Causes of the 2000s United States housing bubble

According to a 2018 review of existing evidence, "inflated house-price expectations across the economy played a central role in driving both the demand for and the supply of mortgage credit before the crisis". The review concluded that the crisis was not driven by reckless lending by lower classes, but rather greater mortgage lending across all income groups.

Government policies

Housing tax policy

In July 1978, Section 121 allowed for a $100,000 (~$376,365 in 2024) one-time exclusion in capital gains for sellers 55 years or older at the time of sale. In 1981, the Section 121 exclusion was increased from $100,000 to $125,000. The Tax Reform Act of 1986 eliminated the tax deduction for interest paid on credit cards. As mortgage interest remained deductible, this encouraged the use of home equity through refinancing, second mortgages, and home equity lines of credit (HELOC) by consumers.

The Taxpayer Relief Act of 1997 repealed the Section 121 exclusion and section 1034 rollover rules, and replaced them with a $500,000 married/$250,000 single exclusion of capital gains on the sale of a home, available once every two years. This made housing the only investment which escaped capital gains. These tax laws encouraged people to buy expensive, fully mortgaged homes, as well as invest in second homes and investment properties, as opposed to investing in stocks, bonds, or other assets.

Deregulation

Historically, the financial sector was heavily regulated by the Glass–Steagall Act which separated commercial and investment banks. It also set strict limits on Banks' interest rates and loans.

Starting in the 1980s, considerable deregulation took place in banking. Banks were deregulated through:

• The Depository Institutions Deregulation and Monetary Control Act of 1980 (allowing similar banks to merge and set any interest rate).
• The Garn–St. Germain Depository Institutions Act of 1982 (allowing Adjustable-rate mortgages).
• The Gramm–Leach–Bliley Act of 1999 (allowing commercial and investment banks to merge).

Federal Home Loan Bank Board allowed federal S&Ls to originate Adjustable-rate mortgages in 1979 and in 1981 the Comptroller of the Currency extended the privilege to national banks. This regulation, enacted during times when fixed-rate loans at 17% were beyond the reach of many prospective home-owners, led to a series of innovations in adjustable-rate financing that contributed the easy credit that help fuel the housing bubble.

Several authors single out the banking deregulation by the Gramm–Leach–Bliley Act as significant. Nobel Prize-winning economist Paul Krugman has called Senator Phil Gramm "the father of the financial crisis" due to his sponsorship of the act but later revised his viewpoint saying repealing Glass-Steagall is "not what caused the financial crisis, which arose instead from 'shadow banks.'" Nobel Prize-winning economist Joseph Stiglitz has also argued that GLB helped to create the crisis. An article in The Nation has made the same argument.

Economists Robert Ekelund and Mark Thornton have also criticized the Act as contributing to the Subprime mortgage crisis. They state that while "in a world regulated by a gold standard, 100% reserve banking, and no FDIC deposit insurance" the Financial Services Modernization Act would have made "perfect sense" as a legitimate act of deregulation, but under the present fiat monetary system it "amounts to corporate welfare for financial institutions and a moral hazard that will make taxpayers pay dearly." Critics have also noted de facto deregulation through a shift in mortgage securitization market share from more highly regulated Government Sponsored Enterprises to less regulated investment banks.

However, many economists, analysts and politicians reject the criticisms of the GLB legislation. Brad DeLong, a former advisor to President Clinton and economist at the University of California, Berkeley and Tyler Cowen of George Mason University have both argued that the Gramm-Leach-Bliley Act softened the impact of the crisis by allowing for mergers and acquisitions of collapsing banks as the crisis unfolded in late 2008. "Alice M. Rivlin, who served as a deputy director of the Office of Management and Budget under Bill Clinton, said that GLB was a necessary piece of legislation because the separation of investment and commercial banking 'wasn't working very well.' Even Bill Clinton stated (in 2008): 'I don't see that signing that bill had anything to do with the current crisis'".

Mandated loans

Republican Senator Marco Rubio has stated that the housing crisis was "created by reckless government policies". Republican appointee to the Financial Crisis Inquiry Commission Peter J. Wallison and coauthor Edward Pinto believed that the housing bubble and crash was due to federal mandates to promote affordable housing. These were applied through the Community Reinvestment Act and "government sponsored entities" (GSE's) "Fannie Mae" (Federal National Mortgage Association) and "Freddie Mac" (Federal Home Loan Mortgage Corporation). Journalist Daniel Indiviglio argues the two GSE's played a major role, while not denying the importance of Wall Street and others in the private sector in creating the collapse.

