Real Estate Market

Unsupervised, risky business, greedy homebuyers tanked the housing market

by Broderick Perkins

Insufficient regulatory oversight leading to excessive risk taking and homebuyers biting off more than they could chew, combined to doom the housing market, according to a Harvard University study from the school's Joint Center for Housing Studies.

"Understanding The Boom And Bust In Nonprime Mortgage Lending" says originating risky mortgages was "inextricably linked to demand on the secondary capital markets for mortgages with higher yields than prime mortgages, as well as the multiplication and magnification of this risk through actions taken in the capital markets."

"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," says 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," he added.

Home buyers didn't help.

Focusing on the monthly mortgage payment rather than the true value of the home, homebuyers used low mortgage rates to bid high in tight housing markets, the report said.

Once house price appreciation took off, the report suggests, backward looking price expectations led both equity grabbing homebuyers and salivating mortgage investors to bank on rapidly rising prices, further fueling the bubble.

Risky loans, the sheer volume of them and the large market share of them made to speculators and those who couldn't really afford a home, followed by bundling the mortgages into securities, crippled the U.S. economy and global financial markets.

Regulatory lapses hurt too, including the failure to closely supervise nonbank financial intermediaries, the failure to prevent unprecedented risk layering in mortgage underwriting, the failure to adequately supervise the credit ratings agencies, the failure to impose greater transparency in the capital markets and the failure to require higher reserves against risks, the report said.

"One of the biggest problems was that the whole system created the illusion that risks were being adequately managed. 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," said report co-author Nela Richardson.

Securities were over collateralized - the process of issuing a smaller face amount of securities than the total face value of loans in the pools - to hold aside reserves against losses.

"The fundamental underpinnings of the models used to rate these securities were deeply flawed and the capacity of third-party insurers and credit default swaps to make good on claims was inadequate," the report said.

The report also discovered that while high priced loans 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 study also found that 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 five 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," commented Belsky.

So-called "Wall Street Reform," the new Restoring American Financial Stability (RAFS) Act of 2010" is heavily laden with strong mortgage regulations.

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."

The report says the bust could have been worse.

"The housing market would have struggled even more to recover, absent federal guarantees of mortgages and mortgage-backed securities, and both the cost and availability of mortgage credit moving forward would be negatively affected by any curtailment in the scope of the guarantees," the report says.

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