Housing, the Great Recession and Myth-Making
In a recent story, Matt Yglesias takes issue with the “myth-making” idea that the recession was essentially the same thing as the housing collapse. He says:
“But the chart also shows us that contrary to a lot of myth-making, the recession is not identical to the downturn in housing. Residential construction peaked way back in 2006, but for about two years the declines in housing were offset by increased imports. That’s a window into a happier alternative history of the housing boom in which the same process just continued. The construction industry collapses and workers shift out of homebuilding into import-competing and exporting occupations. Living standards sort of stagnate awhile because growing net exports means “making more stuff without consuming more stuff” but there’s no mass unemployment. After several years of growth in net exports, households and firms have deleveraged a fair amount and we can go back to building houses. But instead, that happy saga was interrupted by the great crash of 2008, which pulled business investment and exports down with it.”
There were a lot of moving parts in the 2006-2008 period (for instance, the trade weighted USD rallied 35%+ in these two years!), but none was more destructive than the persistent decline in home prices. As you can see below, home prices didn’t even start to accelerate to the downside until 2007. THIS was the tipping point. Actually, “tipping point” is the wrong terminology because this downturn was a process. Just like the boom was a process, so was the bust. It was not an event despite having the appearance of being one. Anyone who was paying attention, for instance, to corporate earnings in various sectors during the 2006-2008 period can vividly remember the dominoes falling. First housing, then commercial, then financials, then consumer discretionary, etc. The balance sheet deterioration was not an event. It was a process that slowly filtered through the economy like a horrible virus. And as the consumer’s largest asset and the most economically important component of the debt markets began to decline in value balance sheets all over the place were impacted. And as the snowball picked up momentum the damage increased. The fact that it fell off a cliff in 2008 doesn’t mean it wasn’t rolling for years before that….
Update - I’ve updated the post with a chart below showing private residential fixed investment and the Case Shiller home price index. They actually peaked within months of one another so the implication that PRFI and home prices were substantially disjointed is just flat out wrong….The home price decline was occurring in unison, but didn’t pick up real momentum until later in 2007. This then filtered through the financial system with insolvencies, defaults, personal bankruptcies and foreclosures all slowly gaining momentum. This all culminated in what appeared like a banking collapse as the customers of banks slowly became insolvent (or less solvent than previously presumed) which further rippled through the asset backed markets and imploded bank balance sheets which had been levered up on the idea that housing prices couldn’t go down. It all goes back to the housing boom and the bust….If you don’t believe me just ask anyone at any of the major banks who understands why Lehman went bankrupt and caused the biggest credit crisis in 80 years. They’ll tell you that their assets collapsed when the residential mortgage market collapsed which led directly to the credit crisis and the surge in unemployment and collapse in GDP.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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19 Comments
This guy makes the same mistake. They’re focusing on the wrong thing. The balance sheet recession was caused by deterioration in balance sheets as a direct result of the debt bubble and the decline in housing prices. That didn’t start until 2007 as you noted and when it gained momentum it caused all hell to break loose. The only people who didn’t understand how the dominoes fell were the one’s not working in finance because they couldn’t see the slow deterioration that was caused by the housing price decline.
http://esoltas.blogspot.com/2012/08/the-recession-and-its-causes.html
It’s data mining anyhow. Have a look at fixed res investment compared to housing prices. They peaked within months of one another….The real deterioration in the economy didn’t show up until the implosion in home prices filtered through the financial system. Culminating with the collapse in asset backed securities which cause the banks to blow-up….I don’t even know why how this is controversial really….The whole thing was triggered by the real estate market. To claim otherwise is crazy. Talk to anyone who worked at Lehman or Bear in 2007 and they’ll tell you exactly what caused it. I know because in large part I am just regurgitating what people inside those firms told me….
Chart shows RE investment turning south before home prices. Did they have a crystal ball?
The market monetarists keep singing this tune because they can’t admit that the Fed couldn’t have stopped the decline by targeting NGDP. But not only do they not understand the boom, but they have no idea how modern banking works and how debt destroys balance sheet stability.
Delong chimes in. http://delong.typepad.com/sdj/2012/08/teaching-the-macro-history-of-2005-2012-long-run-and-short-run.html
Nice post. I’ve made a similar point many times.
http://www.jseydl.com/scott-sumner-wants-the-fed-to-maintain-bubble-inflated-home-prices/
I don’t even know why this needs to be explained to people. Confirmation biases maybe?
I thought the bankers caused it!
The financial crisis was caused by banks and large financial institutions leveraging their assets against the price of real estate. When real estate values went down, those banks and financial institutions took huge losses, which cut off the flow of lending.
The banks want to deflect blame away from their actions.
The most hilarious thing is when pundits blame the guy whose house was foreclosed for causing the crash.
Homeowners were to blame in part. They took on mortgages they couldn’t afford….It’s equally hilarious when people just blame bankers as if the bankers went out and forced everyone to buy homes….
