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The Credit Crunch Deflated the Housing Bubble

Published by Lawrence Roberts | December 26th 2008 | Views:

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Loan standards vary over time as the credit cycle loosens and tightens. Many borrowers in the bubble rally were qualified with low credit scores, very high combined-loan-to-values, high debt-to-income ratios, and little or no income verification. When the ensuing credit crunch occurred, all of these standards were tightened and many of those who previously qualified did not qualify under the new standards. If no other conditions changed, this tightening of standards would have forced many borrowers into foreclosure; however, this credit tightening caused a chain reaction sending market prices for residential real estate which were already falling into an even steeper decline.

The Adjustable Rate Mortgage Reset Chart produced by Credit Suisse in 2007 details the dollar amounts of mortgages facing payment resets in the six years from 2007-2012. The bulk of the first two years are loan resets from subprime borrowers who purchased in 2005 and 2006. These subprime borrowers paid peak prices for properties. Most of these borrowers were given 100% financing (if they could have saved up for a downpayment, they probably would not have been subprime,) and they were often only qualified based on their ability to make the initial payment rather than on their ability to make the payment after the reset.

There was a special loan program called a 2/28 that most subprime borrowers purchased. This loan fixed a payment for two years; afterward, the payment would increase to a higher interest rate and on a fully-amortized schedule over the remaining 28 years. The payment shock was extreme. This created a condition where most subprime borrowers could not refinance or make their payments, and many of these borrowers defaulted on their loans. Data from early 2008 showed the 2006 and 2007 vintage of subprime loans default rates running close to 50%, and this was before the resets were coming due. Most of these subprime borrowers who went into default lost their properties in foreclosure, and these foreclosures were added to the supply of an already overwhelmed real estate market.

As borrowers began to default in high numbers, the banks began losing large amounts of money. The more they lost, and the more losses they saw coming, the more conservative they became in their underwriting. When the losses really started to mount, the lenders panicked, and they stopped lending altogether: a credit crunch. The credit crunch deflated the Great Housing Bubble.
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