Here is another question about housing and the financial crisis that has been bothering me for a couple of years.
Many people seem to blame the Fed for starting things with its easy money policies during the first half of the decade. John Taylor presents the case for this view quite compellingly in this article in Critical Review.
But if money was so easy/loose/cheap, whatever term you want to use, why didn't the CPI take off more than it did. I gather US prices rose by a bit more than the targeted 2% during that period, but not much. And yet the rate of inflation in the housing market was astronomical at the very same time.
I know that monetary policy tends to have its initial impact on housing markets often, but the differences between housing and the rest of the economy were very distortionary and look to me as if there must have been much more going on that would have had such a one-sector impact on housing.
Here is my guess (but I am open to suggestions). As I mentioned in my posting yesterday, the shadow banking system seems to have played a major role in pumping up the demand for mortgages (and hence increase the supply of lendable funds specifically to the housing market). And the way the derivatives evolved, it didn't matter what type of mortgages people provided so long as they could sell them to investment banks who could in turn fob them off onto shadow banks for repackaging as collateralized debt obligations.
With the rapid growth in the demand by lenders for mortgages (increasing the supply of lendable funds for home buyers), outstripping the supply of conventional mortgages, credit standards were lowered ... and lowered some more. It was this set of circumstances that really drove up prices in the housing market. Easy money from the Fed could not have caused the bubble by itself. It was the flood of liquidity from the shadow banks that really drove up housing prices.
But of course it couldn't continue. People who bought a house using a subprime mortgage ran into problems when their adjustable or teaser rates were adjusted upward. Also, not everyone could be induced to keep trading up or into buying second or third homes for speculative purposes. And once the demand for housing slowed a bit, the players in the shadow banking system who were massively leveraged couldn't find people to lend them money in the short-term or overnight money markets.
In the case of investment banks, this reliance on short-term financing required them to return frequently to investors in the capital markets to refinance their operations. When the housing market began to deteriorate and the ability to obtain funds from investors through investments such as mortgage-backed securities declined, these investment banks were unable to fund themselves. Investor refusal or inability to provide funds via the short-term markets was a primary cause of the failure of Bear Stearns and Lehman Brothers during 2008.
When the shadow banks couldn't borrow short-term, and when the underlying mortgages they were holding began to default, and when they couldn't make payments on their CDOs, then they had to turn to the insurers of the the CDOs --- the monoline insurance firms and the investment-bank parents who had provided them with guarantees of liquidity.
If it weren't for the actions of these highly leveraged shadow banks, I have to wonder whether we'd have had such a big housing bubble even with easy money from the Fed; and without the highly leveraged credit from the shadow banks, I have to wonder whether a downturn in the housing market would have caused such serious financial problems for the economy.