Monday, August 17, 2015

Housing Tax Policy, A Series: Part 53 - Asymmetrical Macroprudence is not prudence at all

Ferreira and Gyourko, with the Wharton School at U. Penn. and NBER (HT: EV) have an article that adds credence to the conclusion that it was the drop in home prices that led to foreclosures, and not the other way around.  From the abstract (emphasis mine):
Utilizing new panel micro data on the ownership sequences of all types of borrowers from 1997-2012 leads to a reinterpretation of the U.S. foreclosure crisis as more of a prime, rather than a subprime, borrower issue. Moreover, traditional mortgage default factors associated with the economic cycle, such as negative equity, completely account for the foreclosure propensity of prime borrowers relative to all-cash owners, and for three-quarters of the analogous subprime gap. Housing traits, race, initial income, and speculators did not play a meaningful role, and initial leverage only accounts for a small variation in outcomes of prime and subprime borrowers.
They find that negative equity explains essentially all of the foreclosures among prime borrowers and three-quarters of the foreclosures among subprime borrowers.

From the paper:
(Prime borrowers') share always exceeds 50%, and it rose, not fell, as the boom built, from a low of 54.9% in 2000(1) to a high of 65.6% in 2008(1). Thus, the rough doubling of Subprime share over the same period is at the expense of the FHA/VA-insured sector, not the Prime sector (Table 1).  
This concurs with what I have found.  The rise in subprime mortgages replaced, not prime mortgages, but FHA/VA mortgages.  Here is a graph of Loan to Value (LTV) levels for each mortgage type.  LTV's were improving for all types throughout the boom.  They improved especially for FHA/VA loans, but this is largely a product of the declining rate of new FHA/VA loan originations, so there are relatively fewer new FHA/VA loans as time passed during the boom.  FHA/VA mortgages have very low down payments, so the transition from FHA/VA loans to private market subprime loans was associated with lower LTVs, not higher.  I think the conventional opinion about this is simply wrong, due to the lack of recognition regarding the falling share of FHA/VA loans.  This has led to the assumption that the rise in subprime was due to either (1) a decline in the ability of households to qualify for prime loans or (2) predatory behavior from the banks to pull marginal households into mortgages.  While anecdotal evidence supports these conclusions, they don't appear to be accurate regarding systemic behavior during the boom.

In the sample used in the study, in 1997, subprimes accounted for 8% and FHA/VA for 19% of mortgages.  By 2006, subprimes accounted for 21% and FHA/VA 5%.  This is a huge shift.  And, note that those 19% of mortgages in 1997 had initial LTVs of nearly 100%.  Initial LTV's declined for FHA/VA loans over time, so that they were around 95% by the end of the boom.  Meanwhile, average initial LTV's for subprime loans rose from just over 80% to 85%.  But, keep in mind that there was a huge transfer of more than 10% of all mortgages, from FHA/VA to subprime during that time, so those 85% LTV loans were in lieu of 95% LTVs that previously had been originated by FHA/VA.  Taking these non-prime loans as a group, the average initial equity position nearly doubled between 1997 and 2006.

We can see in the first graph that LTVs were improving throughout the boom, and it was only when prices collapsed well more than 10% in 2008 that LTVs moved out of the range of the previous decade.  Once they did, the price collapse was so severe, that many households were underwater with little relation to their initial LTV.  By 2009, the average prime loan, which had always averaged initial LTVs of less than 80%, was underwater, and remained so until 2011.

Further, regarding the idea that these LTV trends result from rising prices that were hiding the use of newly available home equity for debt, they say, "However, our findings imply no material economic role for this factor in accounting for foreclosure and short sales outcomes across different types of borrowers."  Controlling for refinancing or junior lien activity actually causes loss rates for all loan types to increase.  In other words, borrowers who refinanced before the crisis tended to fare better, all else equal, than those who did not.

The authors speculate that this is because those who were able to refinance were more financially stable.  But, I will note that if "a common factor playing such an influential role in determining foreclosure losses across all types of borrowers" (as the authors describe it) happens to be a liquidity crunch, then households would naturally benefit from taking some liquidity before it dries up.  In hindsight, we might consider describing those households as prudent rather than reckless.


Have you ever noticed that macroprudential regulation is always described in terms of constraints?  Caps, limits, levies, requirements, charges... Isn't the most important macroprudential factor the aggregate value of the collateral?

I know the normal reaction to that idea is that there was a bubble and that speculators pushed prices well above their justifiable levels.  But, research like this shows that the damage hit prudent households.  Even if we attribute all of the subprime defaults that aren't explained by price collapses to reckless speculator behavior, it amounts to a very small portion of the mortgage market, and that damage was inflicted early.  By 2008, after which most of the damage was done, this was a story about prime mortgages.

There is an aesthetic reaction against the idea that stability in real estate values might have been a goal of the federal government.  It smacks of corporate welfare, and it seems like an excuse to support bubbles.  But, what if it wasn't a bubble?  And, how are the regulatory authorities supposed to make that determination anyway?  Isn't the depth and breadth of the damage that was done here enough to argue against this regulatory regime?  Yet, if anything, the clamoring for all of the constraining forms of macroprudential regulation has only intensified from this episode.

The fear seems to be that if there is a credible backstop to asset prices, speculators will bid up prices even further, knowing that their losses will be limited by federal market manipulation.  But, rising prices would, mathematically, mean lower real yields.  And, stability has been associated with higher yields on real and low risk investments.  The low interest rates subsequent to the crisis are related to fears of instability.

The implied yield of houses has been high since the crisis because of a lack of liquidity.  So, as the authors show, if you really want to find housing speculators, you should look in the post-crisis all-cash market.  And those investors are minting money.

It is our asymmetrical macroprudence that is bankrupting households and supporting speculators.


  1. Which one of these posts on your blog gives your explanation for why housing prices fell in the U.S. (but not in Canada), but rents in the U.S. continued to rise relative to the general price level, 2006-2008? I've found your explanations here very interesting.

    1. This one probably addresses that point:

      I started the series in January. I don't have an index yet. You can go to the monthly post list on the right margin and manually click through. I started out thinking that tax policy and interest rates were the largest factors in the boom with tight monetary policy creating the foundation for the bust, but, while I have become more convinced of the devastatingly tight monetary policy that created the bust, I have come more to the conclusion over time that constricted housing supply in a few major metro areas ends up explaining much of the boom.