The 2007-2009 Housing Crisis: Causes, Policy Responses and Long Term Implications

Project Outcomes Statement

The main goal of this project was to gain insight into the determinants and broader implications of the 2007-2009 housing and mortgage crisis in the United States. The first part of the research investigated the role of real estate investors. The research established that investors played a disproportionate role in the rise of mortgage defaults and foreclosures, despite their higher incomes and higher credit scores compared to mortgage holders without investment properties. Investors were found to contract mortgages with shorter maturities and higher interest rates than regular mortgage holders, and displayed higher leverage. Investors in particular displayed much higher ratios of mortgage payments to income, with averages well above 50%, whereas the average value for non-investors was found to be under 30%. Additionally, investors were found to exhibit higher rates of strategic default than regular mortgage holders. There was substantial geographical variation in investor activity across the United States. Areas with more pronounced investor activity also exhibited amplified fluctuations in housing values, with greater house price increases during the 2001-2006 boom and greater house price declines during the 2007-2009 crisis and in ensuing years. There was little correlation between the growth in mortgages and mortgages balances of non-investors and the growth for investors across geographical areas in the United States. The findings suggest that current credit scoring models inadequately capture the higher defaults risk associated with investor mortgages. Additionally, investor activity played a substantial role in exacerbating fluctuations in house prices. Based on the findings, regulations limiting mortgage payment-to-income ratios would have slowed investment activity and substantially reduced foreclosure rates during the crisis.

The second part of the research studied the long-term consequences of the 2007-2009 crisis through its effect on young households. There is a permanent negative effect on earnings of youth who enter the labor market at the start of a recession. The research investigated two aggravating factors that amplified this effect in the Great Recession following the 2007-2009 housing and mortgage crisis and beyond. First, based on the misplaced emphasis on subprime borrowers, low credit score households were all but excluded from mortgage markets, which especially hurt the young. Additionally, young households held unprecedentedly high levels of student debt in this period. This was driven by rising tuition, but also by the loss in net worth experienced by parents as a result of the crisis. The goal of the research was to isolate and quantify the impact of the 2007-2009 crisis on the young via these unique channels.

Using credit report and mortgage level data, mortgage market conditions were shown to be much tighter during and in the immediate aftermath of the Great Recession for the young compared to prior recessions. The restrictions on mortgage conditions faced by young households were shown to be more severe than would be expected given the risk associated to lending to young households. A quantitative model was developed to measure the redistributional impact of employment loss, higher initial indebtedness and overly stringent mortgage conditions on young households. The welfare loss of these cohorts was attributed to the lower home ownership rate and depressed lifetime consumption resulting from these factors. Taken together, the findings suggest that overly stringent credit constraints on young borrowers may have substantially amplified the negative impact of the loss in earnings and the higher level of initial indebtedness of young households at the start of the 2007-2009 crisis.