Working Paper #717
The Housing Bubble
Adam J. Levitin · Susan M. Wachter
Borrowing Constraints Housing Supply Mortgages
There is little consensus as to the cause of the housing bubble that precipitated the financial crisis of 2008. Numerous explanations exist: misguided monetary policy; a global savings surplus; government policies encouraging affordable homeownership; irrational consumer expectations of rising housing prices; inelastic housing supply. None of these explanations, however, is capable of fully explaining the housing bubble.
This paper posits a new explanation for the housing bubble. First it demonstrates that the bubble was a supply-side phenomenon, attributable to an excess of mispriced mortgage finance: mortgage finance spreads declined and volume increased, even as risk increased, a confluence attributable only to an oversupply of mortgage finance. Second, it explains the mortgage finance supply glut as resulting from markets failing to price risk correctly due to the complexity, opacity, and heterogeneity of the unregulated private-label mortgage-backed securities (PLS) that began to dominate the market in 2004. The paper proposes the standardization of PLS as an information-forcing device. Reducing the complexity and heterogeneity of PLS would facilitate accurate risk pricing, which is necessary to rebuild a sustainable, stable housing finance market.