Many commentators link the US house price boom and bust of the past decade to an unsustainable easing of mortgage credit standards. However, few existing empirical house price models take account of changes in credit standards, since they are hard to measure. As a consequence, most models perform poorly during the recent boom and bust in US house prices (see Duca et al. (2011a, 2011b), Gallin (2006) and Geanakoplos (2010), inter alia).

We circumvent this problem by incorporating a plausible measure of mortgage credit standards – the average loan-to-value ratio for first-time homebuyers – into an inverted housing demand model explaining US house prices. We show that this measure of mortgage credit standards is weakly exogenous and is not simply a proxy for expected future house price capital gains or losses. During the subprime boom, mortgage loans were extended to riskier borrowers, who would previously have been denied loans. Many of these loans were for adjustable rate mortgages which particularly benefited from the then lowest interest rates for decades.

The rise in house prices, set in train by these credit-supply and interest-rate changes, fooled many people into thinking that such rises would be sustained. Fundamentals began changing in 2003, as interest rates began to return to more “normal” levels and high rates of building expanded the housing stock, while house prices became increasingly overvalued. As the extent of bad loans became clear, the fundamentals changed again as the supply of credit for all types of mortgages contracted, inducing an unwinding of earlier rises in house prices (Duca et al., (2010))