New Study Identifies The Real Culprits of The Housing Bubble

housing bubble

The financial crisis unleashed in 2008 has gone down in history as the subprime crisis. We were told that the problem had been that poor families “had spent beyond their means” and when it came time to repay the money they could not afford it.

It was said that the defaults of these families were the source of the puncture of a financial bubble. But…what if this story were not real? That is what a study published the economic analysis portal Voxeux, titled Credit growth and the Global Crisis: A new narrative concludes.

Its authors, Stefania Albanesi, Giacomo De Giorgi and Jaromir Nosa have reviewed the data on which the “guilt” of the subprime had been based and have come to another conclusion. The main protagonists of the exacerbated debt increase and the massive defaults that generated the crisis were not the owners of high risk mortgages, but the professional investors in the real estate sector, whose risk profiles were initially medium and low risk.

Beyond a better understanding of what has happened, this new narrative of the origins of the crisis is important in analyzing the measures that have been applied since then, both in the United States and in Europe, to tackle possible financial tensions or problems in this sector.

Since then, the credit tap has been almost closed for those who want to access a home in property, but do not have enough guarantees. What has changed in the market for professional financial investment to contain the risks assumed by this group (high risk consumers)?

The study asserts that real estate investors played a crucial role in the increase and subsequent collapse of the housing market. “They were responsible for most of the increase in the balances and practically all of them are due to the rise in defaults of the main borrowers,” he explains. But nothing has changed to prevent the behavior of this sector is safer.

To reach this conclusion, these economists have examined the evolution of mortgage debt and defaults during the period of the pre-crisis credit boom and its evolution after Lehman Brothers fell, as well as the consequences derived from that activity.

The data analyzed come from the Consumer Credit panel of the Federal Reserve Bank of New York, which contains the complete history of credit and defaults from a representative group of borrowers in the United States. Evaluating risk profiles according to age, postal code of the area of ​​residence and combining these data with the volume of debt assumed, defaults and evictions have been found that:

The homes occupied by their owners had been less sensitive to the increase of value in times of a bubble than those that belonged to professional investors. The former had no intention of abandoning them or doing business with them, while the aim of the latter was to increase the value of their investment as soon as possible and materialize it.

The indebtedness of people with low credit ratings (subprime) was practically constant during the period before the bursting of the financial bubble and also in moments of crisis.

The largest increase in mortgage defaults was among middle-income borrowers, above all, and also in those with a high income profile. Foreclosures in this profile increased from 35% to 70%.

These conclusions are described by the authors of the study as “disconcerting.” In principle, it is not very logical that those owners with medium and high credit profiles are the ones with the highest rate of defaults. For this reason, further investigating, they sought the origin of this strange behavior.

The reason was found in the activity of professional investors in the real estate market. They had taken on a larger number of mortgages from medium and high risk profiles, while their intervention in the subprime market had barely been remarkable.

The volume of mortgages on the balance sheets of professional real estate investors rose from 15% in 2004 to 35% in 2009. While, borrowers with a risk profile rated as subprime (very high risk of default),  barely rose by 5%. In the same way that they took on more risk, they were also the main players in the high delinquency and default rates. This is because:

  • The mortgages subscribed by professional investors were more expensive than those granted to those who financed their principal residence.
  • The prospect of earning significant amounts of money in the near future, because of the rapid growth of property values, encouraged professional investors to take greater leverage. “This strategy,” says Vox’s paper, “increases the potential gains from owning real estate, while losses are limited, especially in those states where payment is allowed.”
  • Finally, the financial and psychological cost of defraying a home mortgage loan is very different if it affects the habitual residence than if it is hovering over a third housing destined to investment.

“Our results point to the fact that the role of real estate investors is critical to future policy and investment,” the authors say. Restricting credit to families, as has been done in recent years, has little effect if the aim is to limit the risks of creating a new housing bubble. On the contrary, the absence of laws and measures that limit the activity of real estate investors may be the nourishment of new financial tensions in the sector.

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