Federal Reserve Bank of New York
Staff Reports
Real Estate Investors, the Leverage Cycle,
and the Housing Market Crisis
Andrew Haughwout
Donghoon Lee
Joseph Tracy
Wilbert van der Klaauw
Staff Report no. 514
September 2011
This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments.
The views expressed in this paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Federal Reserve Bank of New York
Staff Reports
Real Estate Investors, the Leverage Cycle,
and the Housing Market Crisis
Andrew Haughwout
Donghoon Lee
Joseph Tracy
Wilbert van der Klaauw
Staff Report no. 514
September 2011
This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments.
The views expressed in this paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Real Estate Investors, the Leverage Cycle, and the Housing Market Crisis Andrew Haughwout, Donghoon Lee, Joseph Tracy, and Wilbert van der Klaauw
Federal Reserve Bank of New York Staff Reports, no. 514
September 2011
JEL classification: G21, D18, R31
Abstract
We explore a mostly undocumented but important dimension of the housing market crisis: the role played by real estate investors. Using unique credit-report data, we document large increases in the share of purchases, and subsequently delinquencies, by real estate investors. In states that experienced the largest housing booms and busts, at the peak of the market almost half of purchase mortgage originations were associated with investors.
In part by apparently misreporting their intentions to occupy the property, investors took on more leverage, contributing to higher rates of default. Our findings have important implications for policies designed to address the consequences and recurrence of housing market bubbles.
Key words: mortgages, leverage
Haughwout, Lee, Tracy, van der Klaauw: Federal Reserve Bank of New York (e-mail: andrew.haughwout@ny.frb.org, donghoon.lee@ny.frb.org, joseph.tracy@ny.frb.org, wilbert.vanderklaauw@ny.frb.org). The authors have benefited from helpful comments and suggestions from participants at the April 2011 Housing Economics and Research Conference at the University of California, Los Angeles, and the 2011 Society for Economic Dynamics Conference in Belgium. The views expressed in this paper are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.
Real Estate Investors, the Leverage Cycle, and the Housing Market Crisis Andrew Haughwout, Donghoon Lee, Joseph Tracy, and Wilbert van der Klaauw
Federal Reserve Bank of New York Staff Reports, no. 514
September 2011
JEL classification: G21, D18, R31
Abstract
We explore a mostly undocumented but important dimension of the housing market crisis: the role played by real estate investors. Using unique credit-report data, we document large increases in the share of purchases, and subsequently delinquencies, by real estate investors. In states that experienced the largest housing booms and busts, at the peak of the market almost half of purchase mortgage originations were associated with investors.
In part by apparently misreporting their intentions to occupy the property, investors took on more leverage, contributing to higher rates of default. Our findings have important implications for policies designed to address the consequences and recurrence of housing market bubbles.
Key words: mortgages, leverage
Haughwout, Lee, Tracy, van der Klaauw: Federal Reserve Bank of New York (e-mail: andrew.haughwout@ny.frb.org, donghoon.lee@ny.frb.org, joseph.tracy@ny.frb.org, wilbert.vanderklaauw@ny.frb.org). The authors have benefited from helpful comments and suggestions from participants at the April 2011 Housing Economics and Research Conference at the University of California, Los Angeles, and the 2011 Society for Economic Dynamics Conference in Belgium. The views expressed in this paper are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.
The U.S. economy is still recovering from the financial crisis that began in the fall of 2007.
The collapse of house prices across many markets was a precipitating factor in the financial crisis and adverse feedback effects between financial markets and the real economy led to the most severe recession in the post-war period. Extraordinary interventions by fiscal and monetary authorities both in the U.S. and abroad were required in order to prevent a complete collapse of global markets and the potential onset of another great depression.
Attention has shifted from containing the financial crisis to examining its causes and designing policies to limit both the likelihood and the severity of a similar crisis in the future. Given the central role that housing played as a catalyst to the crisis, it is important to better understand the determinants of the dynamics of house prices and of subsequent mortgage defaults over this recent cycle. While house prices were rising in many parts of the country over the period leading up to the crisis, these increases were particularly pronounced in four states Arizona, California, Florida and Nevada (the bubble states). Figure 1 shows the path of house prices in the US, the bubble states as a whole, and in each of these states from 2000 Q1 to 2010 Q4.Over the period from 2000 to 2006
average house prices more than doubled in each of these states. The pace of house price appreciation accelerated starting in 2004. The peaks in prices across the four states occurred within a couple of months of each other in mid-2006. Following the turn in the markets, house prices declined rapidly in each state with much of the earlier gains given back within just two years.2
This rapid run-up and then crash in house prices exacted a terrible cost to homeowners, financial firms and to the economy. Current estimates are that around 23 percent of active mortgages are under water in that the balance on the mortgage exceeds the current value of the 2 California is a bit of an exception in that it appears that average house prices have stabilized at a level 50
percent higher than in 2000.
1
The U.S. economy is still recovering from the financial crisis that began in the fall of 2007.
The collapse of house prices across many markets was a precipitating factor in the financial crisis and adverse feedback effects between financial markets and the real economy led to the most severe recession in the post-war period. Extraordinary interventions by fiscal and monetary authorities both in the U.S. and abroad were required in order to prevent a complete collapse of global markets and the potential onset of another great depression.