The Housing and Urban Development Act of 1992 established an affordable housing loan purchase mandate for Fannie Mae and Freddie Mac, and that mandate was to be regulated by HUD. Initially, the 1992 legislation required that 30 percent or more of Fannie's and Freddie's loan purchases be related to affordable housing. However, HUD was given the power to set future requirements. In 1995 HUD mandated that 40 percent of Fannie's and Freddie's loan purchases would have to support affordable housing. In 1996, HUD directed Freddie and Fannie to provide at least 42% of their mortgage financing to borrowers with income below the median in their area. This target was increased to 50% in 2000 and 52% in 2005. Under the Bush Administration HUD continued to pressure Fannie and Freddie to increase affordable housing purchases – to as high as 56 percent by the year 2008. To satisfy these mandates, Fannie and Freddie eventually announced low-income and minority loan commitments totalling $5 (~$7.13 trillion in 2024) trillion. Critics argue that, to meet these commitments, Fannie and Freddie promoted a loosening of lending standards - industry-wide.

Regarding the Community Reinvestment Act (CRA), economist Stan Liebowitz wrote in the New York Post that a strengthening of the CRA in the 1990s encouraged a loosening of lending standards throughout the banking industry. He also charged the Federal Reserve with ignoring the negative impact of the CRA. American Enterprise Institute Scholar Edward Pinto noted that, in 2008, Bank of America reported that its CRA portfolio, which constituted only 7 percent of its owned residential mortgages, was responsible for 29 percent of its losses. A Cleveland Plain Dealer investigation found that "The City of Cleveland has aggravated its vexing foreclosure problems and has lost millions in tax dollars by helping people buy homes they could not afford." The newspaper added that these problem mortgages "typically came from local banks fulfilling federal requirements to lend money in poorer neighbourhoods".

Others argue that "pretty much all the evidence on the housing crisis shows" that Fannie Mae, Freddie Mac, the (CRA) and their affordability goals were not a major reason for the bubble and crash.

Law professor David Min argues that view (blaming GSE's and CRA) "is clearly contradicted by the facts", namely that

• Parallel bubble-bust cycles occurred outside of the residential housing markets (for example, in commercial real estate and consumer credit).
• Parallel financial crises struck other countries, which did not have analogous affordable housing policies
• The U.S. government's market share of home mortgages was actually declining precipitously during the housing bubble of the 2000s.

However, according to Peter J. Wallison, other developed countries with "large bubbles during the 1997–2007 period" had "far lower ... losses associated with mortgage delinquencies and defaults" because (according to Wallison), these countries' bubbles were not supported by a huge number of government mandated substandard loans – generally with low or no downpayments" as was the case in the US.

Other analysis calls into question the validity of comparing the residential loan crisis to the commercial loan crisis. After researching the default of commercial loans during the financial crisis, Xudong An and Anthony B. Sanders reported (in December 2010): "We find limited evidence that substantial deterioration in CMBS [commercial mortgage-backed securities] loan underwriting occurred prior to the crisis." Other analysts support the contention that the crisis in commercial real estate and related lending took place after the crisis in residential real estate. Business journalist Kimberly Amadeo reports: "The first signs of decline in residential real estate occurred in 2006. Three years later, commercial real estate started feeling the effects. Denice A. Gierach, a real estate attorney and CPA, wrote:

most of the commercial real estate loans were good loans destroyed by a really bad economy. In other words, the borrowers did not cause the loans to go bad, it was the economy.

In their book on the 2008 financial crisis, Business journalists Bethany McLean and Joe Nocera argue that the charges against Fannie and Freddie are "completely upside down; Fannie and Freddie raced to get into subprime mortgages because they feared being left behind by their nongovernment competitors."

Most early estimates showed that the subprime mortgage boom and the subsequent crash were very much concentrated in the private market, not the public market of Fannie Mae and Freddie Mac. According to an estimate made by the Federal Reserve in 2008, more than 84 percent of the subprime mortgages came from private lending institutions in 2006. The share of subprime loans insured by Fannie Mae and Freddie Mac also decreased as the bubble got bigger (from a high of insuring 48 percent to insuring 24 percent of all subprime loans in 2006).

To make its estimate, the Federal Reserve did not directly analyze the characteristics of the loans (such as downpayment sizes); rather, it assumed that loans carrying interest rates 3% or more higher than normal rates were subprime and loans with lower interest rates were prime. Critics dispute the Federal Reserve's use of interest rates to distinguish prime from subprime loans. They say that subprime loan estimates based on use of the high-interest-rate proxy are distorted because government programs generally promote low-interest rate loans – even when the loans are to borrowers who are clearly subprime.

