with all the pain and financial hardship it entails.

Market Solutions

The secondary mortgage market was created in the 1970s by the government sponsored entities, Freddie Mac, Fannie Mae, and Ginnie Mae. This market was expanded by the creation of asset-backed securities where mortgage loans are packed together into collateralized debt obligations (CDOs). This flow of capital into the mortgage market is a necessary and efficient tool for delivering money to borrowers for home mortgages. This market must remain viable for the continued health of residential real estate markets. The problem during the Great Housing Bubble was that the buyers of CDOs did not properly evaluate the risk of loss through default on the underlying mortgage notes that were pooled. The reason these risks were not evaluated properly is due to the appraisal methods used to value real estate serving as collateral backing up these loans.

There is one potential market-based solution that would require no government regulation or intervention that would prevent future bubbles from being created with borrowed capital: change the method of appraisal for residential real estate from valuations based exclusively on the comparative-sales approach to a valuation derived from the lesser of the income approach and the comparative-sales approach. Both approaches are already part of a standard appraisal, so little additional work is necessary–other than appraisers will have to focus on doing the income approach properly. In the current lending system, the income approach is widely ignored. This change of emphasis in valuation methods could come from the investors in CDOs themselves. When the fallout from the Great Housing Bubble is evaluated, it is clear that the comparative-sales approach simply enables irrational exuberance because the past foolish behavior of buyers becomes the basis for future valuations allowing other buyers to continue bidding up prices with lender and investor money. Prices collapsed in the Great Housing Bubble because prices became greatly detached from their fundamental valuation of income and rent. This occurred because the comparative-sales approach enables prices to rise based on the irrational exuberance of buyers. If lenders would have limited their lending based on the income approach, and if they would not have loaned money beyond what the rental cashflow from the property could have produced, any price bubble would have to have been built with buyer equity, and lender and investor funds would not have been put at risk. There is no way to prevent future bubbles, and the commensurate imperilment of our financial system, as long as the comparative-sales approach is the exclusive basis of appraisals for residential real estate.

Investor confidence in the market for CDOs and all mortgages was shaken during the decline of the Great Housing Bubble–and rightly so. Investors were losing huge sums, and nobody clearly understood why. There was a widespread belief these losses were caused by some outside factor rather than a systemic problem enabled by the lenders and investors themselves. [viii] For investor confidence to return to this market, investors must first ascertain a more accurate evaluation of potential losses due to mortgage default. This requires an accurate appraisal of the fundamental value of the residential real estate serving as collateral for the mortgage loans that comprise the CDOs. Since the fundamental value of residential real estate, the value to which prices ultimately fall during a price decline, is determined by the potential for rental income from the property, revaluing properties using the income approach would provide a more accurate measure of the value of the mortgage note and thereby the CDO.

The ratings agencies who rate the various tranches of CDOs must adopt the method of valuation utilizing the lesser value of the income approach and the comparative-sales approach. The ratings agency’s recommendations and ratings carry significant weight with investors, and the ratings agencies clearly made a tragic error in their ratings of CDOs during the Great Housing Bubble. If the ratings agencies properly evaluate the underlying collateral backing up the mortgages that are pooled together in a CDO, investors will regain confidence in the ratings, and money will return to the secondary market. If investors in CDOs recognize the chain of valuation as described, they would be unwilling to purchase CDOs valued by other methods. If investors are unwilling to purchase CDOs where the underlying collateral value is measured using the comparative-sales approach and instead demand a valuation based on the income approach, the syndicators of CDOs will be forced to respond to investor demands or they will not be able to sell their syndications. Investors and the ratings agencies can mandate a new valuation method for residential home mortgages.

In September of 2008, the Federal Government took “conservatorship” of the GSEs responsible for maintaining the secondary mortgage market. With the collapse of the asset-backed securities markets and CDOs, the GSE swaps were the only viable market for mortgage paper. This provides a unique opportunity for changing the market dynamics with limited government intervention. If the government in its role as conservator were to decide to mandate a change in appraisal methods, the secondary market would be forced to accept this change. Like any sweeping change in methodology, it could be phased in over time to properly train appraisers and work out the details of implementation. If the GSEs lead, the rest of the market will follow.

The main objection with the income approach is the difficulty of evaluating market rents, particularly in markets where there may not be many (or any) comparative properties for rent in the market. This is an old problem, one that has been studied in great detail by the Department of Labor Bureau of Labor Statistics. [ix] Comparative rents have been collected by the DOL since the early 1980s as part of their calculation of the Consumer Price Index. The problem of irrational exuberance in the late 1970s in coastal markets, particularly California, caused the consumer price index to rise rapidly. Since the CPI is widely used as an index for cost-of-living adjustments, volatility in this measure caused by the resale housing market needed to be urgently addressed. After over a decade of study, the DOL decided to value the change in housing costs by a comparative rental approach rather than a change in sales price approach used previously. This smoothed the index and reduced volatility because the consumptive aspect of housing services were tethered to rents and incomes rather than being subject to the volatility caused by irrational exuberance in the housing market.

The Department of Labor Bureau of Labor Statistics measures the market rental rate in markets across the United States. It breaks down the market into subcategories based on the number of bedrooms, and it does a good job of estimating market rents in the various subcategories. These numbers are updated each year. The figures from the DOL would serve as a basis for evaluation of market rents, and it may be the only basis in areas where there are few rentals. In submarkets where there is sufficient rental activity, the income approach can use real comparables to make a more accurate evaluation. Appraisers will decry the lack of available data on rentals as many rentals, particularly for single-family detached homes are done by private landlords who do not report these transactions; however, if this method of appraisal were the standard, private companies would spring up to track these transactions and maintain an up-to-date database. Valuing properties based on the income approach may be more difficult than the comparative-sales approach, but when the latter method is fundamentally flawed, ease-of-use is not a compelling reason to continue to rely on it.

