3. Turmoil in Global Housing Markets: Implications for the Future of Housing Finance
In the wake of the global financial crisis of 2007–2009, it is important to understand the implications of this economic tsunami for the future of housing finance, not just in the United States, but around the world. We begin with the collapse of the housing and mortgage markets in the U.S.
The U.S. Housing Crisis1
The residential mortgage market in the United States has worked extremely well over the past two centuries, enabling millions to achieve the dream of homeownership. The homeownership rate reached a record high of 69.2% in the second quarter of 2004 before declining to 65.9% at the end of the second quarter in 2011 (see Figure 3.1), with all segments of society participating during the rate-increasing period.
Source: U.S. Census Bureau.
Figure 3.1 Homeownership rate reached an all-time high in 2004 (1965–2011).
To be sure, these markets have known periods of turmoil. After the Great Depression, the first major episode was the collapse of the savings and loan (S&L) industry in the early 1980s. This led to significant changes in mortgage markets.2
When the Federal Reserve changed its policy to combat inflationary pressures in the late 1970s, short-term interest rates rose rapidly and the yield curve inverted, with short-term rates exceeding longer-term rates.3 At the time, savings and loans were heavily involved in the mortgage market, holding about half of all mortgage loans in portfolio. The vast majority of these loans were traditional fixed-rate, 30-year mortgages. The inverted yield curve meant nearly all savings and loans were insolvent if their mortgage portfolios had been marked to market because the interest rates on their outstanding mortgage loans were lower than the rates on Treasury securities of comparable maturity as well as newly issued mortgage loans. The nearly 4,000 savings and loans in existence at the time were estimated to be insolvent on this basis by roughly $150 billion4 (or $417 billion in 2011 dollars). However, institutions were not required to mark to market their mortgage portfolios.
The reason for this dire situation was that the savings and loan institutions were largely prohibited from offering adjustable-rate mortgages or hedging their interest-rate risk through the use of derivatives. Congress responded to the crisis by broadening the powers of savings and loans so they could operate more like commercial banks, which largely avoided the same plight. Furthermore, savings and loans were also allowed to offer adjustable-rate mortgages.
This financial innovation enabled savings and loans to shift some of the interest-rate risk to borrowers. Although adjustable-rate mortgages accounted for less than 5% of originations in 1980, that share increased to 64% in 2006 before declining to 37% in 2010 as a result of the financial crisis.5
The broader powers of savings and loans also meant a blurring of distinctions among different types of depository institutions. The share of home mortgages held by savings institutions dropped from 50% in 1980 to 8% in 2006, to less than 7% in 2010. Commercial banks saw their share rise from 16% to 21% over the same period.
The percentage increase for commercial banks may seem relatively small, but the total assets of commercial banks in 2010 was $12 trillion, compared to the savings institutions’ $1 trillion in assets. These figures indicate that commercial banks are now more important for financing housing than saving institutions.
The second episode of disruption emerged in summer 2007, triggered by the “subprime mortgage market meltdown.” The 1980s S&L crisis was more regional in nature, while the subprime damage was truly national in scope.
Millions of households with subprime loans (loans made to less creditworthy individuals) became delinquent on their mortgages, and many lost their homes to foreclosure. Many of these homebuyers took out “hybrid” mortgage loans, which featured low introductory interest rates for two or three years but a higher rate thereafter.
This financial innovation was fine as long as home prices continued to rise. With increases in home prices, borrowers could refinance their mortgages at lower interest rates as they built up equity. Such individuals had the opportunity to improve their credit ratings at the same time.
Unfortunately, home prices fell—and fell dramatically. This led to a rise in foreclosures and a tightening of credit standards by lenders that triggered the housing market meltdown and ushered in a more general financial crisis and recession. As of the writing of this book, the pain that began in the housing sector was still being felt throughout the economy. This underscores the importance of promoting well-functioning housing markets in countries around the globe.
Changes in U.S. mortgage markets over the past three decades contributed to the most recent crisis. Before 1980, as already noted, S&Ls made the vast majority of mortgage loans. These institutions originated, serviced, and held these loans in their portfolios. But as early as 1970, the practice of combining these three functions within a single institution began to change, as mortgage loans were increasingly securitized.
In subsequent years, the Government National Mortgage Association (GNMA, or Ginnie Mae), the Federal National Mortgage Association (FNMA, or Fannie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac) became the primary securitizers of home mortgages. These three entities securitized only 1% of all outstanding mortgages in 1965, but their share rose to a high of 48% in 2001 before declining during the financial crisis and then subsequently returning to 48% in 2009 (see Figure 3.2).
