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Housing Prices Always Rise

by Greg Ip

Countless delusions and mistakes brought on our financial crisis, but none did as much damage as the belief that home prices never go down.

People have long seen real estate as a safe investment. The notion is intuitive - the supply of land is limited, and the population is always growing - and until 2007, national home prices had not fallen significantly since the Great Depression.

Yet at the start of this decade, this belief became the lynchpin of an entire investment philosophy, as survivors of the dot-com bubble sought a refuge for their money. When Robert Shiller, a Yale economist, surveyed homebuyers in 2003, he found that 10 times as many said the stock market collapse had encouraged them to buy a home as said it had discouraged them.

At first, home values seemed reasonable when compared with a family's income or with rental prices. But the more people behaved as if home prices could not go down, the more they drove prices beyond reasonable levels. Between the end of 1999 and early 2007, prices soared 70 percent.

The belief was even more consequential for lenders than buyers. Why turn down a mortgage applicant with a bad credit history or no documented income? After all, if prices only went up, a delinquent borrower's home could always be sold to repay the loan. Declines in certain regions could not be ruled out, so investors bought securities backed by a pool of mortgages from around the country for safety. A 2009 study by Federal Reserve staff members found that banks knew from 2004 to 2006 that a big nationwide fall in home prices would trigger catastrophic defaults; they simply thought such a fall impossible.

And most experts agreed. Alan Greenspan had famously warned of irrational exuberance in stocks in the 1990s. But a decade later, the Fed chairman argued that houses were not susceptible to such excess: They were difficult to trade, expensive to build and not very homogenous. "A national severe price distortion seems most unlikely," he said in 2004. Less than a year later, Greenspan, too, became nervous, diagnosing housing "froth" in some regions. But he predicted that even if prices declined, the economy wouldn't suffer much, thanks in part to mortgage securitization.

With hindsight, what should Greenspan have done differently? Raising interest rates just to cap home prices would have invited recession. However, the Fed could have used its regulatory powers to press for tighter loan underwriting standards. Of course, that would have made it harder to buy a home, so a political backlash would have followed. But it might have mitigated the damage when prices eventually fell.

Real estate's appeal in America has waned, but it's alive and well in the red-hot Asian housing markets. Regulators there are trying to learn from America's lessons by insisting on tougher criteria to get a mortgage. If property prices implode, they hope their banks won't follow. We'll see.

Greg Ip is the U.S. economics editor of the Economist.

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