The History of the U.S. Housing Crisis Holger Sieg University of Pennsylvania

1. The History of the U.S. Housing CrisisHolger SiegUniversity of Pennsylvania

2. Mortgages and Foreclosures • Recall that a mortgage is a secured, nonrecourse loan. In the event that the borrower defaults, the creditor takes possession of the house used as collateral. • The creditor has no further recourse against the borrower for any deficiency remaining after foreclosure against the property. If you default on a mortgage you do not have to declare personal bankruptcy! • Owing a house is equivalent to purchasing a call option from the bank that is financing your house. The strike price of the option is equivalent to the amount of principle that is outstanding. • The initial down-payment is the price for the call option and guarantees that the option is in the money when the mortgage is issued, i.e. the purchase price exceeds the remaining principle of the mortgage. • When housing prices decline drastically, the current market price can be well below strike price of the call. • If that happens the value of the call option is near zero and some homeowners decide to default on the mortgage, i.e. not exercise the option.

3. Problems with the Secondary Mortgage Market • Fannie Mae & Freddie Mac hold a large fraction of the undiversified risk in the housing market. The government provides a guarantee for these companies. • Local banks have few incentives to screen mortgage applicants since they no longer bear the credit default risk. Since they heavily rely on commissions from selling mortgages. they have strong incentives to increase volume. • Credit Rating Agencies are careless and misclassify investments. • Investors of MBS have often little knowledge about the exact nature of the risk associated with the MBS that they are holding. • Investment banks do not hold enough capital to absorb large shocks to the value of MBS that they are holding. • Homeowners may keep on buying houses at inflated prices if they believe that high prices can be sustained in the future. • As long as housing prices keep on rising, none of this matters! If housing prices collapse, the market implodes.

4. Financial Innovations: Subprime Mortgages • Lenders started to offer an increasing array of higher-risk loans to higher-risk borrowers. • These high risk loans included the "No Income, No Job and no Assets" loans, sometimes referred to as Ninja loans. • The share of subprime mortgages to total originations was 5% ($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in 1999, and 20% ($600 billion) in 2006. • The average difference in mortgage interest rates between subprime and prime mortgages -- the subprime markup -- declined from 2.8 percentage points in 2001, to 1.3 percentage points in 2007. • The combination of the availability of new types of mortgages, the ability of local banks to unload these mortgages in the secondary market, and the active role of the GSE in the secondary market, led to an increase in owner occupied housing. • These increases in ownership rates are probably not sustainable.

6. Regional Differences in Housing Market Conditions • The housing prices increases during the “bubble years” and the subsequent decreases did not affect the U.S. uniformly. • There are large regional differences that partially explain both the boom and the bust. • Note that many states and cities did not have a “housing price bubble.” • The boom in housing prices was most pronounced in the coastal areas in the Northeast and West. • Some western states of the U.S. (Arizona & Nevada) and some coast regions in the South (Florida, Georgia, South Carolina) also experienced larger price increases.

8. The Four Problem Areas • Arizona/ Nevada: This is the only area were we had a true housing bubble. Land is cheap and widely available. Housing prices should follow construction costs. • California / East Coast: Supply side restrictions (zoning laws) together with a large increase in populations drove up prices in those areas during the “boom years.” • Florida and the Coastal South: The housing boom in these areas was largely driven by an increased demand for second and third homes (i.e. vacation or retirement homes.) The economic recession lead to a collapse of the market for second homes. • Michigan and parts of the Midwest: Regional economic problems have attributed to the housing problems. These regions have seen large declines in population during the past decades.

10. Subprime Mortgage Crisis and the Collapse of the Secondary Market • The current housing crisis started with the end of housing bubble in 2006 and the resulting subprime mortgage crisis. • Note that subprime borrowers had the least equity in their houses. As a consequence their call options were the first to become worthless when housing prices started to decline. • A large number of the subprime borrowers, therefore, started to default on their mortgage payments. • This caused a precipitous decrease in demand for any mortgage-backed securities that were not guaranteed by Fannie Mae or Freddie Mac. • The secondary mortgage market in the U.S. started to collapse because there was too much uncertainty about the value of MBS.

11. Asset-backed Securities • ABS: asset-backed securities • CDO: collateralized debt obligations are a type of structured ABS with multiple “tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. • RMBS: Residential MBS • CMBS: Commercial MBS

13. Lehman Brothers and AIG • This depreciation in home prices and the collapse of the secondary mortgage market led to growing losses for some commercial banks, investment banks and private insurance companies. • Lehman Brothers declared bankruptcy and was sold to Barclays and Nomura. • Bear Stearns and Washington Mutual was sold to JP Morgan. • Lehman's losses were a result of having held on to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages. • Credit default swaps (CDS) are financial instruments used as a hedge and protection for debt holders, in particular MBS investors, from the risk of default, or by speculators to profit from default. • As the net worth of banks and other financial institutions deteriorated because of losses related to subprime mortgages, the likelihood increased that those providing the protection would have to pay their counterparties. • Insurance companies that had been active in the derivatives market such as AIG also collapsed and were bailed out by the government.

