December 6th, 2011
Econintersect: A new Federal Reserve study suggests that real estate “investors” played a major role in amplifying the effects of the housing crisis.
Optimistic investors—speculators—used low-down-payment, nonprime credit to place highly leveraged bets on the housing market, perhaps facilitated for some by reporting an intention to live in the house. Because they didn’t have to put much money at risk, these investors were able to continue to buy housing even as prices rose further. All of these developments were especially noticeable in Arizona, California, Florida, and Nevada. Longstanding tradition in the mortgage lending business and the predictions of economic models hold that investors will quickly default if prices begin a persistent fall. This is what happened starting in 2006, as the charts below show.
It would be expected that the percent of delinquent mortgages for investors should have remained roughly unchanged relative to all delinquent mortgages during the housing crisis. Yet this study shows an investor is two to three times more likely to default during a serious financial / housing crisis than an owner - occupant. The study concludes that investors are only good credit risks when the market moves as expected:
The idea that asset price booms may be driven by optimistic or speculative investors who make highly leveraged bets on asset prices, then quickly default if their expectations are not realized, is not new. Indeed, John Geneakoplos of Yale University argues that such behavior is a fundamental driver of what he calls the “leverage cycle.” To our knowledge, our study provides the first direct evidence that such behavior may have been important in the 2000s housing cycle.
But what, if anything, does it teach us about policy? We conclude that it’s very important for lenders (and regulators) to manage leverage as asset bubbles are inflating. In the 2000s, securitized nonprime credit emerged to allow leverage to increase, with effects that extended far beyond this sector, including spillovers from defaulted mortgages to the value of other properties (see Campbell, Giglio, and Pathak ). Effective regulation of speculative borrowing, like what is being attempted in China today, may be needed to prevent this kind of crisis from recurring.
Source: Federal Reserve