Home / Daily Dose / How Did Refis Impact the 2008 Financial Crisis?
Print This Post Print This Post

How Did Refis Impact the 2008 Financial Crisis?

While there is still debate about the various factors that contributed to the 2008 financial crisis and the collapse of the housing market, a new paper by the Urban Institute suggests that the poor performance of cash-out refinances, and refinances in general, were important contributing factors.

“What Fueled the Financial Crisis? An Analysis of the Performance of Purchase and Refinance Loans,” authored by the Urban Institute’s Laurie S. Goodman and Jun Zhu, opens with a recap of two competing theories about what caused the 2008 financial crisis. On one side, there is the narrative that government policies aimed at building homeownership backfired by encouraging the private sector to offer mortgages to borrowers with poor credit and without the financial stability to afford them. On the other side of the debate places more of the onus on the lenders themselves for lending to subprime borrowers. The Urban Institute report, however, suggests that refinances may have played more of a role in the crisis than has been acknowledged before.

According to the report, recent research suggests first-time homebuyers were not the largest contributors to poor credit performance. Instead, the report points to established borrowers seeking cash-out refinances or second liens on their mortgages. “These borrowers often used non-traditional instruments such as Interest Only loans and negative amortization loans to stretch their buying power,” states the report.

Examining “detailed loan-level information from Fannie Mae and Freddie Mac loan level credit database,” the Urban Institute researchers gathered data on 30-year fixed-term mortgage originations occurring between 1999-2016. From there, they divided the data into subcategories representing purchase loans, rate refi, and cash-out refi. “To qualify a rate refi, the borrower must use the proceeds only to pay off the first mortgage,” explains the report. “The cash out to the borrower cannot exceed 2 percent of the new refi mortgage or $2,000, whichever is less. Otherwise, the new mortgage will be considered as cash out refi.”

The Urban Institute study found that, during the period leading up to the financial crisis, purchase loans accounted for 44-48 percent of the market, whereas refis were taking up an increasing percentage of the market (cash-out refis were at 37 percent during 2005-2008, as opposed to 15 percent in 2006).

Examining default activity for both purchase loans and refis, the Urban Institute researchers found that during the examined years, purchase loans performed much better when it came to default rates than refis did. In 2004, 5.3 percent of purchase loans defaulted [defined here as going 180 days delinquent (D180) or having been “liquidated from a delinquent state prior to the D180 point”]. The rate was 5.8 percent for rate refis and 7.3 percent for cash-out refis. Shifting to 2007, those rates changed to 9.6 percent for purchase loans, 15.9 percent for rate refis, and 17.1 percent for cash-out refis.

“Thus, inconsistent with their weaker credit profile, purchase loans have stronger performance than rate refis,” states the report. “The default rate on cash out refis is much worse than either purchase loans or rate refinances.”

That pattern continues across multiple angles of examination, with purchase loans consistently performing better than rate refis or cash-out refis. “Our results reveal that cash-out refinances has the poorest behavior on every dimension, especially during the financial crisis,” states the report. “Thus, our results show it was not the expansion of lending to include more marginal borrowers that caused the financial crisis. Rather, contributing factors to the crisis include the performance of the cash out refinances in particular, and refinances more generally.”

To read the Urban Institute’s full report, click here.

About Author: David Wharton

David Wharton, Editor-in-Chief at the Five Star Institute, is a graduate of the University of Texas at Arlington, where he received his B.A. in English and minored in Journalism. Wharton has nearly 20 years' experience in journalism and previously worked at Thomson Reuters, a multinational mass media and information firm, as Associate Content Editor, focusing on producing media content related to tax and accounting principles and government rules and regulations for accounting professionals. Wharton has an extensive and diversified portfolio of freelance material, with published contributions in both online and print media publications. He can be reached at [email protected].

Check Also

2023 Was the Least Affordable Year on Record. Will 2024 Follow Suit?

The least affordable markets included Anaheim and San Francisco, where homebuyers with the typical local income would’ve needed to spend over 80% of their pay on monthly housing costs.