The housing meltdown: Why did it happen in the US?
Submitted by Econbrowser
From a timely BIS working paper by Lucy Ellis released on Thursday:
Mortgage lending standards eased in many countries in recent years, but the limited available cross-country evidence does suggest that the process went further in the United States. Standards are difficult to measure because different aspects need not all move together (Gorton 2008), but the observed increase in early payment defaults in the United States (but not elsewhere) provides direct evidence that it occurred (Kiff and Mills 2007); Gerardi, Lehnert, Sherlund and Willen (2008) provide additional detail on the easing in lending standards.
Two developments seem to have spurred the easing in US standards. First, a range of legislative and policy changes had been made to encourage the development of a non-conforming (Alt-A and subprime) lending sector, lying outside the model defined by the government-sponsored enterprises (GSEs, Fannie Mae and Freddie Mac). Part of the motivation for this was a desire to ensure that home ownership was accessible to households who had historically been underserved by mortgage lenders (Gramlich 2007). In addition, the administration had wanted to reduce the GSEs’ domination of the mortgage market. Following problems with accounting and governance at both institutions, the GSEs’ capacity to expand lending was capped by new regulatory limits on their activities (Kiff and Mills 2007, Blundell-Wignall and Atkinson 2008). [emphasis added -- mdc]
Second, origination volumes had fallen following the end of the the refinancing wave of 2003. Lenders therefore faced a substantial reduction in fee income, with implications for the size of the entire industry. The low rates on long-term fixed-rate mortgages available in 2003 had allowed borrowers to cut their interest rate significantly, by one-fifth on average for loans refinanced with Freddie Mac, for example. Total originations peaked at around $4 trillion, with mortgage backed securities (MBS) issuance not much less than that (Figure 3, left-hand panel). As a result, around half the outstanding mortgage stock turned over through moving or refinancing in that year. According to the Federal Reserve’s 2004 Survey of Consumer Finances, 45% of households with a first mortgage had refinanced within the previous three years (Bucks, Kennickell and Moore 2006).
Lenders seem to have responded to these developments by easing underwriting standards across several dimensions. The first of these was that non-conforming mortgages did indeed gain market share. Subprime loan origination grew particularly strongly, but the Alt-A category did as well (Figure 3). Although some full-service lenders branched into these market segments, much of the expansion occurred in lending originated by specialist lenders. This shift included entry into the market by major investment banks via newly acquired mortgage lending subsidiaries. Even if lenders within each category had not eased standards, the result would have been that more of the US mortgage book contained features that raised arrears and default rates. As documented by Quercia, Stegman and Davis (2007), even in the late 1990s, loans originated by designated subprime lenders were much more likely than prime lending to include features that boost default rates, such as prepayment penalties and balloon payments.
The easing in US mortgage lending standards went beyond a shift amongst lenders with different business models. An array of statistical evidence and legal findings shows that underwriting standards of individual lenders eased as well. First, and perhaps most importantly, requirements for documentation of income and assets became progressively laxer. Instead of assessing borrowers’ abilities to service their loans, lenders ended up focusing on collateral values, in effect betting on rising housing prices (Gorton (2008) makes a similar point).
The analysis also indicates that it wasn’t just subprime that exhibited deterioration, although it was by far the one hit hardest. Rather the key distrinction was…
The real distinction is between loans that were in the FHA pool or the conforming market — those insurable by the GSEs — and those that were not in either of those groups. Although there was some easing of standards in the conforming market, especially in the GSE’s extended programs and the FHA seller-financed downpayment program, it was minor compared with the one that occurred in the rest of the market. Arrears rates on the GSEs’ single-family home portfolio have risen a great deal recently, but this only started in the second half of 2007 (Figure 7, right-hand panel). Likewise, the increase in arrears rates on FHA mortgages has been fairly mild.
The report identifies several factor for the fact that the US housing market deteriorated even before the macro economy deteriorated — unlike in Canada and UK.
Figure 7 from Luci Ellis, “The housing meltdown: Why did it happen in the United States?” BIS Working Paper No. 259 (September 2008).(I think if one observes closely the the fact that the scale of the vertical axes are very different, one may very well have an altered perspective on the role of the GSE’s in the mortgage crisis.)
- Supply of new housing is relatively flexible
- Tax system encourages higher leverage and flipping
- Legal system is swift but generous to defaulters
- Lenders could rely on external credit scores
- Cash-out refinancing is inexpensive in the United States
- Structured finance enabled subprime and other non-conforming lending
- Financial regulation did not prevent riskier lending
I excerpt the section on this last point below:
…
The US mortgage market is subject to an array of laws and different regulators. The regulated GSEs enforced quality control in the conforming market, but the rest of the mortgage market was more lightly regulated. Mortgage lenders that were not also depositories were the lightest regulated of all. As one example of the relatively light regulation of many mortgage lenders, consider the new regulations announced by the Federal Reserve in December 2007 and approved in July 2008, as part of its role of enforcer of the Home Ownership and Equity Protection Act. Among the practices newly banned by these regulations were “coercing a real estate appraiser to misstate a home’s value” and “making a loan without regard to borrowers’ ability to repay the loan from income and assets other than the home’s value” (Federal Reserve Board 2008). The implication is that these practices were permitted in the absence of the new regulation, and were common enough to merit an explicit ban. Had all US mortgage originators been bound by a requirement to consider the affordability of the repayment explicitly — as is the case under Australia’s Uniform Consumer Credit Code or the requirements of UK legislation, for example — it seems unlikely that no-documentation (stated-income) mortgages or “exploding ARMs” would have become so prevalent.
In addition, following intervention in 2004 by the Office of the Comptroller of the Currency (OCC), federally regulated lenders were exempted from state legislation which was in many cases stricter than that at the federal level. Some of the practices banned under some states’ law included the prepayment penalties and balloon payments that have been shown to raise default rates, independent of the borrower’s credit score (Quercia, Stegman and Davis 2007).
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A paper well worth reading, for those who want numbers and analytics.
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