(Editor's note: This select print feature will appear in the August 2015 issue of DS News)
By Mark Lieberman
Conventional wisdom holds that subprime loans were at the root of the mortgage crisis which dominated the first decade of this century and contributed to the worst financial calamity in more than 70 years.
But a new analysis of the mortgage crisis, which cost millions of families their homes and brought down storied financial institutions such as Lehman Brothers and Washington Mutual, suggests prime loans, not subprime, were the major driver and “the crisis was not solely, or even primarily, a subprime sector event.”
That’s the conclusion of Fernando Ferreira and Joseph Gyourko of The Wharton School of the University of Pennsylvania in their paper “A New Look at the U.S. Foreclosure Crisis: Panel Data Evidence of Prime and Subprime Borrowers From 1997 to 2012.” This paper was released in June by the National Bureau of Economic Research. Current LTVs, they said in their study, were the reason so many borrowers defaulted.
“There are only seven quarters at the beginning of the housing bust in which there were more homes lost by subprime borrowers than by prime borrowers,” Ferreira and Gyourko said.
According to their research, 39,094 more subprime borrowers than prime borrowers lost their homes from 3Q 2006 through 1Q 2008. The difference, the authors said, was completely reversed by the beginning of 2009 when 40,630 more prime than subprime borrowers lost their homes.
“Sharply higher subprime distress rates became evident early in the housing bust just as the previous literature showed,” the authors said. “However those high rates never affected anything close to a majority of the market. Moreover, loss rates among the much larger group of prime borrowers started to increase shortly thereafter – within a year.”
The observation that loans to subprime borrowers were the first to fall is consistent, said Michael C. Smith, a longtime bank credit officer and former executive a government sponsored enterprise during the peak of the foreclosure crisis, with his own experience.
“I’m not at all surprised the prime foreclosures dominated the foreclosure activity precisely because prime was such a large part of the market and because a lowering tide sinks all boats,” he said.
That simple explanation that prime loans dominated because there a lot more of them, according to Gyourko, is only one factor. Instead, the authors look to current LTV as the principal cause of default.
The terms “prime” and “subprime” generally define not the loan but the borrower, thus “plain vanilla” mortgages made to borrowers with questionable credit histories would be more likely to fall into arrears than loans made to borrowers with perfect credit. The Ferriera and Gyourko paper, however, contains only one reference to underwriting, though they do acknowledge it as a major factor in many other studies of the mortgage crisis.
“Neither borrower traits nor housing unit traits appear to have played a meaningful role in the foreclosure crisis,” they wrote.
Smith, too, suggested underwriting was not to blame.
“Largely very well underwritten loans took a bath because when home values go down 20 to 50 percent a lot of bad happens,” he said “When simultaneously you’ve got a nationwide if not worldwide depression going on, you’ve got the two major drivers, loan-to-value ratio and borrower illiquidity both occurring and affecting a large number of prime borrowers.”
The authors of the paper acknowledged the global economic crisis exacerbated the U.S. mortgage meltdown.
“Prior to the global financial crisis, borrowers in the prime and subprime sector were no more likely to lose their homes than all cash owners once we know their current LTV ratio,” they wrote. “This is not unexpected, as sound underwriting should lead to groups of non-speculator owner-occupiers who are good credit risks.”
Ferriera and Gyourko however made no reference to underwriting distinctions for prime and subprime applicants. The underwriting approach to prime and subprime borrowers – regardless of the loan type – often differs. “Prime” underwriters’ main job seemed to be to find a reason to not make a loan while a “subprime” underwriter approached the loan package knowing the loan would be made, but used skill and knowledge to price it properly.
Other studies, they said, have shown initial LTVs were responsible for 60 percent of the foreclosure crisis. However, they wrote, “our data reveal only modest impacts for these factors on whether owners ultimately lose their homes. We argue that these variables are best thought as helping measure current LTVs more accurately.”
