How much did interest rates matter for the housing boom?

Both theory and data suggest that lower real rates cannot account for more than one-fifth of the boom in house prices.

That's from Edward Glaeser, Joshua Gottlieb, and Joseph Gyourko; here is more.  Here is some of the theory:

If people expect to move in the future, low interest rates today will not lead them to bid up prices so much now because they realise they might have to sell later at a lower price when rates are higher. The option to prepay also weakens the link between current interest rates and house prices for the same reason. Rates also should have little or no impact on prices in elastically supplied markets as shown in Glaeser et al. (2008).

Finally, if people are credit-constrained, lower rates today need not lead to higher prices. After all, if the marginal buyer cannot take advantage of those lower rates, they should not affect the buyer’s valuation of a home. Taken together, we show that these factors can reduce the predicted impact of interest rates on home prices by about two-thirds, bringing it down to 6 or 8 from previous conclusions of around 20.

Comments

Who were these people during the top of the boom that thought they would have to sell their house for less in the future? I know a lot of people who bought expecting to move in <5 years. All of them bought as much house as they could, assuming that their gain would be greater that way.

What is the expected interest rate 10 or 20 years in the future? Isn't it the current interest rate or at least the 20 year forward rate? If that dropped, then it would be rational to increase the price of housing.

Also, the same argument could be used against buying stocks if interest rates drop. After all, if you expect interest rates to go higher, you will not be able to sell for a profit.

In sum, no one really expected rates to go up. Thus housing prices increased.

I would think people who expected to move in the future would prefer renting to buying. To me, buying a house means an attempt at stability and a commitment to settling down at a particular place for the foreseeable future. It's too bad that today's economy doesn't really allow for that kind of stability for most people. Some of our parents had jobs they could stay in for 10 years or more, and at one time that was typical.

"If people expect to move in the future, low interest rates today will not lead them to bid up prices so much now because they realise they might have to sell later at a lower price when rates are higher."

We are talking about the people that purchased a home maxing out the legal DTI using zero amortization loans with teaser adjustable-rates.

These people that bid up prices are retarded. Do not use rational expectations models. Sorry if I have just insulted retarded people.

@Jay, I think you've hit the nail on the head. There is no rational explanation, because the whole exuberant episode was irrational!

@Jay/Tim,

I really don't see the irrationality. Notwithstanding the elevated housing prices at the peak of the market, if you wanted to live in a house, you had to pay the price! The real estate market is a market. How could you predict where the top would be? Go back and look at Case-Schiller indices. We've only retraced a portion of the overall advance in house prices since the late 1980s. Individuals who bought houses during that time period might have had all kind of good reasons for doing so.

Credit-constrained? Who was credit-constrained? I think we can pretty safely disregard this aspect of the theory

Both theory and data suggest that the heat generated from the friction in striking a match cannot account for more than an infinitesimal proportion of the resulting heat in the fireplace.

(Not trying to be glib, but the Vernon Smith and Shiller studies both show these small triggers to be potentially significant.)

Growing up in the 60s, buying a house was a want to improve one's living conditions, generally more room, or at least the option to expand with an add-on. Maybe in 30 years, the mortgage is paid off and retiring becomes more affordable.

No one saw houses as something that generated "wealth", unless you bought a duplex or four flat. And lots of people did buy duplexes, renting half out to family or friends. Of course, lots of people bought larger houses for their kids, or maybe for parents, and then when they were gone, took in boarders. My grandmother whose husband died in the line of duty took in railroad men to supplement her widow's pension.

It was in the middle of the 80s when I was hearing from everyone that I should buy as large a house as possible because I'll make more money on it, and in a few years I should trade it in for a bigger place, taking out a bigger loan.

I was told it was the best way to get rich.

I was told I couldn't lose because housing prices never went down.

I was told that this was the way to get rich without paying taxes.

I was told that large mortgage payments were all interest and so they were big tax deductions.

I was told to think of the Federal tax deductions on property taxes.

I was told to think about not paying taxes when I sold after age 55.

So, the message was buying more and paying more was great because of the tax cuts from the deductions, plus the tax cuts from excluding the gain when I got older, and the tax deferral from upgrading to bigger houses.

