Housing Bubble and Crash Explained – The Common Sense Explanation
Thousands of articles have been written explaining how the bubble in housing developed and why it subsequently came crashing down, causing the collapse of some of the biggest financial institutions in the United States. Perhaps most of us are simply worn down or confused by the plethora of articles and resigned to the fact that we may never really know the full story. For those still searching for answers to the crash, FDIC Chairman Sheila Bair provides a common sense, lucid explanation well worth reading.
In a speech on June 18 to the Wharton School, International Housing Finance Program, Ms. Bair made the following comments on the housing bubble, the housing collapse and the future of U.S. mortgage financing.
There is no single fix that will restore confidence or immediately repair the dislocations that have taken place in housing and mortgage markets. But if we are willing to take bold steps, and return to the fundamentals of mortgage lending and securitization, we can get back to a more rational world where consumers are protected, risks are contained, and our scarce resources are allocated to their highest and best use.
Underwriting: Back to Basics
First, we must recognize that the financial crisis was triggered by a reckless departure from tried and true, common-sense loan underwriting practices.
Traditional mortgage lending worked so well in the past because lenders required sizeable down payments, solid borrower credit histories, proper income documentation, and sufficient income to make regular payments at the fully-indexed rate of the loan. Not only were these bedrock principles relaxed in the run-up to the crisis, but they were frequently relaxed all at once in the same loans in a practice regulators refer to as “risk layering.”
As all of you know, the long-term credit performance of a portfolio of mortgage loans can only be as sound as the underwriting practices used to originate those loans.
Implications of Faulty Underwriting
The FDIC is in the midst of cleaning up the damage wrecked by the bursting of the greatest real estate bubble in U.S. history. A key lesson of this crisis is that weak underwriting practices have macro implications for home prices, economic performance, and the stability of our financial system.
Let’s look back for a moment to how the housing crisis unfolded. At the end of 2003, we were already well into a historic housing boom. Over the previous decade, nominal home prices had risen by 81 percent, while per capita disposable incomes were up by just over half. You might have expected a cooling off in home prices after this remarkable run. Instead, during the next three years we saw an acceleration of home price increases.
Between 2003 and 2006, average prices rose by another 38 percent, almost two and a half times faster than incomes. It was this surge in home prices, preceded by a decade of steady increases, that took prices far above any reasonable measure of the fundamentals.
More than any other factor, what explains the post-2003 acceleration of home prices is an extreme deterioration in mortgage lending practices. For example, subprime mortgages rose to more than 20 percent of all originations between 2004 and 2006, compared with less than 10 percent in 2003. And so-called Alt-A mortgages rose four-fold between 2003 and 2006. Many did not require amortization of principal during the first five years, and many required little or no documentation. By early this year, almost 40 percent of 2006 Alt-A vintage loans were in default.
The Role of the Capital Markets
So, why it is that these changes took place so suddenly? One reason was the decline in prime mortgage originations after the refinancing boom of 2003. Almost $4 trillion in mortgages were originated in 2003 as prime mortgage rates fell to their lowest level in more than 40 years. That was a tough act to follow. Lenders who wanted to try to keep up the pace turned to subprime and nontraditional mortgages, most of which were securitized by private issuers of mortgage backed securities.
From 2003 through 2006, the share of total U.S. mortgage debt held by these private issuers more than doubled, from 9 percent to just over 20 percent. All told, over $2.1 trillion in private securities backed by risky subprime and Alt-A mortgages were issued between 2004 and 2006.
How was it that investors were so willing to invest so much in securities with such poorly underwritten loans?
These complex, opaque CDO deals obscured and spread the risks associated with subprime and Alt-A securities, but they certainly did not make the risk go away. By the summer of 2007, the capital markets began to realize the extent of these risks and the flaws in the securitization structures that had spawned them.
Foreign money also flooded in, helping keep mortgage rates low and deal-flow high. Between 2004 and 2007, foreign holdings of U.S. agency debt almost doubled to over $1.4 trillion, while foreign holdings of U.S. asset-backed securities more than tripled to just over $900 billion.
