The evaluation of potential macroprudential tools that might be used to address emerging financial imbalances is another high priority. For example, the new Basel III regulatory capital framework includes a countercyclical capital buffer, which may help build additional resilience within the financial sector during periods of buoyant credit creation. Staff members are investigating the potential of this and other regulatory tools, such as cyclically sensitive loan-to-value requirements for mortgages, to improve financial stability. A number of countries, including both advanced and emerging-market economies, have already deployed such measures, and their experiences should be instructive. Although, in principle, monetary policy can be used to address financial imbalances, the presumption remains that macroprudential tools, together with well-focused traditional regulation and supervision, should serve as the first line of defense against emerging threats to financial stability. However, more remains to be done to better understand how to design and implement more effective macroprudential tools and how these tools interact with monetary policy.

The immediate trigger of the crisis, as you know, was a sharp decline in house prices, which reversed a previous run-up that had been fueled by irresponsible mortgage lending and securitization practices. Policymakers at the time, including myself, certainly appreciated that house prices might decline, although we disagreed about how much decline was likely; indeed, prices were already moving down when I took office in 2006. However, to a significant extent, our expectations about the possible macroeconomic effects of house price declines were shaped by the apparent analogy to the bursting of the dot-com bubble a few years earlier. That earlier bust also involved a large reduction in paper wealth but was followed by only a mild recession. In the event, of course, the bursting of the housing bubble helped trigger the most severe financial crisis since the Great Depression. It did so because, unlike the earlier decline in equity prices, it interacted with critical vulnerabilities in the financial system and in government regulation that allowed what were initially moderate aggregate losses to subprime mortgage holders to cascade through the financial system. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, deficiencies in risk measurement and management, and the use of exotic financial instruments that redistributed risk in nontransparent ways. In the public sector, vulnerabilities included gaps in the regulatory structure that allowed some systemically important firms and markets to escape comprehensive supervision, failures of supervisors to effectively use their existing powers, and insufficient attention to threats to the stability of the system as a whole.

Losses in housing wealth have held back consumer spending, sapped household confidence, and reduced the ability of small-business owners to obtain credit. Further, housing issues continue to affect bank earnings and credit quality.

During the mid-2000s, many forms of collateral around the world were either implicitly or explicitly backed by U.S. residential land. As I’ve described, beginning in mid-2007, it became clear that this asset had more risk than financial markets had originally appreciated. It was not clear, though, how much more risk was involved. As a result, financial markets became increasingly uncertain about how to evaluate assets backed by U.S. land. That uncertainty translated into uncertainty about the ultimate solvency of institutions holding those assets—and the ultimate solvency of any of those institutions’ creditors. Spreads in credit markets between Treasury returns and other bond returns began to widen—at first slightly and then alarmingly.

Note that I’m talking about land, not housing. Theoretically, it is hard to motivate the existence of significant overvaluation in housing structures (they’re readily replaceable). Empirically, there is considerably less evidence of overvaluation for structures than for land. Here, I refer to data from the Lincoln Institute of Land Policy that separates the price of housing into the price of structures and the price of land. The data were originally constructed by Davis and Heathcote (2005, 2007), and are derived from the Case-Shiller housing price index. These data indicate that the price of housing structures rose by less than 100% in nominal terms from 1996 to 2006, and has fallen by less than 10% since that date. 

Our research has led us to understand that the housing market collapse is the result of a destructive cycle that feeds on itself. In our region, mortgage delinquencies led to a high number of foreclosures, which led to an oversupply of housing, which led to home prices depreciating and borrowers and financial institutions taking on big losses.

To break this cycle, a coordinated set of policies is needed to target multiple points of the breakdown in the housing market.

So, did accommodative interest rates fuel the housing bubble? Actually, the relationship between interest rates and bubbles is not as obvious as one might think... I am not saying that low rates could have had no role in moving housing prices higher. But I suspect the booming demand for real estate derived in large measure from incorrect expectations that housing prices would not fall, rather than from the short-run effect on housing demand of low short-term rates and slightly lowered mortgage rates.

Now, let me be clear: I do not believe the Fed to be blameless in the run-up to the crisis we are now working our way out of. For quite some time, I have respectfully differed with Chairman Bernanke, saying that I felt the Fed held interest rates too low for too long in the early half of the 2000s, thus fueling reckless speculation in housing and other sectors. And I have freely admitted that a host of regulators, including those at the Federal Reserve, were caught unawares by the risk being taken by large financial institutions that later came a cropper.

