Download Mitchel Gorecki Urban Economics The Perfect Storm The

Mitchel Gorecki
Urban Economics
The Perfect Storm
The advancement of knowledge is a double-edged blade that has been able to both provide
society with immense benefits, while at the same time slice out the general foundation of thought
from which these benefits were spawn. Many times the truth is lost or forgotten for a greater
assumption just because it is accepted throughout a community. Time and time again, popular
mediocracy distorts our perception, controlling the ideas that become the ‘truth’. The purpose of
this survey is to use three works written in 1988, 2002 and 2008 to analyze how, in context of the
housing market, the social and economic pitfalls of each era led to the major crash in 2007. The
ultimate goal is to provide a probable cause as to why no one was able to identify or correct the
financial crisis before it occurred. The results of this survey show that rather than a single cause, the
depression was the result of a trifecta of social and economic issues that each contributed to create
the perfect storm that would catch society with its pants down.
The first paper by Mankiw (1998) uses data from US censuses between 1960-1988 in an
attempt to identify a relationship between changes in the major demographic and the US housing
market. He hypothesizes that given historical relations, real housing prices will substantially fall over
the next two decades. The rational was that demographic changes impact demand for housing,
which alter residential investment and pricing. Mankiw was able to find a corollary R value of .86,
meaning he had successfully identified a relationship between fluctuations in demand for housing
and the birth rates. With this, he devised a model to predict changes in the housing market. The link
between age and housing was such that individuals in their mid twenties experienced the greatest
demand for housing, which decreased by 1% every year past age 40. Those under 20 exhibited
essentially zero demand for housing. With the understanding that supply and demand are needed to
reach an equilibrium, Mankiw tried to show that large swings in the average age of Americans would
have a substantial impact on the housing market. What he found was that for every 1% increase in
housing demand, there was a 5.3% increase in the real price of housing, the converse also being true.
The data showed that in 1980, 44.6 million Americans, or 19.7%, had reached the age range of 2030. This was also the same year the housing industry reached its peak. The real value of housing had
incrased almost 50% over this decade. This was attributable to the increase in worker productivity
and 22% increase in disposable income. Since the price elasticity of housing demanded is less than
one, an increase in the price of housing resulted in a corresponding increase in value.
This proved to be the fatal element in Mankiw’s findings. With 93.2% confidence, the data
concluded that by 2007, the housing market would see a 47% devaluation of homes. This was highly
problematic simply because each aspect of the economy is tied to the next. The stock of houses
depends on past investments, which depends on the current housing prices, which depends on
expectations of rents and market performance, which depends on the stock of houses. If at any
point in the chain the system fails, the whole market experiences turbulence. He was plainly quoted,
“even if the housing prices fall only one-half what our equation predicts, it will likely be one of the
major economic events of the next two decades” (14). Despite this, he attributes the major problem
to the “naïve” characteristics of those in the market. At the time, Americans believed that the
current housing prices would always be expected to remain at least that high. The problem is that
the housing market cannot be seen as an efficient market in which prices fully reflect the available
information. Thus, by 1988, Americans had been overinvesting in residential capital. As such,
Mankiw concludes that the predicted large and sudden drop in housing prices and residential
investment would result in huge macroeconomic instability, all due to the naïve outlook of
Americans. This only surmounted since falling housing prices would induced increased savings as
individuals watched their retirement plans go down the drain. Regardless, not until much later were
warnings of future economic downturn addressed. This takes us to the next paper covered in this
survey.
Elliehausen and Staten (2002) analyzed the implementation of restrictions in North Carolina
lending laws and the negative impacts on the flow of money through the economy. In the 1990s
there was a lot of development of the subprime mortgage market, expanding mortgage credit to lowincome and high-risk consumers. This provided access to home ownership as well as the ability to
borrow against home equity. Despite these benefits, many individuals chose to abuse the system
with high fees, repeated refinancing, and equity stripping, all of which resulted in foreclosures. This
rapidly became known as ‘predatory lending’. In response, the federal Home Ownership and Equity
Protection Act (HOEPA) was passed in 1994, which limited many contractual features. The North
Carolina legislature further pressed to impose restrictions, increasing the cost of providing loans.
The adoption of this regulatory approach took back many of the benefits of the increased mortgage
credit obtained during the 1990s. Thus, the goal of Elliehausen and Staten was to show how the
restriction on credit harmed more than it helped, escalating the current economic issues into an all
out crisis. This was done by showing that the increased restrictions imposed additional costs to
lending, ultimately decreasing the supply of loans and tanking the economy.
There were three primary aspects of the newly passed law that restricted the profits on
loaners. The first was the limit on certain contractual features that were designed to mitigate or
compensate for higher credit or prepayment risk. Secondly, the law imposed new disclosure
requirements. Lastly, it called for the expansion of lender legal and reputational liability. The analysis
to see if these aspects of the law really could cause so much economic turmoil used two economic
models as predictors; one for demand and the other for supply. The independent variables
considered were mortgage credit, time period, price, income, existing debt, house value, flawed
credit history, life-cycle characteristics and market size. These variables were chosen on part because
of the ease at which data could be acquired and that two previous studies failed to mention many of
these variables, leaving them to create confounding error in results. Elliehausen and Staten could
compare market performance by measuring the number of subprime loans granted, allowing them
to reach some conclusion regarding the impact of the new laws.
The results showed with 91% confidence that the restrictive laws had caused a 14% decrease
in lending between Q4 1999 and Q1 2000. Of this 14%, 84% pertained to subprime loans. The laws
originally intended to protect lower income families were disproportionally hurting them.
