A so-called "glut" of easy money in the housing market led to an explosion in demand and a "staggering" amount of risk-taking in the lead-up to the financial collapse of 2008, according to a report from the Cambridge-based Harvard University’s Joint Center for Housing Studies.
"The combination of a glut of global liquidity, low interest rates, high leverage and regulatory laxity in the context of initially tight and then overvalued housing markets triggered staggering risk taking," said Eric S. Belsky, managing director of the Joint Center and one of the study’s authors. "Capital markets supplied credit through Wall Street in large volumes for risky loans to risky borrowers and then multiplied these risks by issuing derivatives that exposed investors to risks in amounts much larger than the face amount of all the loans."
The report points out that many other nations saw booms in home prices during the first half of the 2000s as mortgage interest rates globally fell sharply and stayed there for a time, according to a statement. Homebuyers tend to focus on monthly payments when deciding how much to bid for a home; lower mortgage rates allowed them to go after prices higher in the context of housing markets that were tight-at least at first.
The report suggests that once house price appreciation took off, backward looking price expectations led both homebuyers and mortgage investors to count on rapidly rising prices, further fuelling a bubble. But the volume, and riskier nature of, the loans tolerated in the country and the way they were bundled into securities and written into credit default swaps caused much more damage to this nation’s economy and global financial markets than did mortgage loans originated in these other nations.
The report found that regulatory failures allowed the market to chase higher returns through excessive leverage and risk taking, according to a statement. Regulatory lapses included the failure to closely supervise nonbank financial intermediaries, prevent unprecedented layering of risk in mortgage underwriting, adequately supervise the credit ratings agencies and impose stiff enough counterparty risk controls, such as insisting on greater transparency in the capital markets and requiring higher reserves against risks.
"One of the biggest problems is that the whole system created the illusion that risks were being adequately managed," said report co-author Nela Richardson. "This is because rating agencies assigned AAA-ratings to large portions of securities backed by subprime and Alt-A loan pools and synthetic derivatives based on them."
The report also found that Alt-A loans contributed disproportionately to Fannie Mae and Freddie Mac’s losses during the crisis and that AAA-rated securities backed by subprime mortgages they purchased may have helped support the market for these securities.
While high price loans as reported under the Home Mortgage Disclosure Act were disproportionately concentrated in low-income, predominantly minority census tracts, the vast majority of high-priced loans were issued to homeowners outside these communities, the report found. Loans made by financial institutions regulated under the Community Reinvestment Act in areas where they were assessed for meeting the credit needs of low and moderate income communities constituted less than 5 percent of all high-price loans at the peak in 2005.
"Looking forward, it is encouraging that actions have been taken within the past two years intended to address many of the regulatory problems we found," said Belsky. "But many of the details are left for regulators to work out and how they do so will determine the balance achieved between consumer protection and management of systemic risk on the one hand and financial innovation, efficiencies, and consumer access on the other."