According to Min, while Fannie and Freddie did buy high-risk mortgage-backed securities,

they did not buy enough of them to be blamed for the mortgage crisis. Highly respected analysts who have looked at these data in much greater detail than Wallison, Pinto, or myself, including the nonpartisan Government Accountability Office, the Harvard Joint Center for Housing Studies, the Financial Crisis Inquiry Commission majority, the Federal Housing Finance Agency, and virtually all academics, including the University of North Carolina, Glaeser et al. at Harvard, and the St. Louis Federal Reserve, have all rejected the Wallison/Pinto argument that federal affordable housing policies were responsible for the proliferation of actual high-risk mortgages over the past decade.

Min's contention that Fannie and Freddie did not buy a significant amount of high-risk mortgage backed securities must be evaluated in light of subsequent SEC security fraud charges brought against executives of Fannie Mae and Freddie Mac in December 2011. Significantly, the SEC alleged (and still maintains) that Fannie Mae and Freddie Mac reported as subprime and substandard less than 10 percent of their actual subprime and substandard loans. In other words, the substandard loans held in the GSE portfolios may have been 10 times greater than originally reported. According to Peter Wallison of the American Enterprise Institute, that would make the SEC's estimate of GSE substandard loans about $2 trillion - significantly higher than Edward Pinto's estimate.

The Federal Reserve also estimated that only six percent of higher-priced loans were extended by Community Reinvestment Act-covered lenders to lower-income borrowers or CRA neighborhoods. (As it did with respect to GSE loans, the Federal Reserve assumed that all CRA loans were prime unless they carried interest rates 3% or more above the normal rate, an assumption disputed by others.) In a 2008 speech, Federal Reserve Governor Randall Kroszner, argued that the CRA could not be responsible for the subprime mortgage crisis, stating that

"first, only a small portion of subprime mortgage originations are related to the CRA. Second, CRA-related loans appear to perform comparably to other types of subprime loans. Taken together... we believe that the available evidence runs counter to the contention that the CRA contributed in any substantive way to the current mortgage crisis"

Others, such as Federal Deposit Insurance Corporation Chairman Sheila Bair, and Ellen Seidman of the New America Foundation also argue that the CRA was not responsible for the crisis. The CRA also only affected one out of the top 25 subprime lenders. According to several economists, Community Reinvestment Act loans outperformed other "subprime" mortgages, and GSE mortgages performed better than private label securitizations.

Nonetheless, economists at the National Bureau of Economic Research concluded that banks undergoing CRA-related regulatory exams took additional mortgage lending risk. The authors of a study entitled "Did the Community Reinvestment Act Lead to Risky Lending?" compared "the lending behavior of banks undergoing CRA exams within a given census tract in a given month (the treatment group) to the behavior of banks operating in the same census tract-month that did not face these exams (the control group). This comparison clearly indicates that adherence to the CRA led to riskier lending by banks." They concluded: "The evidence shows that around CRA examinations, when incentives to conform to CRA standards are particularly high, banks not only increase lending rates but also appear to originate loans that are markedly riskier." Loan delinquency averaged 15% higher in the treatment group than the control group one year after mortgage origination.

Historically low interest rates

According to some, such as John B. Taylor and Thomas M. Hoenig, "excessive risk-taking and the housing boom" were brought on by the Federal Reserve holding "interest rates too low for too long".

In the wake of the dot-com crash and the subsequent 2001–2002 recession the Federal Reserve dramatically lowered interest rates to historically low levels, from about 6.5% to just 1%. This spurred easy credit for banks to make loans. By 2006 the rates had moved up to 5.25% which lowered the demand and increased the monthly payments for adjustable rate mortgages. The resulting foreclosures increased supply, dropping housing prices further. Former Federal Reserve Board Chairman Alan Greenspan admitted that the housing bubble was "fundamentally engendered by the decline in real long-term interest rates".

Mortgages had been bundled together and sold on Wall Street to investors and other countries looking for a higher return than the 1% offered by Federal Reserve. The percentage of risky mortgages was increased while rating companies claimed they were all top-rated. Instead of the limited regions suffering the housing drop, it was felt around the world. The Congressmen who had pushed to create subprime loans now cited Wall Street and their rating companies for misleading these investors.

In the United States, mortgage rates are typically set in relation to 10-year treasury bond yields, which, in turn, are affected by Federal Funds rates. The Federal Reserve acknowledges the connection between lower interest rates, higher home values, and the increased liquidity the higher home values bring to the overall economy. A Federal Reserve report reads:

Like other asset prices, house prices are influenced by interest rates, and in some countries, the housing market is a key channel of monetary policy transmission.

