Today’s edition of The Wall Street Journal contains a review of two books that deal with the real estate bubble that continues to dissipate. The books assert that a combination of easy credit and the preceding dot.com bubble helped fuel the real estate bubble. The link between the two asset bubbles is something I posted on earlier (http://www.debatepolitics.com/econom...te-bubble.html). In that earlier post, one can see from the illustration how the housing prices began to rise relative to nominal GDP at around the time stock valuations (as reflected by the S&P 500) commenced a steep decline relative to nominal GDP.

As with all asset bubbles, easy credit played an important role. In fact, mortgage debt relative to nominal GDP began rising increasing rapidly after 1995. In 1995, mortgage debt amounted to 61.5% of nominal GDP. By 1999, it had reached a record 67.2% of GDP, breaking the earlier mark of 65.9% of GDP set in 1991. From there the “rocket” sailed well beyond any earlier precedent. Mortgage debt ultimately peaked at 105.5% of nominal GDP in 2007. As of 2008 Q1, mortgage debt still stood at 103.7% of GDP.

At that level of leverage, housing purchases had essentially become a speculative endeavor in the broader macroeconomic framework. That development entailed added economic risk. Research by Hyman Minski et al., has found that “the greater the proportion of speculative…finance units in an economy, the greater the fragility of the financial structure.”

Home prices as measured by the CSXR-10, began rising relative to nominal GDP shortly after mortgage debt had begun to rise. Home prices peaked in 2006 and then began their ongoing decline.



It should be noted, I used 2002 to mark the beginning of bubble conditions, as at that time, the change in home prices from 1995 exceeded change in nominal GDP from that year by more than 20%.

But that is not all. The data also shows an adverse feedback loop in which rising debt fueled increased demand for homes. In turn, that increased demand increased home prices. The increase in home prices fueled increased mortgage debt. This feedback loop shows up quite well when one measures the annual change in mortgage debt relative to nominal GDP and the annual change in home prices relative to nominal GDP. The lines intersect where feedback is occurring.



During the adverse feedback loop, more and more credit was sucked into home mortgages. In fact, during 2003-2007, consumer credit (excluding mortgages) declined from 17.7% of nominal GDP to 16.9% of nominal GDP.

As happened following the start of the 1989-94 housing bust, the slowdown in increased mortgage debt and later decline in mortgage debt followed the slowing of home price gains and then decline in home prices. This lag might well be explained by a persistence of expectations for increased home prices even after the housing market began softening.

In the immediate aftermath of the dissipating housing bubble, one may be witnessing the emergence of a transfer of leverage from mortgages to consumer debt. So far, about 60% of the decline in mortgage debt relative to nominal GDP has been replaced by an increase in consumer debt relative to nominal GDP. At the end of March 2008, consumer debt (excluding mortgages) stood at a record 17.9% of GDP. It remains to be seen whether this trend will continue, especially as some consumer debt e.g., credit card debt, bears much higher interest rates than mortgage debt. To the extent that such credit substitution is helping fuel personal consumption expenditures, there will be added risk that such expenditures, which amount to just over 70% of GDP, could falter, especially if inflation continues to rise and interest rates on such debt increase, as well.

In any case, the magnitude of the mortgage debt explosion that helped fuel the real estate bubble suggests that the potential exists for an extended credit squeeze. As a result, once home prices bottom out, no strong increases in home prices will be likely perhaps for an extended period of time.