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By STEVEN GJERSTAD and VERNON L. SMITH=20


Bubbles have been frequent in economic history, and they occur in the labor=
atories of experimental economics under conditions which -- when first stud=
ied in the 1980s -- were considered so transparent that bubbles would not b=
e observed.=20



We economists were wrong: Even when traders in an asset market know the val=
ue of the asset, bubbles form dependably. Bubbles can arise when some agent=
s buy not on fundamental value, but on price trend or momentum. If momentum=
 traders have more liquidity, they can sustain a bubble longer.=20



But what sparks bubbles? Why does one large asset bubble -- like our dot-co=
m bubble -- do no damage to the financial system while another one leads to=
 its collapse? Key characteristics of housing markets -- momentum trading, =
liquidity, price-tier movements, and high-margin purchases -- combine to pr=
ovide a fairly complete, simple description of the housing bubble collapse,=
 and how it engulfed the financial system and then the wider economy.=20




[Review & Outlook]

In just the past 40 years there were two other housing bubbles, with peaks =
in 1979 and 1989, but the largest one in U.S. history started in 1997, prob=
ably sparked by rising household income that began in 1992 combined with th=
e elimination in 1997 of taxes on residential capital gains up to $500,000.=
 Rising values in an asset market draw investor attention; the early stages=
 of the housing bubble had this usual, self-reinforcing feature.=20



The 2001 recession might have ended the bubble, but the Federal Reserve dec=
ided to pursue an unusually expansionary monetary policy in order to counte=
ract the downturn. When the Fed increased liquidity, money naturally flowed=
 to the fastest expanding sector. Both the Clinton and Bush administrations=
 aggressively pursued the goal of expanding homeownership, so credit standa=
rds eroded. Lenders and the investment banks that securitized mortgages use=
d rising home prices to justify loans to buyers with limited assets and inc=
ome. Rating agencies accepted the hypothesis of ever rising home values, ga=
ve large portions of each security issue an investment-grade rating, and in=
vestors gobbled them up.=20



But housing expenditures in the U.S. and most of the developed world have h=
istorically taken about 30% of household income. If housing prices more tha=
n double in a seven-year period without a commensurate increase in income, =
eventually something has to give. When subprime lending, the interest-only =
adjustable-rate mortgage (ARM), and the negative-equity option ARM were no =
longer able to sustain the flow of new buyers, the inevitable crash could n=
o longer be delayed.=20



The price decline started in 2006. Then policies designed to promote the Am=
erican dream instead produced a nightmare. Trillions of dollars of mortgage=
s, written to buyers with slender equity, started a wave of delinquencies a=
nd defaults. Borrowers' losses were limited to their small down payments; h=
ence, the lion's share of the losses was transmitted into the financial sys=
tem and it collapsed.=20



During the 1976-79 and 1986-89 housing price bubbles, the effective federal=
-funds interest rate was rising while housing prices rose: The Federal Rese=
rve, "leaning against the wind," helped mitigate the bubbles. In January 20=
01, however, after four years with average inflation-adjusted house price i=
ncreases of 7.2% per year (about 6% above trend for the past 80 years), the=
 Fed started to decrease the fed-funds rate. By December 2001, the rate had=
 been reduced to its lowest level since 1962. In 2002 the average fed-funds=
 rate was lower than in any year since the 1958 recession. In 2003 and 2004=
 the average fed-funds rates were lower than in any year since 1955 when th=
e rate series began.=20




[Review & Outlook]

Monetary policy, mortgage finance, relaxed lending standards, and tax-free =
capital gains provided astonishing economic stimulus: Mortgage loan origina=
tions increased an average of 56% per year for three years -- from $1.05 tr=
illion in 2000 to $3.95 trillion in 2003!=20



By the time the Federal Reserve began to slowly raise the fed-funds rate in=
 May 2004, the Case-Shiller 20-city composite index had increased 15.4% dur=
ing the previous 12 months. Yet the housing portion of the CPI for those sa=
me 12 months rose only 2.4%.=20



How could this happen? In 1983, the Bureau of Labor Statistics began to use=
 rental equivalence for homeowner-occupied units instead of direct home-own=
ership costs. Between 1983 and 1996, the price-to-rental ratio increased fr=
om 19.0 to 20.2, so the change had little effect on measured inflation: The=
 CPI underestimated inflation by about 0.1 percentage point per year during=
 this period. Between 1999 and 2006, the price-to-rent ratio shot up from 2=
0.8 to 32.3.=20