Note: “Other” includes funding from life insurance companies, private pension funds, state and local government employee retirement funds, finance companies, and real estate investment trusts.
Source: Federal Reserve.
Figure 3.2 Securitization significantly reduced the importance of financial institutions in funding home mortgages (1952–2010).
Furthermore, financial institutions themselves began to securitize mortgages, referred to as private-label-backed mortgage pools, which was an innovation. Figure 3.2 shows that their share of home mortgages was less than 1% in 1984 but then increased to a high of 21% in 2006 before declining to 14% in 2009. The private-label-backed mortgage pools increased significantly before the financial crisis and then declined abruptly during and after the crisis. As of mid-2011, nearly all securitization of mortgages was being done by Ginnie Mae, Fannie Mae, and Freddie Mac. The role of private-label securitizers in financing housing had become virtually nonexistent.
Securitization, including that by the private-label firms, contributed to the unbundling of the home mortgage process. Depository institutions no longer had to hold these mortgages in their portfolios. At the same time, investors in mortgage-backed securities provided an additional source of funding beyond deposits of financial institutions.
The origination and servicing of mortgages became separate functions not performed entirely by financial institutions. In this regard, there were 7,000 U.S. mortgage brokers in 1987, but that figure increased to 53,000 by 2006 before declining during and after the financial crisis. Their share of mortgage originations increased from 20% in 1987 to 68% in 2003 before declining to 58% in 2006 and even more so thereafter (see Figures 3.3 and 3.4).
Source: Wholesale Access.
Figure 3.3 Mortgage brokerages became major players in originating home mortgages (1987–2006).
Source: Wholesale Access.
Figure 3.4 Mortgage brokers accounted for the majority of recent mortgage originations (1987–2006).
The unbundling of the mortgage process into these three separate functions (funding, origination, and servicing) meant there were three sources of revenue to be earned. Unlike the savings and loans, and even the commercial banks, investors who bought securities based on pools of mortgage loans became further removed from the homes serving as collateral; therefore, they relied heavily on rating agencies to accurately assess the credit quality of these securities. For many investors, this proved to be a mistake.
Securitization and adjustable-rate mortgages contributed to the development of the U.S. mortgage markets by providing more diverse sources of funding for home mortgages and a wider choice of mortgage products for consumers. Increased use of adjustable-rate mortgages also allowed lenders and borrowers to share the interest risk.
Borrowers who chose adjustable-rate mortgages typically received an initial interest rate that was lower than what they could obtain with a fixed-rate mortgage, but then they faced the prospect of higher rates. At the same time, the development and wide use of credit scores for individual borrowers and credit ratings for individual issuances of mortgage-backed securities provided more information for lenders and borrowers to better assess and price risk—or, at least, that was the goal.
Beginning in the second half of the 1990s, subprime mortgage loans grew rapidly in importance. The subprime share of total originations was less than 5% in 1994, increased to 13% in 2000, and then grew to more than 20% in 2005 and 2006 before declining to 0.3% in 2010 and at the end of second quarter of 2011 (see Figure 3.5). Furthermore, the share of subprime originations packaged into mortgage-backed securities (MBSs) more than doubled over the same period, from 31.6% to 80.5%, before declining to zero in 2010 and at the end of second quarter of 2011 (see Table 3.1).
Sources: Inside Mortgage Finance, Milken Institute.
Figure 3.5 Subprime took an increasing share of all home mortgage originations (2001 to first half of 2011).
Table 3.1 Growing Importance of Subprime and Securitization of Home Mortgage Originations (1994 to first half of 2011)
Source: The 2011 Mortgage Market Statistical Annual, Inside Mortgage Finance.
The subprime mortgage market essentially shut down in 2009 and in the subsequent year and a half. But this was not all that was happening. MBSs were put into pools and new securities were issued, referred to as collateralized debt obligations (CDOs). The issuers of CDOs were the major buyers of the low-rated classes of subprime MBSs in 2006.6 CDOs were also put into pools and still newer securities, known as “CDOs-squared,” were issued.
As already noted, Ginnie Mae, Freddie Mac, and Fannie Mae no longer overwhelmingly dominated security issuance. Home mortgage loans securitized by nonagency entities grew from $386 billion in 2000 to $2.2 trillion in the third quarter of 2007. The growth of subprime lending and nonagency securitization was stimulated by relatively low interest rates and increased reliance on credit scoring and risk-based pricing.
The ten-year Treasury note rate fell from 6% in 2000 to 4% in 2003, rose to 4.8% in 2006, and declined to 3.3% at year-end 2010.
