« "What Can Save the Euro?" | Main | Possible Fed Communication Strategy »

Monday, December 05, 2011

Investor Speculation and the Housing Bubble

Research from Andrew Haughwout, Donghoon Lee, Joseph Tracy, and Wilbert van der Klaauw of the NY Fed shows that speculative behavior driven by highly leveraged loans was "much more important in the housing boom and bust during the 2000s than previously thought." Thus, this supports the limits on leverage I and others have been calling for as a means of limiting the fallout from the collapse of asset bubbles:

“Flip This House”: Investor Speculation and the Housing Bubble, by Andrew Haughwout, Donghoon Lee, Joseph Tracy, and Wilbert van der Klaauw, FRBNY: The recent financial crisis—the worst in eighty years—had its origins in the enormous increase and subsequent collapse in housing prices during the 2000s. While the housing bubble has been the subject of intense public debate and research, no single answer has emerged to explain why prices rose so fast and fell so precipitously. In this post, we present new findings from our recent New York Fed study that uses unique data to suggest that real estate “investors”—borrowers who use financial leverage in the form of mortgage credit to purchase multiple residential properties—played a previously unrecognized, but very important, role. These investors likely helped push prices up during 2004-06; but when prices turned down in early 2006, they defaulted in large numbers and thereby contributed importantly to the intensity of the housing cycle’s downward leg. ...
At the peak of the boom in 2006, over a third of all U.S. home purchase lending was made to people who already owned at least one house. In the four states with the most pronounced housing cycles, the investor share was nearly half—45 percent. Investor shares roughly doubled between 2000 and 2006. While some of these loans went to borrowers with “just” two homes, the increase in percentage terms is largest among those owning three or more properties. In 2006, Arizona, California, Florida, and Nevada investors owning three or more properties were responsible for nearly 20 percent of originations, almost triple their share in 2000.
Because investors don’t plan to own properties for long, they care much more about reducing their down-payments than reducing their interest rates. The expansion of the nonprime mortgage market during the 2000s provided the perfect opportunity for optimistic investors to get low-down-payment credit, albeit at high interest rates..., investors were far more likely than owner-occupants to use nonprime credit to make their purchases, especially at the peak. ...
So far, we have half the story: Optimistic investors—speculators—used low-down-payment, nonprime credit to place highly leveraged bets on the housing market, perhaps facilitated for some by reporting an intention to live in the house. Because they didn’t have to put much money at risk, these investors were able to continue to buy housing even as prices rose further. All of these developments were especially noticeable in Arizona, California, Florida, and Nevada. Longstanding tradition in the mortgage lending business and the predictions of economic models hold that investors will quickly default if prices begin a persistent fall. This is what happened starting in 2006...

An interesting feature ... that we document in our study is that borrowers with multiple mortgages start out being better risks—their loans were less likely to become seriously delinquent before 2006—but end up accounting for a disproportionate amount of defaults thereafter. What changed in 2006? Prices started to fall. In 2007-09, investors were responsible for more than a quarter of seriously delinquent mortgage balances nationwide, and more than a third in Arizona, California, Florida, and Nevada. While this sharp change in the risk assessment of owners of three or more properties may not seem surprising, it also applied to investors with “just” two homes. If there were reason to believe this latter group was less prone to act like investors, the data don’t support this view....
We conclude that investors were much more important in the housing boom and bust during the 2000s than previously thought. The availability of low- and no-down-payment mortgages in the nonprime sector enabled investors to make these bets. This may have allowed the bubble to inflate further, which caused millions of owner-occupants to pay more if they wanted to buy a home for their family. In the end, even the value of the 20 percent down-payments made by responsible, prime borrowers was wiped out—leaving the housing market, and the economy, in the vulnerable state we find them in today.
The idea that asset price booms may be driven by optimistic or speculative investors who make highly leveraged bets on asset prices, then quickly default if their expectations are not realized, is not new. Indeed, John Geneakoplos of Yale University argues that such behavior is a fundamental driver of what he calls the “leverage cycle.” To our knowledge, our study provides the first direct evidence that such behavior may have been important in the 2000s housing cycle.
But what, if anything, does it teach us about policy? We conclude that it’s very important for lenders (and regulators) to manage leverage as asset bubbles are inflating. In the 2000s, securitized nonprime credit emerged to allow leverage to increase, with effects that extended far beyond this sector, including spillovers from defaulted mortgages to the value of other properties (see Campbell, Giglio, and Pathak [2009]). Effective regulation of speculative borrowing, like what is being attempted in China today, may be needed to prevent this kind of crisis from recurring.

This is pretty far away from the (false) story that Republicans tell about the crisis being caused by the government forcing banks to make loans to unqualified borrowers.

    Posted by on Monday, December 5, 2011 at 11:07 AM in Economics, Financial System, Housing | Permalink  Comments (48)

          


    Comments

    Feed You can follow this conversation by subscribing to the comment feed for this post.