Much of the blame for the housing bubble and the subsequent recession has been attributed to the growth in subprime lending between 2002 and 2007. However, a simultaneous development of broader importance was the steady relaxation of affordability standards, which allowed prospective home buyers to qualify for increasingly large loans.In concert with the growth in the subprime market, lenders' tinkering with time-honored underwriting metrics eventually linked the two sectors in a massive feedback loop that distorted both real estate prices and the mortgage markets.
Lenders have traditionally defined "affordability" through qualifying metrics such as debt-to-income (DTI) ratios. Such ratios limit the amount of debt service to which borrowers can commit and, by implication, constrain the amount that buyers can spend on home purchases. At the macro level, their pervasive use forced home prices and incomes to rise proportionately, and acted as a brake on unsustainable home price appreciation.
Early in the last decade, however, mortgage lenders responded to rising home prices by marketing a series of new products and programs. These allowed home buyers to qualify for increasingly expensive homes and large loans without commensurate increases in income. While subprime loans pioneered the stretching of DTI guidelines well past traditional norms, "affordability products" altered critical aspects of loans' cash flows and underwriting. These changes impacted both sides of the DTI framework. On the debt side, monthly payments were reduced through lower interest rates (i.e., ARMs with rates generated off the short end of the yield curve) and deferring principal payments (through interest-only and negative amortization products). On the income side, relaxed documentation requirement allowed wage earners to misrepresent their incomes in order to qualify for loans. These trends eventually resulted in the proliferation of the ultimate affordability product, the stated-income option ARM.
After 2001, the mortgage lending industry evolved from one with a limited set of loan products to a consumer-driven industry offering a broad menu of products and options. Ostensibly a consumer-friendly development, the reduced reliance on traditional affordability metrics and qualifying standards removed a critical restraint on home prices. The result was a decoupling of home prices and incomes; after tracking each other fairly closely over the prior decade, median home prices rose by 45% between 2001 and 2007 while median income increased by only 15%.
Equally important, however, was the impact of outsized real estate appreciation on mortgage credit performance. Rapidly appreciating home prices masked the deteriorating fundamentals of the mortgage market and artificially boosted its performance. In particular, the strong housing market obscured the dependence of new products' performance on continued home price appreciation. By 2006, superficially strong credit performance led to total complacency on the part of lenders and investors.
This circular process also worked in reverse, creating a vicious cycle of home price declines and mortgage defaults beginning in 2007. The collapse of the private-label MBS market, particularly for non-traditional products, removed much of the easily available credit on which housing markets had become dependent. While the resulting decline in home prices caused the performance of all mortgage products to deteriorate, it particularly impacted products for which affordability was severely stretched at origination.
Rather than simply the bursting of the housing bubble, the financial crisis and recession of the last few years reflected the painful unwinding of the "real estate-mortgage complex" that developed earlier in the decade. Of the lessons to be drawn from these observations, managers and regulators need to be aware of the potential for new mortgage products and lending practices to amplify the cyclicality inherent in both the housing and mortgage markets.
Bill Berliner is consultant based in Southern California. His Web site is www.berlinerconsulting.net
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