The Real Causes — and Casualties — of the Housing Crisis

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Wharton's Susan Wachter and Benjamin Keys discuss the impact of the subprime lending and housing crisis.

The U.S. is not about to see a rerun of the housing bubble that formed in 2006 and 2007, precipitating the Great Recession that followed, according to experts at Wharton. More prudent lending norms, rising interest rates and high house prices have kept demand in check.

However, some misperceptions about the key drivers and impacts of the housing crisis persist – and clarifying those will ensure that policy makers and industry players do not repeat the same mistakes, according to Wharton real estate professors Susan Wachter and Benjamin Keys, who recently took a look back at the crisis, and how it has influenced the current market, on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

According to Wachter, a primary mistake that fueled the housing bubble was the rush to lend money to homebuyers without regard for their ability to repay. As the mortgage finance market expanded, it attracted droves of new players with money to lend. “We had a trillion dollars more coming into the mortgage market in 2004, 2005 and 2006,” Wachter said. “That’s $3 trillion dollars going into mortgages that did not exist before — non-traditional mortgages, so-called NINJA mortgages (no income, no job, no assets). These were [offered] by new players, and they were funded by private-label mortgage-backed securities — a very small, niche part of the market that expanded to more than 50% of the market at the peak in 2006.”

Keys noted that these new players brought in money from sources that traditionally did not go towards mortgages, which drove down borrowing costs. They also increased access to credit, both for those with low credit scores and middle-class homeowners who wanted to take out a second lien on their home or a home equity line of credit. “In doing so, they created a lot of leverage in the system and introduced a lot more risk.”

Credit expanded in all directions in the build-up to the last crisis – “any direction where there was appetite for anyone to borrow,” Keys said. “An important lesson from the crisis is that just because someone is willing to make you a loan, it doesn’t mean that you should accept it.”

Lessons from those experiences are relevant to current market conditions, Keys said. “We need to keep a close eye right now on this tradeoff between access and risk,” he said, referring to lending standards in particular. He noted that a “huge explosion of lending” occurred between late 2003 and 2006, driven by low interest rates. As interest rates began climbing after that, expectations were for the refinancing boom to end. A similar situation is playing out now in a rising interest rate environment. In such conditions, expectations are for home prices to moderate, since credit will not be available as generously as earlier, and “people are going to not be able to afford quite as much house, given higher interest rates.”

“There’s a false narrative here, which is that most of these loans went to lower-income folks. That’s not true. The investor part of the story is underemphasized.” –Susan Wachter

Wachter has written about that refinance boom with Adam Levitin, a professor at Georgetown University Law Center, in a paper that explains how the housing bubble occurred. She recalled that after 2000, there was a huge expansion in the money supply, and interest rates fell dramatically, “causing a [refinance] boom the likes of which we hadn’t seen before.” That phase continued beyond 2003 because “many players on Wall Street were sitting there with nothing to do.” They spotted “a new kind of mortgage-backed security – not one related to refinance, but one related to expanding the mortgage lending box.” They also found their next market: Borrowers who were not adequately qualified in terms of income levels and down payments on the homes they bought — as well as investors who were eager to buy.

The Lesser-known Role of Investors

According to Wachter, a key misperception about the housing crisis is that subprime borrowers were responsible for causing it. Instead, investors who took advantage of low mortgage finance rates played a big role in fueling the housing bubble, she pointed out. “There’s a false narrative here, which is that most of these loans went to lower-income folks. That’s not true. The investor part of the story is underemphasized, but it’s real.”

The evidence shows that it would be incorrect to describe the last crisis as a “low- and moderate-income event,” said Wachter. “This was an event for risk-takers across the board. Those who could and wanted to cash out later on – in 2006 and 2007 — [participated in it].” Those market conditions also attracted borrowers who got loans for their second and third homes. “These were not home-owners. These were investors.”

Wachter said “some fraud” was also involved in those settings, especially when people listed themselves as “owner/occupant” for the homes they financed, and not as investors. They took advantage of “underpriced credit,” which she and her co-author Andrey Pavlov detail in a research paper titled “Subprime Lending and Real Estate Prices.” Those borrowers had “put” options and “non-recourse” loans, which meant they could therefore “walk away from [their] mortgage [obligations],” she said. “If you’re an investor walking away, you have nothing at risk.”

Who bore the cost of that back then? “If rates are going down – which they were, effectively – and if down payment is nearing zero, as an investor, you’re making the money on the upside, and the downside is not yours. It’s the bank’s [downside],” Wachter said. There are other undesirable effects of such access to inexpensive money, as she and Pavlov noted in their paper: “Asset prices increase because some borrowers see their borrowing constraint relaxed. If loans are underpriced, this effect is magnified, because then even previously unconstrained borrowers optimally choose to buy rather than rent.”

