From Boom to Bust: The Mortgage Crisis in Perspective

Christian E. Weller, Ph.D.Associate Professor, McCormack Graduate School, Univ. of Mass. BostonSenior Fellow, Center for American Progress

October 2007

Overview

The crisis in the subprime market is only a symptom of several much larger

problems: 1) rising foreclosures; 2) tightening credit; 3) weakening economy;

and 4) faltering labor market.

A combination of economic fundamentals caused the crisis: a weak labor

market, unprecedented house price increases, and high liquidity in an

increasingly deregulated market.

Public policy needs to provide three solutions: 1) workouts for homeowners

in trouble; 2) liquidity; and 3) financial stability.

October 2007

Foreclosures have risen substantiallyShare of Mortgages, Where Foreclosure Procedures Have Started, 1979 to 2007

0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%

Mar-79 Mar-84 Mar-89 Mar-94 Mar-99 Mar-04

Date

Per

cen

t o

f M

ort

gag

es

Source: Mortgage Bankers Association, National Delinquency Survey, Washington, DC: MBAA. Data are not seasonally adjusted.

October 2007

Banks have more troubled loansNoncurrent Residential Loans, 1997 to 2007

0.6%

0.7%

0.8%

0.9%

1.0%

1.1%

1.2%

1.3%

Oct-95 Jul-98 Apr-01 Jan-04 Oct-06 Jul-09

Date

Perc

en

t o

f L

oan

s

Source is Federal Deposit Insurance Corporation, Quarterly Performance Report, Washington, DC: FDIC.

October 2007

Banks are tightening loan standardsNet Percentage of Senior Loan Officers Reporting Tightening Loan Standards for Mortgages

-20%

-10%

0%

10%

20%

30%

40%

Sep-90 Sep-93 Sep-96 Sep-99 Sep-02 Sep-05

Date

Pe

rce

nt

of

Su

rve

y R

es

po

nd

en

ts

Source: Board of Governors, Federal Reserve System, Senior Loan Officer Opinion Survey on Bank Lending Practices, Washington, DC: BOG.

October 2007

The economy is slowing due to a weakening housing market

Source: Bureau of Economic Analysis, National Income and Product Accounts, Washington, DC: BEA.

Percentage point growth contribution from residential real estate, 2001 to 2007

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07

Date

Percen

tag

e p

oin

ts

October 2007

The construction boom drove the labor marketChange in Construction and Related Employment as Share of Private Sector Employment Change,

Averages

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

03/01-03/02 03/02-03/03 03/03-03/04 03/04-03/05 03/05-03/06 03/06-03/07 03/07-08/07

Date

Pe

rce

nt

of

Pri

va

te S

ec

tor

Em

plo

ym

en

t G

row

th

Source: Bureau of Labor Statistics, Current Employment Statistics, Washington, DC: BLS.

October 2007

House values outpaced incomesHome Values Relative to Income

60%

80%

100%

120%

140%

160%

180%

200%

Mar-52 Mar-57 Mar-62 Mar-67 Mar-72 Mar-77 Mar-82 Mar-87 Mar-92 Mar-97 Mar-02

Date

Pe

rce

nt

of

Inc

om

e

Source: Board of Governors, Federal Reserve System, Flow of Funds Accounts of the United States, Washington, DC: BOG.

October 2007

Weaknesses in the labor market led to decreasing incomes

Employment growth in the current business cycle was 0.6% per month (annualized), about one-third the average growth rate of previous business cycles.

Wage growth was flat. Hourly and weekly earnings were about 2% higher in July 2007 than in March 2001.

Benefit coverage has decreased. Employer pension coverage in the private sector amounted to 43% in 2006, down from 50% in 2000. Employer health insurance coverage fell from 64% to 60% during the same period.

October 2007

Prices for big items rose twice as fast as prices for smaller items

From March 2001 to June 2007, prices for top five items rose faster than prices for bottom five items:

• Top 5:

• Health care: 22.8%

• Housing: 25.6%

• Food: 16.9%

• Household operation: 18.6%

• Cars: -2.2%

• Bottom 5:

• Furniture: -26.6%

• Recreation: 17.8%

• Clothing: -9.4%

• Gasoline: 89.9%

• Transportation: 16.9%

October 2007

Families borrowed money to maintain standard of livingHousehold Debt Relative to Disposable Income

0%

20%

40%

60%

80%

100%

120%

140%

Mar-52 Mar-57 Mar-62 Mar-67 Mar-72 Mar-77 Mar-82 Mar-87 Mar-92 Mar-97 Mar-02 Mar-07

Date

Perc

en

t

Source: Board of Governors, Federal Reserve System, Flow of Funds Accounts of the United States, Washington, DC: BOG.