Lending institutions and investors seeking higher yields in the earlier years of the decade found the subprime market attractive but apparently underestimated the risks. At the same time, the prospect of subprime loans coupled with rising home prices undoubtedly enticed borrowers in many parts of the country.
Home prices jumped nationally at an average annual rate of nearly 9% from 2000 to 2006 after rising an average of slightly less than 3% per year in the 1990s (see Figure 3.6). Stated another way, a home worth $150,000 in 2000 was worth $251,565 in 2006. This environment undoubtedly fueled optimism on the part of lenders, borrowers, and investors.
Source: S&P/Case-Shiller (Bloomberg) and OFHEO/FHFA.
Figure 3.6 Home prices peaked in 2006 and subsequently declined. (1st Quarter 1991–2nd Quarter 2011; Index, 1st Quarter 1991=100)
Subprime loans also lured mortgage brokers, who could earn fees while passing along any credit risk to others. These brokers were frequently paid fees by lenders for finding customers for home loans.
Although lenders had in-house mortgage brokers, they turned increasingly to outside brokers to accommodate more would-be homebuyers. Obviously, outside operations were harder for the lenders to monitor. At the same time, the prospect of earning more fees gave outside brokers an incentive to qualify as many borrowers as possible. After the financial crisis became full blown, lenders shifted their operations to rely more on their own brokers than outsiders. This led to a substantial decline in the number of independent mortgage brokers.
In summer 2007, several subprime lenders filed for bankruptcy, and other financial firms suffered heavy losses on subprime securities. The storm clouds had been gathering for years.
The rate of foreclosures on subprime loans increased—by some estimates, nearly doubling—from 2000 to 2006. For loans made in 2006, the foreclosure rate was 5.5% after just six months from origination. This exceeded the corresponding rates for all previous years.
Most subprime foreclosures occurred in the first few years after the loans were made. Based on LoanPerformance data, the national foreclosure rate on subprime mortgages originated in 2006 was slightly higher than 10% from January 2006 through September 2007, and nearly 20% for loans made in California. As of November 2007, there was one foreclosure for every 617 households, according to RealtyTrac.
This led to many condemnations of subprime mortgages, particularly hybrid loans or loans with interest rate resets. The process of securitizing loans was questioned. Some critics argued that subprime borrowers should not have been offered many of the innovative financial products that became available before the housing market collapse.
It is important to remember, however, that the growth in this market reflected a combination of factors, including the increase in first-time homeownership attributable to less rigorous screening of loan seekers. Subprime loans also let some borrowers improve their credit scores and then qualify as prime borrowers.
The distinction between prime and subprime borrowers is not as clear-cut as one might think, as Figure 3.7 illustrates. The data from LoanPerformance show that prime borrowers can have FICO scores below 400, while subprime borrowers can score above 820. There is no standard industry-wide definition of the term subprime. This means each lender makes its own determination.7 In fact, if appropriate risk-based pricing is used, the distinction between prime and subprime lending becomes artificial.
Source: LoanPerformance.
Figure 3.7 Distribution of prime and subprime mortgage originations by FICO score (2006).
Furthermore, as Figures 3.8 and 3.9 show, most of the same types of mortgage products offered to subprime borrowers were also offered to prime borrowers. And the securitization of these products was important in enhancing the liquidity of mortgage loans and increasing the supply of funds for such loans.
Sources: LoanPerformance, Milken Institute.
Figure 3.8 Prime mortgage originations (January 1999 to July 2007).
Sources: LoanPerformance, Milken Institute.
Figure 3.9 Subprime mortgage originations (January 1999 to July 2007).
Most importantly, the factors that cause individuals to enter foreclosure are generally based not on simply the type of product they receive, but rather on the financial straits they find themselves in after they obtain mortgage loans. These difficulties include unemployment, divorce, health problems, and, especially, a decline in housing prices that leaves homes worth less than their outstanding mortgage balances.
By recognizing the key role these factors play, it becomes clear that additional legislation and regulations cannot—and should not—try to prevent subprime lending (or innovation in the mortgage markets more generally), because that will simply shut off credit to less creditworthy individuals who want to become homeowners.
Instead, efforts should focus on better educating consumers about complex loan products and simplifying the documents necessary for informed decision making. Consumers must be allowed to choose mortgage products, even if some expose borrowers to interest-rate risk.
Also, investors, domestic and foreign, in securities backed by subprime loans—particularly in the more exotic types—must more fully appreciate the fact that the marketplace is sometimes quite harsh in punishing those who seek ever higher returns without taking into account the correspondingly greater risk.
Lastly, in view of the fundamental determinants of foreclosures, more thought should be given to what foreclosure rate is acceptable on subprime mortgage loans. Surely, it would be unreasonable to implement regulations based on the premise that the socially desirable foreclosure rate is zero. If that were the case, hardly anyone would qualify for a mortgage.
