Lessons from the Housing Bubble

Does the Federal Reserve bear the blame for the housing bubble? Critics say yes, arguing that the Fed kept interest rates too low for too long, while Fed board members—past and present—are taking their defense to the public. In the aftermath of the great financial crisis of 2008 and 2009, largely triggered by the bursting of the housing bubble, and in the midst of the debate about what form future regulatory oversight should take—the question isn’t merely academic.

In my view, the Fed wasn’t the main actor, but it certainly played a key role. No single performer dominated the stage, though home buyers in general played the main protagonist by adopting an increasingly speculative attitude about price appreciation. In 2001, when home sales posted an all-time record high, fewer than 6% of consumers said it was because housing presented a “good investment.” By 2005, the fifth consecutive year of record sales, that figure had risen to 11% —more than at any time except the late 1970s, when real estate and other tangible assets were considered a hedge against rampaging inflation.

Investors desperate for yield costarred in the drama. When the 10-year Treasury note hit a 40-year low yield of 4% in 2003, investors everywhere saw value in the exotic mortgage backed securities that could double, or triple, that return. Between home buyers and investors were a host of supporting actors. Banks and other lenders played their part, originating the loans. Broker-dealers securitized them for the secondary market. Credit agencies adjudicated the loans’ worth. And still others—notably Congress and the government supported enterprises of Fannie Mae and Freddie Mac—advanced the plot by advocating the virtue of homeownership.

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So, where does the Fed fit in? In 2003, as the U.S. economy struggled to get its footing after the recession of 2001, the Fed lowered its bellwether federal funds rate to a 50-year low of 1%, where it remained for a year. By 2005, this key interest rate still averaged just 3.2%, lower than inflation at the time. Stanford economist John Taylor, whose eponymous monetary policy rule provides a guideline for determining the federal funds rate, argues that this excessively easy policy inflated the bubble and contributed to the subsequent crisis.

According to the Taylor Rule, the federal funds rate should be determined by two things: inflation and economic slack. High inflation should be matched with a high federal funds rate, and economic slack (e.g. unemployment) should be matched with a low federal funds rate. In a perfect world, following this rule leads to the central banker’s nirvana—stable prices and full employment. But that’s not what the Fed did, says Taylor. Plugging the historical data into the simple formula yields a federal funds rate about two points higher than it actually was from 2002 to 2006—precisely when the housing bubble inflated.

What the Fed has to say

For its part, the Fed offers a two-part defense. Part one, recently proffered by Chairman Bernanke, argues that the formula needs a tweaking: The Fed must always be forward looking, so instead of actual inflation, the Fed should focus on future inflation, as best it can predict. Under this alternative approach, the federal funds rate wasn’t all that low, Bernanke points out. Instead of being two points below what was implied by the conventional Taylor Rule, the federal funds rate was probably less than a point below the modified prescription (though it was still below). More important: The Fed’s inflation forecasts during that time proved to be lower than subsequent reality. In effect, Bernanke is saying: We didn’t get interest rates wrong, we just screwed up the inflation forecast on which interest rates were based.

Part two of the Fed’s defense, recently outlined by ex-Chairman Greenspan, argues that it was long-term interest rates, over which the Fed had little control, which ultimately mattered for the housing market. Even when the Fed eventually lifted the federal funds rate in 2004 and 2005, he asserts, a tsunami of foreign capital flooded the U.S. bond market and prevented long-term interest rates from rising as much as they ordinarily would have.

But here the maestro falls short. First, short-term interest rates do matter for the housing market, arguably never more so than at that time. As house prices became increasingly unaffordable, buyers attempted to offset higher prices with lower interest rates provided by adjustable rate mortgages (ARMs) that are closely tied to the federal funds rate. According to Fannie Mae, ARMs accounted for one-third of its originations in 2004-2005, in contrast with 6% now. And the one-third figure surely understates the overall housing market reliance on ARMs at that time because the Fannie Mae data exclude the burgeoning subprime market, which was then almost entirely ARM based.

Second, it’s an exaggeration to dismiss the Fed’s influence over long-term interest rates. In fact, in 2003, the Fed deliberately used the phrase “considerable period” to describe the likely duration of its low interest rate policy in order to restrain an increase in longer term interest rates. Today, it’s using the phrase “extended period” for precisely the same reason. Had it chosen to do so, the Fed could have used less comforting words , citing an “impending increase,” for example, to spur the opposite reaction in long-term interest rates.

Even if the Fed can’t influence the bond market, it can offset it to some extent. After all, the Fed has less influence over stocks than bonds, but it nonetheless raised the federal funds rate in the late 1990s, in part, to offset the effects of the stock market boom.

Much as Chairman Bernanke and his predecessor at the Federal Reserve might want to escape the pointing fingers, the fact is, the Fed does bear some responsibility for the housing bubble and the impact of its subsequent implosion. But as for the question of whether some other regulatory body could have done a better job, that’s much less clear. Congress is now pondering the development of a new oversight council, with what Senate Banking Committee Chairman Christopher Dodd describes as “a highly sophisticated staff of economists, accountants, lawyers, former supervisors and other specialists to support the council’s work.”

But even if such a council had been up and running for the past decade, would things have turned out differently? The folks at the Fed are no dummies. They simply erred. And the notion that we can fill another room with infallible public servants is nice but not realistic.