Non-Traditional Mortgages and the Housing Bubble

Non-Traditional Mortgages and the Housing Bubble

One of the features of the financial system that makes it particularly tricky to regulate is financial innovation, where new securities or investments arrive on the scene (sometimes as a form of regulatory arbitrage) that are different from what came before. The rise of mortgages with non-traditional features, such as negative amortization, teaser interest rates, balloon payments, or interest-only loans are a prime example of this phenomenon.

A new paper from the Federal Reserve Bank of Chicago finds that the rise of these non-traditional mortgages fueled the 2008 housing crisis by making subprime loans to borrowers trying to keep up with rising housing costs in areas where wage growth was low or stagnant:

At their peak in 2005, roughly 60 percent of all purchase mortgage loans originated in the United States contained at least one non-traditional feature. These features, which allowed borrowers easier access to credit through teaser interest rates, interest-only or negative amortization periods, and extended payment terms, have been the subject of much regulatory and popular criticism. In this paper, we construct a novel county-level dataset to analyze the relationship between rising house prices and non-traditional features of mortgage contracts. We apply a break-point methodology and find that in housing markets with breaks in the mid-2000s, a strong rise in the use of non-traditional mortgages preceded the start of the housing boom. Furthermore, their rise was coupled with declining denial rates and a shift from FHA to subprime mortgages. Our findings support the view that a change in mortgage contract availability and a shift toward subprime borrowers helped to fuel the rise of house prices during the last decade.

 

To begin, the paper contrasts pre-2000 housing price booms with ones that began around 2003-2004. These pre-2000 booms, which had relatively little incidence of such non-traditional mortgage loans and can be found in cities such as San Francisco or Boston, were more based on economic fundamentals such as increases in wages (and, of course, artificially restricted housing supply growth.)

Not so in areas where incomes were largely stagnant. In these areas (the “sand states” of California, Arizona, Florida, Nevada), “late-booming markets experience[d] significant shifts in the supply of mortgage credit that predated the start of local house price booms” with the growth of non-traditional mortgages as a cause.

 

These non-traditional loans were issued in part to help prospective homeowners keep up with housing prices, but also to speculate on such appreciation. But the key finding here is that the falling “cost of capital…drove [banks] towards secondary markets, where non-traditional products flourished.”

Rather than enabling homeowners to keep up with housing prices, cheap capital instead fueled the housing bubble.

I didn't find this helpful.This was helpful. Please let us know if you found this article helpful.
Loading...
By |2019-02-05T12:04:58+00:00February 5th, 2019|Blog, Financial Regulation|