If a person's assets grow in value, he can borrow more against them, or expect a lower interest rate if he does not increase his borrowing (for then the lenders have more security). This is true of houses as of other assets. In a growing economy, with the amount of land available for housing more or less fixed, the value of residential property can be expected to increase--over the long run. But in the short run, asset prices may stagnate or even decline. In recent years, homebuyers have been willing to take on historically unprecedented risk in the form of 100 percent mortgages (on the subprime bubble, see my posting of June 24) and floating interest rates. As a result, if housing prices fall, a buyer can find himself with negative equity (that is, owing more than his house is worth) and paying a much higher interest rate than the rate prevailing when he bought the house.
Although a floating interest rate shifts risk from lenders to borrowers, lending without requiring a significant (or sometimes any) down payment imposes substantial risk on lender as well as borrower, since they have in effect a joint interest in the property that secures the loan. Moreover, the costs of foreclosure and resale are considerable and amplify the loss of value when housing prices fall and precipitate defaults.
Back in 2005, both the Economist magazine and the Federal Deposit Insurance Corporation, along with many others, warned that American housing prices were growing at unsustainable rates; the FDIC noted that in the five years ending in 2004, U.S. home prices had risen by 50 percent. There is a long history of housing busts following housing booms, and although generally in this country the booms and busts have been local rather than nationwide, Japan famously experienced an extremely severe nationwide drop in housing prices in 1990. One might have expected concerns with the possibility of a bust, given the housing bubble and risky lending, to drive up interest rates, but this did not happen, because lenders were willing to assume a very high level of risk. In part this was because the initial lenders could sell loan packages to hedge funds and other specialists in risk bearing.
The bubble burst, defaults ensured, interest rates rose--precipitating more defaults--and some lenders were wiped out. Finally the Federal Reserve Board stepped in and eased interest rates by providing additional capital to the banking industry.
The only justification for bailing out risk takers is to avoid a depression (or as it is politely called nowadays, a "recession", but, oddly, the worse the macroeconomic consequences of a speculative boom and bust, the stronger the argument for punishing the risk takers (which include both borrowers and lenders) by not bailing them out. The punishment should fit the crime (I use "crime" in a figurative sense); the worse the crime, the heavier the optimal punishment, setting aside issues of detectability. If the government relieves risk takers of the consequences of their risks, there is a divergence between social and private risk. An example is subsidized flood insurance, which leads to excessive building in floodplains.
There seems a particular perversity in making credit cheaper, since cheap credit fed the boom. Lower interest rates encourage borrowing and hence spending and also increase the price of imports by making the dollar worth less relative to other currencies. Moreover, government intervention to help lenders and borrowers invites further government regulation--for example limits on subprime lending. There is no more reason to discourage risk taking than to bail out the risk takers when the risks they have voluntarily assumed materialize.
The losses sustained by hedge funds in the bursting of the subprime bubble lend a note of irony to opponents of taxing them comparably to other investment companies. They argue that hedge funds play an essential role in bringing market values into phase with the underlying real economic values. It now seems that a number of hedge funds were caught up in a speculative frenzy, and that far from bringing about convergence between market and real values they enlarged the wedge between them.
Studies in cognitive and social psychology have identified deep causes for the overoptimism, wishful thinking, herd behavior, short memory, complacency, and naive extrapolation that generate speculative bubbles--and that require heavy doses of reality to hold in check. Any efforts to soften the blow will set the stage for future bubbles.