Flaws in Private Securitization Structures
We come now to the crux of the matter. Ordinarily you expect long-term investors to carefully scrutinize the securities they buy. However, in this episode, market discipline was tossed to the wind.
This is where the story reconnects with loan underwriting. Had those MBS and CDO investors not been so passive, they would have pulled away and imposed the market discipline needed to uphold best practices at the front end of these deals, when the loans were made. The lack of market discipline also relates to a near-complete divergence in financial incentives between the originators and deal underwriters, on the one hand, and the investors on the other.
In contrast to the long-term payoffs that are expected by investors, many other parties – from the mortgage brokers, to the lenders, to the securities underwriters, to the ratings agencies – got paid upfront. This divergence of financial interests, and the lack of market discipline that it created, explains why loan originators failed to apply appropriate underwriting standards in the first place.
It also explains why trillions of dollars in faulty mortgage paper was issued before the home price bubble finally collapsed.
Restoring Confidence in U.S. Mortgage Finance
We need to have some basic underwriting guidelines that apply to mortgages originated not just by FDIC-insured depository institutions, which are already heavily regulated, but also for the thousands of mortgage brokers who fall outside the rules for banks and thrifts. Basic limits on loan-to-value and debt-to-income ratios, and consistent documentation requirements should be set for any loans held by a depository institution or sold to a securitization trust. Equally important will be to have higher, more consistent standards for consumer disclosures and for ensuring that the loan serves the long-term interests of the borrower.
Reforming the GSEs
Since the 1930s, the federal government has played a major role in facilitating the development of a strong secondary market for mortgage loans. Through the Federal Housing Administration and the government-sponsored enterprises, the government has directly or indirectly provided credit guarantees that have promoted the origination and securitization of mortgage loans that conform to certain standards and size limits.
However, in the aftermath of the mortgage credit crisis and the conservatorship of Freddie Mac and Fannie Mae, the implicit backing of these entities is now an explicit cost. Federal subsidies for the GSEs in 2009 and 2010 are estimated at over $300 billion.
In banking, the implicit backing of large financial institutions under the doctrine of Too Big to Fail led to moral hazard and excessive risk taking. This is a problem that Congress is attempting to fix. In the wake of the financial crisis, the U.S. and other governments around the world are feeling the brunt of a wide range of “implicit liabilities” that are quickly becoming explicit obligations in times of financial distress.
Restoring Balance to Our Economy and to Housing Policy
Homeownership is certainly a worthy national goal. But does it make sense for the federal government to subsidize homeownership in an amount three times greater than the subsidy to rental housing? In the end, these subsidies have helped to promote homeownership, but have failed to deliver long-term prosperity.
I am not advocating a specific proposal. I’m only pointing out that where homeownership was once regarded as a tool for building household wealth, in the crisis it has instead consumed the wealth of many households. Foreclosures continue to take place at a rate of about two-and-a-half million per year, and an estimated 11 million households owe more on their mortgage than their home is worth.
We need to get back to a world where our financial sector supports the functioning of our economy, and not the other way around. And we need to fix what caused the crisis by reforming our mortgage lending and securitization practices. Only by getting back to basics in these most fundamental areas of our financial system can we begin to restore balance to our broader economy and confidence in our economic future. Thank you.
Regulators Ignored Reckless Lending Practices
Chairman Bair clearly summarizes the primary cause for the housing bubble – trillions of dollars in “no questions asked” mortgage loans that provided the easy financing that allowed home prices to soar beyond reason. The subsequent crash occurred when mortgage loans made to “borrowers” who had absolutely no ability to repay the loans defaulted. Ms. Bair correctly identifies the major cause of the housing bubble and collapse – “an extreme deterioration in mortgage lending practices, and a reckless departure from tried and true, common sense underwriting practices“.
Unfortunately, Chairman Bair does not address the most obvious question that a reasonable observer would ask. Why did tens of thousands of banking regulators at a multitude of federal and state regulatory agencies ever allow this type of reckless lending to occur?? While the government is zealously prosecuting the parties who executed reckless and outrageous lending policies, where is the accountability by regulators?? Had regulators properly enforced “safe and sound lending policies”, the financial meltdown of the banking and housing industry could not have occurred.