Just as it is difficult to distinguish between prime and subprime borrowers on the basis of FICO scores, it is also difficult to distinguish between them on the basis of the mortgage products they use. Over the past decade, most—if not all—of the products offered to subprime borrowers have also been offered to prime borrowers. In fact, from January 1999 through July 2007, prime borrowers obtained 31 of the 32 types of mortgage products—fixed-rate, adjustable-rate, and hybrid mortgages, including those with balloon payments—obtained by subprime borrowers.
Although differences exist in the extent to which the same types of mortgage product are offered to prime and subprime borrowers, both groups have had access to a wide range of products. Furthermore, regulators have noted that “subprime lending is not synonymous with predatory lending.”8
If the loan product itself were the problem in the subprime market, one might expect all borrowers using that product to be facing foreclosure. But this is not the case. Foreclosure rates were rising, as already noted, but the rates differ widely by type of product and borrower. Most important, the foreclosure rates on all mortgage products still fell far short of 100%, which means many borrowers were benefiting from them.
To argue that the product is the source of the problem is to ignore a fundamental truth: The ability or willingness to repay loans depends on financial factors. The marketplace and a borrower’s financial circumstances may deteriorate, leading to serious problems, including foreclosure. In some parts of the country, for example, real estate prices fell so far that houses were worth less than the balances owed on them.
In addition, borrowers lost jobs, suffered divorce or serious illness, or otherwise faced severe financial straits. These factors, more than anything else, contributed to increases in foreclosures, regardless of the mortgage product.
Some products, however, did become associated with relatively high and rising foreclosure rates, especially among subprime borrowers. But both prime and subprime borrowers experienced foreclosures for 29 of the mortgage products, indicating that virtually every mortgage product—whether prime or subprime—is a candidate for foreclosure.
Of course, foreclosure rates on subprime mortgages are typically higher than those for prime mortgages, regardless of product type. Subprime borrowers are, by definition, riskier.
Furthermore, as Figure 3.10 shows, the loan-to-value ratio may be a more important determinant mortgage loan risk than the borrower’s FICO score. In particular, subprime borrowers received a larger proportion of loans with loan-to-value ratios greater than 80%, as compared to prime borrowers.
Sources: LoanPerformance, Milken Institute.
Figure 3.10 Mortgage originations: loan-to-value (LTV) ratio (2006).
So what can we conclude? Product innovation is beneficial, and attempts to curtail such innovation in the mortgage market could deny credit for borrowers who would not otherwise qualify for loans. Legislative or regulatory actions that are too sweeping and severe could limit the availability of mortgage products, denying borrowers a wider menu from which to choose the product that best suits their needs.
Of course, innovative new products require education on the part of lenders and borrowers. If problems arise for lenders, they will make adjustments in the products they offer. Borrowers, too, must educate themselves on which products are most suitable for their current and expected financial status.
The process by which lenders and borrowers decide on specific mortgage products is imperfect and can create difficulties for both at times, resulting in renegotiations of mortgage terms and even the curtailment or discontinuation of some products, as was seen in the recent mortgage market turmoil. Regulatory authorities also should be vigilant against fraudulent activity.
Rising foreclosure rates are a serious issue. But as Lawrence Summers of Harvard University stated in September 2007, “[W]e need to ask ourselves the question, and I don’t think the question has been put in a direct way and people have developed an answer; what is the optimal rate of foreclosures? How much are we prepared to accept?”9
The same type of argument applies to securitization. Securitization, per se, is not a problem; the quality of the products that are securitized and the creditworthiness of the borrowers present potential problems. For example, to the extent that subprime loans created problems, securities backed by such loans would face similar problems.
Many subprime mortgages were hybrid loans or loans with interest rate resets, as noted earlier. Some of the mayhem in the mortgage market was blamed on interest rates that reset upward after an initial two- or three-year period.
These loans are known as “hybrids” because their interest rates are fixed for a period and then become variable, often with caps that limit the increase over a year or over the term of the loan. A relatively large number of borrowers with shaky credit histories took out hybrid mortgages.
Hybrids typically do not pose problems, as long as home prices rise and individuals refinance their loans before the interest rates reset to a higher level. But as already noted, home prices did not continue rising, and borrowers had trouble refinancing. As a result, foreclosures became more common in recent years.
