Academic journal article The Cato Journal

Asset Bubbles and Supply Failures: Where Are the Qualified Sellers?

Academic journal article The Cato Journal

Asset Bubbles and Supply Failures: Where Are the Qualified Sellers?

Article excerpt

From their peak during the third quarter of 2007, to their trough during the first quarter of 2009, stock prices as measured by the S&P 500 fell 48 percent (see Figure 1). Through the third quarter of 2009, stock prices subsequently increased more than 40 percent. In contrast, housing prices, as measured by the Case-Shiller index, which fell 31 percent from their peak in the first quarter of 2006 to the first quarter of 2009, had not yet shown any sign of recovery.

In both markets, we observed the bursting of an asset bubble, but, while one market quickly began the process of recovery, the other did not. As of the writing of this article, the housing market is still characterized by large unsold inventories, rising foreclosures, and a damaged construction industry. Why did the stock market, which fell farther and faster and--with the exception of the financial services and auto industries--was not supported by the government, recover when the housing market did not?

We argue that, when a housing bubble bursts, the combination of high loan-to-value mortgages and costly foreclosures can inhibit house prices from quickly falling to their new equilibrium levels. The adjustment problem manifests itself, among other ways, in homeowners being unable to complete the sale of their houses at current market values. For some time, the resulting supply failure distorts the supply of houses offered for sale, inventories of houses listed for sale, and the relative prices of different quality houses. Public policies have been targeted mostly at maintaining house prices by propping up demand. Those policies exacerbate the problems associated with this supply failure and can result in substantial reduction of social welfare due to misallocation of resources.

[FIGURE 1 OMITTED]

The model we develop suggests instead that public policy should focus on unwinding uneconomic contracts in order to enable house prices to fall quickly to their equilibrium levels. Such policies would enable more homeowners to sell their houses at then current market prices, restoring the normal turnover of the housing stock and housing mobility to families. Indeed, by returning a measure of liquidity such policies would, in the long term, contribute to the demand for housing.

Asset Bubbles

An asset bubble can be said to exist when the price of the asset exceeds its fundamental or intrinsic value. (1) Krainer (2003), for example, says that a housing bubble occurs when the ratio of house prices to rent trends above its long-run average. Asset bubbles are usually if not always associated with an expansion of money and credit. In the recent stock and housing bubbles, financial innovations were involved during the run-up in prices, such as risk-shifting through collateralized debt obligations and credit default swaps. Those innovations facilitated an increase in the flow of credit to the housing market, but also built up a mismatching of assets and their claims. Eventually, the stock and housing bubbles burst because of these mismatches, mortgage defaults, and the loss of confidence in asset-backed commercial paper. Brunnermeier (2009) estimates that in the year following the stock market peak in October 2007, stocks lost $8 trillion. The fall in stock prices was brutal both in terms of the extent and quickness of the loss. The fall in housing values was nowhere near as brutal. As measured by the biennial American Housing Survey, the median value of houses fell $21,500 from 2007 to 2009, for a total loss of $1.9 trillion, about one quarter of the stock market loss. But, whereas stock values began to recover in the second quarter of 2009, housing values continued to deteriorate through 2009.

Previous examinations of the phenomenon of bubbles have focused mainly on the conditions for the existence of bubbles (e.g., Tirole 1982, 1985a, 1985b; Grossman and Yanagawa 1993; Allen et al. 1993; Kunieda 2008). …

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