Since the financial crisis of 2008, approximately 90 percent of the housing finance system has migrated into the federalized auspices of FHA and the GSEs, Fannie Mae and Freddie Mac. With taxpayer money at risk and hopes of revitalizing the private market, policymakers have proposed new ways to transition away from this nationalized system. The central debate rests on the government’s role in the long run: Should it continue to guarantee safe, affordable mortgage products, or can market stability exist without taxpayers assuming the tail risk? Of equal importance, but less acknowledged, is the necessity of comprehensive reform, including transparency and standardization for all mortgage products and securities, government-backed or not.

Real estate booms and busts have been a recurring feature of the global economy for decades, including in the 20th century, the Great Depression, the thrift crisis of the 1970s and 1980s, the East Asian Crisis of the late 1990s, and the recent crisis. Real estate is particularly prone to pro-cyclical behavior due to the temporal lag in construction and the difficulty in short selling the underlying asset and the lack of effective derivatives to trade bubbles. In the most recent cycle, real estate investment trusts may have helped prevent overbuilding, but the complexity, heterogeneity, and opacity of mortgage securitization products encouraged the market to underprice risk, resulting in a credit bubble. While regulatory efforts and market memory may contain oscillations for some time, we have not seen the end of booms and busts in real estate markets.

This article describes the causes of the boom and bust in the U.S. housing market that brought down not just the U.S. financial system but the global economy. How did this vicious cycle begin? How did home prices appreciate so far and so fast?Why did rational investors not recognize and stop mispricing and investing in these loans on Wall Street? The authors find that at the root of the subprime problem was a new class of specialized mortgage lenders and securitizers unrestricted by regulations governing traditional lending and securitization. Aggressive lenders piled in by offering loans with low upfront costs, attracting first-time homebuyers previously unable to afford houses, repeat buyers buying pricier homes and second homes, and speculators. These practices drove prices particularly high in Arizona, California, Florida, and Nevada, which had significant land-use regulations and environmental controls that reduced supply elasticity, leading increases in demand to trigger mostly higher prices instead of a greater supply of housing.