Bankruptcy

Monetary Policy and the Housing Bubble

By Adam Levitin

A popular explanation of the financial crisis lays the blame at the feet of the Federal Reserve for lax monetary policy.  In this story, the Fed dropped interest rates starting in 2001 and kept rates too low for too long.  Low rates induced an orgy of mortgage borrowing for leveraged home speculation. 

It's a nice story.  Only problem is it doesn't really hold up under inspection.  Low rates in 2001-2003 did fuel an amazing mortgage refinancing boom, but not a purchase boom, and the boom was mainly in conventional fixed-rate mortgages, not the exotic products later years.  Moreover, despite the refinancing boom, no housing bubble was emerging in this period. 

The Fed started to raise rates in mid 2004 and continued to do so until mid-2006.  It was during this period that the bubble emerged, when rates were going up.  (To be fair, some might argue for an earlier date to the bubble, even as far back as the late 1990s.)  If we date the bubble from 2004, it's not consistent with a rate-driven bubble story, although rates were still extremely low in absolute terms during this period. 

The monetary policy story, however, really falls apart when one compares the US and Canada, as the graph below does.  Canadian interest rates, and perhaps more importantly, Canadian mortgage rates, track US rates pretty closely.  Yet the US had a housing bubble, and Canada did not.   This means we have to look somewhere other than monetary policy to explain the housing bubble.  The answer, I believe, lies in method and regulation of housing finance. 

Canada has a very different system than the US.  There is almost no private-label securitization in Canada; mortgages are either on banks' books or securitized in issues that "bear the Beaver."  (Ginnie Maes, guaranteed by the US government, are said to "carry the Eagle," and different types of FHA-approved lenders are referred to as Full Eagle or Mini Eagle lenders.) 

Moreover, all mortgages with LTV>80% are required to have private mortgage insurance, and there's a pretty limited market, basically the Canadian Mortgage Housing Corporation (government entity) and Genworth.  The rates are identical (perhaps regulated), so the only way to gain market share is to loosen underwriting, and that's a riskier move for an insurer to make (yes, they can reinsure, etc. but still). 

The Canadian system seems to have been able to keep out most of the exotic products that sprouted up in the US.  There is concern that Canada is currently developing a housing bubble (their price/rent ratio is pretty high).  Indeed, the growth of NHA MBS makes one wonder if all the questionable mortgages are just getting picked up by the government, akin to what might be happening here with FHA now.  Nonetheless, it seems that so far, the Canadian system likely shielded our northern neighbors a mortgage market disaster. 

Full post as published by Credit Slips on February 06, 2010 (boomark / email).