Was it the availability of credit that lead to the housing bubble?

A popular explanation of the booming in house prices according to, well, everyone is that there was lots of “credit washing around” which convinced people that they should go and bid up house prices. An example of this logic is shown in this statement at the very good Big Picture blog:

The bubble in home prices, fueled by the ready availability of credit, resulted in an underestimate of the risks of residential real estate

Personally, I think this type of thinking has the causality all mixed up – if there was any error it was because people “underestimated the risks” associated with the price of residential real estate, and therefore given the “price” of credit the housing market appeared to be a better bet than it actually was. As a result, the entire blame for the bubble and associated crisis should lie with the fact that risk wasn’t being appropriately identified – not with some mystical belief that credit was springing up all over the place. If the risk problem was unsolvable, then we can blame central banks for leaving the price of credit (not its “availability) to low – however, this is a secondary issue to risk.

The whole concept of the “availability of credit” is somewhat of a misnomer.

There is always more credit available, always, it just may be at a higher interest rate than you are willing to pay. As a result, demand for credit (which falls as the interest rate rises) will always post a binding constraint on the ability of credit to appear in house prices.

During the current bubble money demand rose more than it should of according to fundamentals, because of higher price expectations and low perceived risk.

With no institutions available to counter act this change in expectations, and with the wrong information being disseminated by both the suppliers of credit as well as those that demanded credit, we ended up in an untenable situation – where something has to give.

As a result, I would not blame the free “availability” of credit for the housing factor – using this term is a smokescreen to deflect liability from central banks (which should have lifted interest rates faster and further) and the institutions that were supposed to help inform investors of risk.

BTW, if anyone is going to try telling me that higher interest rates increase the “availability” of credit, and therefore leads to more borrowing read this before saying anything – a demand curve is a binding constraint.

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  • Steve

    Not quite so sure I agree with all of this;
    You have missed the additional point, which is why so many people are affected, that these “bad credit” loans were being repackaged to reduce the cost of borrowing (and therefore pass these savings on to those who have bad credit and get loans for houses). the repackaged bit meant that you could buy a share of the 80% best loans, and someone else bought the 20% worst loans. (remeber we don’t know which are the best and worst, the person who buys the 80% best is not affected untill more than 20% of people default). The repackaged loans could then be presented as a huge chunk of safe loans, and a very small chunk of junk loans at a massive rate. This way, finance companies, banks, mortgage lenders, could appear to have good credit ratings and people invest etc.

    I’m sure someone can explain it better than me, but the snowball effect of loans collapsing is the mess America is in right now.

  • Miguel Sanchez

    I suspect that’s a reason why the US housing boom/bust has been more severe than elsewhere. But most of the Western world has had a housing bubble, and the only common theme I can think of is too-low interest rates.

  • Steve

    absolutely too low interest rates as this blog rightly points out. My point was that the excess risks taken on by banks were passed on to many investors because the loans could be repackaged and sold to funds/investors/you and I, and we don’t see the risk because of the way the loans were repackaged. My point was that if the loans couldn’t be repackaged in the way they were (not saying this should be illegal, just properly rated) then the mess may not have spread as far afield.

    The real mistake here was they way standard and poors etc evaluated the repackaged loans as being top quality, when the majority of the loans weren’t quality, just someone else was taking the risk of the “first one’s” collapsing.

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  • “You have missed the additional point, which is why so many people are affected, that these “bad credit” loans were being repackaged to reduce the cost of borrowing”

    First, I am talking about the global housing bubble (most specifically the New Zealand one).

    Secondly, even in the case of the US housing bubble, the “bad credit” was only able to be packaged in this way because people were people purchasing the CDO also underestimated the risk associated with them – as the ratings agencies that specified the risk underestimated the risk associated with the housing market. Which is why the pricing of risk is the primary issue with the springing up of a housing bubble.

    In fact you raise the risk point in your comments – I’m not sure we are really disagreeing

    That is how I think of it anyways 🙂

  • It was not the availability of the credit It was the people that were put in charge of its care. http://www.revolutioncreditsolutions.com

  • “It was not the availability of the credit It was the people that were put in charge of its care.”

    If by care you mean that risk wasn’t being disseminated efficiently in the market place because of asymmetric information then yes

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