With home price increases out of the CPI and the price-to-rent ratio rapidl=
y increasing, an important component of inflation remained outside the inde=
x. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that =
year was underestimated by 2.9 percentage points (since "owners' equivalent=
 rent" is about 23% of the CPI). If home-ownership costs were included in t=
he CPI, inflation would have been 6.2% instead of 3.3%.=20



With nominal interest rates around 6% and inflation around 6%, the real int=
erest rate was near zero, so household borrowing took off. As measured by t=
he Case-Shiller 10 city index, the accumulated inflation in home-ownership =
costs between January 1999 and June 2006 was 151%, but the CPI measured a m=
ere 23% increase. As the Federal Reserve monitored inflation in the early p=
art of this decade, home-price increases were no longer visible in the CPI,=
 so the lax monetary policy continued. Even after the Fed began to slowly r=
aise the fed-funds rate in May 2004, the average rate remained low and the =
bubble continued to inflate for two more years.=20



The unraveling of the bubble is in many ways the most fascinating part of t=
he story, and the most painful reality we are now experiencing. The median =
price of existing homes had fallen from $230,000 in July to $217,300 in Nov=
ember 2006. By the beginning of 2007, in 17 of the 20 cities in the Case-Sh=
iller index, prices were falling. Serious price declines had not yet begun,=
 but the warning signs were there for alert observers.=20



Kate Kelly, writing in this newspaper (Dec. 14, 2007), tells the story of h=
ow Goldman Sachs avoided the fate of many of the other investment banks tha=
t packaged mortgages into securities. Goldman loaded up on the Markit ABX i=
ndex of credit default swaps between early December 2006 and late February =
2007, as their price dropped from 97.70 on Dec. 4 to under 64 by Feb. 27. B=
ut the market was not yet in free-fall: The insurance on AAA-rated parts of=
 the mortgage-backed securities (MBS) remained inexpensive. By mid-summer 2=
007, concern spread to the AAA-rated tranches of MBS.=20



At the end of February 2007, the cost of $10 million of insurance on the AA=
A-rated portion of a mortgage-backed security was still only $68,000 plus a=
 $9,000 annual premium. Housing-market conditions deteriorated further in t=
he first half of 2007. Case-Shiller tiered price sequences in Los Angeles, =
San Francisco, San Diego and Miami all show serious declines by the summer =
of 2007. Prices in the low-price tier in San Francisco were down almost 13%=
 from their peak by July 2007; in San Diego they were off 10% by July 2007.=
 Startling developments began to unfold that month. Between July 9 and Aug.=
 3, 2007, the cost of insuring AAA MBS tranches went from $50,000 upfront p=
lus a $9,000 annual premium for $10 million of insurance to over $900,000 u=
pfront (plus the annual premium).=20



Once the cost of insuring new mortgage-backed securities skyrocketed, mortg=
age financing from MBS rapidly declined. Subprime originations plummeted fr=
om $160 billion in the third quarter of 2006 to $28 billion in the third qu=
arter of 2007. Mortgage-backed security issuance fell comparably, from $483=
 billion in all of 2006 to only $30.7 billion in the third quarter of 2007.=
 Other measures of new loan originations were falling at the same time. The=
 liquidity that generated the housing market bubble was evaporating.=20

Trouble quickly spread from the cost of insuring mortgage-backed securities=
 to problems with credit markets generally, as the spread between short-ter=
m U.S. Treasury debt and the LIBOR rate increased to 2.40% from 0.44% betwe=
en Aug. 8 and Aug. 20, 2007. Since U.S. Treasury debt is generally consider=
ed secure, but a bank's loans to another bank carry some risk of default, t=
he spread between these rates serves as an indicator of perceived risk in f=
inancial markets.=20



In one city after another, prices of homes in the low-price tier appreciate=
d the most and then fell the most; prices in the high-priced tier appreciat=
ed least and fell the least. The price index graphs for Los Angeles, San Fr=
ancisco, San Diego and Miami show that in all of these cities, prices in th=
e low-price tier have fallen between 50% and 57%. Moreover, housing prices =
have continually declined in every market in the Case-Shiller index. Accord=
ing to First American CoreLogic, 10.5 million households had negative or ne=
ar negative equity in December 2008. When housing prices turned down, many =
borrowers with low income and few assets other than their slender home equi=
ty faced foreclosure. The remaining losses had to be absorbed by the financ=
ial system. Consequently, the financial system has suffered a blow unlike a=
nything since the Great Depression, and the source is the weak financial po=
sition of the people holding declining assets.=20



