There have been seemingly innumerable explanations for the causes and effects of the recent housing market boom and bust. The list includes subprime mortgage lending, irrational expectations among homebuyers and lenders, the complex securitization process, government policies to promote affordable lending, measures that foster excessive risk-taking due to the backing of institutions deemed “too big to fail,” and, as in many economic debacles, greed.
The boom and bust, however, varied greatly across housing markets, which suggests that local conditions also were important in determining how the crisis played out—and may be playing out again. Las Vegas and some communities in California, for instance, are seeing cash investors competing with each other to sharply drive up home prices.
These developments, like the post-2006 bust in many markets, are heavily influenced by localized phenomena or what are referred to as local market conditions. Thus, efforts to help prevent future bubbles and to respond to them once problems emerge require localized approaches. In fact, after thorough study, we have found that national responses are not always the best answer to housing market problems.
Below are some lessons we learned from the last real estate cycle that are worth heeding:
- Look at the hyperlocal data. We are in the midst of a data revolution that will ultimately enable us to measure house price trends at highly granular levels. For example, while not available early in the recent crisis, house price data at the zip code level and below are now commonplace. Critical measures of the distressed real estate inventory also are widely available now. New information sources provide opportunities that make it more possible to address the wide variation in local market conditions. Using these data wisely, we can do a better job of predicting and heading off future house price bubbles.
- Stop issues from spreading. Applying policies to a specific geographic area can be difficult. One option is to implement what are known as countercyclical capital buffers, an approach that could be market-specific and would increase the cost of borrowing as evidence of a price bubble emerges. The availability of higher-quality local data offers great potential for developing such targeted responses that would help avert a mortgage market collapse such as the one from which the nation is still recovering. Such reforms could be structured through a more decentralized market-based approach, which we see as having many advantages. However, maintaining a more centralized approach while accounting for the great variation across markets would still represent a marked improvement over practices pursued during the most recent crisis.
- Detect price bubbles early. Develop, maintain, and update a statistical or econometric model that captures the relationships between house prices and other variables. These can produce out-of-sample predictions of future house prices, which may offer a signal about implausibly high price levels. While our ability to predict the formation of house price bubbles or fragility in house prices is far from perfect, the econometric results do provide valuable information that can help guide policy.
- Consider a more tailored response to a crisis. When the market crashed, the government applied a blanket response. But next time—and there is always a next time—policy makers could take a more measured approach that would involve more localized policy responses and explicit partnerships with state and local governments in the hardest-hit areas. Lessons learned from such early test cases could be used to design a more effective program for other parts of the country.
- Apply countercyclical capital policies. Capital requirements for ﬁnancial institutions should be based on local market conditions. The basic idea is straightforward: when prices for a particular asset or sector are rising much faster than market fundamentals justify, bank regulators would increase the capital ratios for that asset. In the case of housing, the capital ratios would apply to residential mortgages. For example, during “normal” times, a bank might be required to have a capital ratio of 4 percent for a traditional mortgage with a loan-to-value ratio of 80 percent or less. If evidence of a price bubble was increasing, the ratio could be raised to, say, 6 percent. As such, countercyclical capital requirements offer two major beneﬁts: they better enable ﬁnancial institutions to withstand severe shocks, and they lower the likelihood of an extreme event. If this policy had been in place prior to the recent boom/bust cycle, it would have helped temper both lending and housing demand.
The problem with national monetary policy is that it’s national. What is needed are actions and interventions that operate on a more regional level. Everyone knows that real estate is all about location. The market drivers in the Northeast are different from those in, say, the Sunbelt. The 2008 crash led to the disappearance of trillions of dollars in assets value and dragged the entire economy down close to a depression. While prices in many markets are recovering, it seems prudent to be prepared—for example, by looking closely at the markets that are already showing warning signs.
James R. Follain and Seth Giertz are the authors of Preventing Housing Price Bubbles: Lessons from the 2006–2012 Bust, published by the Lincoln Institute of Land Policy.