For this reason, some have criticized then Fed Chairman Alan Greenspan for "engineering" the housing bubble, saying, e.g., "It was the Federal Reserve-engineered decline in rates that inflated the housing bubble." Between 2000 and 2003, the interest rate on 30-year fixed-rate mortgages fell 2.5 percentage points (from 8% to all-time historical low of about 5.5%). The interest rate on one-year adjustable rate mortgages (1/1 ARMs) fell 3 percentage points (from about 7% to about 4%). Richard Fisher, president of the Dallas Fed, said in 2006 that the Fed's low interest-rate policies unintentionally prompted speculation in the housing market, and that the subsequent "substantial correction [is] inflicting real costs to millions of homeowners."

A drop in mortgage interest rates reduces the cost of borrowing and should logically result in an increase in prices in a market where most people borrow money to purchase a home (for instance, in the United States), so that average payments remain constant. If one assumes that the housing market is efficient, the expected change in housing prices (relative to interest rates) can be computed mathematically. The calculation in the sidebox shows that a 1 percentage point change in interest rates would theoretically affect home prices by about 10% (given 2005 rates on fixed-rate mortgages). This represents a 10-to-1 multiplier between percentage point changes in interest rates and percentage change in home prices. For interest-only mortgages (at 2005 rates), this yields about a 16% change in principal for a 1% change in interest rates at current rates. Therefore, the 2% drop in long-term interest rates can account for about a 10 × 2% = 20% rise in home prices if every buyer is using a fixed-rate mortgage (FRM), or about 16 × 3% ≈ 50% if every buyer is using an adjustable rate mortgage (ARM) whose interest rates dropped 3%.

Robert Shiller shows that the inflation adjusted U.S. home price increase has been about 45% during this period, an increase in valuations that is approximately consistent with most buyers financing their purchases using ARMs. In areas of the United States believed to have a housing bubble, price increases have far exceeded the 50% that might be explained by the cost of borrowing using ARMs. For example, in San Diego area, average mortgage payments grew 50% between 2001 and 2004. When interest rates rise, a reasonable question is how much house prices will fall, and what effect this will have on those holding negative equity, as well as on the U.S. economy in general. The salient question is whether interest rates are a determining factor in specific markets where there is high sensitivity to housing affordability. (Thomas Sowell points out that these markets where there is high sensitivity to housing affordability are created by laws that restrict land use and thus its supply. In areas like Houston which has no zoning laws the Fed rate had no effect.)

Return to higher rates

Between 2004 and 2006, the Fed raised interest rates 17 times, increasing them from 1% to 5.25%, before pausing. The Fed paused raising interest rates because of its concern that an accelerating downturn in the housing market could undermine the overall economy, just as the crash of the dot-com bubble in 2000 contributed to the subsequent recession. New York University economist Nouriel Roubini opined that "The Fed should have tightened earlier to avoid a festering of the housing bubble early on."

There was a great debate as to whether or not the Fed would lower rates in late 2007. The majority of economists expected the Fed to maintain the Fed funds rate at 5.25 percent through 2008; however, on September 18, it lowered the rate to 4.75 percent.

Regions affected

Home price appreciation has been non-uniform to such an extent that some economists, including former Fed Chairman Alan Greenspan, arguedthat the United States was not experiencing a nationwide housing bubble per se, but a number of local bubbles. However, in 2007 Greenspan admitted that there was in fact a bubble in the US housing market, and that "all the froth bubbles add up to an aggregate bubble".

Despite greatly relaxed lending standards and low interest rates, many regions of the country saw very little growth during the "bubble period". Out of 20 largest metropolitan areas tracked by the S&P/Case-Shiller house price index, six (Dallas, Cleveland, Detroit, Denver, Atlanta, and Charlotte) saw less than 10% price growth in inflation-adjusted terms in 2001–2006. During the same period, seven metropolitan areas (Tampa, Miami, San Diego, Los Angeles, Las Vegas, Phoenix, and Washington DC) appreciated by more than 80%.

Somewhat paradoxically, as the housing bubble deflates some metropolitan areas (such as Denver and Atlanta) have been experiencing high foreclosure rates, even though they did not see much house appreciation in the first place and therefore did not appear to be contributing to the national bubble. This was also true of some cities in the Rust Belt such as Detroit and Cleveland, where weak local economies had produced little house price appreciation early in the decade but still saw declining values and increased foreclosures in 2007. As of January 2009 California, Michigan, Ohio and Florida were the states with the highest foreclosure rates.