Because hybrid loans—especially subprime hybrids—have become so controversial, it is important to assess their longer-term role in home foreclosures against other products in the mortgage market. Figure 3.11 shows that subprime borrowers did account for a larger proportion of adjustable rate mortgages than prime borrowers. In addition, Figure 3.12 shows that subprime borrowers received the largest share of hybrid mortgages; Alt-A borrowers, those with little or no documentation of their income or net worth, received the second-largest share of such mortgages; and prime borrowers received the smallest share.
Sources: Mortgage Bankers Association, Milken Institute.
Figure 3.11 The largest share of ARMs went to subprime borrowers (quarterly, 2001 to Q2 2008).
Source: Freddie Mac.
Figure 3.12 Hybrids dominated subprime home mortgage originations (2006).
Figures 3.13–3.16 show mortgage originations and cumulative foreclosures for prime and subprime borrowers. The numbers, covering the period from January 1999 to July 2007, before the financial crisis fully emerged, are based on a sample of 80 million mortgage loans from LoanPerformance. Figure 3.13 shows that, of 71 million prime mortgage originations, nearly 84% were fixed-rate mortgages (mostly 30-year, fixed-rate loans), 10% were adjustable-rate mortgages, and fewer than 5% were hybrid mortgages. In contrast, Figure 3.15 shows that, of the 9.5 million subprime mortgage loan originations, 44% were fixed-rate mortgages, 16% were adjustable-rate mortgages, and 32% were hybrid mortgages.
Source: LoanPerformance.
Figure 3.13 Prime mortgage originations January 1999–July 2007 (Total Number = 70.8 million).
Source: LoanPerformance.
Figure 3.14 Cumulative foreclosures through September 2007 on prime mortgages originated January 1999–July 2007 (Total Number = 1.4 million).
Source: LoanPerformance.
Figure 3.15 Subprime mortgage originations January 1999–July 2007 (Total Number = 9.5 million).
Source: LoanPerformance.
Figure 3.16 Cumulative foreclosures through September 2007 on subprime mortgages originated January 1999–July 2007 (Total Number = 1.3 million).
Prime and subprime borrowers used all three loan products, but subprime borrowers relied more heavily on hybrid loans. Most of those were 2/28 and 3/27 mortgages, with short-term, fixed interest rates (two and three years, respectively), followed by variable interest rates for the remaining 28 or 27 years. (The 2/28 mortgages also include 2/6 and 2/1 mortgages, or mortgages that reset after six months and one year, respectively, after the two-year fixed-rate period ends; 3/27 mortgages include 3/6 and 3/1 mortgages, or mortgages that reset after six months and one year after the three-year fixed-rate period ends.)
Figures 3.14–3.16 present the cumulative foreclosure starts (and not all starts end in foreclosure) of the different mortgage products. Even though almost all the attention is focused on high and rising foreclosure rates in the subprime market, the total number of foreclosures on prime mortgages was slightly higher than the total number of foreclosures on subprime mortgages: 1.4 million versus 1.3 million over the period indicated.
Of all prime mortgage foreclosures, 74% occurred with 30-year, fixed-rate loans. Hybrids and adjustable-rate mortgages accounted for fewer than 12% of foreclosures. In contrast, hybrid loans accounted for 36% of all subprime foreclosures (with 2/28 and 3/27 loans accounting for most of these). Yet fixed-rate loans accounted for nearly as many foreclosures, at 31%, and adjustable-rate loan foreclosures were not far behind, at 26%.
Clearly, a difference exists in the types of products associated with foreclosures for prime and subprime borrowers. It is important to note, however, that more than 800,000 homes financed by subprime loans other than hybrid loans went into foreclosure by the end of September 2007, according to data from LoanPerformance. Subprime mortgage foreclosures were obviously a problem, even without taking into account hybrid loans and their interest rate resets.
When home prices declined as the financial crisis unfolded, hybrid loans exacerbated the foreclosure problem as more interest rates reset upward, but they were not the basic cause of it. Indeed, all the 2/28 and 3/27 subprime loans in foreclosure as of July 2007—57% and 83%, respectively—had not yet undergone any upward reset of the interest rate.
In the first part of this decade, foreclosures were mainly a problem of the prime mortgage market. In recent years, they became chiefly a problem in the subprime mortgage market. In response to the worsening problems associated with the subprime loans, lenders dramatically reduced the origination of such products, particularly those with reset features. However, many subprime borrowers benefited from the product diversity that provided access to credit and homeownership. Once again, it is important that any legislative or regulatory action not unduly curtail subprime mortgage loans.
A final note: Many subprime borrowers got financing on extremely generous terms. In many cases, lenders extended credit without requiring a down payment. Borrowers were able to take out loans on the basis of the equity they had built up over time in their homes, especially during the period of rapidly increasing home prices. Of course, when home prices declined, many of these owners found that they owed more on their homes, including the first and second lien mortgages, than their homes were worth. This provided an incentive to stop making payments and allow homes to go into foreclosure. Again, the ability and willingness to repay loans matters, not the method of finance.
