Financial Crisis Post-Mortem: Interest Rates Rather than Housing Bubble Drove Mortgage Crisis

The common narrative of the mortgage crisis is that real estate prices in the U.S. were an overvalued bubble destined to pop. Home price indexes were at their unsustainable peak in 2005-2006 and everybody always assumed prices would continue to rise until they finally didn't.

But the regular increase in U.S. home values is a remnant of inflation. When housing prices are adjusted for inflation, there is no regular increase in the value of U.S. housing stock. The growth in housing value that existed between 2004-2006 was driven by low interest rates set by the Federal Reserve. When interest rates rose, starting in 2004 and continuing through 2006, it dramatically affected interest rates on adjustable rate mortgages leading to a raft of foreclosures.

While various factors can affect housing prices, between 2004-2006 changes in the inflation adjusted housing prices correlate with the change in the Federal Reserve's federal fund rate.

In a 2009 op-ed for the Wall Street Journal, ex-chairman Alan Greenspan highlighted the connection between mortgage rates and the federal funds rate, but he added that the two had become uncoupled between 2002-2005 and that it was long term interest rates driven by international markets that were the true culprit.

Yet it was long term interest rates that had become decoupled from mortgage rates—not the federal funds rate—between 2002-2005. Thirty-year U.S. Treasuries declined statically during that time period, almost exactly pegged to inflation. When those interest rates started to rise, it was after mortgage rates and the Federal Funds rate had already started to rise at the beginning of the mortgage crisis, not before.

The increase in the Federal Funds rate came first. It began to increase in June of 2004 for the first time in about four years, and that increase was followed by the growth in mortgage rates and then the growth in long-term interest rates.

Contrary to Greenspan's op-ed, the Federal Funds rate is substantially correlated with mortgage rates (Pearson=.82), both before and during the mortgage crisis. It was only after 2008, between 2008-2015 specifically, that the funds rate was decoupled from mortgage rates. Not just a simple correlation, many rates on adjustable interest mortgages are pegged to federal interest rates or the London Interbank Offered Rate (LIBOR).

The changes to the Federal Funds rate also mirrored the changes to housing stock surrounding the crisis. The Federal Funds rate rose in lock step with the value of pre-2000 housing stock in 2004-2005 and then declined in lock step in 2008-2009. Post-2000 housing stock data was not included because it's not a fixed quantity; housing stock grows with recent construction.

When the value of U.S. housing stock is adjusted for inflation, the constant rise seen in common charts of home price indexes largely disappears. Instead, housing values are generally flat except for periodic peaks and valleys.