A decade after it began, the Great Recession is now commonly blamed on a subprime mortgage crisis – banks extending too many loans to low-income borrowers with high risk of default.
But Professor Manuel Adelino found that narrative doesn’t fit the facts.
Adelino, a finance professor at Duke University’s Fuqua School of Business, along with co-authors Antoinette Schoar of MIT and Felipe Severino of Dartmouth, reviewed nationwide income, home sales and mortgage data from the years before and during the financial crisis. They found the banking collapses that sparked the recession were the result of spiking loan defaults among buyers with higher incomes.
The resulting research, The Role of Housing and Mortgage Markets in the Financial Crisis, was recently published in the Annual Review of Financial Economics.
Adelino discusses the findings in this Fuqua Q&A.
You found low-income buyers weren’t to blame for the financial collapse that led to the recession. How did you conclude that?
The subprime crisis argument is that the supply of credit to low-income households fueled increasing house prices, and was the source of the crash. We studied data on all mortgages originated in the United States between 2002 and 2006. We could see the size of the mortgage and the income reported by the buyers. We also had ZIP code-level data from the IRS, and we had access to a sample of mortgages for which we could see whether they were still current on their payments or had defaulted.
We found there was no explosion of credit offered to lower-income borrowers. In fact, home ownership rates among the poorest 20 percent of Americans fell during the boom because those buyers were being priced out of the market. Instead, we found credit was expanded across the board. Everybody was playing the same game. But credit expanded most drastically in areas where house prices were rising the most, and these were markets that were beyond the reach of lower-income borrowers.
The overwhelming majority of mortgages were going to middle income and relatively high income households during the boom, just as they have always done.
Even if low-income households weren’t getting more credit, defaults caused the recession. Don’t lower income borrowers default more often?
That is usually the case. You become a subprime borrower by having a low credit score, and you get a low credit score by defaulting on your debt obligations. It’s not surprising that mortgages that go to subprime borrowers have higher default rates because that’s how they became subprime in the first place.
But what caused the financial crisis was that middle- and high-income borrowers – including speculators who bought up homes to sell for profit – began defaulting at unprecedented rates. We had a crisis because non-subprime borrowers defaulted, where previously they very rarely had.
In 2003, 71 percent of delinquent mortgages were held by subprime borrowers. But by 2006, subprime borrowers were holding only 39 percent of delinquent mortgages. Not only that, there just aren’t enough low-income borrowers to bring down the financial system, it’s too robust for that.
Why does it matter if people get this wrong about the recession?
Because regulators responded based on the belief that there had been an explosion of credit given to low-income borrowers. They restricted mortgage credit to subprime borrowers based on the belief those loans had put the banking system at risk. This made it more difficult for people with lower incomes to get credit for several years, just as house prices were lower, when first-time buyers and those with less money would otherwise have been able to enter the market and help it recover. Home ownership rates among low income borrowers have collapsed since the crisis because of the active limiting of credit to those borrowers. This did not add any stability to the banking system as intended.
The financial crisis changed the way we do research in economics and finance. We now think there’s a link between the massive increases in default and foreclosures, and losses in long term economic growth. A deeper understanding of the housing market’s boom and bust can lead to better understanding for regulators and business when a similar situation occurs in the future.