New York Fed: Lax Lending Not to Blame

A ""recent study"":http://www.newyorkfed.org/research/current_issues/ci15-3.pdf published by the ""New York Federal Reserve"":http://www.newyorkfed.org says that lax lending standards were not the air that inflated the market’s latest housing bubble and propelled the nation into an economic tailspin. Instead, the government bank argues that consumers’ misjudgments and swings in labor productivity played a significant role in the boom and bust of residential real estate.
James Kahn, author of the study and a professor of economics at Yeshiva University, explained, ""What appears in retrospect to be relatively lax credit conditions in the early part of this decade may have emerged in part because of then-justifiable, although ultimately misplaced, optimism about income growth.""
In the report, Kahn says a widely held view among market observers is that the rapid growth in home prices from the mid-1990s until the recent crash reflected a ""bubble,"" brought on by excessively lax lending standards and a belief that house prices would increase indefinitely. In this view, the bubble was destined to burst, triggering a dramatic decline in the housing sector.
Kahn contends it was consumer confidence that persuaded people they could afford more expensive homes. He says consumers believed they were working harder than the previous decade and expected their paychecks to likewise increase. Their optimism continued until 2007, Kahn says, when it became clear this was not the prevailing trend - a slowdown in productivity helped dash expectations of further income growth and stifle the boom in residential real estate.
These productivity swings helped determine the price of housing through their effects on income growth and long-term income expectations, Kahn says - both factors that directly influence what consumers are ready to pay for housing and what mortgage providers are willing to lend.
Using a recently developed model of housing prices, Kahn shows how a large share of price fluctuations over the last 45 years can be attributed to changes in productivity growth. Applied to the most recent housing cycle, the model suggests that the surge in home prices from the mid-1990s to 2007 was fueled at least in part by the belief that ongoing productivity advances would lead to continued strong growth in income.
Kahn explains that the relationship worked in reverse as evidence mounted in 2007 that productivity growth had slowed - at that time, expectations of further income growth declined, helping to quash the housing boom and jeopardizing mortgages and other investments.
Kahn’s argument attaches considerable importance to the perception of productivity shifts. He says housing market participants were slow to perceive the productivity decline because the data released through mid-2007 gave little indication of it. Subsequent data revisions, though, made it clear that productivity had in fact begun to decelerate in 2004.
According to Kahn, if productivity growth returns, then housing prices could bottom out and begin to move upward. But if productivity slows further or grows only modestly, he says property values will remain low or fall even further.