Housing Problems in Other Countries
The United States was not the only country to endure problems in its housing sector in recent years. As Figure 3.17 (a-c) shows, a number of countries experienced significant increases in housing prices during the past decade before prices declined in nearly all of the ten countries shown by 2009. The two countries that experienced biggest declines in prices were Ireland (−18.5%) and the United States (−12.4%). Portugal experienced a 0.2% increase in prices in 2009. Italy saw a 2% increase in 2008.
Source: HYPOSTAT 2009: A Review of Europe’s Mortgage and Housing Markets, November 2010.
Figure 3.17 House price changes in selected countries.
From 1998 to 2009, Spain, the United Kingdom, Greece, and Ireland experienced the biggest average increases in home prices and ranked in that order (see Table 3.2). The United States experienced the third-lowest increase in prices, after Germany and Portugal. However, focusing on just the period before the global crisis, Spain had the largest average price increase (12%) from 1998 to 2006, with the United Kingdom, Greece, and Ireland not far behind. The United States ranked eighth, with an average price increase of 6.5%. During the crisis years, Ireland and the United States had the biggest average declines in home prices, at 11.6% and 7.7%, respectively.
Table 3.2 Average House Price Changes in Selected Countries
Source: HYPOSTAT 2009: A Review of Europe’s Mortgage and Housing Markets, November 2010.
Table 3.3 provides information on homeownership rates for the same countries included in Table 3.2. Comparing these two tables illustrates that there is not always a one-to-one correspondence between price increases and homeownership rates. Germany had the lowest homeownership rate among the countries and the lowest average increase in home prices during 1998–2009. It even had the lowest average price increase during the period preceding the global financial crisis. Spain, on the other hand, had the highest homeownership rate and the highest average increase in home prices during both periods. However, other countries, such as Italy, had relatively modest average increases in home prices but relatively high homeownership rates.
Table 3.3 Homeownership Rates (%) for Selected Countries
Source: Based on the latest available data from HYPOSTAT 2009: A Review of Europe’s Mortgage and Housing Markets, November 2010.
The question now becomes, despite the fact that some countries experienced bigger increases in home prices than the United States, why did the U.S. housing market suffer far worse than the markets in these other countries?
For one thing, riskier borrowers increasingly were granted a larger share of mortgage loans, and lending standards were far more lenient in the United States. According to Lea (2010), “First sub-prime lending was rare or non-existent outside of the U.S. The only country with a significant subprime share was the U.K. (a peak of 8 percent of mortgages in 2006). Subprime accounted for 5 percent of mortgages in Canada, less than 2 percent in Australia and negligible proportions elsewhere.”
In the United States borrowers with little or no documentation regarding their income or net worth were able to obtain mortgage loans. Interest-only and negative amortization loans were also made available to many borrowers. Lastly, loan-to-value ratios exceeded 100% in some cases. Although some of these practices existed in other countries, they were far less prevalent than in the United States.10 In Germany, moreover, the maximum loan-to-value ratio was 80%.
You might think that the country with the highest level of mortgage debt relative to GDP would also be the country with the worst-performing mortgage market. Table 3.4 shows that this country would be the Netherlands. However, as Table 3.2 shows, home prices in the Netherlands rose relatively modestly before the crisis and even rose during the crisis period. The fact that prices did not collapse as in the United States spared the Netherlands problems in its housing market.
Table 3.4 Mortgage Debt-to-GDP Ratios for Selected Countries
Source: Based on the latest available data from HYPOSTAT 2009: A Review of Europe’s Mortgage and Housing Markets, November 2010.
In addition, although the Netherlands did extend high loan-to-value mortgages to borrowers, they remained a small minority of total mortgages. The tax subsidy extended to borrowers, moreover, was less in the Netherlands than in the United States.11
In contrast to the Netherlands, Ireland had a substantial increase in home prices before the crisis and the biggest collapse in home prices during the crisis, as shown in Table 3.2. Table 3.4 also shows that Ireland had the second-largest mortgage level relative to GDP, at 90%. Its housing market also suffered severely in recent years.
