In a 4/6/09 WSJ op-ed, a former Nobel Laureate in Economics, Vernon Smith, and a research associate, Steven Gjerstad, examined the several decade long causes of the real estate bubble.

In 1983, the Bureau of Labor Statistics (BLS) changed their methodology for measuring the housing cost portion of the Consumer Price Index (CPI). “They began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs.”

From 1983 to 1996, home prices were about 20 years worth of rent payments. Between 1996 and 2006, they increased to over 32 years of rent payments. Had this housing inflation been reflected in the CPI, “inflation would have been 6.2%, instead of 3.3%.” Remember that 6% real inflation figure.

The many economists at the Federal Reserve Board (“Fed”) looked at the modest increases in the CPI over the past decade and, concerned as they were about the increasingly heated housing market, didn’t see a direct correlation with the CPI. They attributed this to productivity gains, the lower cost of computers, appliances, etc. The Fed kept interest rates low.

Joe and Mary, average American homeowners, may not have known about the housing component metrics of the CPI. All they knew was what things cost the previous year and what they cost this year. With mortgage money at about 6%, Joe and Mary instinctively knew that they could borrow money on their house at an effective 0% interest rate, the real CPI of 6% minus the 6% mortgage interest rate. It was free money, and “household borrowing took off.” The CPI data model was out of sync with reality, a reality that Joe and Mary knew well.

The authors compare the crash of 2000 – 2002 with this one. That earlier crash wiped out $10T in equity assets yet it caused no damage to the financial system. In this crash, a relatively small $3T decrease in real estate equity has decimated the financial system. How? Like the great depression, it was leverage.

The authors point to a misconception that the market crash of 1929, with 9 to 1 leverages on stock, brought the financial system down. But the banks did not begin their tumble till after the drastic fall in real estate prices beginning in 1930. Mortgage debt during the 1920s had more than tripled.

In the 2000 crash, most owners owned their stock holdings outright. They absorbed the loss of falling equity prices. In this real estate crash, leverages of 9 to 1, or 99 to 1, were common. Lower priced housing was hit hardest, declining by 50% in some cities, and this fall in home equity hit an economic group that could least withstand the impact.

In a WSJ article 3/18/09, Kathy Shwiff reported that delinquencies of Alt-A, or alternative documentation, home loans issued in the past few years have climbed to more than 20%. These loans were issued to people based solely on their credit scores. Often, there was no documentation or verification of income or whether the person’s income would reasonably allow them to make payments on the mortgage.