I kept telling people houses were a liability, prices were way too high, and no one should see housing as a way to make money. I bought a house based on a desire for a place I could do what I wanted without the hassle of a landlord, and that cost over the long term a price equal to rent for less.

Two years later, after putting 33% down, I had about 5% equity, circa 1988. I did a 10 second coulda woulda, and moved on because I expected prices to fall, just not that far.

I knew the past decade was a looming bubble because I was hearing everything I heard in the 80s, and there were the promises of tax cuts to make real estate the way to get rich without paying taxes.

To constant themes: tax cuts from buying real estate, and housing prices never go down.

Just think of the cut in your Federal taxes by paying $3000 a month in interest only!

At 10% $3000 a month is only a $360K mortgage, but at 4% you can get a $900K mortgage.

20% would be plenty enough to ruin your day wouldn't it?

But then this:

"The combination of a nearly 200 basis-point decline in real interest rates and semi-elasticity of 20 implies that the changes in real rates can account for the bulk of the 50%-plus boom in prices experienced in the aggregate US data (Himmelberg et al. 2005, Mayer and Sinai 2005).

But there are two reasons to question this conclusion. Our own work amends the standard house price model of Poterba (1984) and identifies various reasons why interest rates can have a much smaller impact on house prices than the traditional calculations suggest (Glaeser et al. 2010). Particularly important factors are the combination of mean reversion in interest rates and normal household mobility."

So, theory actually says it's 50%, except for the author's recent paper theories.

Further, all the boom came from credit. That is, all the money that went there was credit and availability may be more important than interest rates. The availability of credit from the savings glut kept rates from rising. How do we know what rates should have been? I think we have an idea because housing plummeted. People were not credit constrained nor interest rate constrained. They may have an expectation that someone should constrain them and if they are not constrained than it is an implicit endorsement.

Then there is this "real" interest rate business. If true, the people at The Fed will be sad to learn that all their tweaks don't do anything and they can just shutter the place.

Lastly, houses are like cash. How much would you hold if you 'knew' the price would only go up? Don't we kind of call that a big deal under the 'deflation' scenario? But homes are even better than cash, they are also places to live and enjoy. They are not just a financial investment. But, as a financial investment, they looked a lot better than stocks coming off the tech bubble or fixed income investments at low rates. I don't know their theory or analysis, but under these conditions it seems like small interest changes on levered assets could have a outsized effect.

Finally, home prices are linked to incomes both before and after loans are generated. The economic slowdown in employment catalyzed a lot of the defaults that lead to lone losses that led to bank losses that led to credit contraction. Rates had been falling for years before the peak of the housing boom. People could buy bigger houses in hot markets based on prospects of increasing cash flow and future mortgage refinancing- future expectations of ever lowering rates. I'm not saying they are wrong (I wouldn't dare) but a lot of these factors are compounding (multiplied) and an assumption here and there and suddenly the number can jump just as high as they trimmed it lower. The creditors and the borrowers side both expected the other side to tell them no and noone ever did. Both sides kept saying yes, and they took that as an endorsement.

"If people expect to move in the future, low interest rates today will not lead them to bid up prices so much now because they realise they might have to sell later at a lower price when rates are higher."

The problem is failing to realize this is a collective action scenario. There is no "them" buying houses; there are individuals who perceive that buying a house in this environment would yield benefits in massive excess of costs. Each individual fails to take into account the pecuniary externalities he or she imposes on the system.

This is a pretty simple story. It's possible the authors do consider this and I am completely missing the point, but it doesn't sound that way from the paper.

Homebuyers were, in general, unable to imagine that house prices could fall, or even that they might plateau. They were unable to properly anticipate (or in some cases were utterly unaware of) the 100% contractual certainty that their teaser rates would go up.

And yet we are to believe that they collectively looked ahead to a (supposedly inevitable) next move and shrewdly took into account the possible impact of fluctuating interest rates? On what planet?

Most people based their homebuying decision solely on what monthly payment they were being offered. To the extent that lower interest rates meant they could buy a more expensive house for the same monthly payment, that caused house prices to go up. Teaser rates, zero down payment, and negative amortization gimmickry only exaggerated the trend.

Based on the phrasing used here, can I conclude that interest rates accounted for roughly 4/5ths of the increase?

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