Another difference between the housing markets in the United States and in other countries is that only the United States has government-sponsored enterprises such as Freddie Mac and Fannie Mae. These two financial institutions were chartered by the U.S. government and were expected to not only maximize profits for their shareholders, but also provide mortgage credit to make housing finance more affordable to moderate- and low-income households. Unfortunately, this dual mandate led to the insolvency of both of these giant mortgage institutions, and they were placed into conservatorship by the U.S. government. The actions of these institutions worsened the performance of the housing market in the United States.12
Still another important difference between the financing of housing in the United States and in other countries is the use of covered bonds instead of securitization. In Denmark, for example, covered bonds are the dominant source of housing finance, as noted in Chapter 2, “Building Blocks of Modern Housing Finance.” This form of financing is an alternative to securitization of mortgages, which has been so important in the United States. The advantage of covered bonds is that the bonds remain on the balance sheets of financial institutions and are collateralized with home mortgages that also remain on the balance sheets. Although covered bonds are extremely important in Denmark, they are used in many other European countries, though to a far lesser degree. During the past decade, Denmark was subjected to greater fluctuations in housing prices than the United States, yet Denmark avoided the housing problems the U.S. experienced. Covered bonds may therefore be a good complement, if not a substitute, for securitization.
Housing Problems in the United States Versus Canada
Comparing the performance of the housing markets in Canada and the United States is instructive. As Figure 3.18 shows, these two countries have fairly similar homeownership rates, and both of these rates have tended to trend upward until the global financial crisis. At the same time, home prices in Canada and United States moved fairly close to one another until 2003, when U.S. prices rose faster and then declined more abruptly and further than those in Canada. Home prices in both countries rose from their lows in 2009 and were increasing in 2010 (see Figure 3.19).
Note: The rate for Canada in 2010 is an estimate from Scotia Economics.
Sources: Statistics Canada, U.S. Census Bureau.
Figure 3.18 Homeownership rates in Canada and the United States.
Sources: S&P Case-Shiller/Fiserv, Bank of Canada, Royal LePage (Q2-2010).
Figure 3.19 Canada and U.S. home prices (year-over-year percentage change).
In terms of residential delinquency rates, Figure 3.20 shows that the United States performed far worse than Canada during the global financial crisis. Indeed, the delinquency rate for Canada has remained relatively flat over the entire past decade. This is in sharp contrast to the tremendous rise in the delinquency rate beginning in 2007 in the United States. The question is why the Canadian housing market did not perform in the same troublesome way as the U.S. market, given that both countries have the same general pattern in homeownership rates.
Sources: Canadian Bankers Association, Mortgage Bankers Association (Q2-2010).
Figure 3.20 Canada and U.S. residential delinquency rates.
One important distinction between Canada and the United States is the extent of government involvement in the housing market. Figures 3.21 and 3.22 show that the U.S. government plays a far greater role in supporting the financing of housing than does the Canadian government.
Note: “Other” includes life insurance companies, nondepository credit intermediaries/other financial institutions, and pension funds.
Sources: Canada Mortgage and Housing Corporation, Bank of Canada (through August 2010).
Figure 3.21 Home mortgage debt outstanding by type of holder for Canada.
Note: “Other” includes households and nonprofits, nonfarm nonfinancial corporate business, nonfarm noncorporate business, state and local governments (including pension funds), federal government, life insurance companies, and private pensions.
Source: Federal Reserve Flow of Funds (through Q2-2010).
Figure 3.22 Home mortgage debt outstanding, by type of holder, for the United States.
Financing and mortgage insurance support in the United States is provided by Freddie Mac and Fannie Mae, both of which have specific housing goals set by the U.S. Department of Housing and Urban Development, and Ginnie Mae.13 These three institutions provided nearly 60% of the funding for home mortgages in 2006. All three have a mandate to support housing in a way that is not strictly comparable to the approach that would be taken by a firm focusing on risk–return tradeoffs to maximize shareholder value. Canada does have a government-owned mortgage insurance agency, the Canada Housing and Mortgage Corporation, but the insurance provided is not targeted to affordable housing.14 Canada does not have any entities similar to Freddie Mac and Fannie Mae.
Furthermore, in contrast to the United States, securitization in Canada provided slightly less than 20% of the funding for mortgages in 2006. Banks and credit unions, on the other hand, provided slightly more than 70% of funding in that year.
Canada does not have legislation similar to the Community Reinvestment Act, which was enacted in 1977 to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods. These differences contributed to greater problems in the housing market in the United States than in Canada.
Table 3.5 shows more differences in mortgage finance between Canada and United States. Whereas Americans benefit from a mortgage interest deduction from their taxes, such a benefit is not available to Canadians. In addition, Canadians who become delinquent on their mortgage loans and eventually end up in foreclosure are subject to recourse by lenders. This is not the case in the United States, which provides a greater incentive for individuals to default on their mortgages, especially when they owe more than their homes are worth.
