A combination of risky mortgages and growing demand in the secondary capital markets for higher yields than those available on prime mortgages led to the boom and bust of nonprime mortgage lending in the U.S. that brought down the global financial system and precipitated a recession, researchers at the Joint Center for Housing Studies of Harvard University conclude in a report released on Sept. 27.

“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 Belsky, managing director of the Joint Center and one of the authors of the study.

“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 said.

In the boom in home prices seen during the first half of the 2000s by the U.S. and many other nations, home buyers, who tend to focus on monthly payments, found that lower mortgage rates allowed them to chase prices higher in tight housing markets — at least at first.

Once the price appreciation took off, both home buyers and mortgage investors counted on prices to continue rising as rapidly as they had, further fueling a bubble.

But the report — “Understanding the Boom and Bust in Nonprime Mortgage Lending” — says that the riskier nature of the loans tolerated in the U.S., their sheer volume, the share of them made to speculators and the way they were bundled into securities and written into credit default swaps caused much more damage to the U.S. economy and global financial markets than did mortgage loans originated in other nations experiencing a housing boom.

Illusory AAA Ratings

The report finds that regulatory failures allowed the market to chase higher returns through excessive leverage and risk taking. Regulatory lapses included the failure to closely supervise nonbank financial intermediaries, prevent unprecedented layering of risk in mortgage underwriting, adequately supervise the credit rating 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,” according to report co-author Nela Richardson, “is 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.”

Many of the securities were also over-collateralized — issuing a smaller face amount of securities than the total face value of loans in the pools — to hold aside reserves against losses. In addition, monocline insurance could be purchased and credit default swaps entered into to further hedge against risk. Yet 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.

In assessing the role of Fannie Mae and Freddie Mac in the crisis, the report finds that Alt-A loans contributed disproportionately to their losses and that AAA-rated securities backed by subprime mortgages they purchased may have helped support the market for these securities.

However, the report says, the vast majority of nonprime mortgages that were securitized went through private conduits on Wall Street, not Fannie Mae and Freddie Mac. Investors other than Fannie and Freddie mostly bore the risk of defaults of these loans.

In addition, the demand for exposure to the risk and returns on underlying nonprime mortgages was so great that credit default swaps and synthetic Collateralized Debt Obligations made up of these swaps were issued in amounts over and above the mortgages themselves.

The report also finds that while high-priced 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 home owners outside these communities.

A Role for the Federal Government

It also finds 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 5% of all high-priced 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. “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.”

A central issue — the role of the federal government moving forward in backing mortgages through guarantees — has not yet been tackled and will have an impact on cost, availability and access to mortgage credit in the years ahead.

The report also argues that the housing market would have struggled even more to recover in the absence of 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.

It notes, however, the importance of the government charging for these guarantees rather than allowing unfunded implicit guarantees of the kind that Fannie and Freddie offered.

To read the report, click here.

Register for Fall Construction Forecast Conference Webinar on Oct. 27

The Fall Construction Forecast Conference (CFC) Webinar will feature three distinct perspectives  on the housing industry and its near- and long-term future. The webinar will be held from 2:00-4:00 p.m. EDT on Wednesday, Oct. 27.

Speakers David Crowe, NAHB chief economist; Eric Belsky, managing director of Harvard University’s Joint Center For Housing Studies; and Maury Harris, managing director and chief U.S. economist at UBS, will present the latest economic data and opinions in a streamlined, efficient format that will enable attendees to interact directly with them.

The fee is $29.95 for NAHB members and home builders associations and $49.95 for non-members.

To Register

For more information and to register, visit www.nahb.org/cfc.

Visit NAHB’s ‘Eye on Housing’ Blog for the Latest Economics and Housing Policy News and Analysis

Housing and economics followers can get the latest economics and housing policy news, analysis, studies, charts and graphs from NAHB’s free new blog, “Eye on Housing,” at http://eyeonhousing.wordpress.com.

Featuring NAHB Chief Economist David Crowe, as well as observations and comments from NAHB economists Bernie Markstein, Paul Emrath, Robert Dietz, Peter Grist and Robert Denk, the blog also includes links to relevant housing stories and information from other news sources.

Blog entries will be updated on a regular basis as the news related to housing occurs. The blog also will replace the content in NAHB’s Eye on the Economy. While subscribers will still receive their regular issues of Eye on the Economy, the e-newsletter will serve primarily as a digest of the content featured on the "Eye on Housing" blog.

Readers can either visit the free blog directly at http://eyeonhousing.wordpress.com, or subscribe to the RSS feed on the blog to have the latest entries sent to them as they are posted.

Want to Know Your State’s Starts Forecast for 2010-2011?

Find out in HousingEconomic.com’s State Starts Forecast (sample).

The forecasts include downloadable Excel tables of total, single-family and multifamily starts by region and state.

To learn more, visit www.housingeconomics.com.