Business & Economics

On the linkage between energy prices and the financial crisis

David Zilberman

In 2007 an acquaintance of mine, a housing developer, told me that he lost his investment in a new development near Tracy, CA (a commuter town about 60 miles outside San Francisco) and further told me that this community, as well as other commuter towns in the Central Valley, suffered incredible high rates of defaults. During the course of our conversation, he suggested that the rising gasoline prices made it unaffordable for many people to live there. Soon after, one of my students told me a similar story about a developer in Indio in Southern California who suffered a similar fate. These anecdotal stories ended up inspiring a paper coauthored with Steve Sexton and Junjie Wu, “How High Gas Prices Triggered the Housing Crisis: Theory and Empirical Evidence”.

The main academic objective of the paper is to link the economics of energy prices to the economics of housing and housing finance and ultimately to the macro economy. While the paper develops new theoretical linkages, it also has a very practical dimension that is illustrated using empirical data. Namely the rise of energy prices was crucial contributor to the burst of the housing bubble, which as we all know, led to the financial crisis.

This theory does not downplay the importance of subprime and ‘predatory’ lending practices as a major factor; rather it complements it and explains why events unfolded as they did. In essence, these subprime mortgages and lending practices provided the fuel for the financial crisis but high gasoline prices (almost doubled between from 2004-2006) was the match that started the fire.

We have in mind, the following story: during the early 2000’s and even before that, low interest rates and government desire from both political parties, to provide employment and to encourage an ‘ownership society’, gave rise to policies that provided easy access to credit to individuals with limited financial means and thus many of them became new home owners. Much of the new housing developments were farther away from the city, expanding commuter communities. For example, in the SF Bay Area, there has been a unofficial limit on population growth and thus many people settled in commuter towns in the Central Valley. In southern California there was expansion to the ‘Inland Empire’ people commuting to Long Beach, etc. While the terms of credit were tempting, consumers assumed the loan because they expected to be able to pay their mortgages given cheap gas prices at the time. Clearly most buyers did not anticipate the drastic rise of energy prices that occurred and I’m sure not many developers did either. The good terms of credit enabled people to assume large loans with minimal down payment, whereby increasing home prices which made it even more enticing to develop as well as buy houses in the future and thus the bubble continued to expand.

But then, boom. Energy prices doubled within a short period of time. New buyers thought twice about purchases in these commuter towns and for sure, assuming large debts given rising transportation costs were no longer appealing. Home prices in these commuter locations began to fall, which led to the reversing of the trend of rising home prices in all locations, and thus the housing crisis began. Individuals in commuter towns suddenly had to contend with the doubling of their transportation costs and given that many of them were already lower income, they started to have cash-flow problems. For example, for individuals in commuter towns, the share of commuting costs reached 20%, or even more, of net income after the rise in gasoline prices placing them in a financial bind. Furthermore, the value of the houses were declining and actually became negative, thus paying the mortgage was no longer an investment, but rather throwing good money after bad. This sad situation led to the defaults and when defaults started occurring, the impacts on the neighborhood became negative whereby declining home values even further, inducing even more defaults. As times got bad: people lost jobs and this further contributed to the growing default rates. The decline in home values that spread throughout the economy as well as unemployment, caused defaults in low-income areas that were not necessarily in far away commuter towns. Once a large number of homeowners defaulted on payment, banks and insurers of mortgages got into trouble and the economy as a whole was in crisis.

Our paper has numerical exercises and empirical evidence that demonstrate that default rates were much higher in commuter towns, leading the way in terms of share of houses underwater. This paper’s emphasis is on theory and basic evidence but we will follow it with further econometric analysis. Our analysis only considered the impact of rising gasoline prices but at the same time, the cost of heating and cooling also increased and negatively affected the well being of new buyers of large homes in suburbia that became quite expensive to maintain. Another interesting note is that I speculate that you don’t see many Priuses in suburbia but less fuel-efficient cars (Priuses are owned by people that may need them least).

Our analysis has a lot of implications. If we expect energy prices to rise more in the future, our suburban communities will be in trouble and we may need to grow vertically rather than horizontally, which will be good from a greenhouse gas perspective and will save a lot of time and reduce our carbon footprint but will require changes in zoning, lifestyles and perspectives.

As an economist, I have been a supporter of carbon taxes and high-energy taxes to offset their externality costs, but now I can understand better why some people are opposed to them. I can also understand the political acceptability of fuel standards rather than taxations. Our paper suggests the importance of energy conservation for transportation and otherwise and it also suggests the importance of developing alternative energies that reduce its price, especially energies that also meet environmental objectives.

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Comments to "On the linkage between energy prices and the financial crisis":
    • alice

      On January 1st, 2007, James Howard Kuntsler predicted peak oil and consequent high energy prices would pop the housing bubble eventually in Forecast For the Year Ahead.
      http://www.kunstler.com/mags_diary20.html

      …the stresses, distortions, and perversities we see in the financial markets and the economy are largely attributable to the peculiar circumstances of Peak Oil — namely, a grinding background reality that this point of the world’s highest-ever petroleum production represents the final blow off of an economy that really has no future, an economy in which typical industrial growth is no longer possible. And if this growth, this ceaseless expansion of everything is no longer possible, if instead we enter a wholesale global contraction of available energy, of industrial activity, and expectation of future activity, why then the markers used to signify the expectation of growth (at least the retention of wealth) — currencies, stock certificates, bonds, derivative contracts, mortgages — all these things lose their legitimacy and finally their value. That is the fundamental underlying reality in Peak Oil’s relation to our modern economies in general and to the finance sector that is supposed to serve it.

      Also Gail Tverberg after the crash gives perspective March 25, 2009
      http://www.theoildrum.com/node/5230
      Where we are headed: Peak oil and the financial crisis

      So so so many people have been predicting the housing market crash since 2002, and within peak oil websites as well this seemed like it would be the tipping point. Now that we’re on a plateau according to Robert Hirsch (nature and science magazines and the IEA all say peak oil occured 2005-2006), and we’ve been on a plateau ever since, you can expect high oil prices again, and another crash, and even more underwater homes and foreclosures — it ain’t over yet…

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