A Tale of Two (Housing) States
There is never a problem so small that central planners cannot make far worse. So-called “Smart Growth” regulations have crippled the market’s ability to produce a stable home price environment and have aided the housing and credit crises.
In the ‘90s, urban sprawl became a buzzword amongst environmentalists and the urban planning community. It was supposedly ugly, polluting, and destroying open space. The most objectionable quality, however, was that our cities did not fit the idyllic patterns of the Europe experienced on college semesters abroad. Parts of the country, notably California, gave license to urban planners to force new development patterns mimicking those of centuries past. By employing a myriad of limits and mandates, the plans forced growth into dense urban centers. The ideas hopped the pond and spread the world over.
Not understanding that the economics of home construction will not match a predetermined plan, new myopic regulations ran amok. The supply of new homes in these Smart Growth markets began to slow. By rationally responding to this new artificial restriction on supply, home prices rose rapidly. For a while, Smart Growth was making many people very rich on paper.
Other cities, however, imbibed much less of the Smart Growth kool-aid and prices stayed low. According to the S&P Case-Shiller Index, home prices in the Los Angeles and San Diego metros soared by 18% and 15% annually between 2001 and mid-2006. At the same time in the Atlanta and Dallas metros prices grew a mere 4.4% and 3% annually. Index data prior to 2001 is unavailable for Dallas, but home prices in Atlanta grew at the same 4.4% between 1991 and 2001. Adding to this price paradox is that Atlanta and Dallas were consistently among the fastest growing metropolitan areas in the United States.
It was then in mid-2006 that home prices in many of the highflying cities hit their all-time highs. Afterwards, home prices began to ease in L.A., San Diego, and San Francisco all before the foreclosures began to rise. The stock price of Countrywide hit an all-time high on Feb 2, 2007, showing that mortgage-lending investors had little idea of what was coming.
Home prices when rising at double-digit rates in a liquid market allow many to avoid foreclosure. Equity was growing too quickly to catch many people underwater on their mortgage. When home prices rose to more than ten times median income in California, demand simply could not continue to rise. Flat and then falling prices revealed how many people really could not afford to own a home.
For California, RealtyTrac data shows that foreclosures did not appreciably rise until August of 2006, but home prices were already flat in L.A. and falling in San Diego and San Francisco. Within six months, foreclosures in California grew by 30% and then a whopping 256% more within a year. The massive wave of foreclosures did not occur until nearly a year after prices had already started to drop.
The credit crisis began in part by the way that mortgage-backed securities are priced and by the highly leveraged nature of the mortgage lending industry. This home price boom wreaked havoc on a financial system unaccustomed to such volatility. Ratings are given to mortgage-backed securities based on backward looking analysis of defaults. In an environment where rapidly rising home prices mask foreclosures, risk premiums were too low and values too high on these securities. This practice had been a reliable model due to decades of steady trends. The mortgage lending business model was based on borrowing at low interest rates, lending to consumers at higher rates, and reselling the overpriced mortgage bundles to institutional investors. This system was unprepared for the fundamental changes brought by Smart Growth.
Defaults began to climb as prices fell, causing both the rate and severity of foreclosures to increase. At the same time interest rates were rising. The margins for mortgage lenders disappeared, and some companies collapsed. Any company or hedge fund that leveraged itself assuming faulty valuations of mortgage-backed assets was suddenly in trouble as well.
With less demand for their mortgage bundles, fewer loans were arranged. A vicious cycle set in where falling prices left more people underwater on their loans leading to more foreclosures. More foreclosures increased the supply of homes on the market leading to falling prices.
Painting Smart Growth as the culprit becomes inevitable because other theories on the housing crisis offer no explanation for geography. The Dallas metro was not experiencing the same surging prices as Los Angeles, but the differences do not stop there. Foreclosure rates in Texas have remained flat in the last two and a half years. Even with all the alleged and rampant fraud, resetting of ARMs, and irresponsible borrowers, Texas saw no surge in foreclosures. The only effect seen is slower sales after tightened credit requirements late in 2007. In Texas, there never was a bubble nor would there ever have been a credit crisis.
The only rational explanation for the differences between cities experiencing the housing crisis, and those that are not, is the prevalence of “Smart Growth” legislation. Sinister mortgage lenders and reckless borrowers are not the culprits. This housing crisis is an unprecedented disaster because of unprecedented meddling in the economics of housing development by the peddlers of “Smart Growth”. This scenario will happen again and again if its distortions are not removed.