I’ve written a lot about the housing market over the years. I thought I would put together a coherent story for what I think has transpired.My first essay on the state of the housing market was this one, written in June of 2004, when some economists already were worried about a bubble. The main point of the essay was that I thought that interest rates were suspiciously low (of course, if you believe in efficient markets, you should assume that the market knows better than you do what long-term interest rates are going to do).

What I was saying about the housing market is that house prices were high because of those low interest rates. I was suggesting that house prices would not fall by themselves, but they might be threatened by higher interest rates.

Since then, mortgage rates trended upward until about a month ago. But the rise was not spectacular. Meanwhile, for much of this period home prices continued to surge. The house price increases were more than what I would have expected, and the interest rate increases were perhaps a bit less than what I was looking to see.

In retrospect, the key factor in the final phase of the house price surge was not mortgage rates. It was mortgage availability. For a variety of institutional reasons, a trend emerged in mortgage lending to allow minimum down payments and unrealistic relationships between income and house prices. Above all, the lenders in this game were betting, consciously or otherwise, that what they had observed as home prices were rising would continue.

The lenders saw low default rates, even on loans to risky borrowers. The reason is that with house prices rising, an overstretched borrower could always escape by selling the house or taking out new loan. But when that music stopped, a lot of folks were left in awkward positions.

So how far do home prices have to fall? My view continues to be “not far.” In fact, I think that, outside of California, home prices already have overshot equilibrium on the down side. My guess is that in the majority of markets outside of California today, if you buy a home for the long term, you will earn an above-normal rate of return.

California is another country. There, it is hard to see how big declines are unavoidable. Note, however, that Margaret Hwang Smith and Gary Smith calculated, as of 2005, that California rents and home prices were in line. In contrast, I see median home prices as way too high relative to median rents. This could be because rentals and owner-occupied housing are so segmented (with lower incomes dominating the former and higher incomes dominating the latter) that the Smith’s method of calculation simply will not work.

Another point about the current situation is that there was a lot of predatory borrowing. Early-payment defaults, in which the borrower stops meeting payments less than 12 months after taking out the mortgage, are almost always indicators of fraud.

In my view the biggest problem ahead is that the housing market is likely to over-react on the down side. Expectations of low or falling prices are going to be built into consumers’ and lenders’ thought processes. As a result, prices will fall more than they should. So, some people will be able to buy houses at what a decade from now will seem like bargain prices.

Worse things have happened.