HOUSING CRISIS OF 2008 THROUGH THE LENS OF DATA
PART 2: FROM BURST TO DUST
Welcome back to our series featuring the Financial Crisis of 2008. In the first article, we explored the early signs of the crisis with real data such as rising housing prices, decreasing interest rates, increasing number of mortgages, and the danger of adjustable-rate mortgages. In this article, we are exploring an even more exciting chapter of the crisis: the peak of subprime mortgage-backed securities and the downfall of major investment banks that terrified the world in 2008. Let’s dive in!
Subprime mortgage-backed securities, the “timed bombs” of the crisis
Wall Street always found creative ways to make money. After purchasing mortgages from commercial banks, investment banks like Bear Stearns and Lehman Brothers would bundle them together into a pool of thousands of mortgages and then sell shares of this pool to investors or hedge funds. These shares were called subprime mortgage-backed securities (MBS). The reason behind this strategy was the principle of diversification: when you only had one mortgage, you would lose all money when the borrower defaulted, but if you owned shares of thousands of mortgages that were grouped together, you would not be affected much by just one or two defaults. Combined with rising house prices, this principle made MBS the most lucrative asset of the time due to its low risk and high return.
Another significant contributor to the popularity of this asset was the credit ratings, which were the main tool for investors to evaluate different kinds of assets. A rating of triple-A (AAA) indicated the highest level of creditworthiness and the lowest risk of default whereas a rating of BB or BBB signified a higher level of credit risk. In the 2000s, MBS was constantly rated AAA by credit rating agencies, consolidating its validity among investors.
However, the problem was these agencies did not rate these bonds accurately and ethically. As delinquencies (the rate of borrowers not making their mortgage payments on time) and defaults (the rate of borrowers failing to make their mortgage payments) rose dramatically in 2006, ratings for MBS were supposed to decrease since they were made of these bad mortgages. However, the ratings remained unchanged because credit rating agencies such as S&P 500, Moody’s, and Fitch got paid by investment banks to give high ratings to MBS. If they gave poor ratings, investment banks might go to their competitor for a good rating so they could continue selling MBS to investors.
When the bubble busted…
The most obvious sign near the outburst of the housing bubble was the number of delinquencies in subprime mortgage-backed securities.
Figure 5 shows the serious delinquency rate of subprime loans one year after origination by five credit score groups. We can see that the lower the credit scores, the higher the rate of delinquencies. A lot of the mortgages at the time were given to people with lower than a 600 credit score. According to the graph, this group of people had a delinquency rate of about 12% in 2005, 17% in 2006, and roughly 21% in 2007. But even among the people with high credit scores — above 700 — delinquency rate was still high at above 10% in 2007. Not only were these extremely high numbers, they increased over time until the market crash in 2008.
Without breaking down the data into groups of credit scores, the number of delinquencies appeared to be even more significant. Figure 6 presents the percentage of delinquencies 90 days or more past due in four different loan types. As we know, the risk of subprime loans has always been significantly higher than that of others. Since the early 2000s, the delinquency rates of subprime loans (adjustable-rate and fixed-rate) have been fluctuating around 10% compared to prime loans at nearly 0%. Most dangerously, subprime adjustable-rate loans rose significantly to 30% in 2008, indicating the outburst of the housing bubble.
As banks used unethical lending practices, they were paving the path for mortgage defaults as most loans were given to high-credit-risk borrowers. As delinquencies increased in around 2004 and 2005, so did defaults. Figure 7 shows early payment defaults on subprime loans, depicting that the default rate has been increasing since 2004. In the 12 months since origination, the percentage of defaults rose from 1.5% in 2004 to 2% in 2005 to 4.5% in 2006 and a record high of 8% in 2007.
In the early 2000s, the Fed reduced interest rates to a record low of around 1% to encourage home buying and support the housing market. This policy led to a high number of adjustable-rate mortgages that gave low-income borrowers a low payment rate at first, but then the rate would vary based on market conditions. As depicted in Figure 8, the Fed raised the interest rate from 1% in 2004 to a peak of 5.26% in 2007. When the Federal Reserve increased its target interest rate, the rates on adjustable-rate mortgages would follow suit, leading to higher monthly payments for borrowers with adjustable-rate mortgages (ARM). This was the “real rate” of ARM while the previous low rate was just a “teaser rate”. When subprime borrowers faced the real rate, they realized they were not financially prepared for it, so they looked for options to refinance their mortgages.
