Andrew F. Hauth, Donghun Lee, Joseph Tracy, Wilbert van der Klaauw
The recent financial crisis is the worst in the last 80 years, and its roots lie in the massive rise and subsequent collapse of home prices in the 2000s. The housing bubble has been the subject of intense public debate and research, but no single answer has emerged to explain why prices rose and fell so quickly. In this article, we present new insights from a recent study by the Federal Reserve Bank of New York. Using unique data, the study suggests that real estate “investors” – borrowers who use financial leverage in the form of mortgages to purchase multiple residential properties – played a previously unrecognized but very important role. These investors likely drove prices higher from 2004 to 2006, but when prices fell in early 2006, large numbers of investors defaulted on their loans, contributing significantly to the severity of the downturn in the housing cycle.
Housing and mortgage market investors
Nearly everyone who buys a home hopes for price appreciation, and most use leverage (debt) (in this case a mortgage) to buy more home than they can afford to pay cash for. While the majority of borrowers have a consumption motive (they intend to live in the home as “homeowners”), some borrowers own the home purely as an investment. As mortgage lenders have long known, investors are more likely to walk away from a mortgage-inflated property than homeowners. Therefore, if a borrower admits on their mortgage application that they will not live in the home, lenders will typically require a higher down payment and charge a higher interest rate to reflect the additional default risk. Within the real estate investor category, some purchase properties with the intent of renting, while others simply intend to “flip the house” and sell it quickly for a capital gain.
The chart below shows the share of new purchase mortgage debt held by investors with multiple first lien mortgages on their credit reports, as reported by the New York Fed Consumer Credit Panel (CCP). Since each property can only have one first lien (primary mortgage), the number of first liens reflects the minimum number of properties a borrower can own (it's “minimum” because, of course, you can own your home unsecured). The color of the bars in the chart indicates how many properties a borrower owns after taking on this new purchase mortgage debt. The left side shows data for the whole country, and the right side shows data for four states where the housing cycle was particularly pronounced: Arizona, California, Florida, and Nevada.
A surprising fact emerges from the graph: At the peak of the boom in 2006, more than one-third of home purchase loans in the United States were made to people who already owned at least one home. In the four states where the housing cycle was most pronounced, the investor share was nearly half, or 45 percent. The investor share nearly doubled between 2000 and 2006. While some of these loans went to borrowers who owned “only” two homes, the percentage increase was greatest among those who owned three or more properties. In 2006, investors who owned three or more properties in Arizona, California, Florida, and Nevada accounted for about 20 percent of loans, nearly triple their 2000 share.
Investors are different from owner-occupants
Whether buying a vacation home or flipping a home, real estate investors behave very differently than borrowers with only one first lien (arguably the majority of home dwellers). First, investors are very unlikely to move into the home they purchase, especially if they own three or more properties. In rising markets, “buy-and-flip” investors typically want to hold onto properties for a relatively short period of time, and studies have shown that those who owned multiple properties in the mid-2000s tended to sell their properties much faster than those with only one first lien. Importantly, buy-and-flip investors also show that they can make higher bids on homes, even with relatively little cash, by using loans with smaller down payments. Non-prime credit (mortgage lending to borrowers who cannot or will not qualify for cheaper prime loans) allowed optimistic investors to speculate by making highly leveraged bets on home prices.
Because investors don't intend to own a property long term, they are more interested in lowering their down payment than lowering interest rates. The expansion of the non-prime mortgage market in the 2000s presented a great opportunity for optimistic investors to obtain loans with higher interest rates but lower down payments. As the chart below shows, especially at the peak, investors were much more likely to purchase with non-prime financing than homeowners. Again, the colors indicate the number of properties a borrower owns, but this time we include borrowers with only one property for comparison.
We created these graphs by matching a CCP sample based on Equifax credit reports with data from CoreLogic's Loan Performance data set of securitized nonprime mortgages. Another benefit of this matched sample is that it helps explain why we first noticed the importance of investors in the mortgage market in the 2000s. The next two graphs show the share of mortgage lending using two different measures of investor status. The first measure, shown as a dashed line, is reported in the Loan Performance data and is whether the borrower self-reported to the lender that he or she was not an owner-occupant. The second measure, shown as a solid line, is the recommended measure from the CCP and is whether the borrower owned more than one home at the time this purchase was completed. In the significant nonprime sector, the share of borrowers who acknowledged investor status remained relatively low and constant, less than 20% throughout the boom. However, by our definition, at its peak, the investor share of this market was more than double the self-reported rate.
Did that matter in bankruptcy?
So far, we are only telling half the story. Optimistic investors, or speculators, made highly leveraged bets on the housing market, with low down payments, non-prime credit. Perhaps for some investors, this was encouraged by their intention to live in the house. With less money to risk, these investors were able to continue buying homes even as prices rose further. All these developments were especially evident in Arizona, California, Florida and Nevada. Longstanding traditions in the mortgage lending industry and predictions of economic models dictate that if prices start to fall continuously, investors will soon default. That is exactly what has happened since 2006, as the graph below shows.
An interesting feature that is less clear here but documented in our research is that borrowers with multiple mortgages start out as lower risk because they were less likely to get seriously delinquent before 2006, but then disproportionately default more. What changed in 2006? Prices started to fall. From 2007 to 2009, speculators accounted for more than a quarter of seriously delinquent mortgage balances nationwide, and more than a third in Arizona, California, Florida, and Nevada. This sharp shift in risk assessment for investors who own three or more properties may not seem surprising, but it was also true for investors who own “only” two homes. Even if there was reason to think that the latter group was less inclined to behave like an investor, the data does not support this view.
What are the lessons to be learned?
They conclude that investors played a much more important role in the housing boom and bust of the 2000s than previously realized. The availability of low- or no-down-payment mortgages in the non-prime sector encouraged investors to make these bets, further inflating the bubble and potentially forcing millions of homeowners to pay more if they wanted to buy a home for their family. Eventually, even the value of the 20 percent down payments made by responsible, prime borrowers evaporated, leaving the housing market and economy in the fragile state it is in today.
The idea that asset price surges may be driven by optimistic or speculative investors who make highly leveraged bets on asset prices and then quickly default when their expectations do not materialize is not new. Indeed, Yale University's John Geneakopoulos has argued that such behavior is a fundamental driver of what he calls “leverage cycles.” To our knowledge, our study provides the first direct evidence that such behavior may have been important in the housing cycle of the 2000s.
But what can it tell us about policy? We conclude that as asset bubbles inflate, it is crucial for lenders (and regulators) to control leverage. The 2000s saw the emergence of securitized non-prime credit, which enabled increased leverage, but whose impacts extended far beyond this sector, including spillover effects from defaulted mortgages to the values of other real estate (see Campbell, Giglio, and Pathak). [2009]Preventing a recurrence of this type of crisis may require effective regulation of speculative borrowing, as is currently being attempted in China.
Disclaimer
The views expressed in this blog are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the sole responsibility of the authors.