In a paper on subprime lending and house price volatility(forthcoming in the Journal of Real Estate Research), Wharton professor of real estate and finance Susan Wachter, and visiting professor of real estate at Wharton Andrey Pavlov (Simon Fraser University), show that the presence of aggressive lending instruments magnify real estate market cycles. Wachter presented the paper at the Far East and South Asian Meeting of the Econometric Society 2008, jointly hosted by the School of Economics and Sim Kee Boon Institute for Financial Economics,Singapore Management University.

According to the authors, markets with high concentration of aggressive lending are likely to see larger price declines following a negative demand shock. Furthermore, markets that decline the most after a negative demand shock are the ones which experience the largest withdrawal of aggressive lending. This magnifying effect is present even in the absence of sizeable default rates, showing it is the fluctuation in the use of aggressive instruments (mortgages with more embedded risk such as teaser rate adjustable rate mortgages) which exacerbates the market downturns, and not the fact that such instruments generate higher default rates.

“The market has seen more aggressive mortgage lending in recent years, which recently peaked and then declined,” said Wachter and Pavlov. The amount of aggressive mortgage lending is huge. Interest only loans, negative amortisation loans, zero or low equity loans and teaser-rate adjustable rate mortgages accounted for about two-thirds of all US home loans since 2003, according to the Federal Deposit Insurance Corporation (FDIC).

Pavlov and Wachter demonstrate theoretically that aggressive lending increases asset prices (home prices) since buyers can further leverage their current income and wealth. The new lending instruments allow more borrowing than would otherwise occur because of higher demand in less affordable housing markets. Many young households are forced to turn to these instruments, partly because they find it difficult to borrow against their human capital.

Background

Aggressive mortgages became possible through deregulation and financial liberalisation. According to Wachter, “automated underwriting made lending riskier mortgages practical. Such lending became more widespread in the late 1990s through private label securitisation of non-conventional loans.”

Private label securitisers are investment banks which package the loans. In some respects, they expand on the role of Fannie Mae and Freddie Mac which account for about half (US$5 trillion) of all the nation’s mortgages. A major difference however is that Fannie and Freddie did not and do not securitise non investment grade mortgages unlike the private labels.

Further increasing risk is the fact that private label securitisations were often made without recourse. This means the ones who originally made or packaged the loans are not required to buy them back if they default. “The result of having these securities, of course, is that an additional source of funding makes it easier for someone to buy a home,” says Pavlov. “It increases demand which pushes up market prices.” 

The biggest price rises occur in high density areas. As new building opportunities are limited, it results in an inelastic supply of housing in these areas. This magnifies home prices increases. The prices are boosted further by aggressive lending and creative securitisation. When markets collapse, the new securities get re-priced if they are able to be sold at all. As the price of the securities drop, so do home prices since ability to issue new securities becomes limited.

The ability to “put” the options back to the issuer may also be limited. While some securitisations came with recourse, the “with-recourse” feature is likely to have been under-priced because of the underestimated risk of the originator defaulting. New Century Financial is an example.

The authors test the aggressiveness of the mortgage instruments against prices in different residential markets over time. While this is the first study of the link between affordable lending and home prices, other studies have identified various factors influencing real estate prices, such as how under-pricing of default risk leads to inflated asset prices. This can also exacerbate crashes in asset markets.

Some studies, such as Hung and Tu (2006) also find that use of adjustable rate mortgages (a type of aggressive lending) is related to the increase in home prices in California. States Wachter, “the IMF report on World Economic Issues also suggests that countries using more adjustable rate mortgages have more volatile housing markets. Their focus is on interest rates. As interest rates adjust higher, mortgages become more expensive for homeowners, causing a decline in home prices. Of course, this works the other way around when interest rates fall adding volatility to the market.”

Housing Model

The model developed by the authors shows that a negative demand shock will result in a price decline that is more than proportionate to the shock. Therefore, the aggressive lending magnifies the effect on price, even if the lenders correctly anticipate the re-pricing of all the lending instruments. The effect is larger in markets with high concentration of aggressive lending. 

The authors also show that the share of aggressive mortgages declines following a negative demand shock. According to Pavlov, “effects of under-pricing risk can also be shown in the model.  It shows how lax underwriting standards can be sustained over time. They also show the institutional and market circumstances which make this under-pricing likely.”