My objective today has been to review the evidence on the link between monetary policy in the early part of the past decade and the rapid rise in house prices that occurred at roughly the same time. The direct linkages, at least, are weak...

Is there any role for monetary policy in addressing bubbles? Economists have pointed out the practical problems with using monetary policy to pop asset price bubbles, and many of these were illustrated by the recent episode. Although the house price bubble appears obvious in retrospect--all bubbles appear obvious in retrospect--in its earlier stages, economists differed considerably about whether the increase in house prices was sustainable; or, if it was a bubble, whether the bubble was national or confined to a few local markets. Monetary policy is also a blunt tool, and interest rate increases in 2003 or 2004 sufficient to constrain the bubble could have seriously weakened the economy at just the time when the recovery from the previous recession was becoming established.

That said, having experienced the damage that asset price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated. All efforts should be made to strengthen our regulatory system to prevent a recurrence of the crisis, and to cushion the effects if another crisis occurs. However, if adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks--proceeding cautiously and always keeping in mind the inherent difficulties of that approach...

[I]f a dangerous asset price bubble is detected and action to rein it in is warranted, is conventional monetary policy the best tool to use? Going forward, I am hopeful that capital standards and other tools of macroprudential supervision will be deployed to modulate destructive boom-bust cycles, thereby easing the burden on monetary policy.5 However, I now think that, in certain circumstances, the answer as to whether monetary policy should play a role may be a qualified yes. In the current episode, higher short-term interest rates probably would have restrained the demand for housing by raising mortgage interest rates, and this might have slowed the pace of house price increases. In addition, tighter monetary policy may be associated with reduced leverage and slower credit growth, especially in securitized markets.6 Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage.

Let me turn now to more specific comments on the housing sector. Private single-family housing starts peaked in January 2006 at an annual rate of 1.823 million units. Since that time, housing starts have continued to fall; in April 2008, they were only at an annual rate of 692 thousand units, roughly 38 percent of the previous peak value. As striking as these statistics appear, they are not unprecedented. To put the contraction in housing production in a longer-term perspective, it is useful to divide housing starts by the number of households. In February 2006, housing starts per household peaked at 1.65 percent. In March 2008, they had declined to 0.64 percent per household. A startling fall, to be sure, but it has happened before. In January 1973, housing starts per household peaked at 2.10 percent before declining to a trough of 0.94 percent in February 1975. The 1973-75 decline was similar in magnitude to our current situation, according to this metric. A similar phenomenon occurred later in the 1970s. In December 1977, housing starts per household were 2.03 percent before beginning to fall. They fell all the way to 0.66 percent in November 1981. These statistics remind us that housing can be a highly cyclical industry. They also illustrate that the current contraction has clear precedents. Indeed, it is perhaps comforting that the order of magnitude in the previous declines is not unlike today’s figures and that, when housing starts per household have fallen this low in the past, it was near a turning point.

The housing boom came to an end because rising prices made housing increasingly unaffordable.  The end of rapid house price increases in turn undermined a basic premise of many adjustable-rate subprime loans--that home price appreciation alone would always generate enough equity to permit the borrower to refinance and thereby avoid ever having to pay the fully-indexed interest rate.  When that premise was shown to be false and defaults on subprime mortgages rose sharply, investors quickly backpedaled from mortgage-related securities.  The reduced availability of mortgage credit caused housing to weaken further.

Research suggests that it was not so much interest rate resets that triggered the rise in subprime problems, as many expected. Indeed, reductions in short-term interest rates since the onset of the crisis should diminish the danger of foreclosures from such resets going forward. Rather, the single most important determinant of the level and change in subprime delinquency rates has been the pace of house price changes.

There were many different factors that led to a certain frothiness in the housing market, and these varied from region to region. There were a lot of local factors, not just national ones.

From Q&A as reported by Market News International

 Indeed, even as house prices were rising, economists in the Fed and elsewhere were analyzing how a downturn in the housing sector might affect the economy and evaluating potential policy responses. At the time, however, it was simply not anticipated that house price declines would contribute to such burgeoning delinquencies and defaults among subprime borrowers, and that those problems would set off a chain of events that would rattle the financial system, resulting in the credit crunch that is now severely restraining economic activity and employment.