Back in the 1990s, the world seemed to go nuts - well, a small bit, for a while anyway. We had the dot com boom, and for a while it seemed like all you needed was a website and sock puppet and you too could be a millionaire for a day. The air was heady and anything seemed possible, with that frantic feeling you get when you know that a disaster is bearing down on you. And, during the presidential campaign of 2000, the slow-motion disaster started. In March/April 2000, the NASDAQ market peaked, and the expected an inexorable drive down started. Your humble correspondent went from pretend millionaire to unemployed and seemingly unemployable in the space of two years. Some one million tech workers, nearly 10% of the boom-time work force, lost their jobs in the collapse.
In order to avert a national recession, Alan Greenspan, then the head of the Federal Reserve, implemented a series of moves to pump the economy back up. Basically, he used the Fed's one basic tool, its control over a specific interest rate, to push interest rates down through most segments of lending. This had two effects: the major one, of making it cheaper and easier to borrow money, and the seemingly minor effect of reducing the payout people could get from the normal sorts of safe investments retirees and pension funds go for - savings accounts, government bonds of various sorts, blue chip stocks and the like. With interest rates cut to the bone all over, this class of investors was not able to get the sorts of returns that they would normally see.
This would not necessarily have been a problem, except that in the aftermath of the dotcom collapse, in which many people and institutions lost a bundle of money, these sorts of investors were now looking to make up their losses. Pension funds, school boards, municipalities and states funding retiree benefits, all were looking for higher returns on their investments to fill in the hole. For governments, the dotcom collapse had been a double whammy, because not only had they lost money on supposedly-safe technology stocks, they also lost the taxes that they had been collecting on the private and public sales of those stocks, the capital gains taxes, income taxes and so on.
So, in the aftermath of the 2000 bust, there was a hunger for higher yields. Fortunately, or so it seemed at the time, there were new tools to generate those desirable yields - securitization, derivative instruments and the like. Ordinary loans could be bundled into groups and then sliced up into layers. The safest layers had stronger payback guarantees but got less of the interest payments; the icing was that the most risky layers got more interest money - more return on the investment. What was best of all for the bundlers of these securitized loans is that, aside from the fat fee they collected for creating the bundle, they could have the entire bundle rated based on safest part of the loan, not on the riskiest bit. As a result, securitized mortgage bonds carried AAA ratings, the highest the raters gave, basically independently of the underlying mortgages. This was the first breakdown in the mortgage system.
These AAA-rated high-yield bonds did what you would expect - people who needed to put money into safe investments that would help them make back what they lost in the last collapse flocked to them. Not only did individuals sign up for them, but also major institutions that looked no further than the AAA rating. After all, if it was good enough for Standard & Poors or Moodys, it was good enough for them.
All of this money flooding into the credit markets in turn did what basic economics teaches us. Lots of money plus a fixed supply of goods (in this case, houses) equals inflation. Starting in 2001-2002, housing prices took off like a cat with its tail on fire. It didn't matter what the house had sold for, what normal price rises looked like in the market, how much people who worked in that city or town or neighborhood made and what they could afford, house prices doubled. All of the sudden, your basic three or four bedroom family home was going for double what it had just five years previously. And, for some reason, everyone thought this was OK. As a matter of fact, everyone thought it was peachy keen. Realtors saw their commissions double for doing no more work than they had in 2001, homeowners saw their home turn into an endless piggy bank that somehow they'd never have to refill, and the powers that be saw the wheels turning and all was good. Even appraisers, who should have had some sense of history, some rules of thumb for valuing homes, signed off on the new valuations, disabling another key check on the mortgage market. This was the second systemic failure.
Now, it so happens that there is a basic rule of thumb for knowing whether housing prices are reasonable or not. It's called the rent ratio, and what you do is you find out what the house - or a same-sized apartment - would rent for per month, and you multiply that by 180. That's what that house should cost, give or take one year's rent (monthly rent times 12). This rule has been good all over the US for a long time, and the nice thing about it is that it works for each neighborhood. You don't have to look at what some house sold for two towns over - because there's no other similar house closer - and try to guess whether that town and your town cost about the same, have comparable neighborhoods, and the like. Now, realtors don't like to talk about the rent ratio, at least not with buyers and sellers, because they like to pretend that pricing a house is a big secret that only they know. But the fact of the matter is that this works...except during a bubble. During the bubble, houses were going for up to 288 times the monthly rent, or 60% higher than they were worth.
So, appraisers, bankers and the ratings agencies should have been watching the rent ratio when they were writing and approving mortgages. But they weren't and so prices got way out of whack with values. Now, buyers have figured out that something is seriously wrong, and they're waiting for prices to drop. They'll come back down to the historical rent ratio, maybe even a little lower due to overshoot. Until then, they are going to drop - it's inevitable, and those who talk about stopping it, about getting house prices back "up to where they belong," well, they're don't know what they're talking about. There is one, and only one, way to push house prices back up to 2006 levels, and that is to have massive inflation in wages, prices and everything else. Otherwise, it's back down to 180 times rent, and the mortgage holders just better adjust to that reality.