Essentially, the higher cost mortgage laws made high-risk loans unprofitable, thus reducing creditors’
lending to high-risk consumers. It was believed that the risk premium associated with subprime
loans was far too high. In the eyes of the NC legislature, the positive relationship between risk and
premium had been restored. Although, this does not necessarily mean all lending to high risk
individual ceased. Rather, those ‘predator loaners’ found ways to circumvent the laws, creating even
higher premiums for such loans. This was done by shifting higher risk loans from close to open-end
loans, something the new laws did not address. Elliehausen and Staten (2002) concluded that the
new laws only succeeded in impeding the flow of mortgage credit to higher risk borrowers and that
any reductions in predatory lending were actually shifts from close to open-loans. In context of the
previous paper, these new restrictions had set the stage for a situation of restricted lending in a
market on the path to crashing. Despite this, Elliehausen and Staten did note that the economy
might have had a chance to recover if the regulations had been sooner enacted and better enforced.
Rather than poor legislature, Coleman, LaCour-Little, and Vandell placed direct blame for the
market outcomes on the “housing bubble” associated with the mere presence of subprime
mortgages.
Coleman, LaCour-Little, and Vandell (2008) set out to show that the widespread availability
of subprime mortgages, coupled with increasing consumption levels and homeownership rates, were
the direct cause for the financial crisis of 2007. Just as Mankiw had predicted, housing prices
between 2007-2008 had fallen by 12.5%. The delinquency rate on subprime loans was 13.7%.
Following the “naïve” model, expectations of future price increases caused prices to temporarily
elevate. These expectations gave investors the perception that housing prices were unlikely to fall,
and subsequently a good investment, further causing prices to rise. Thus, a tremendous housing
bubble had formed. This speculative bubble further became an issue when it was realized that the
default on subprime loans were incredibly high, coupled with over-valuation of assets. Much like the
previous paper, Coleman, LaCour-Little, and Vandell (2008) used a supply and demand model to
generate conclusions about the data.
What they found was that subprime lending was largely responsible for the unanticipated
increase in housing prices. These increasing prices prompted other investors to exploit imbalanced
economic equilibrium, further driving up housing prices. Both of these components had equal hands
in the skyrocketing housing prices. The ultimate conclusion was that the existence of subprime loans
alone did not merit primary blame for current problems faced in the housing and mortgage markets.
Instead, political and regulatory actions as well as economic conditions were the main factors that
led to the disruption of the market.
Over time we have seen a paradigm shift regarding the reason for the financial crisis of 2007.
As far back as 1988, Mankiw used a census of birth rates, housing prices and the application of a few
economic principles to precisely identify the outcome of the market two decades prior to its
occurrence. Despite his warning, the issue of impending downfall did not strike the concern of the
typical American. Why is this so? Superfreakonomics believes it is because humans are incapable of
accurately evaluating the impact of the future given the present. For instance, if offered 10 dollars
today or 12 dollars three months from now, only an economist would accept the 12 dollars. This is
because the mindset of most Americans is stuck in the now, rather than forward thinking. This alters
the unavoidable problem of a shift in demand for housing to that of an issue with the American
psyche. Despite a two-decade early warning, the currently stable economy had us all fooled. The
general high sentiment amongst society had brought about the neglect of signs for future struggle.
This pitfall translates straight into the work done by Elliehausen and Staten (2002).
This paper recognizes the government’s attempt to slow subprime mortgages and their
effects on the uncontrolled increasing housing prices. Although, by this point in time, the laws
passed were too little too late. Rather than correcting the situation, the new legislature restricting
loaning merely decreased the supply of loans, sacking the lower-income, high-risk individuals
seeking home ownership. As a result, these people were forced to find funds elsewhere, such as
through open-ended loans, incurring additional costs to covered the risks associated with such loans.
The result was an economy in which individuals were overinvested in homes whose values were
already overinflated due to the high demand of the baby boomers. Before the new laws were even
passed, the problem had escalated to the point at which regardless as to however many warning
signs the economy chose to exhibit, the bubble was going to pop. This leads into the final paper
analyzed in this survey contributing real-time analysis of the economic shock.
Coleman, LaCour-Little, and Vandell (2008) produced a work that also followed the other
two models’ idea that the American psyche was “naïve” to the times. The expectations of home
owners and investors was that housing prices were unlikely to fall, a fallacy that could easily be
debunked through the analysis of house prices over time. Regardless, the problem only persisted. At
this late stage, it would seem impossible for someone not to have identified this major problem in
the economy. So the question remains, how is it that despite all the signs, we let this monster
problem persist to fester? The answer resides in two overbearing ideas.
The first is that from 1988 to 2008 the American people had neither the will nor mindset to
face the ensuing problems. This could be for a variety of reasons, partly because of what was then
seen as economic stability, if not growth. The second, more malicious thought is that those who
were aware of the economic situation took advantage of those who were not. In doing so, they
purposefully chose to keep the general knowledge from the public in interest of their own benefit. A
follow-up study would be to research where the wealth gets redistributed once the economy reaches
a solid equilibrium. Regardless, it is this trifecta of social and economic issues that allowed the
pitfalls of each era to surmount to a problem big enough to cause major crash in 2007. The three
papers each identified key problems that led to creation of the perfect storm that caught society with
its pants down.
References
Coleman IV, LaCour-Little M, and Vandell K. D., “Subprime Lending and the Housing Bubble: Tail
Wags Dog?” ASSA response presentation in New Orleans: April 2008.
Elliehausen, G. and Staten M. E., “Regulation of Subprime Mortgage Products: An Analysis of
North Carolina’s Predatory Lending Laws.” Kluwer Academic Publishers: Journal of Real Estate
Finance and Economics 2002, 29:4, pg 411-433.
Mankiw, Gregory N., “The Baby Boom, The Baby Bust, And The Housing Market.” Working Paper
No. 2794 1988. (unpublished manuscript)