Certainly, reducing the down payment requirement does not cause market interest rates to be lower. So between those two variables, causality can run at most in one direction.
You are saying that the real estate industry is not going to push for lowering the down payment requirement in a high interest-rate environment. I can see that if the marginal homebuyer is low on income and low on assets. If nominal interest rates are high, the monthly payment will be daunting, and lowering the down payment requirement cannot help this person.
On the other hand, suppose that the marginal homebuyer has decent income and low assets. Even in a high interest-rate environment, lowering the down payment requirement might help that person. And if interest rates are high because of general inflation, including house price inflation, then from the bank’s point of view it is safer to lower the down payment requirement in this environment than in an environment of low inflation.
I think that the main reason that down payment requirements went down was because the people lending the money at least implicitly assumed rising house prices. In addition, government officials were beating up on lenders for rejecting applicants from what was called the “under-served” segment of the market. (Of course, by 2010, government officials described this segment as “borrowers who were not qualified” and were shocked, shocked that the evil, predatory lenders had forced these people to take loans that they could not repay.)
These are good points. He had commented that aggressive financing methods like low down payments had pushed home prices up. I responded that the causation went the other way. Low long term interest rates caused housing prices to go up and also created pressure for reduced down payments.
The reinterpretation I am suggesting reverses the causation at another level also. There was a AAA-rated securities bubble within the banking sector and, separately, a housing boom.
I think the conventional version of the causality says that low short term rates ("loose money") caused the banking bubble which caused a housing bubble. I am proposing that low long term rates ("tight money") caused a housing boom (not a bubble) which fed a banking bubble in AAA-rated securities.
Low rates from loose money ---> Banking Bubble ---> Housing Bubble
Low rates from tight money ---> Housing Boom (not a bubble) ---> Banking Bubble
(I extend the causation pattern here.)
My main point is that homes are like very long term TIPS bonds. Real rates, even at the long end of the yield curve had decreased by several percentage points over the previous 25 years. A reduction of 3% in long term real interest rates could justify an increase in home prices of 50% or more. This factor alone can explain most or all of the rise in home prices. An excess of aggressive financing might have added some froth at the end, but this factor is not necessary to justify the general price movements we saw.
The accumulation of equity among homeowners and the new subsets of the population who could qualify for mortgages because of low monthly payments were reasonable outgrowths of the boom. The bubble in banking was the result of institutionally rigid rule sets which regulated banking activity. Pressures to increase exposure to subprime lending, static rules regarding leverage of this credit, and legal protections for bank creditors were the pathogens, and all this new housing equity was the agar.
1) So, largely exogenous factors led to low long term real rates, which, combined with low inflation due to longstanding Fed money supply policy, led to a sharp increase in home prices.
2) High home prices, together with an unfortunate combination of public banking policies, led to a banking bubble.
3) The Fed countered the banking bubble with even tighter monetary policy, which created a credit crisis that brought down the banks and the housing boom.
4) Because the basic ingredients for increased home prices are still in place, we are now seeing a renewed increase in home prices. This is happening in the face of credit markets that are still hobbled. But, the power of low real and nominal rates regarding home prices is so strong that home prices have stabilized and begun to rise again at elevated levels even though a large share of home purchases are from all-cash investors, due to the credit crisis. This is kind of the opposite of the case from the 1970's that Arnold mentioned, where a low-asset, high-income household might have been willing to lower their down payment in the 1970's in order to establish home ownership. Now we have banks that are incapable of loaning to a large number of home-buyers, even though the interest rate context would attract them. So, private equity investors with their own sources of cash are stepping into the market.
The sad irony is that, on the margin, loose monetary policy in the 1970's kept home prices from rising to the levels we saw in the 2000's. But, public sentiment is going to pressure the Fed to tighten money again as home prices continue to rise. Tight monetary policy can lower inflation, and at the extreme, lower real incomes, like it did in 2008. Since lower inflation will only increase real home prices by lowering nominal mortgage rates, if the Fed becomes determined to knock down home prices, it will have to tighten again to the point of damaging real incomes. That would be unfortunate.