The Federal Reserve has offered its own interpretation, which, by title, conflicts with Ferreira and Gyourko. According to the history by John V. Duca of the Federal Reserve Bank of Dallas, “The subprime mortgage crisis of 2007–10 stemmed from an earlier expansion of mortgage credit, including to borrowers who previously would have had difficulty getting mortgages, which both contributed to and was facilitated by rapidly rising home prices.”
In the early and mid-2000s, Duca wrote, lenders began offering new generally “high-risk” mortgage products, funding them by repackaging them into pools to be sold to investors. The new products, he said in his history, enabled more first time homebuyers to obtain mortgages. The resulting demand sent house prices up, more so in areas where housing was in tight supply, leading to expectations of still more house price gains, which in turn further increased housing demand and prices, a classic definition of a bubble.
Smith also pointed to securitization.
“Subprime loans were still two times if not three times more likely to go into foreclosure [than prime loans] but even though they were two or three times more likely, there weren’t enough of them to dominate the foreclosure market,” he said. “To conclude therefore the foreclosure crisis was primarily a prime borrower event overlooks the fact that it was all the subprime securitization which drove both the peak of the housing bubble and the worldwide recession.”
When house prices peaked, Duca added, mortgage refinancing and selling homes became a less viable means of settling mortgage debt and mortgage loss rates began rising for lenders and investors.
“Because the bond funding of subprime mortgages collapsed, lenders stopped making subprime and other nonprime risky mortgages,” according to Duca. “This lowered the demand for housing, leading to sliding house prices that fueled expectations of still more declines, further reducing the demand for homes. Prices fell so much that it became hard for troubled borrowers to sell their homes to fully pay off their mortgages, even if they had provided a sizable down payment.”
Lenders, he wrote, subsequently made qualifying for high- and even relatively low-risk mortgage loans even more difficult, which depressed housing demand further.
With foreclosures increasing, repossessions multiplied, boosting the number of homes being sold into a weakened housing market. At the same time, delinquent borrowers were attempting to sell their homes to avoid foreclosure, sometimes in “short sales,” in which lenders accept limited losses if homes were sold for less than the mortgage owed.
“In these ways, Duca concluded, “the collapse of subprime lending fueled a downward spiral in house prices that unwound much of the increases seen in the subprime boom.”
According to Ferreira and Gyourko, the unwinding of home prices spread the contagion to prime borrowers.
“Given that the vast majority of foreclosures occurred in [the prime] sector from 2009 on, this suggests the crisis was largely one of sound borrowers falling into negative equity because of very large declines in house prices.
“This couldn’t have been contained as a subprime problem,” Smith offered. “It couldn’t be contained as a subprime problem because home values came down through the entire market and increasingly prime borrowers were using home equity, spending their home equity. The LTV impact of the bubble bursting was inevitably going to drive the prime mortgage performance because of the heavy volume of loans we saw. It was impossible for prime borrowers to escape the side effects of the crash; that wasn’t a function of the kind of loan they had, it was a function of what was happening in the economy and what was happening in the housing market.”
Ferreira and Gyourko looked at but dismissed other aspects of the borrower equation, including race and gender.
“The race and gender of the owner, the self-reported initial income of the owner and our imputation for whether the owner is a speculator,” they said, “could impact foreclosures in a number of ways.”
Race, they acknowledged, could have been a factor since their data showed minorities had a larger share of subprime mortgages relative to prime, and other studies have suggested minorities usually have less wealth than non-minorities.
“These are all plausible,” they concluded “but adding these household traits to the specification including census tract-by-quarter fixed effects is barely more impactful than adding housing unit traits was. Thus, owner demographics, reported income and speculator status cannot account for differences in foreclosure/short sale outcomes across borrower/owner types, and they do not vitiate the influence of negative equity in explaining those differences.”
In sum, they said, “controlling for current LTV accounts for virtually all of the increase in foreclosures among prime borrowers and a substantial fraction of the surge in subprime home losses.”
Prime borrowers, Smith said, were definitely not the cause of the meltdown, quite the opposite.
“I would characterize the prime borrower as the victim.”