A Maturing View of the Housing Crisis

By Patricia Liever, staff editor The Sanford School of Public Policy is lucky to be hosting visiting professor Michael Stegman this semester to teach a seminar entitled “Remaking National Housing Policy.”  In just a few short weeks, this seminar has challenged my views of the housing crisis and forced me to reconsider the popular view of the events that have likely changed the fundamentals of the American economy for some time to come.

Before this semester, my easiest explanation of the housing crisis was to chalk it all up to “bad behavior”.  Families took out mortgages on houses they could not afford, banks made predatory and irresponsible loans, and Wall Street packaged worthless securities and knowingly sold them to pension funds and Icelandic banks all in a scheme to make a quick buck.  This explanation of how we got here is easy to understand, but ignores the structural mechanisms that allowed it all to happen.  The majority of these “bad behaviors” were completely legal – if not encouraged -  under the system of laws and regulations that governed the housing finance market prior to the passage of the Dodd-Frank Financial Reform legislation.

There are elements of truth in this “bad behaviors” explanation, for sure, but it ignores the most basic underlying assumption of free market economics: rational choice.  It is my belief that every individual or institution involved in the lead up to the housing crisis was acting in exactly the way that economic theory would predict.  Most home buyers, if given the choice, would prefer a four bedroom house to one with three bedrooms.  And if mortgage brokers tell them that they can afford the bigger house through exotic mortgage products, most individuals will do so.  At the same time, those same mortgage brokers would often earn heftier commissions by originating an exotic loan than they would with a plain vanilla 30 year fixed-rate mortgage – so why should we be surprised that they did so with such frequency?

Even with so many interconnected parts to this crisis, there are two clear losers: homebuyers and investors.  According to data from the Center for Responsible Lending, over 4.8 million foreclosures have been initiated since the beginning of 2008.  Untold amounts of equity have been lost as a result of the housing crisis and many are predicting that it will get worse before it gets better.   Millions of families have lost their homes and their greatest source of wealth.  On the other end of the pipeline, many investors had no reason to suspect the quality of the securities they were purchasing.  Credit ratings agencies had given top grades to these financial products, and when the bubble burst it resulted in trillions of dollars in lost global wealth.  These consequences of rational decision making are staggering.  But these outcomes beg the question: if individuals and institutions were acting rationally given the constraints they faced, what does that say about our definition of rationality?

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