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The Great Housing Boom and BustLessons Relearned

Edward Pinto Codirector

AEI International Center on Housing RiskEdward.Pinto@AEI.org

HousingRisk.org

February 4, 2014

The views expressed are those of the author alone and do not necessarily represent those of the American Enterprise Institute.

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Lessons Relearned from 2007 Housing Collapse

• Mortgage loans are only as sound as the practices used to underwrite and originate them.• Relative loan performance is largely determined by risk characteristics at origination.

• Market stability depends on the preponderance of loans being low risk, defined as good performance under stress. • This promotes mortgage debt being used to smooth housing consumption, not take on

excessive debt to support consumption in excess of income.

– Martin Luther King Jr. recognized the problem of living beyond one’s means in his 1968 “The Drum Major Instinct” speech.

• Political pressures will likely degrade sound lending practices over time.

• Lack of robust risk measures limits the market’s ability to impose discipline.

• Bottom line: Transparent and objective measures of mortgage risk, home-price risk, and the capital adequacy needed to evaluate and manage housing risk.

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A Century of Lessons

• The deterioration of lending standards from the early 1990s to 2007 has historical precedents.

• Earlier episodes: 1926-33, late 1950s and 1960s, early 1980s, and late 1980s.

• Mortgage default rates rose in every case, sometimes to disastrous levels.

• Prudent lending practices (or at least less risky practices) were then re-established and defaults declined.

• The pattern is clear: the abandonment of sound mortgage underwriting standards leads to trouble.

4Source: “Securitization in the 1920’s”, William Goetzmann , 2009, Securitization in the 1920's - Yale University

Mortgage Trouble Occurs When Mortgage Debt Grows Faster than Home Value

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Mortgage Trouble Occurs When Home Values Grow Faster than Fundamentals

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What Will the Housing Risk Center Do to Fill the Void?

The AEI/Pinto-Oliner Risk Indices:

• National Mortgage Risk Index (NMRI) – Classifies loans into low, medium, and high risk based on default experience of 2007

vintage loans with similar characteristics.• MSA level indices to be added in early 2014.

– Currently covers nearly all gov’t-guaranteed mortgages for home purchases (about 75% of all purchase loans)

– Limited to purchase loans now; refi loans to be added in 2014.

• 10-metro Composite Collateral Risk Index (CRI) – Metro areas chosen to represent housing market in U.S. as a whole.– Expected release dates: DC-area index, early 2014; other metro areas throughout

2014.– Have plans to expand to 25 metros based on market support.

• Capital Adequacy Index (CAI)– Assesses capital reserves at institutions with large mortgage exposure. – Under development. Expected release date: Late 2014.

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NMRI for Home Purchase Loans

* Index changes measured from first month shown.Source: AEI International Center on Housing Risk, www.HousingRisk.org. Separate index not available for VA guaranteed loans. RHS is Rural Housing Service.

All indexes shown are high relative to prudent standards and have trended up.

Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-134%

8%

12%

16%

20%

24%

4%

8%

12%

16%

20%

24%

Fannie/Freddie: +0.9 ppt, from 4.9% to 5.8%*

Composite: +0.2 ppt, from 10.6% to 10.8%*

Stressed default rate

FHA/RHS: +1.3 ppt, from 22.2% to 23.5%*FHA/RHS accounts for 30% of all purchase loans and is the main factor behind high level of composite index.

Shifts in market share caused the composite index to decline from Nov. to Dec. even though the components were steady or edged up.

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Calibrating Mortgage Safety

• Composite index substantially above 1990 level, but not approaching 2007 level when underwriting was exceptionally lax.

• Fannie/Freddie index somewhat above 1990 level and rising.

• FHA index extremely high and rising. Sharp contrast with safe underwriting during 1935-55.

NMRI - purchase loans Latest dateLatestValue

1935-1955 vintages (est.)

1990 vintage (est.)

2007 vintage (est.)

Composite index Dec. 10.8% NA 6% 19%

Fannie and Freddie Dec. 5.8% NA 4% 13%

FHA Dec. 24.1% 3% 15% 30%

A low-risk loan has an average default rate under stress of 3% and a maximum default rate of less than 6%. An index value of less than 6% is indicative of conditions conducive to a stable market.

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Purchase Loan Origination Shares, by Risk Level

Source: AEI International Center on Housing Risk, www.HousingRisk.org.

Less than half of new purchase loans are low risk, and the share has edged lower on net since Aug. Likely would lead to market difficulties in event of recession.

Aug-13 Sep-13 Oct-13 Nov-13 Dec-1320%

25%

30%

35%

40%

45%

50%

20%

25%

30%

35%

40%

45%

50%

Low risk

High risk

Medium risk

Low risk defined as stressed default rate of less then 6%, medium risk is 6% to 12%, and high risk is 12% or higher.

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GSE Low-Risk Origination Shares, Purchase Loans

Source: AEI International Center on Housing Risk, www.HousingRisk.org.

Downward trend, especially for Fannie Mae..

Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-1360%

62%

64%

66%

68%

70%

72%

74%

60%

62%

64%

66%

68%

70%

72%

74%

Freddie Mac

Fannie Mae

Combined

Note: FHA/RHS low-risk share (not shown) is about 2%.

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Purchase Loans with DTI Greater Than 43%

Source: AEI International Center on Housing Risk, www.HousingRisk.org.

Nearly one in four loans don’t meet DTI limit in QM – and likely won’t going forward because Federally guaranteed loans are exempt from limit.

Aug-13 Sep-13 Oct-13 Nov-13 Dec-1310%

20%

30%

40%

50%

10%

20%

30%

40%

50%

FHA/RHS

Composite

Fannie/Freddie

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Purchase Loans with Down Payment of 5% or Less

Source: AEI International Center on Housing Risk, www.HousingRisk.org.

Nearly half of all purchase loans and about a quarter of Fannie/Freddie purchase loans have a minimal down payment.

Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-1320%

25%

30%

35%

40%

45%

50%

20%

25%

30%

35%

40%

45%

50%

Fannie/Freddie

Composite

All FHA/RHS purchase loans are assumed to have down payment of less than 5%.

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Lesson: Homeownership rate has been stagnant since 1960 notwithstanding dramatic upward shift in

leverage and defaults

• t

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Lesson: Risk Level Correlates to Default Rate Regardless of Vintage

*30 year, fixed rate, fully amortizing, fully documented, owner occupied loans

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Lesson: Combined LTV and FICO Are Heavily Determinative of Default Rate for Home Purchase

Loans (2007 Vintage)

• t

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Lesson: Combined LTV and FICO Are Heavily Determinative of Default Rate for Cash Out with

Refinance Loans (2007 Vintage)

• t

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Quick survey - please rate the DC Metro Market

• Very strong

• Strong

• Average

• Below average

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Composite Collateral Risk IndexHouse Price Decline in Fairfax, VA: 2006-2012

*Range of house price decline by quintile for Fairfax Co., Prince William Co., Montgomery, Co. and Prince George’s Co. (rounded to the nearest1%) is less than 18%, 18% to 22%, 22% to 34%, 35% to 41%, and 41% to 51%. Source: Author's calculations using data from FNC, Inc.

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Composite Collateral Risk IndexHouse Price Decline in Prince George’s, MD: 2006-2012

*Range of house price decline by quintile for Fairfax Co., Prince William Co., Montgomery, Co. and Prince George’s Co. (rounded to the nearest1%) is less than 18%, 18% to 22%, 22% to 34%, 35%

to 41%, and 41% to 51%. Source: Author's calculations using data from FNC, Inc.