Mortgage Bailout

Economic Fundamentals Leading to the Mortgage Crisis

The proximate cause of the most recent financial crisis was the tremendous growth in the U.S. mortgage market and the meltdown in that market that began in 2006.1 This section describes the fundamental factors influencing the tremendous growth in the U.S. mortgage market between 2000 and 2007. Three central, interrelated factors fueled the tremendous growth of the mortgage market beginning in 2000: the high rate of price appreciation in the housing market, the rapid and extensive decline in mortgage underwriting standards, and the tremendous growth of the private-label RMBS market.2

Figure 1 shows the unprecedented rate of housing price appreciation in the U.S. between 2000 and 2006. Although the housing boom was international in scope, this paper focuses on the U.S. market, since the growth and collapse of the U.S. mortgage market was central to the ensuing financial collapse. The boom in housing prices fueled the demand of buyers who saw housing as a profitable investment opportunity.3 The boom in house prices also helped fuel the supply of mortgage loans, since rising prices increase a borrower's equity, thereby lowering default rates, ceteris paribus.

Fig. 1 Historical record of housing market boom (1968-2006). Note: US National Index-Solid Line for level (left axis); Dotted line for change (right axis)

During this period, there was also a pronounced decline in underwriting standards. Figures 2 and 3 show that market share of subprime mortgages grew rapidly from 2.4% in 2000 to 13.5% in 2006, and the volume grew from about $150 billion in 2000 to almost $700 billion in 2006. However, the growth in the share of subprime loans does not tell the whole story. Underwriting standards also declined dramatically within the category of subprime loans. Figure 4 shows that the median combined loan-to-value (CLTV) ratio for subprime loans raised from under 90% in 2003 to 100% in 2006. Similarly, Fig. 5 shows that the share of subprime loans with piggy-back mortgages (simultaneous second mortgages) and low documentation increased substantially over this period. The decline in underwriting standards can also be shown through more formal estimation of mortgage default models. Demyanyk and Van Hemert (2009) estimate the survival time of mortgage loans, controlling for characteristics of the borrowers, characteristics of the individual loans, and macroeconomic factors. They find that the quality of subprime mortgages has been deteriorating monotonically every year since 2001. However, the decline in lending standards did not lead to high rates of default until house prices were no longer appreciating rapidly. Demyanyk and Van Hemert (2009) also show that the deterioration in underwriting standards occurred across all mortgage product types. These results are also supported in Jimenez et al. (2007), Dell'Ariccia et al. (2008), and Mian and Sufi (2009).

Fig. 2 Subprime share of mortgage market

Fig. 3 Volume of subprime mortgage

Fig. 4 Median combined LTV for mortgages in subprime and Alt-A pools. Source: Mayer et al. (2009) “The rise in mortgage defaults”

Fig. 5 Percentage of piggy back loans in subprime and Alt-A pools. Source: Mayer et al. (2009) “The rise in mortgage defaults”

A third central factor in the mortgage boom ...