The Global Financial Crisis

Module 3 Housing and Mortgages

Andrew Metrick
Outline
Module 3

01 Housing bubbles and financial 05 Are subprime mortgages

crises “designed to fail”?

02 Mortgages: fixed and adjustable 06 Some foreclosure facts

03 Mortgages: prime 07 Crisis terminology

04 Mortgages: nonprime 08 Summary

The Global Financial Crisis
Module 3 Housing and Mortgages

01 Housing Bubbles and Financial Crises

Housing Bubbles and Financial Crises

Reinhart and Rogoff (2008) identify the “big five” crises since WWII
– Spain (1977), Norway (1987), Finland (1991), Sweden (1991), and
Japan (1992) – plus 13 other bank-centered crises in developed
countries.

Housing price appreciations are a standard feature of financial

crises, and as of 2007 the United States appeared to be in great
danger.
Real Housing Prices and Financial Crises

Index, t-4=100

135

130

125

120 US, 2003=100

115

110
Average for banking crises in
advanced economies
105

100
Average for the “Big 5” Crises

95
t-4 t-3 t-2 t-1 T t+1 t+2 t+3
The Global Financial Crisis
Module 3 Housing and Mortgages

02 Mortgages: Fixed and Adjustable

Mortgages

The standard mortgage in the United States has a 30-year term,

with fixed interest rates. Every year you pay interest and an
amortization of the loan.

Alternative structures have adjustable interest rates for all or

part of the term (“ARMs”, 2/28, 5/25 or 5/1, 7/23 or 7/1 etc.), with
the adjustable rate set to some spread above a reference rate.

• Initial fixed rate will typically be lower than for 30-year fixed
mortgage, sometimes called a “teaser”.

• These alternative structures are more popular outside the

United States.

More complex structures allow for flexible payment sizes:

negative amortization, balloon payments, pre-payment
penalties, and other elements that can reduce payment sizes in
early years.
The Global Financial Crisis
Module 3 Housing and Mortgages

03 Mortgages: Prime
Prime Mortgages

Conforming/Prime/Agency

This is the core category of mortgages in the United States,

used for loans that “conform” to Government Sponsored
Enterprise (“GSE”, or just “agency”) standards for:

• loan-to-value (LTV)
• credit score
• maximum loan size
• occupancy rules
• income limits and documentation

Such loans are eligible to be purchased, guaranteed, and

combined into agency Mortgage Backed Securities.

Loans that would satisfy these criteria except for being too
large are called “jumbo” or “super-jumbo” mortgages, and
cannot be guaranteed by the GSEs.
The Global Financial Crisis
Module 3 Housing and Mortgages

04 Mortgages: Nonprime
Nonprime Mortgages

Subprime “Although categories are not rigidly defined, subprime loans are
generally targeted to borrowers who have tarnished credit
histories and little savings available for down payments.”
(Mayer, Pence, and Sherlund, 2009)

Near-prime or “Alt-A” “Near prime mortgages are made to borrowers with more minor
credit quality issues or borrowers who are unable or unwilling to
provide full documentation of assets or income …”
(Ibid)

Together, subprime and Alt-A are known as “nonprime”.

Nonprime mortgages are not new products, but their use in the
United States increased dramatically in the 2000s.
Subprime Mortgage Originations

Billion Dollars
Non-securitized Securitized Subprime Share of Entire Mortgage Market

700 25
23.5%
22.7%
20.9%
600
20

500

15
400

8.3%
10.6%
9.5% 9.8% 10.4% 10.1%
300 9.2%
10
7.6% 7.4%
200

5
100 1.7%

0 0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Note: Percent securitized is defined as subprime securities issued divided by originations in a given year. In 2007, securities issued exceeded originations.
Source: Inside Mortgage Finance.
The Global Financial Crisis
Module 3 Housing and Mortgages

05 Are Subprime Mortgages “Designed to Fail”?

Are Subprime Mortgages “Designed to Fail”?

In a typical subprime mortgage, an initial “teaser” rate will be set to

adjust after two or three years, usually to be much higher than the
original rate.

A borrower can get out of this higher rate by refinancing, but this
action may incur a pre-payment penalty.