Earlier, during the downturn in the equities market between December 1999 a=
nd September 2002, approximately $10 trillion of equity was erased. But a m=
easure of financial system performance, the Keefe, Bruyette, & Woods BKX in=
dex of financial firms, fell less than 6% during that period. In the curren=
t downturn, the value of residential real estate has fallen by approximatel=
y $3 trillion, but the BKX index has now fallen 75% from its peak of Januar=
y 2007. The financial sector has been devastated in this crisis, whereas it=
 was almost completely unaffected by the downturn in the equities market ea=
rly in this decade.=20



How can one crash that wipes out $10 trillion in assets cause no damage to =
the financial system and another that causes $3 trillion in losses devastat=
e the financial system?=20



In the equities-market downturn early in this decade, declining assets were=
 held by institutional and individual investors that either owned the asset=
s outright, or held only a small fraction on margin, so losses were absorbe=
d by their owners. In the current crisis, declining housing assets were oft=
en, in effect, purchased between 90% and 100% on margin. In some of the cit=
ies hit hardest, borrowers who purchased in the low-price tier at the peak =
of the bubble have seen their home value decline 50% or more. Over the past=
 18 months as housing prices have fallen, millions of homes became worth le=
ss than the loans on them, huge losses have been transmitted to lending ins=
titutions, investment banks, investors in mortgage-backed securities, selle=
rs of credit default swaps, and the insurer of last resort, the U.S. Treasu=
ry.=20



In an important paper in 1983, Ben Bernanke argued that during the Depressi=
on, severe damage to the financial system impeded its ability to perform it=
s economic role of lending to households for durable goods consumption and =
to firms for production and trade. We are seeing this process playing out n=
ow as loan funds for automobile purchases have withered. Auto sales fell 41=
% between February 2008 and February 2009. Retail and labor markets too are=
 now part of the collateral damage from the housing debacle. Housing peaked=
 in early 2006. Losses from the mortgage market began to infect the financi=
al system in 2006; asset prices in that sector began to decline at the end =
of 2006. Meanwhile, equities and the broader economy were performing well, =
but as the financial sector deteriorated, its problems blindsided the rest =
of the economy.=20



The events of the past 10 years have an eerie similarity to the period lead=
ing up to the Great Depression. Total mortgage debt outstanding increased f=
rom $9.35 billion in 1920 to $29.44 billion in 1929. In 1920, residential m=
ortgage debt was 10.2% of household wealth; by 1929, it was 27.2% of househ=
old wealth.=20



The Great Depression has been attributed to excessive speculation on Wall S=
treet, especially between the spring of 1927 and the fall of 1929. Had the =
difficulties of the banking system been caused by losses on brokers' loans =
for margin purchases in 1929, the results should have been felt in the bank=
s immediately after the stock market crash. But the banking system did not =
show serious strains until the fall of 1930.=20



Bank earnings reached a record $729 million in 1929. Yet bank exposures to =
real estate were substantial; as the decline in real estate prices accelera=
ted, foreclosures wiped out banks by the thousands. Had the mounting diffic=
ulties of the banks and the final collapse of the banking system in the "Ba=
nk Holiday" in March 1933 been caused by contraction of the money supply, a=
s Milton Friedman and Anna Schwartz argued, then the massive injections of =
liquidity over the past 18 months should have averted the collapse of the f=
inancial market during this current crisis.=20



The causes of the Great Depression need more study, but the claims that los=
ses on stock-market speculation and a monetary contraction caused the decli=
ne of the banking system both seem inadequate. It appears that both the Gre=
at Depression and the current crisis had their origins in excessive consume=
r debt -- especially mortgage debt -- that was transmitted into the financi=
al sector during a sharp downturn.=20



What we've offered in our discussion of this crisis is the back story to Mr=
. Bernanke's analysis of the Depression. Why does one crash cause minimal d=
amage to the financial system, so that the economy can pick itself up quick=
ly, while another crash leaves a devastated financial sector in the wreckag=
e? The hypothesis we propose is that a financial crisis that originates in =
consumer debt, especially consumer debt concentrated at the low end of the =
wealth and income distribution, can be transmitted quickly and forcefully i=
nto the financial system. It appears that we're witnessing the second great=
 consumer debt crash, the end of a massive consumption binge.=20



Mr. Gjerstad is a visiting research associate at Chapman University. Mr. Sm=
ith is a professor of economics at Chapman University and the 2002 Nobel La=
ureate in Economics.=20