Cullen, you know many home buyers were gulled by greedy RE Agents and Bankers giving mortgages to people they would never have dealt with in the days before they could sell the mortgages and avoid responsibility. Remember 25% down payments? A basic mistake of naive buyers was not engaging a lawyer in the process.
Then that’s the homeowner’s mistake. RE brokers and bankers don’t forecast prices for you. They sell you a product at the best price they can find on the market. They don’t make you sign the dotted line, they don’t have a crystal ball, they don’t analyze jack for you. They are sales people. If you didn’t know this buying a home then that’s your fault. It’s not the banks fault that people bought homes they couldn’t afford and then lost money on it. Yes, there was fraud and I am aware that I am generalizing to some degree, but we’re really letting homeowners off the hook here without placing any of the blame on them as well. It wasn’t all fraud and it wasn’t all just bankers running around taking advantage of people.
There is clearly a whole lot of blame to go around (greedy/ignorant home owners, banks, investors, regulators, politicians, ect.) and focusing on any on particular group is incredibly counterproductive. However we have given the financial industry the ability to create. It doesn’t seem too unreasonable to ask the lenders to do their due diligence when making loans, instead of making as many loans as they could to sell for repackaging purposes. It seems that if the lenders had done their job then some of these greedy and irrational borrowers would’ve been turned away at the door with their no income, no job, and no assets application. But that didn’t happen because there was a mismatch between risk (long term) and reward (short term).
I realize these are broad brush strokes and it wasn’t all bad but there was enough bad to cause a near financial collapse.
That was certainly a part of it, but there were also plenty of new real estate “investors” and people who money out of their home b/c “housing always goes up.”. There was an appetite for high yield and subprime – Wall Street was demanding it, and sketchy companies like Ameriquest were happy to push the ethical boundaries to satisfy that demand.
I’m a Realtor and can tell you I never sought out potential buyers – they sought me out. If anything I wanted to represent Sellers because it was so damn easy to sell a home as there seemed to be 10 to 50 qualified buyers per home. Buyer’s wanted in and showed me their lender qualification letters.
On the other hand, I was approached by mortgage brokers – literally on the street at times when they saw me picking up my open house signs – explaining they could get anyone I knew a loan, no matter who else turned them down, and that they would pay me a referral fee. In CA those referral fees are illegal, so I knew immediately they were unscrupulous.
So who is at fault? In essence the guy who approached me on the street was a drug dealer with a lot of product to sell. Of course he’s at fault… but without drugs available he wouldn’t exist.
The person taking the drugs – homeowners, were just gullible non-experts who were told it was healthy for them – and they were told this by the media, their politicians, their accountants, their friends, their family. Are they to blame – sure, but again, if there were no drugs, how could they have participated???
So the fault is in all the many areas that allowed free, no money down, interest only, etc loans (drugs) to be created and brought into the market. And the shame is all of this is that they got bailed out – and homeowners are still being blamed and the only bailouts they get are the kinds that ruin their credit and destroy them financially. Good times
In the same vein, Mr. Sumner commented: “One of our most famous claims is that tight money caused the recession, not a collapsing housing market. I’ve often pointed to the fact that the unemployment rate showed almost no change during the great 27 month housing crash of January 2006 to April 2008. “
I sympathize with his interpretation, but it is nothing more than that. One could also argue:
(a) Ponzi schemes always eventually collapse from tight money; you could say the natural rate of interest rises as the doubt rises.
(b) other economic indicators, e.g. trannies, risk private credit were all pointing to a slowdown by early 2007. I remember being 0% equity by spring 2007, so it is very fresh in my memory.
(c) sector rotation is very common during bubbles, similar to your comment on imports, before the s* hits the fan. Remember the tech bubble (browser stocks, then portal stocks, then pet stores, then …). Anyone that has invested in real estate sees the same pattern rotating from condos to homes in the best neighborhoods to … eventually denial reaches reality.
Employment is a classic lagging indicator. Sumner should know that and he should never use it to prove that something wasn’t “happening”. Check out every recession and you’ll notice a very clear lag (sometimes years of lag) between the beginning of a recession, the end and the cycle in employment. In fact, there aren’t many indicators that are MORE lagging than the unemployment rate….
Yes, Yglesias doesn’t fully understand the BS recession and the dynamics of credit creation. He’s been pounding the table for looser monetary policy like the Fed really has the power to pull us out of this mess. So many people were completely dependent on cash-out refis during the bubble. Their incomes could not support their mortgage payments, so if prices stopped declining they were underwater and screwed. This made it impossible for them to borrow further to finance consumption. As Cullen said it was process as falling demand and incomes in one industry filtered through to the next, and when it hit the financial sector that’s when things really went south.
Who’s fault was the dot.com NASDAQ bust? Stock Buyers?
What caused the implosion in home prices? Home Buyers?