After the housing bubble burst in 2008, the number of foreclosed homes available for investors surged. That actually helped homeowners who held properties that lost value, especially those that were underwater. “Without that Wall Street step-up to buy foreclosed properties and turn them from home ownership to renter-ship, we would have had a lot more downward pressure on prices, a lot of more empty homes out there, selling for lower and lower prices, leading to a spiral-down — which occurred in 2009 — with no end in sight,” said Wachter. “Unfortunately, [those] people who were foreclosed upon and couldn’t own had to rent. But in some ways it was important, because it did put a floor under a spiral that was happening.”

“An important lesson from the crisis is that just because someone is willing to make you a loan, it doesn’t mean that you should accept it.” –Benjamin Keys

The Hit to Minorities

Another commonly held perception is that minority and low-income households bore the brunt of the fallout of the subprime lending crisis. “The problem is that the most vulnerable households to recession are minority and low-income households,” Wachter said. “The fact that after the [Great] Recession these were the households that were most hit is not evidence that these were the households that were most lent to, proportionally.” A paper she wrote with coauthors Arthur Acolin, Xudong An and Raphael Bostic looked at the increase in home ownership during the years 2003 to 2007 by minorities. “The increase was higher in the majority area than the minority area,” she said. “So the trope that this was [caused by] lending to minority, low-income households is just not in the data.”

Wachter also set the record straight on another aspect of the market — that millennials prefer to rent rather than to own their homes. Surveys have shown that millennials aspire to be homeowners. The problem is that they find it harder to secure housing loans as lenders have tightened their requirements after the defaults that occurred in the last crisis. “One of the major outcomes – and understandably so – of the Great Recession is that credit scores required for a mortgage have increased by about 100 points,” Wachter noted. “So if you’re subprime today, you’re not going to be able to get a mortgage. And many, many millennials unfortunately are, in part because they may have taken on student debt. So it’s just much more difficult to become a homeowner.”

Keys noted that many borrowers, especially first-time borrowers, use FHA (Federal Housing Administration) programs, where they make 3% down payments, or programs for veterans where in many cases the down payment could be zero. “So while down payments don’t have to be large, there are really tight barriers to access and credit, in terms of credit scores and having a consistent, documentable income.” In terms of credit access and risk, since the last crisis, “the pendulum has swung towards a very tight credit market.”

Signs of the Wounded

Chastened perhaps by the last crisis, more and more people today prefer to rent rather than own their home. “The rate of growth in the transforming of the home-ownership stock to the renters stock has slowed considerably,” said Wachter. Homeownership rates are not as buoyant as they were between 2011 and 2014, and notwithstanding a slight uptick recently, “we’re still missing about 3 million homeowners who are renters.” Those three million missing homeowners are people who do not qualify for a mortgage and have become renters, and consequently are pushing up rents to unaffordable levels, Keys noted.

Rising housing prices no doubt exacerbate the overall inequality in wealth and income, according to Wachter. Prices are already high in growth cities like New York, Washington and San Francisco, “where there is an inequality to begin with of a hollowed-out middle class, [and between] low-income and high-income renters.” Residents of those cities face not just higher housing prices but also higher rents, which makes it harder for them to save and eventually buy their own house, she added.

“Many millennials unfortunately are [subprime], in part because they may have taken down student debt. It’s just much more difficult to become a homeowner.” –Susan Wachter

Although housing prices have rebounded overall, even adjusted for inflation, they are not doing so in the markets where homes shed the most value in the last crisis. “The comeback is not where the crisis was concentrated,” Wachter said, such as in “far-out suburbs like Riverside in California.” Instead, the demand — and higher prices – are “concentrated in cities where the jobs are.”

Even a decade after the crisis, the housing markets in pockets of cities like Las Vegas, Fort Myers, Fla., and Modesto, Calif., “are still suffering,” said Keys. “In some of these housing markets, there are people who are still under water on their mortgage, and [they] continue to pay.” He noted that markets that have seen the biggest shifts – “the Phoenixes and the Las Vegases” — are experiencing a relatively depressed housing market overall; it may be a matter of time before they recover along with the rest of the economy.

Clearly, home prices would ease up if supply increased. “Home builders are being squeezed on two sides,” Wachter said, referring to rising costs of land and construction, and lower demand as those factors push up prices. As it happens, most new construction is of high-end homes, “and understandably so, because it’s costly to build.”

What could help break the trend of rising housing prices? “Unfortunately, [it would take] a recession or a rise in interest rates that perhaps leads to a recession, along with other factors,” said Wachter. She noted that some analysts speculate that another recession could take place by 2020.

Regulatory oversight on lending practices is strong, and the non-traditional lenders that were active in the last boom are missing, but much depends on the future of regulation, according to Wachter. She specifically referred to pending reforms of the government-sponsored enterprises – Fannie Mae and Freddie Mac – which guarantee mortgage-backed securities, or packages of housing loans. “They’ve been due to be reformed for 10 years now.” Although the two organizations “are part of a stable lending pattern right now, the taxpayer is a 100% at risk” if they were to face a crisis.

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