Eugene Fama, a brilliant economist at the University of Chicago, is one of the principal founders of modern finance theory, and is an especially strong proponent of the “efficient markets” theory of asset pricing, whereby the prices of common stocks or other traded assets are assumed to impound the best available information about their value, including future value discounted to the present. Fama is not a dogmatic proponent of the theory; some of his pioneering research has identified anomalies in stock pricing that seem to contradict the theory. But he supports the theory in the main and one consequence is that he is extremely skeptical of the existence of asset-price “bubbles.”
A bubble is an increase in the price of an asset that cannot be explained by changes in conditions of demand or supply that could be expected to alter the value of the asset relative to the value of other goods or services. (More precisely, a bubble can be defined as a disequilibrium event involving a steep increase in price that persists for a significant time, cannot be explained by fundamentals, and, after peaking, quickly gives way to a steep decrease in price.) We experienced what is widely believed (and what I believe) to be a bubble in housing prices between 1996 and May 2006, when average housing prices plateaued and immediately began to decline. Between 2002 and May 2006 the median price of a house rose by almost 50 percent. Between then and 2010 it fell by a third, and it has since risen slightly.
One can imagine factors that would explain a steep rise and later a steep fall in the price of housing. They might include a sharp increase in incomes or wealth, or in population, or big changes in construction costs, zoning and building codes, commuting costs, family size, and so on, but such changes cannot account for the pattern of housing prices. What seems to have happened was that the prosperity of the second half of the 1990s increased the demand for and hence (because the housing stock is very durable, so that increases in demand are not immediately reflected in increases in supply) the price of houses, and that the upward trend continued into the early 2000s because of the mistaken decision of the Federal Reserve to push short-term interest rates way down in 2001, to keep them down, to raise them only gradually, and to lower them again if necessary to prevent the market from dropping (the “Greenspan put”). Because houses are bought mainly with debt (a mortgage), and because short-term interest rates influence long-term rates, such as mortgage interest rates—and in fact those rates fell in the wake of the Fed’s pushing down short-term rates—people found it cheaper to finance a house purchase and so demand continued to increase, driving up price.
So far, no bubble. But even after the Fed started raising short-term interest rates, albeit very gradually, in 2004, and mortgage interest rates began to rise as well, house prices continued their rapid climb. At this point, rising house prices became a bubble phenomenon. Prices continued rising because prices were rising. People who did not own a house watched prices rise and inferred that other people knew or thought that houses were underpriced—were a good value, a good investment. Observing such behavior, and inferring that therefore prices might well continue rising, people who didn’t own a house began to think it was a good time to buy a house; indeed some people began buying houses as a speculation. The buying frenzy was facilitated by the adjustable-rate mortgage, which enabled people to buy houses with little or no down payment and very low (“teaser”) interest rates for the first couple of years followed by a much higher “reset” rate. If during that period house prices continued to rise, the buyer would have substantial equity in the house and would be able to refinance his house with a conventional 30-year mortgage at a low rate, and so would never have to pay the reset rate on his original, adjustable-rate mortgage. If prices didn’t rise, he could abandon the house at the end of the two years, ordinarily at no cost except a moving cost.
Buying a house or other asset because other people are doing so may seem an example of irrational “herd” behavior. But herd behavior is not irrational. If you are an antelope, and you see your fellow antelopes begin to stampede, you are well advised to join them, because they may be fleeing from a lion. We commonly take our cues from people who we believe have desires and aversions similar to our own.
Fama believes that the housing “bubble” was not a bubble—that, rather, people rationally if mistakenly believed until May 2006 that houses were underpriced, and beginning then believed that they were overpriced. But he acknowledges that he has not been able to identify the demand or supply factors that would have given rise to such beliefs. Nothing much about the housing industry seems to have changed over the period of a few years in which housing prices rose by almost 50 percent and then plunged to nearly their previous level.
If rational (or at least not demonstrably irrational) herd behavior explains the bubble, what explains its bursting? Obviously the price climb must end well short of the point at which the entire Gross Domestic Product is being spent on housing. Eventually everybody who wants a house and can afford it at the existing price level has bought it. But why don’t prices level off when that happens, rather than fall? The reason is that the satiation point is not an equilibrium. When prices stop rising, people who counted on continued price increases to enable them to refinance their mortgage, or who had bought houses as speculative investments, begin to abandon or sell the houses, and with the supply of housing rising but demand not rising, prices fall. Now reverse bubble thinking sets in. People infer from declining house prices that other people think houses are not a good investment after all. They begin to worry that as more people abandon their houses or put them up for sale, prices will continue falling, so they decide to get out while the getting is good, and as more people do that prices fall faster and farther.
The run that brought down Lehman Brothers in September 2008 and threatened to bring down much of the rest of the banking industry was a similar phenomenon. Most of Lehman’s capital was short term, and unlike deposits in commercial banks its capital was not federally insured. When it was realized that Lehman was heavily invested in mortgage-backed securities, whose value was plummeting in the wake of the bursting of the housing bubble, the suppliers of Lehman’s short-term capital began withdrawing their capital from Lehman—less because they thought that Lehman’s assets no longer exceeded its liabilities than because they feared that other suppliers of Lehman’s capital thought Lehman was broke and therefore would withdraw their capital as fast as possible and that—a classic bank run—would break Lehman. It was another example of rational herd behavior.
What brought down Lehman and threatened to bring down much of the rest of the banking industry was the bursting of another bubble—the housing-credit bubble. The firms that finance the purchase of housing, whether they are mortgage lenders or purchasers of securitized mortgage debt, are essentially joint venturers in the housing market. If they are financing a housing bubble and it bursts, they are losers along with the house owners. The bursting of the housing bubble will precipitate defaults and reduce the value of the house as the collateral for the mortgage.
So why did the sophisticated finance industry finance a housing bubble whose bursting was bound to hurt the industry? There were plenty of warnings that there was a housing bubble; why did the industry ignore them? I think it was another though somewhat more complex example of rational herd behavior. The major assets of a modern financial institution are short-term capital and talented staff, and both are highly mobile assets that the institution will lose if it is less profitable than its competitors, and it will be less profitable if it refuses to make risky mortgage loans. Just as the adjustable-rate mortgagee’s downside risk is truncated by his ability to abandon the home if house prices don’t rise, so the financial institution’s downside risk is truncated by limited liability, which protects shareholders and managers from having to pay their company’s debts out of their own pockets.
Thus I don’t think bubble behavior is necessarily or even characteristically irrational. Often, including in the case of the housing and housing-credit bubbles, it is a rational adaptation to uncertainty. It is not efficient behavior in an overall social sense, and so efforts at detection and prevention of bubbles are probably worthwhile. Given the abundant warning signs and explicit warnings of a housing bubble and a housing-credit bubble, the failure of the Federal Reserve under Greenspan and Bernanke, the federal housing authorities, other economic organs of government, and almost the entire economics profession to detect these bubbles cries out for an explanation.