However, at the same time, house prices declined sharply. In Figure 9, the home price index dropped from 195 in 2006 to 150 in mid-2008. Such a decrease in house prices reduced home equity, making it harder for mortgage borrowers to refinance because they may no longer meet lender requirements for sufficient collateral. As a result, subprime loans were not able to refinance their mortgage and were required to pay the new high rate of interest, leading to an even higher proliferation in the number of mortgage defaults.
So how did mortgage defaults cause problems in the housing market?
Let’s imagine we had 5000 mortgages and 5 of those defaulted, which means that 5 of the borrowers failed to pay back the mortgage. The bank could take back 5 houses and sell them for a profit since house prices were rising every day. However, what if we had 4000 defaults among the 5000 mortgages? In this case, the bank would have 4,000 instead of 5 houses to sell, which would increase the supply of houses. According to the law of supply and demand, when the supply of a good or service increases while demand remains constant, the price of that good or service will decrease. Therefore, as defaults rose, prices of houses decreased considerably as presented in Figure 9 and when this happened, the banks would face a loss when they tried to sell the house. Moreover, when house prices fell and defaults continued to rise, the people who held subprime mortgage-backed securities — usually investment banks and investors — would lose all of their money. That’s when the housing bubble destroyed the economy.
“This business kills a part of life that is essential. The part that has nothing to do with business.”
-The Big Short-
It all came crashing down…
The peak of the crisis was marked by the collapse of two of the biggest investment banks of the time: Lehman Brothers and Bear Stearns. The two banks enjoyed the highest stock value in their history in 2007 thanks to increasing value of MBS. Yet, only 1 year later, when the housing market crashed, their significant exposure to these bonds pushed them to the edge of bankruptcy. As seen in Figure 10, Lehman Brothers’ stock declined from a record high of roughly $220 in February, 2007 to almost $0 in October 2008.
Similarly, Figure 11 shows that Bear Stearns’ stock experienced a peak of about $175 in 2007 then plummeted to less than $20 in 2008.
The crisis’ effect did not stop at Wall Street, its impact traveled into the world economy.. Figure 11 demonstrates a sharp dip in the real GDP in 2008 of some of the biggest economies in the world, including the US, Germany, Spain, the UK, and Italy. The most significant economic impacts could be witnessed in Spain and The United Kingdom with the former saw their real GDP drop from a positive 4% in 2007 to a negative 4% in 2009, and the latter saw theirs drop from a positive 3% in 2008 to a negative 7% in 2009.
Magic lies in the data
In the movie The Big Short, when asked how he knew about the housing bubble before anyone else, Dr. Burry said: “I just know how to read numbers” ([9] The Big Short, 2015). Perhaps, the housing crisis of 2008 was actually predictable. Most people did not see it, but the signs were there, in the balance sheets, the graphs, and the data that we analyzed in this article. From the very first sign of rapidly rising house prices, to the number of mortgage borrowers with low credit scores, to the danger of increasing numbers of subprime lending, to the threat of changes in interest rates, to the critical evidence of increasing mortgage delinquencies and defaults, data told us everything — the truth, the unseen, the “seemingly unpredictable.”
Sources
[1] Yuliya Demyanyk, Did Credit Scores Predict the Subprime Crisis?, 2008
[2] The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report, 2011
[3] Comparing the Default Numbers on Subprime Mortgages and For-Profit College Loans, https://rortybomb.wordpress.com/2011/09/12/comparing-the-numbers-on-subprime-mortgages-and-for-profit-college-loans/, 2011
[4] International Monetary Fund, Interest Rates, Discount Rate for United States [INTDSRUSM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTDSRUSM193N, November 7, 2023
[5] Tim Ellis, Rochester, Buffalo and Hartford Least at Risk of a Housing Downturn in the Next Recession, 2019
[6] The impact of Lehman Brothers on Romanian banks listed on BVB — Scientific Figure on ResearchGate. Available from: https://www.researchgate.net/figure/Figure-no1-Evolution-of-Lehman-Brothers-stock-during-June-2004-October-2010_fig5_241751939 [accessed 28 Nov, 2023]
[7]What Happened to Bear Stearns? Who Bought It?, https://www.thestreet.com/banking/bear-stearns, 2023
[8] Paulina Restrepo-Echavarría , Maria A. Arias, U.S., European Economies and the Great Recession, 2017
[9] Lewis Ranieri, movie The Big Short, 2015
[10] Lawrence M Ball, https://www.theguardian.com/commentisfree/2018/sep/03/federal-reserve-lehman-brothers-collapse , 2018