The empirical implications are:

(i) Aggressive lending increases asset prices.  (ii) If lenders underestimate declining housing demand, it increases the probability of the drop in demand occurring. Then, housing prices will decline more than proportionately to the demand decline.  (iii) Markets with high concentrations of aggressive lending practices tend to amplify the decline in home prices. (iv) After a price decline, lenders cut back on making aggressive home loans. The authors find these effects occur even if lenders anticipate them, although the magnitude of the effects is reduced by the behaviour of lenders.

The under-pricing of default risk of mortgages also has the effect of inflating real estate prices. The greater the number of aggressive mortgages outstanding, the more home prices become inflated.

Empirical Findings

The authors use data from 1990 to 1995 in downtown Southern California. They divide Los Angeles County into 22 areas and calculate the per cent price decline in each region between May 1990 and October 1995. The dates represent the top and bottom of the Los Angeles real estate cycle.

Wachter points out, “The finding is that, in 1990, for each 1% higher share of adjustable rate mortgages (ARMs) -- which proxy for aggressive lending since they tend to be targeted to affordability constrained households -- the price decline increase 1.37% for that neighbourhood.

She adds, “The price rises are key because they hide the fact that lending standards are becoming lax. In absence of price rises, the decreased lending quality would have been observed in higher defaults. The lagged response is observed when the process of liberalised lending and ensuing price increases comes to an end.” The finding is consistent with the theoretical result that aggressive lending instruments magnify negative demand shocks.

The authors also find that areas suffering the largest price declines during a crash are where ARMs declined the most. The authors compare aggressive lending instruments such as ARMs to “hot money”. In hard times, aggressive lending flees the scene more quickly than traditional lending instruments. The authors also find that including income changes does not alter the findings.

National Data

The authors extend their investigations nationwide, looking at cities which suffered at least a 5% price decline at any time in the past. It includes ten cities: Boston, Dallas, Denver, Honolulu, Los Angeles, New York, Phoenix, Salt Lake City, San Diego and San Francisco. Data comes from the Federal Housing Finance Board and reports on conventional mortgages.

Findings support the theoretical model and show that the proportion of aggressive lending (ARMs) in most markets that experienced a large negative demand shock was above the national average at the respective peaks of those markets. Furthermore, the proportion of ARM originations fell below the national average following the negative demand shock in each city.

Pavlov states that “The empirical results also confirm that the proportion of ARMs (indicating aggressive lending) at the top of the market magnify the subsequent negative demand shock. The effects, using national data, are less than for the Los Angeles neighbourhoods.

When the authors studied the impact of ARMs across the nation in both rising and falling markets, they found that the high share of ARMs have a positive impact on subsequent price changes during up markets and a negative impact during down markets. A high concentration of aggressive lending resulted in larger price fluctuations over the market cycle, as predicted by the theoretical model.

Recent Subprime Evidence

To investigate recent subprime evidence, the authors look at the period 2001 to 2005 and compare this to prices outcomes in 2007, the most recent period for which data are available. The results show that aggressive lending (subprime loans) produce higher price appreciation in up markets and larger price depreciation in down markets. 

All the empirical evidence of the study confirms the theoretical finding that aggressive lending exacerbates the cycle by boosting prices in up markets and reducing them in down markets. Because subprime loans might be made more often in markets with high appreciation rates (thus reversing causality), the authors test for the impact by using the Housing Opportunity Index (an index which shows the percent of the population with the median income in the area that would be able to afford the median-priced house) which should not be correlated with price changes. The results show that aggressive lending raises prices rather than price increases leading to more aggressive lending.

The cities with high concentrations of aggressive lending instruments showed larger price rises during rising markets and bigger price drops in declining markets. After the bubble busts, aggressive lending tends to flee the areas that have suffered the largest price declines.

Five markets with the highest concentration of aggressive lending instrument (such as ARMs) are Florida, Arizona, District of Columbia, Nevada and California for prime loans. For subprime loans they are Illinois, Utah, California, Arizona and Nevada. The model predicts these markets will experience the largest market declines in the face of otherwise equal negative demand shocks, as they have.