Let’s get something straight: we did not have a housing “bubble”, in the usual sense of the word. The mainstream narrative of crazed, greedy, irresponsible homeowner-wannabes driving prices unsustainably high, causing the still ongoing crash is wrong. Yes, we had a housing “bubble” in one sense; prices soared way beyond reality because excess demand fueled irrational bidding wars. The lie deals with why we had a housing bubble. The lie matters because like all problem-defining narratives, it shapes the policy solutions offered. So let’s take a look at the lie.

Consumer Driven Bubbles

The classic example of a demand-driven bubble is Holland’s tulip craze in the 1600s. A much more recent version was the DotCom fever a couple of decades ago. And at the risk of dating myself, the most vivid consumer-good craze of my youth was “Cabbage Patch Dolls” (not that I had one; I wasn’t into dolls.) How did these bubbles happen? Simple. Irrational economic actors, that is, normal people acting as consumers, got a kind of mob/herd madness/fever and outbid each other endlessly, until suddenly reality intruded and they stopped.

But here’s the thing: Houses are not like tulips, shares of stock, dolls, or any other mass-market consumer product. They just cost too much. The only people who can buy a house simply because they want to are cash buyers. No one will argue that cash buyers drove the housing bubble of 2005 onward (or whatever year you want to peg its start.) Cash buyers don’t fuel a foreclosure crisis either, though banks have been known to foreclose on cash buyers anyway.

We didn’t have a housing bubble in the ordinary sense because consumers don’t buy houses; banks buy houses. The housing market cannot undergo a demand-driven bubble without lender collusion and complicity.

No Bubble Without Bankers Blowing It

Home buyers who don’t have enough cash have to get a bank’s permission to buy. The dollars involved are big enough that banks historically did not hesitate to say “No, sorry, I know you want that house, but the house just isn’t worth that much, and besides, even if it were, you’re kidding yourself when you think you can repay the loan you want. No dice. Go find something more reasonable and we can talk again.”

In normal times, meaning, when bankers care if the loan will be repaid, bankers have two basic tools to protect their interests: appraisals and underwriting. Both get used conservatively, because if an appraisal is too high, the collateral isn’t worth the loan the banker’s making, sharply increasing his risks. If an appraisal’s too low, well, the deal might not get done, but from the banker’s perspective, better no deal than a loser. Ditto with underwriting. If the standards are very loose, the loans will default and foreclosures follow; if the standards are very tight, well, that shrinks the market and keeps prices down, but again, the bankers are happy: they’re getting paid back consistently. Bottom line: across most of the housing market’s history, bankers’ self-interest foreclosed any possibility of a housing bubble.

Obviously, the fact that the entire nation underwent a housing bubble the last decade or so means something changed. Given the market dynamics, only one thing can have changed: lenders’ incentives. People didn’t suddenly become nuts about housing; Americans have been so nuts about housing for so long the “American Dream” shifted from my immigrant grandparents’ dream of “equal opportunity to get ahead, hard work and talent is all it takes” to the “dream of home ownership.”

Or to put it another way: what evidence is there that circa 2005 wannabe homebuyers became so sophisticated–nationwide, simultaneously–that they could con bankers who cared about ensuring loans made against sufficient collateral would be repaid into making huge numbers of loans that couldn’t be, against collateral that today’s market exposes was worth nowhere near the amounts claimed? Did some evil villain put something in the public water supply that somehow made wannabe homebuyers into talented con men and bankers gullible rubes?

Of course we got a housing bubble because lender behavior changed, not because consumer behavior did. And we can see it clearly by looking at what happened to underwriting and appraisals.

Fraudulent Underwriting

“Stated income loans,” which have become derisively known as “Liar’s loans,” actually have a longstanding and legitimate place serving a very specific, narrow slice of the housing market. Well, longstanding, yes, legitimate, sort of. For years these loans were made to high income self-employed people whose various tax-avoidance strategies didn’t reveal to the IRS all the income they could use to pay a mortgage loan back. So rather than document income with tax returns, these buyers would be allowed to “state” their income to the banks’ underwriters. I made the snide comment about these loans being sort of legitimate because I don’t consider dodging taxes legitimate, even when legal, but from an underwriting perspective they made sense. The stated income was more accurate than the tax returns. One way to see how lenders abandoned underwriting is to see the huge expansion of stated income loans, transforming them into liar’s loans.