Attention has shifted from containing the financial crisis to examining its causes and designing policies to limit both the likelihood and the severity of a similar crisis in the future. Given the central role that housing played as a catalyst to the crisis, it is important to better understand the determinants of the dynamics of house prices and of subsequent mortgage defaults over this recent cycle. While house prices were rising in many parts of the country over the period leading up to the crisis, these increases were particularly pronounced in four states Arizona, California, Florida and Nevada (the bubble states). Figure 1 shows the path of house prices in the US, the bubble states as a whole, and in each of these states from 2000 Q1 to 2010 Q4.Over the period from 2000 to 2006
average house prices more than doubled in each of these states. The pace of house price appreciation accelerated starting in 2004. The peaks in prices across the four states occurred within a couple of months of each other in mid-2006. Following the turn in the markets, house prices declined rapidly in each state with much of the earlier gains given back within just two years.2
This rapid run-up and then crash in house prices exacted a terrible cost to homeowners, financial firms and to the economy. Current estimates are that around 23 percent of active mortgages are under water in that the balance on the mortgage exceeds the current value of the 2 California is a bit of an exception in that it appears that average house prices have stabilized at a level 50
percent higher than in 2000.
1
house.3 As of 2010 Q4, nearly 2.8 million homes have gone through foreclosure, and another 2
million homes are in the process of foreclosure.4 Serious delinquencies continue to add new homes to the foreclosure pipeline over time. Nationally distress sales represent around half of all repeat-sale transactions. These distress sales continue to exert downward pressure on house prices making it more difficult for housing markets to recover.
A focus on residential mortgage finance in order to understand what the determinants were of the house price and mortgage default dynamics generated over the recent cycle would inform efforts to enhance financial stability. A more robust system of residential mortgage finance should aim to limit the degree to which house prices rise and fall over a credit cycle. Reducing the amplitude of the house price swings will limit the potential for collateral damage created by housing markets for the real economy.
Related Literature
Given that housing is a durable asset, periods of rising prices are indicative of increasing demand for housing.5 One strand of the literature on housing demand focuses on the determinants that affect the user cost of housing.6 The user cost of housing ( UC) is the annual flow cost to the owner per dollar of house price, taking into account after-tax financing costs, property taxes and insurance, maintenance and depreciation costs and the expected risk-adjusted return to owning the house. The value of the housing service flow is proxied by the annual rent ( R). If we assume that there is arbitrage between owned and rental housing, then the annual rent should equate to the price of housing ( P) times the user-cost.
3 http://www.corelogic.com/About-Us/News/New-CoreLogic-Data-Shows-23-Percent-of-Borrowers-Underwater-with-$750-Billion-Dollars-of-Negative-Equity.aspx
4 http://www.ots.treas.gov/_files/490069.pdf
5 That is, with the exception of natural disasters and periods of armed conflict, the supply of housing in a market cannot contract significantly over a short period of time to drive up house prices.
6 See Hendershott and Slemrod (1983) and Poterba (1984) for early discussions.
2
house.3 As of 2010 Q4, nearly 2.8 million homes have gone through foreclosure, and another 2
million homes are in the process of foreclosure.4 Serious delinquencies continue to add new homes to the foreclosure pipeline over time. Nationally distress sales represent around half of all repeat-sale transactions. These distress sales continue to exert downward pressure on house prices making it more difficult for housing markets to recover.
A focus on residential mortgage finance in order to understand what the determinants were of the house price and mortgage default dynamics generated over the recent cycle would inform efforts to enhance financial stability. A more robust system of residential mortgage finance should aim to limit the degree to which house prices rise and fall over a credit cycle. Reducing the amplitude of the house price swings will limit the potential for collateral damage created by housing markets for the real economy.
Related Literature
Given that housing is a durable asset, periods of rising prices are indicative of increasing demand for housing.5 One strand of the literature on housing demand focuses on the determinants that affect the user cost of housing.6 The user cost of housing ( UC) is the annual flow cost to the owner per dollar of house price, taking into account after-tax financing costs, property taxes and insurance, maintenance and depreciation costs and the expected risk-adjusted return to owning the house. The value of the housing service flow is proxied by the annual rent ( R). If we assume that there is arbitrage between owned and rental housing, then the annual rent should equate to the price of housing ( P) times the user-cost.
3 http://www.corelogic.com/About-Us/News/New-CoreLogic-Data-Shows-23-Percent-of-Borrowers-Underwater-with-$750-Billion-Dollars-of-Negative-Equity.aspx
4 http://www.ots.treas.gov/_files/490069.pdf
5 That is, with the exception of natural disasters and periods of armed conflict, the supply of housing in a market cannot contract significantly over a short period of time to drive up house prices.
6 See Hendershott and Slemrod (1983) and Poterba (1984) for early discussions.
2
,
, , ,
where r is the mortgage financing rate, ? describes the tax environment, ? the depreciation rate on m
housing net of that offset by maintenance expenditures, g e the risk adjusted expected return to housing, and Y is the average income.
This framework suggests several possible candidates for explaining the rise in house prices in the early to mid-2000s. A rise in income in a housing market will increase area rental rates to a degree that reflects the elasticity of supply of rental housing in that local market. Higher rents will translate into higher house prices by a factor given by the reciprocal of the user-cost in that market.
As a consequence, house prices will vary more with changes in rents in markets with low user-costs of housing.7 The accommodative monetary policy following the bursting of the tech bubble lowered mortgage interest rates by over 300 basis points from mid-2001 to mid-2003, and facilitated a resumption of income growth after the end of the recession .8 Lower financing costs
