part5
lower Lending Standards SPREAD AND cause the Housing Bubble
Risky mortgage lending, particularly loans with very low down payments, contributed
directly to the rise of a housing bubble. Had this risky lending been contained within the low-income segment of the market targeted by politicians advocating more “innovation” in “affordable lending,” the damage to the wider economy might have been minimal. However, these “innovations” in “flexible” loans products spread beyond just affordable lending into the entire U.S. mortgage market. The lure of reduced underwriting standards held true not just for borrowers of modest income but for those at all income levels. Although the erosion of mortgage underwriting standards began in Washington with initiatives like the CRA as a way to reduce “barriers to homeownership,” this trend inevitably spread to the wider mortgage market. One observer noted:
Bank regulators, who were in charge of enforcing CRA standards, could hardly disapprove of similar loans made to better qualified borrowers. This is exactly what occurred.
Borrowers – regardless of income level – took advantage of the erosion of underwriting standards that started with government affordable housing policy. As one study observed,“[o]ver the past decade, most, if not all, the products offered to subprime borrowers have also been offered to prime borrowers.”24 For example, Alt-A and adjustable-rate mortgages became incredibly popular with borrowers – who were generally not low-income – engaging in housing speculation. As home prices continued their dizzying rise, many people decided to cash in by buying a house with an adjustable-rate mortgage featuring a low introductory teaser rate set to increase after a few years. These borrowers, confident in the oft-cited assertion that U.S. home values had never before fallen in the aggregate, planned to sell or refinance their investment before the mortgage rate adjusted upward, pocketing the difference between the initial purchase price and the subsequent appreciation in value. However, buyers failed to grasp the effect of a government policy that had quietly eroded the prudential limits on mortgage leverage, creating a dangerous speculative bubble. As the size of down payments for mortgages fell, so too did borrowers’ equity stake in the homes they purchased. This had two important effects. First, it eliminated the borrower’s “skin in the game,” increasing the likelihood that he or she would walk away from the mortgage if times got tough. It also increased the borrower’s leverage (debt) as measured by the Loan-to-Value ratio.25 This leverage allows borrowers to purchase more expensive houses than they would otherwise be able to afford at a given level of income. It was this process of steadily increasing leverage that drove the complete decoupling of home prices from Americans’ income and fed the growth of the housing bubble. As the average down payment shrank and leverage correspondingly increased, the amount of mortgage debt relative to borrowers’ income increased. This increasing leverage in turn eroded the power of supply and demand to restrain irrational price increases. In a normal housing market, free of government intervention, an increase in home prices would have been restrained when the marginal, or next, home seller tried to charge a price too high for prospective borrowers to afford. This home seller would have been forced to cut his or her unreasonable price. Once government-sponsored efforts to decrease down payments spread to the wider market, home prices became increasingly untethered from any kind of demand limited by borrowers’ ability to pay. Instead, borrowers could just make smaller down payments and take on higher debt, allowing home prices to continue their unrestrained rise. Some statistics help illustrate how this occurred. Between 2001 and 2006, median home prices increased by an inflation-adjusted 50 percent, yet at the same time Americans’ income failed to keep up. For the 30 years prior to 2000, the ratio of U.S. home prices to income averaged only about 4-to-1 – in other words, the average American lived in a home costing four times his annual income. In just five years, from 2000 to 2005, that ratio doubled to 8-to-1. As a result of homes becoming more expansive and seemingly less affordable, the only way for many Americans to buy a home during the housing bubble was to dramatically increase their leverage. It is not surprising, then, that between 2000 and 2006 mortgage debt in the U.S. increased by 80 percent. According to one early
warning in 2006, the odds against such an increase in the price-to-income ratio occurring naturally were greater than 300-to-1.26 Government actions distorted the housing market, yet advocates of affordable housing policies, such as Congressman Barney Frank (D-MA), have asserted that those who criticize these policies seek to place blame for the financial crisis solely on borrowers of modest means.27 This misses the mark entirely. In fact, responsibility for the erosion of mortgage lending standards, which began with government affordable housing policy, rests squarely on the policy makers who advocated these ill-conceived policies in the first place. Borrowers quite naturally responded to the incentives they were given, irrespective of their socioeconomic status, and risky lending spread to the wider mortgage market.
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