Professional Documents
Culture Documents
Vol. 2, No. 11
NOVEMBER 2007
After booming the first half of this decade, U.S. housing activity has retrenched
Past behavior suggests sharply. Single-family building permits have plunged 52 percent and existing-home sales
that housing markets’ have declined 30 percent since their September 2005 peaks (Chart 1).
adjustment to more A rise in mortgage interest rates that began in the summer of 2005 contributed
realistic lending to the housing market’s initial weakness. By late 2006, though, some signs pointed to
standards is likely renewed stability. They proved short-lived as loan-quality problems sparked a tightening
to be prolonged. of credit standards on mortgages, particularly for newer and riskier products. As lenders
cut back, housing activity began to falter again in spring 2007, accompanied by addi-
The recent boom-to-bust housing cycle raises important questions. Why did
it occur, and what role did subprime lending play? How is the retrenchment in lending
activity affecting housing markets, and which reflect the highest default risk skip payments by reducing equity or,
will it end soon? Is the housing slow- and warrant the highest interest rates. in some cases, obtain a mortgage that
down spilling over into the broader Near-prime mortgages, which are exceeded the home’s value.
economy? smaller than jumbos, are made to bor- These new practices opened
rowers who qualify for credit a notch the housing market to millions of
Rise of Nontraditional Mortgages above subprime but may not be able Americans, pushing the homeowner-
Monitoring housing today entails to fully document their income or pro- ship rate from 63.8 percent in 1994
tracking an array of mortgage prod- vide traditional down payments. Most to a record 69.2 percent in 2004.
ucts. In the past few years, a fast- mortgages in the near-prime category Although low interest rates bolstered
growing market seized upon such are securitized in so-called Alternative- homebuying early in the decade, the
arrangements as “option ARMs,” “no- A, or Alt-A, pools. expansion of nonprime mortgages
doc interest-onlys” and “zero-downs Some 80 percent of outstanding clearly played a role in the surge of
with a piggyback.” For our purposes, U.S. mortgages are prime, while 14 homeownership.
it’s sufficient to distinguish among percent are subprime and 6 percent Two crucial developments
prime, jumbo, subprime and near- fall into the near-prime category. spurred nonprime mortgages’ rapid
prime mortgages. These numbers, however, mask the growth. First, mortgage lenders adopt-
Prime mortgages are the tradi- explosive growth of nonprime mort- ed the credit-scoring techniques first
tional — and still most prevalent — type gages. Subprime and near-prime loans used in making subprime auto loans.
of loan. These go to borrowers with shot up from 9 percent of newly origi- With these tools, lenders could better
good credit, who make traditional nated securitized mortgages in 2001 to sort applicants by creditworthiness and
down payments and fully document 40 percent in 2006.1 offer them appropriately risk-based
their income. Jumbo loans are gener- The nonprime boom introduced loan rates.
ally of prime quality, but they exceed practices that made it easier to obtain By itself, credit scoring couldn’t
the $417,000 ceiling for mortgages loans. Some mortgages required have fostered the rapid growth of
that can be bought and guaranteed by little or no proof of income; others nonprime lending. Banks lack the
government-sponsored enterprises. needed little or no down payment. equity capital needed to hold large
Subprime mortgages are extended Homebuyers could take out a simulta- volumes of these risky loans in their
to applicants deemed the least credit- neous second, or piggyback, mortgage portfolios. And lenders of all types
worthy because of low credit scores at the time of purchase, make inter- couldn’t originate and then sell these
or uncertain income prospects, both of est-only payments for up to 15 years, loans to investors in the form of resi-
dential mortgage-backed securities,
or RMBS —at least not without added
protection against defaults.
The spread of new products offer-
Chart 1
ing default protection was the second
Housing Activity Drops Off crucial development that fostered sub-
prime lending growth. Traditionally,
Millions of units Millions of units
banks made prime mortgages funded
2 8 with deposits from savers. By the
Mortgage
rates start rising 1980s and 1990s, the need for deposits
1.8
had eased as mortgage lenders created
7
a new way for funds to flow from sav-
1.6
ers and investors to prime borrowers
through government-sponsored enter-
prises (GSEs) (Chart 2, upper panel).
1.4 6
Subprime Fannie Mae and Freddie Mac are
woes hit
the largest GSEs, with Ginnie Mae
1.2
Total existing-home sales Single-family being smaller. These enterprises guar-
building permits 5
antee the loans and pool large groups
1
of them into RMBS. They’re then sold
to investors, who receive a share of
.8 4
’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07
the payments on the underlying mort-
SOURCES: National Association of Realtors; Census Bureau; authors’ calculations. gages. Because the GSEs are feder-
ally chartered, investors perceive an
Pr tgag
m
nonprime interest rates to levels out-
im e
or
e s
s
sit
side the reach of targeted borrowers.
po
De
This is where financial innova-
tions came into play. Some — like col- Savers Prime
lateralized debt obligations (CDOs), and mortgage
a common RMBS derivative — were investors borrowers
designed to protect investors in
nonagency securities against default Bu MB
yG S
s
losses. Such CDOs divide the streams
R
mo rime
age
SE
of income that flow from the under-
rtg
P
lying mortgages into tranches that
Mortgage
absorb default losses according to a
originators
preset priority.
The lowest-rated tranche absorbs
the first defaults on the pool of
underlying mortgages, with succes-
sively higher ranked and rated tranches
absorbing any additional defaults. If .
2000–06 Banks
defaults turn out to be low, there may
be no losses for higher-ranked tranches
Pr tgag
m
im e
or
SE
age
Bu gen
rtg
P
7
Single-family homes Financial Turmoil
By August 2007, the housing
6
market’s weaknesses were apparent:
5
loan-quality problems, uncertainty
about inventories, interest rate resets
4 and spillovers from weaker home pric-
3
All homes es. These, coupled with ratings agen-
’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 cies’ downgrading of many subprime
NOTE: The all-homes category covers single-family homes, condominiums and nonrental apartments. Shaded areas RMBS, led to a dramatic thinning in
indicate recession.
SOURCE: National Association of Realtors.
trading for subprime credit instru-
ments, many of which carried synthet-
Macroeconomic Effects
A housing slowdown mainly affects
gross domestic product by curtailing