This sounds like a horrible trap, like a financial product that is

“designed to fail”.
Are Subprime Mortgages “Designed to Fail”?

A subprime mortgage only makes sense if everyone expects

housing prices to rise.

In this case, it can be a useful financial innovation, allowing

borrowers to share the potential upside of their housing investment
to get a lower overall rate.
 Are Subprime Mortgages “Designed to Fail”?

Initial Year
Homeowner takes out
teaser-rate, adjustable
mortgage with pre-
payment penalty

Home Value $300,000

Homeowners’ Equity $15,000 (5% down payment)

 Are Subprime Mortgages “Designed to Fail”?

Initial Year
Homeowner takes out
teaser-rate, adjustable
mortgage with pre- Home prices
payment penalty appreciate 10%

Home Value $300,000

Homeowners’ Equity $15,000 (5% down payment)

 Are Subprime Mortgages “Designed to Fail”?

3 years later, as teaser rate

Initial Year expires
Homeowner takes out
teaser-rate, adjustable
mortgage with pre- Home prices Homeowner sells house
payment penalty appreciate 10% or refinances at lower
rate

Home Value $300,000 $330,000

Homeowners’ Equity $15,000 (5% down payment) $45,000 – Pre-payment Penalty

The Global Financial Crisis
Module 3 Housing and Mortgages

06 Some Foreclosure Facts

Foreclosure: Localized But Global

In the United States, foreclosure was a national

phenomenon, but was worst in the “sand states” of:

Arizona
California
Florida
Nevada
Mortgage Delinquencies by Region
Arizona, California, Florida and Nevada – the “sand states” – had the most problem loans

Percent

16
Sand States U.S. Total Non-sand States

13.6%

12

8.7%
8

7.0%

0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Note: Serious delinquencies include mortgages 90 days or more past due and those in foreclosure.
Source: Mortgage Bankers Association National Delinquency Survey.
Foreclosure: Localized But Global

In the United States, foreclosure was a national

phenomenon, but was worst in the “sand states” of
Arizona, California, Florida, and Nevada.

All types of loans had elevated foreclosure rates in the

crisis, with subprime loans and ARMs performing worse.
Mortgage Delinquencies by Loan Type
Serious delinquencies started earlier and were substantially higher among subprime adjustable-rate loans, compared with other loan types

Percent

Subprime Adjustable Rate Subprime Fixed Rate Prime Adjustable Rate Prime Fixed Rate

50

40

30

20

10

0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Note: Serious delinquencies include mortgages 90 days or more past due and those in foreclosure.
Source: Mortgage Bankers Association National Delinquency Survey.
Foreclosure: Localized But Global

In the United States, foreclosure was a national

phenomenon, but was worst in the “sand states” of
Arizona, California, Florida, and Nevada.

All types of loans had elevated foreclosure rates in the

crisis, with subprime loans and ARMs performing worse.

The United States had the worst foreclosure crisis, but

some (not all) other developed countries also had
problems.
Non-Performing Housing Loans by Country

Percent
U.S. Spain U.K. Australia Canada
10

0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Research Institute for Housing (2010), ARPA, Bank of Spain, Canadian Bankers’ Association, Council of Mortgage Lenders, FDIC, RBA.
The Global Financial Crisis
Module 3 Housing and Mortgages

07 Crisis Terminology
Crisis Terminology

Some sources will refer interchangeably to the “housing

crisis”, the “financial crisis” and the “Great Recession”,
especially in the United States.

To be more precise, we should say that the housing

crisis was a primary driver of the financial crisis, and
that both were major contributors to the Great
Recession.
Crisis Terminology

To see how the housing crisis was a primary driver of

the financial crisis, we must shift attention over to the
“demand” side for mortgages, which we will do in the
next module.

Together, the crises in housing and in the financial

sector deepened the real economic effects of what
would later be called “The Great Recession”.
The Global Financial Crisis
Module 3 Housing and Mortgages

08 Summary
Summary

Housing crises and financial crises are intertwined, but

are not exactly the same thing.

In the United States, foreclosure was a national

phenomenon, but it was significantly worse in some
regions and for some types of mortgages.