To get a flavor of how the volume of liar’s loans exploded during the bubble, see this column by Joe Nocera of the New York Times. A couple of key excerpts:

“…stated-income loans became a means for both borrowers and lenders to commit fraud….Real estate speculators used stated-income loans to buy properties that would otherwise have been out of reach, hoping to flip them quickly, before their lack of income caught up with them. Far more frequently, however, mortgage originators used stated-income loans to put people into homes that were far beyond their means, knowing full well that the chance of the borrower ever paying back the loan was practically nil.”

and from a lawsuit against Countrywide Nocera quotes:

“By about 2006, Countrywide’s internal risk assessors knew that in a substantial number of its stated-income loans — fully a third — borrowers overstated income by more than 50 percent….Countrywide deliberately disregarded these and other signs of fraud in order to increase its market share.”

Lenders did two other things that made all the eventual varieties of liar’s loans (stated income; stated income stated assets; stated income, stated assets, stated job) so fraudulent: they automated underwriting, and they incentivized closing loans. Automated underwriting meant loan officers could game the system, as this one from Chase urged an investment home buyer to do, leading to the classic ‘garbage in, garbage out’ problem. Basing loan officers’ pay on funding loans meant that they would in fact game the system.

Liar’s loans aren’t the only way underwriting disappeared in the bubble years, but they illustrate the point. The other key change was what happened to appraisals. A couple months ago Reuters reported on a Countrywide whistleblower exposing appraisal fraud there. Consider this petition from 2005, which 11,000 appraisers signed with their names and addresses:

We, the undersigned, represent a large number of licensed and certified real estate appraisers in the United States, who seek [government regulators'] in solving a problem facing us on a daily basis. Lenders (meaning any and all of the following: banks, savings and loans, mortgage brokers, credit unions and loan officers in general; not to mention real estate agents) have individuals within their ranks, who, as a normal course of business, apply pressure on appraisers to hit or exceed a predetermined value.

This pressure comes in many forms and includes the following:

  • the withholding of business if we refuse to inflate values,
  • the withholding of business if we refuse to guarantee a predetermined value,
  • the withholding of business if we refuse to ignore deficiencies in the property,
  • refusing to pay for an appraisal that does not give them what they want,
  • black listing honest appraisers in order to use “rubber stamp” appraisers, etc.

We request that action be taken to hold the lenders responsible for this type of violation and provide for a penalty on any person or business who engages in the practice of pressuring appraisers to do dishonest appraisals that do not provide for independent judgment. We believe that this practice has adverse effects on our local and national economies and that the potential for great financial loss exists. We also believe that many individuals have been adversely affected by the purchase of homes which have been over-valued.

(As of March 2005, when the think tank Demos published a report on appraisal fraud, the above petition had 8,000 signatures; the petition was closed after the 11,000 was reached.) In 2006, the Wall Street Journal reported on appraisal fraud, including a survey of appraisers from 2003 found many faced pressures to inflate values. The author of the Demos report noted nearly a year ago that the narrative is shifting to make banks the victims rather than the organizers of appraisal fraud. (Of course, builders struggling to sell homes complain that today’s appraisals are too low.)

So there you have it: American underwent a massive wealth destroying housing bubble not because crazed consumers got out of hand, as they have in every other bubble in history. No. We got a housing bubble because the lenders’ historical incentives to regulate consumer demand, ensuring accurate property valuations and real ability to repay, evaporated.

Why did lenders’ incentives change? That’s a long story for another day, but it boils down to this: lenders no longer faced consequences if the loans weren’t repaid. They’d offloaded that risk to securities investors.

As long as people continue to believe that crazed consumers created a housing bubble, the kinds of policies needed to end the appraisal, underwriting and securities fraud that really did create the bubble have no chance of succeeding. So make sure your friends understand the housing bubble lie.