Housing Crisis: What is the Problem?

I've been putting off writing about proposed responses to the housing crisis, and new proposals keep popping up. So far, I see distinct proposals from Obama, Clinton, Bush, Alan Blinder, Larry Summers, and Dean Baker, and I'm sure there are lots of others out there. I'll write a brief description and evaluation of the proposals soon.

But first, in not too many words, what's the problem? Starting around 2000, residential housing prices skyrocketed. According to the Case-Shiller housing price index (which controls for quality and covers only major metropolitan areas), prices nationally in mid-2006 were more than double those in 2000, with even more spectacular growth taking place in LA, Miami, DC, and San Diego. (The index is normalized to be equal to 100 in January 2000.)
Now that the housing bubble has burst, prices are dropping precipitously. Over the long run, our best guess is that housing values will grow at a constant rate. Taking as a very, very rough guide to long run price growth the average annual growth rate of the Case-Shiller index between 1987 and 2000 (3.6%), and extrapolating forward from January 2000 (making the heroic but not crazy assumption that prices at that point were at their long-run level) we would expect that the recent value of the Case-Shiller index would be about 130 rather than 200. In other words, nationally, residential housing is about 50% overvalued. Assuming prices drop back to their long-term trend values, we expect a decline of 20-30% from current values over the next five years.

As prices have started to decline, many people who bought properties with the expectation that they could quickly sell them again for a profit are faced with mortgages that they are unable or unwilling to pay. A not mutually exclusive category consists of those who got mortgages with a variety of gimmicky payment plans--teaser rates, exploding adjustable rates, etc.--and now can't afford their payments.

At the risk of sounding like a cold-blooded economist, it's important to specify exactly why this is a bad thing. Those who were more prudent may find it hard to find much sympathy for those who gambled in the housing market and are now suffering for it. That said, there are reasons to think government should do something about the housing crisis.

First, some people truly didn't understand the risks they were taking, in part because mortgage companies skirted the laws requiring transparency and didn't inform them. It is the job of the government to regulate mortgages and enforce disclosure laws, and the government failed to protect those people.

Second, the empty houses that result from repeated foreclosures can have a large negative effect on nearby homes, leading to neighborhood decay, and accelerating the decline in housing prices.

Third, a quick drop in prices can bring a drop in consumer spending (through so-called wealth effects), which is not what we need at a time when recession clouds are brewing.

The second and third reasons are in economic parlance "externalities," which is every economist's favorite rationale for government intervention.

The options for dealing with the problem, as I see them, are 1) mandate a moratorium on foreclosures and/or a freeze on adjustable rates , 2) buy up some mortgages and refinance them, 3) provide limited government financial assistance to those having trouble paying their mortgages, 4) or make some tweaks to foreclosure and/or bankruptcy law. In my next post, I'll evaluate the main solutions and look at the Obama and Clinton plans in particular.