The Great Housing Mania - Insight from Martin Conrad

This is hands-down the best article I have ever read on the housing crisis.  It is short, succinct, and very insightful.  There is no finger pointing, no emotions, no politics, it is just what happened.  Economics is all about choice.  If we choose this, this will be the consequences both intended and non-intended.  Be careful how you choose.

The article written by Martin Conrad of CIG is in italics and the bold is my emphasis.  From Barron's:

The full story about housing and the economy has been ignored too long. Like all manias, it was a long time building.

The boom of the 1950s and 1960s, featuring rising incomes and wealth, occurred in a well-balanced economy. The benefits of economic growth were fairly evenly distributed. That was an economy where the U.S. manufacturing sector was competitive and flourishing, its infrastructure was adequate and being improved, and housing valuations were at least fair, if not cheap. The value of housing averaged 80% to 90% of gross domestic product in this era -- about half of the peak value set in the mania that ended so badly in 2008.

During the 1970s and 1980s, as the large baby-boom generation grew to adulthood and formed households, housing markets were distorted. The result: about a 50% rise in the aggregate value of housing, to 120% of GDP. At the end of this period, there was a solvency crisis in the thrifts and banks that had financed the housing sector. A few thousand of them had to be liquidated by the federal government.

During the 1990s, the U.S. enjoyed renewed prosperity, with a booming stock market and the creation of 20 million jobs. Housing valuations moderated, and the aggregate value of housing declined to a bit over 100% of GDP, not much higher than the average during the postwar boom.

More ominously, the few thousand thrifts and banks that had been lost during the savings-and-loans crisis were mostly being replaced by a mortgage-securitization process, not by new banks and thrifts using traditional credit standards. The new home-loan system soon came to be dominated by Wall Street investment banks.
In the late 1990s, there was a major banking reform. The Glass-Steagall Act, a reform of the Depression era that had separated investment banking from commercial banking and had given only the latter government-supported deposit insurance, was repealed. This began an era of mass securitization of mortgages, which enabled large-scale lending to subprime borrowers. Other features of the period included making loans with little or no documentation of borrowers' ability to pay, and loans with low or no down payments. The easy money for homeowners stimulated widespread speculation in everything related to housing, including precarious financing.

This culminated in a final manic race to the top, when the aggregate value of housing exceeded 170% of GDP.
THE INEVITABLE BUT UNEXPECTED RESULT was a wave of mortgage defaults and a catastrophic decline in housing values. The market for securitized mortgages declined and then collapsed in 2008. In that year, houses with mortgages had about $11 trillion in aggregate mortgage debt that was collateralized by a net equity of zero.

At its peak in 2006, 2007, and 2008, this mania had overallocated as much as $10 trillion to the housing sector, based on the long-term average of housing value to GDP. This misallocation came at the expense of more productive and more sustainable economic opportunities in manufacturing, infrastructure, and technological innovation. The catastrophic losses also were a major factor in the extremely unequal distribution of national wealth, as the middle class lost approximately 40% of its net worth, most of it on overpriced and overleveraged housing.

Knowledgeable insiders who were aware of the distortions and the dangers headed for the exits early, leaving the masses with gigantic losses and unmanageable debt. There was an enormous rise of insider selling in 2005 by senior management of the major home builders, and in 2008 there was an epidemic use of derivatives to speculate against overleveraged Wall Street securitizers.

Eventually, the huge unknown risk associated with these complex derivatives led to a crisis of confidence: Could the counterparties pay on their losing bets? Would they pay, even if they could? This lingering destructive counterparty risk is still huge and its many connections mostly unknown, and hence it continues to paralyze investment confidence.
Manias occur for many reasons, but great manias are made possible and sustained by errant government policies that may seem to have good reasons, none of them with any long-term economic value. Housing, despite high leverage, high transaction costs, and poor liquidity, was promoted as a dream investment for everyone. Massive intervention in this market by populist government policies and agencies fostering affordability exacerbated these normal defects and disastrously distorted the market. It was a "dream," in the sense of confused, wishful thinking. But to think and act this way with many trillions of dollars, most of it borrowed, was irresponsible on an historic scale.

There is now much media commentary that no sustained and robust recovery is possible until the housing sector recovers (that is, until house prices rise again). This desire to simply reinflate the collapsed bubble would likely yield the same disastrous result again. Another course would likely be more effective: restructuring away from so much dependence on leveraged, expensive, and speculative housing values. We should no more regret the demise of expensive housing than we should the decline of expensive oil, both of which are poorly correlated with productive, sustainable economic growth, but strongly correlated with damaging inflation.

Disciplined buyers -- too long unfairly disadvantaged by government policies -- are now sitting on trillions in savings that are earning, doing, and financing nothing. This money could clear the housing market, but only at lower, fairer prices. That would finally be "affordable housing."

Manias begin in obscurity and pessimism, rise with confidence and imitation, reach a state of euphoria and finally end in tragedy. They often change history in ways that are not foreseeable.