Table 3.5 Key Differences in Mortgage Finance: Canada versus United States
Note: FRM refers to fixed-rate mortgages.
Source: Virginie Traclet, “An Overview of the Canadian Housing Finance System,” Housing Finance International (Autumn 2010).
Note further that, in 2006, the subprime share of total outstanding mortgages was less than 5% in Canada, while in the United States, the share was 20%. In addition, Canada relies to a far greater degree on on-balance-sheet funding than the United States, which relies more on securitization. As noted earlier, with a greater degree of subprime mortgages and with a large fraction of them securitized, the result was worse performance of the housing market in United States.
Lastly, Canada relies on mortgages with a fixed rate, typically for five years, but sometimes as short as one year or as long as ten years. The rate is then renegotiated at the end of this period and adjusted to the current market rate. This enables borrowers to better manage their interest-rate risk by changing the length of the fixed-rate period, depending on the level and trend of interest rates.
Yet another difference between the two countries is that 80% of Canadian homeowners with mortgages had equity that was 20% or more of the value of their homes in 2010. Only 2% of mortgage holders in Canada had negative equity (see Table 3.6). In contrast, about 25% of mortgage holders in United States had negative equity.
Table 3.6 Positive Equity Is the Norm in Canada
Source: Canadian Association of Accredited Mortgage Professionals (Fall 2010); CoreLogic (*Q2-2010).
Moreover, Canada had more conservative lending policies than the United States during the past decade; the proportion of loans with little or no down payment was far less than in the United States. As Lea (2010) points out, while Canada “relaxed documentation requirements there was far less ‘risk layering’ or offering limited documentation loans to subprime borrowers with little or no downpayment. There was little ‘no doc’ lending.”15
Summary
Policymakers must be careful in reacting to the subprime mortgage market turmoil with measures that would curtail credit for those with limited access to traditional mortgage products. A wider range of products is meant to accommodate borrowers with different degrees of risk and to better match risk-and-return combinations. However, it is important to consider factors that caused the U.S. housing market to perform worse than those in other countries, even though its housing price changes were not as extreme.
Endnotes
1 This section draws heavily from James R. Barth, with Tong Li, Wenling Lu, Tripon Phumiwasana, and Glenn Yago, The Rise and Fall of the U.S. Mortgage and Credit Markets: A Comprehensive Analysis of the Meltdown (Hoboken, New Jersey: John Wiley & Sons, 2009); and James R. Barth, Tong Li, Triphon Phumiwasana, and Glenn Yago, Perspectives on Sub-Prime Markets, Milken Institute Research Report, December 2007.
2 James R. Barth, Susanne Trimbath, and Glenn Yago, eds., The Savings and Loan Crisis: Lessons from a Regulatory Failure (Norwell, MA: Kluwer Academic Publishers, 2004).
3 James R. Barth, Tong Li, Triphon Phumiwasana, and Glenn Yago, “Inverted Yield Curves and Financial Institutions: Is the United States Headed for a Repeat of the 1980s Crisis?” Banks and Banking Systems 2, no. 3, (2007).
4 James R. Barth, The Great Savings and Loan Debacle (Washington, DC: American Enterprise Institute, 1991).
5 Office of Thrift Supervision, 2010 Fact Book: A Statistical Profile of the Thrift Industry (June 2011).
6 See Richard J. Rosen, “The role of securitization in mortgage lending,” Chicago Fed Letter, The Federal Reserve Bank of Chicago, no. 244, November 2007.
7 Federal Register (12 July 2002).
8 FDIC press release, “Statement on Subprime Mortgage Lending” (PR-55-2007), 29 June 2007.
9 Lawrence Summers, “Recent Financial Market Disruptions: Implications for the Economy and American Families,” panel discussion, The Brookings Institution, Washington, DC, 26 September 2007.
10 See Michael Lea, Testimony to Subcommittee on Security and International Trade and Finance: Committee on Banking, Housing and Urban Affairs, United States Senate, 29 September 2010; and Luci Ellis, “The Housing Meltdown: Why Did It Happen in the United States?” BIS Working Papers, No. 259, Bank for International Settlements, September 2008.
11 See Ellis (2008).
12 James R. Barth, with Tong Li, Wenling Lu, Tripon Phumiwasana, and Glenn Yago, The Rise and Fall of the U.S. Mortgage and Credit Markets: A Comprehensive Analysis of the Meltdown (Hoboken, New Jersey: John Wiley & Sons, 2009).
13 Ibid.
14 See Michael Lea, Testimony to Subcommittee on Security and International Trade and Finance: Committee on Banking, Housing and Urban Affairs, United States Senate, 29 September 2010.
15 Ibid.