October 2007

The debt boom was a mortgage boom

Tax advantages of mortgages over other forms of credit have fuelled a boom in home equity lines. Mortgages relative to disposable income increased from 66% in March 2001 to 100% in June 2007, while credit card debt decreased from 9.4% to 8.9% during the same period.

Financial deregulation has led to a consolidation in the financial services industry with greater markets for individual institutions.

Market conditions for securitization have improved.

Foreign capital inflows have financed trade deficits and fuelled market in asset backed securities, among other things. These were often funded by less regulated institutions, such as hedge funds.

October 2007

Private securitization fuelled the mortgage market

Share of Net New Mortgages Securitized by Private Issuers

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07

Date

Per

cen

t o

f N

et N

ew M

ort

gag

es S

ecu

riti

zed

Source: Board of Governors, Federal Reserve System, Flow of Funds Accounts of the United States, Washington, DC: BOG.

October 2007

Quality of mortgages decreased

Subprime mortgages rose from about 7% of total mortgage originations in

2002 to 22% of mortgage originations in 2005 and 2006.

Subprime loans are high risk loans for borrowers:

• Exploding ARMs: 70-80% of subprime market

• Stated income loans: 50% of subprime market

• No down payments/negative equity: 80% of subprime market

• Prepayment penalties: 80% of subprime loans

• 12.5% of subprime loans originated in 2000 had foreclosed by May 2005

October 2007

Latinos are the first to feel the brunt of the current crisis

Latino men disproportionately benefited from the gains in the construction sector

and thus saw better employment performance than whites or African-

Americans.

Latinos saw homeownership rates rise faster than other groups.

Latinos disproportionately depended on variable interest rate debt that is

currently resetting.

Latinos had fewer assets outside the home than other groups.

October 2007

Limited or no regulatory oversight

Alan Greenspan warned of “froth” in the housing market in 2005, but had encouraged borrowers to seek alternative mortgage products just a year earlier.

The Fed announced new draft regulations to tighten lending standards in March 2007, but in May 2007, Fed chairman Bernanke still maintained that the crisis will not spread.

The new guidelines for mortgage lenders went into effect in late June 2007. They do not require mandatory compliance and only apply to federally regulated lenders. 51% of subprime lenders are not federally regulated.

Sen. Schumer (D-NY) introduced the Borrower’s Protection Act of 2007 to improve lending standards of mortgage brokers.

October 2007

First, help those most affected by the foreclosure wave Goals:

• Provide mortgage assistance, if temporary financial constraints emerge.

• Refinance into more affordable and less risky mortgage products.

• Orderly workouts, so that homes can be sold.

Approaches:

• Mortgage insurance

• Foreclosure prevention counseling

• Legal aid

Legislative proposals:

• Sen. Reed (D-RI) proposed $50 million for State Homeownership Protection Centers; $260 million in state grants for revolving loan funds; $300 million in funding for HUD-approved counseling agencies, among others.

• Sen. Clinton (D-NY) proposed $1 billion fund to assist troubled homeowners; expand Fannie and Freddie’s foreclosure prevention efforts.

October 2007

Also, ease credit crunch

The Federal Reserve’s interest rate cut will have a limited effect and could even have an adverse impact.

Higher loan limits on Fannie and Freddie could provide additional liquidity in the securitization market.

Additional proposals:

• Modernizing FHA insurance (raise limit; lower down payment requirements) – likely, e.g. legislation by Reps. Waters (D-CA) and Frank (D-MA) .

• Create banking development districts – potential at state level (New York, Texas, and California).

• Revive home owners’ loan corporations (HOLC) – idea proposed.

• Replace liability based reserve requirements with asset based requirements – pie-in-the-sky.

October 2007

Prevent similar crisis in the future

A range of proposals are intended to prevent a similar crisis from happening in the future:

• Stop fraudulent and predatory practices, e.g. Sen. Obama’s (D-IL) STOP FRAUD Act.

• Create licensing and fiduciary requirements for mortgage brokers, e.g. Sen. Schumer’s

(D-NY) Borrower Protection Act of 2007.

• Establish suitability standards for lenders.

• Attach assignee liability to everyone involved in mortgage process.

• Create asset-based reserve requirements.

October 2007

Conclusion

The crisis is much larger than simply a subprime problem. The end of the housing and mortgage booms are expected to shave 1-1.5 pct. pt. off of economic growth in 2007 and 2008. This implies a loss of $300+ billion.

The current crisis could have been prevented with smarter economic policy that would have focused on creating an income-driven, instead of debt-driven, economy.

A number of steps need to be taken now to prevent anything worse from happening:

• Help struggling homeowners.

• Ease the credit crunch.

• Reassure financial markets and consumers with prudent and thoughtful regulatory reform.