14. The Bailout of the CGE • This depreciation in home prices and the collapse of the secondary mortgage market also led to growing losses for the GSE. • In addition to political pressure to expand purchases of higher-risk affordable housing mortgage types, the GSE were also under significant competitive pressure from large investment banks and mortgage lenders. • For example, some analysts estimate that Fannie's market share of subprime mortgage-backed securities issued dropped from a peak of 44% in 2003 to 22% in 2005, before rising to 33% in 2007. • On September 7, 2008, Federal Housing Finance Agency (FHFA) director James B. Lockhart III announced he had put Fannie Mae and Freddie Mac under the conservatorship of the FHFA. • The U.S. government provided an infusion of $188 billion dollars during the crisis to keep the GSE financially viable.

16. Policy Proposals during the Crisis • The U.S. has an excess supply of single family homes that were built for ownership. These homes need to be converted into rental units. • The U.S. has an excess supply of secondary homes and apartments in places such as Florida and Arizona. Foreigners may buy some of them. Others need to be converted into vacation or rental units. • There are a number of local markets such as Nevada and Arizona were housing prices will not recover in the foreseeable future. Lenders could be incentivized to renegotiate the mortgage terms of a large number of owners in these states. • The government and the federal reserve need to develop a strategy to unload its holdings of MBS. • The foreclosure process is ineffective in many states and needs to be reformed.

17. Where do we stand in 2013? • Fannie and Freddie will have basically paid back $188 billion of aid they received from the U.S. government by the end of 2013. • 2.6 % of loans backed by the Fannie and Freddie were 90 days or more past due at the end of September. • That is down from peaks of 5.5% and 4.1% for Fannie and Freddie respectively in early 2010. • Housing prices are up sharply in most parts of the U.S. • Fannie and Freddie charge “guarantee fees” when they buy mortgages from local banks and lenders. Those fees have more than doubled in the last three years, implying a tightening of credit standards.

18. More on Fanny and Freddie • The U.S. government (Federal Housing Finance Agency) has won large settlements against J.P Morgan Chase ($4 billion) and UBS ($885 million). There will be more settlements. • Other companies were forced to buy back defaulted mortgages that ran afoul of underwriting guidelines. • Some of the losses were exaggerated due to tax related write-downs that have been reversed. • Fannie and Freddy have very little competition from private companies since there are few investors willing to invest in mortgage backed securities.

20. Recapitalization of Banks • The large banks have been recapitalized largely due to the low interest rate policy of the Federal Reserve Bank. • The stock prices of most of the major U.S. banks have recover from the recession lows. • If you had invested in stocks of the main U.S. commercial banks, as David Tepper did 2008 and 2009, you would have done. • For example, J.P. Morgan Chase trade as low as $15.93 during the peak of the crisis. It is currently trading at around $51.75. • J.P. Morgan reaches a $13 billion settlement with the DoJ to settle all charges from the Housing Crisis. • Nevertheless, most analysts seem to agree that the take-over of Bear Stearns by J.P. Morgan was a good deal. JP Morgan paid $10 a share for a bank that a year earlier was worth $170 a share. • It also got the Fed to cover possible losses from about $30 billion in risky Bear Stearns assets.

21. The Housing Sector in 2013 • Housing and banking crises are fairly common in U.S. history. This was not the first housing crisis in the U.S. It will not be the last. • The long run GNP share of the housing industry is around 5 percent. It fell to 2.5 percent during the current recession. It will take some time before it reaches historical averages again. • New housing construction is picking up in the U.S. • Vacancies rates are at an all time low in some parts of the U.S. • Housing prices have increased on average 15 percent in 2013.

22. Improving Public Policy • The U.S. government may need to rethink its policy towards subsidizing home ownership. • Ownership rates in excess of 65 percent may be hard to maintain given current and likely future economic conditions. • Current subsidies encourage urban sprawl and excessive housing consumption. • Current policies provide large subsidies to the construction industry which may be the primary beneficiary of the mortgage interest deductibility. • Ending the mortgage interest deductibility could be a desirable first step to reduce federal subsidies. • Rethinking other popular programs such as the federal flood insurance program may also be necessary to discourage future construction in areas that will be more vulnerable in the future.