Prime mortgage borrowers caused the housing bust
Prime borrowers using negative amortization loans were largely responsible for inflating the housing bubble, and their defaults lead to the crash.
Most people believe the housing bubble and bust was caused by subprime lending.
The housing debacle was caused by a rapid expansion of credit to prime borrowers, particularly through the proliferation of negative amortizations loans. The housing bubble inflated because too much money was loan to everyone, not just subprime borrowers.
Since bubble-era home prices depended on unstable loan products, the collapse was inevitable. Although the subprime borrowers defaulted first, all borrowers defaulted in large numbers because the loans there were given were toxic; in fact, delinquency rates were many times normal for prime borrowers as well as subprime.
Ben Bernanke famously (and inaccurately) quipped that the housing bust was “contained” to subprime and it wouldn’t bleed over to prime borrowers. He was either knowingly lying or astonishingly ignorant; neither alternative casts him in a positive light.
While bankers clung to wishful thinking and feeble hope to stop foreclosure in Phoenix, their alt-a and prime borrowers also defaulted in large numbers, a fact often overlooked by those who want to characterize the housing bubble as a subprime problem.
Besides the hidden racial bias, the worst part about the “blame the poor subprime borrower” meme was the gross distortion of truth. This wasn’t primarily a subprime problem that caused problems with better borrowers — the problem with delinquency was primarily a problem of higher wage earners and wealthy borrowers; in fact, the bigger the loan, the more likely the borrower was to become delinquent.
At first banks allowed these borrowers to squat because foreclosing on them assured the banks of losses far in excess of what they could afford; thus you get borrowers like Peggy Tanous who lived payment-free for over six years. It was the prime borrowers taking out huge loans that were responsible for the housing bubble.
When we talk about the past decade’s housing crisis, it’s natural to talk about subprime loans. Subprime loans give us a convenient, conventional story: predatory lenders charging people unconscionable interest rates, forcing innocent people into foreclosure and the rest of us into the worst financial crisis since the Great Depression.
There is only one small problem with this story, which is that lots of prime borrowers defaulted too. In fact, according to a new paper by Fernando Ferreira and Joseph Gyourko, subprime loans accounted for only a bare majority of defaults at the beginning of the housing crisis. Between the third quarter of 2006 and the third quarter of 2012, twice as many prime borrowers lost their homes as subprime borrowers. …
Subprime loans certainly caused a lot of problems, but they did not cause all the problems by any means. They could not have driven us into crisis if the rest of us had not so eagerly gone along.
So what role did they play?
Subprime lending fueled demand that pushed prices higher. This prompted “innovations” in mortgage lending to allow both subprime and prime borrowers opportunities to buy even at ridiculously inflated prices. The toxic mortgage products developed in response to affordability problems inflated the bubble, which is why they were banned by Dodd-Frank.
I think we can tell a very plausible story that still assigns subprime loans a central role:
Once upon a time, there was a country with a housing market that started to rise. As the market started to rise, housing defaults started to fall. They fell not because people had gotten wiser about borrowing, or better at managing their money, but because borrowers in a rising housing market virtually never need to default; they can always simply sell the house, walking away with whatever equity is left over after paying off the mortgage.
Lenders loved this. “Splendid! If default has become less likely,” the lenders said, “we do not need to worry so much about things like down payments or credit histories. Who cares if they can’t pay the mortgage each month; if they get into trouble, they’ll just sell the house and pay us.”
Now, a housing market is sort of like a room with two doors. On the one side people are entering; on the other side of the room, people are exiting. The more people there are in the room, the more valuable your little patch of ground to stand on becomes. The effect of expanding subprime loans was to make the entrance door wider, allowing a lot of people in who had not previously been able to secure a spot inside. This made spots inside even more valuable, and drove defaults even lower, encouraging the bankers to make even riskier loans.
Unfortunately, there were only so many people in the waiting room who wanted to get in. Once they’d all passed through, two things happened: The number of people bidding for spots fell, and people started to notice that it was getting kind of crowded in there. Prices stopped rising inside.
Once that happened, the risk of those subprime loans became apparent. They’d always been bad credit risks, but that risk had been masked by the rising prices. Defaults started going up. The folks in the waiting room decided maybe they’d wait a little while to see how it settled out. Lenders didn’t have money to make new risky loans. The subprime borrowers were the first to go, and the hardest hit.
In March of 2008, I first wrote about the problems with the subprime business model:
There is an important distinction that must be made between the default rate on a mortgage loan and the resultant loss incurred when a default occurs. High mortgage default rates do not necessarily translate into high mortgage default losses and vice-versa.
Subprime loans have had high default rates since their introduction. When subprime mortgages began to capture broader market share starting in 1994, the rate of home ownership in the United States began to rise. The increasing use of subprime loans and the subsequent increase in home ownership rates put upward pressures on house prices. As house prices began their upward march, the default losses from subprime defaults began to fall because the collateral was obtaining more resale value. This made subprime lending, and its associated high default rates, look less risky to investors because these default rates were not translating into default losses. As time went on and prices continued to rise, subprime lending established a track record of investor safety which drew more capital into the industry; however, since the relative safety of subprime lending was entirely predicated upon rising prices, it was an industry doomed to fail once prices stopped rising.
Take this phenomenon to its extreme and its instability becomes readily apparent. Imagine a time when prices are rising, perhaps even due to the buying of subprime borrowers, and imagine what would happen if 100% of the subprime borrowers defaulted without making a single payment. It would take approximately one year for the foreclosure and relisting process to move forward, and during that year, the prices of resale houses would have increased. When the lender would go to the open market to sell the property, they would obtain enough money to pay back the loan and the lost interest so there would be no default loss. What just happened? Lenders became de facto real estate speculators profiting from the buying and selling of homes in the secondary market rather than lenders profiting from making loans and collecting interest payments. This profiting from speculation is the core mechanism that disguised the riskiness of subprime lending. When these speculative profits evaporated when prices began declining, the subprime industry imploded and its implosion exacerbated the decline of home prices.
It’s taken seven years, but academics conducted a study confirming what I wrote back in 2008. I hope this leads to a broader and better understanding of what really happened.
The middle class is responsible
Far too much money was loaned to middle-class borrowers who didn’t have the capacity to pay it back. These middle-class borrowers never had the capacity; it wasn’t a matter of rich people losing wealth in the stock market or high wage earners getting laid off. People with modest incomes who didn’t lose their jobs were given debts they could never repay — loans in excess of $750,000 — and they defaulted.
To characterize this as a problem of rich versus poor isn’t accurate either. These were middle-class borrowers pretending to be rich, aspiring to be rich, borrowing money to speculate in the can’t-lose real estate market. Many of the households given $750,000+ loans had combined family incomes of less than $100,000 thanks to the Option ARM, teaser rates, liar loans, and the general insanity of lending during the 00s.
The housing bubble was not a subprime problem: it was a middle-class prime borrower problem. It’s time for everyone to quit blaming subprime borrowers and look in the mirror.