There is also the objection that the income approach method of valuing residential real estate has the same problems as the comparative-sales approach because both approaches rely on finding similar properties and making an estimation of market value by adjusting the values of comparative properties. In both approaches the appraiser must explain their reasons for the adjustments to justify the appraised value of the subject property, and this is a potential source of abuse of the system. No system is perfect, but the potential to inflate prices though manipulating appraisals based on the income approach is far less than the potential problems emanating from the comparative-sales approach because the basis of adjustment in the income approach is a property’s fundamental value whereas the basis of adjustment in the comparative-sales approach is the prices paid by buyers subject to bouts with irrational exuberance. If lenders start accepting appraisals where the income approach contains adjustments to value that increase the appraised amount 100%–something that would have been required to justify pricing seen during the Great Housing bubble–then the system is hopelessly broken. The main argument for using the income approach is that its basis is the fundamental value whereas the basis for the comparative-sales approach is whatever price the market will currently bear. Prices are not likely to decline below a properties fundamental value where as a property may decline significantly from a point-in-time estimate of market value. Using the income approach lessens the risk to lenders and investors and ensures the smooth operation of the secondary mortgage market. Using the comparative-sales approach exclusively results in the turmoil witnessed during the price decline of the Great Housing Bubble.


Japan endured 15 years of slow deflation from the combined stock market and real estate bubbles of the late 1980s. The 1990s are known in Japan as “the lost decade” due to the problems from the slow deflation of their asset bubble.

In July of 2008, the Fed made changes to Reg Z which would have been helpful in reducing the size of the housing bubble, the amount of fraud during the bubble, and the resulting pain of the bust.  Unfortunately, they were at least five years too late. The changes to Reg Z were: The rule, for “higher-priced loans: 1. Prohibits a lender from making a loan without regard to borrowers’ ability to repay the loan from income and assets other than the home’s value.  A lender complies, in part, by assessing repayment ability based on the highest scheduled payment in the first seven years of the loan. To show that a lender violated this prohibition, a borrower does not need to demonstrate that it is part of a “pattern or practice. 2. Prohibits a lender from relying on income or assets that it does not verify to determine repayment ability. 3. Bans any prepayment penalty if the payment can change during the initial four years.  For other higher-priced loans, a prepayment penalty period cannot last for more than two years. 4.Requires that the lender establish an escrow account for the payment of property taxes and homeowners’ insurance for first-lien loans.  The lender may offer the borrower the opportunity to cancel the escrow account after one year. The rule, for all closed-end mortgages secured by a consumer’s principal dwelling: 1. Prohibits certain servicing practices:  failing to credit a payment to a consumer’s account as of the date the payment is received, failing to provide a payoff statement within a reasonable period of time, and “pyramiding” late fees. 2. Prohibits a creditor or broker from coercing or encouraging an appraiser to misrepresent the value of a home. 3. Creditors must provide a good faith estimate of the loan costs, including a schedule of payments, within three days after a consumer applies for any mortgage loan secured by a consumer’s principal dwelling, such as a home improvement loan or a loan to refinance an existing loan. The rule, for all mortgages: Requires advertising to contain additional information about rates, monthly payments, and other loan features.  The rule also bans seven deceptive or misleading advertising practices, including representing that a rate or payment is “fixed” when it can change. “

[iii] In their paper Predicting Bubbles and Bubble Substitutes (Thompson, Treussard, & Hickson, 2004), the authors contend that certain kinds of bubble intentionally created by government authorities can have positive long-term effects.

[iv] The subprime mortgage industry may mount a comeback in the aftermath of the Great Housing Bubble. The original business plan was to take borrowers who had good incomes and savings to put toward a downpayment, but they had low FICO scores which prevented them from getting a Prime loan. These borrowers used subprime as bridge financing until their FICO scores improved and they could refinance into Prime loans. The subprime business plan relied on capacity (income) and collateral (downpayment) to make up for the lack of good credit. Those who go through foreclosure in the bubble will end up with bad credit, but they may have good income and savings. They will be an underserved borrower class that will likely prompt resurgence in subprime lending. The problem with subprime was not that the borrowers had poor credit scores; it was that lenders ignored capacity and collateral on the loans. This is why Alt-A and Prime loans also performed poorly when prices deflated. Subprime will likely resurface, whereas Alt-A is permanently defunct.

[v] Much of California’s lingering economic troubles of the early 90s can be linked to diminished consumer spending due to excessive mortgage obligations. Many people inaccurately point to job losses in the aerospace industry as the cause of California’s economic weakness, but this sector was small, and the contraction only lasted a couple of years, whereas the economic slump persisted almost 6 years.

[vi] This is the primary argument against any kind of legislative reform (Wallace, Elliehausen, & Staten, 2005).

[vii] When credit first began to tighten in 2007, the government sponsored entities who insure mortgage loans for sale in the secondary market issued a series of guidelines on the loans they would insure. In the first version, debt-to-income ratios were limited to 50%. In a subsequent revision in late 2007, the debt-to-income ratio was limited to 45%. The tightening of credit was slow enough to keep some transactions occurring in the market, but fast enough to stop underwriters from originating bad loans. As of the time of this writing it is anticipated that the ratio will continue to fall.

[viii] In his groundbreaking work The Black Swan: The Impact of the Highly Improbable (Taleb, 2007), the author describes how unpredictable and dramatic events shape our history.

[ix] There is a great synopsis of the history and calculation of the rental components of the consumer price index contained in the report Treatment of Owner-Occupied Housing in the CPI (Poole, Ptacek, & Verbrugge, 2005).