Lessons of the Bubble
In the decade before it burst, the housing bubble provided both policymakers and families with a false sense of progress. Minnesota incomes in 2007 were lower than in 1998, yet lenders were giving families bigger and easier housing loans. This easy credit allowed many people to become homeowners for the first time. But the crash erased gains in homeownership, as many of these new homeowners lost their homes. Now that the economy is recovering, it’s time to consider what made these gains so ephemeral and how to refocus on homeownership policies that won’t just help people get into homes, but also help keep them there.
In a traditional mortgage transaction, the homeowners and the lender share the risks associated with a mortgage. If something happens to prevent the homeowners from repaying the loan, the lender risks losing its money and the homeowners risk losing their house and damaging their credit. This shared risk gives each side a reason against entering into a loan for more money than the homeowners can repay.
In the buildup to the financial collapse, however, these limits broke down. Lenders came to believe that they could protect themselves from their side of the risk through securitization—combining mortgages into complicated new financial instruments. As a result, they set out to make as many loans as possible. Homeowners likewise came to underestimate the risks they faced. This underestimation grew both from a widespread belief that housing prices would never fall and from the activities of unscrupulous lenders to disguise the risks posed by certain mortgage agreements.
With both lenders and homeowners mistakenly believing that they were free of the risks related to mortgage lending, nothing remained to limit the size and number of mortgage loans. For many people, this was a way to get bigger, better houses. Others borrowed against their home equity to make other purchases. Others became speculators. Still others became homeowners for the first time. As a society, we cheered these homeownership gains, generally associated with improved neighborhood stability, the opportunity for families to build wealth, improved civic engagement, and the other positive social benefits.
However, the inherent risks of lending had not been eliminated. Millions of Americans couldn’t repay their mortgages and defaulted. The financial instruments that lenders believed would protect them turned out to be nearly useless. Realizing their mistake, lenders dramatically restricted residential mortgage lending. With fewer home purchasers able to get big loans, housing prices collapsed, leaving millions of people with mortgages larger than the values of their homes. Many lost their homes entirely: Minnesota’s homeownership rate, which had reached 78.8 percent in the first quarter of 2005, dropped to 69.4 percent by the first quarter of 2011, the lowest level since 1994.
Since the crash, federal and state authorities have mounted a robust policy response. New measures are in place to control mortgage securitization, and Congress created the new Consumer Financial Protection Bureau to ensure that mortgage brokers don’t foist risky mortgages unto unwary borrowers. Through controlling risky lending, these and other measures hope to prevent an unsupportable increase in housing prices and prevent families from taking on debt burdens they can’t afford. However, as banks take fewer risks, some people lose the ability to get mortgage loans at all. How can we help these aspiring homeowners get the credit they need without encouraging the kind of risky lending that created the bubble?
I see two ways. First, we can help people become better credit risks—and to demonstrate that fact to lenders. For example, Minnesota has already experienced success with homebuyer education programs. These programs help prospective homeowners evaluate the risks involved in taking on a mortgage and learn how to prepare financially to be responsible borrowers. We can also develop new ways for people to show their ability to be financially responsible. Some people are already experimenting with this: Experian, a credit reporting agency, has begun including rental history in its credit reports. This and other such nontraditional measures of credit worthiness could help those with little credit history get housing loans.
Second, government can reduce the risk of loaning to prospective homebuyers by assuming some of the costs. The social benefits of homeownership justify investing public funds to promote it, so long as that investment does not contribute to market instability. Down-payment assistance and government subsidized loans to first-time homebuyers makes homeownership a possibility for many people without exposing the new homeowners, the government, or private lenders to new risks. And, because this assistance is targeted at new entrants to the homeownership market, it does not inflate housing demand so much that it creates another bubble.
These policies all acknowledge that risk is inherent in lending. In the lead up to the crash, our policymakers and financial institutions convinced themselves otherwise and, as a result, expanded housing demand heedless of the risk they were creating. When time revealed this error, the gains in homeownership evaporated, and the public ended up bearing the costs, in the form of corporate bailouts, reduced economic growth, and strain on the social safety net. This time, let’s do things differently.
Ben Schweigert grew up in St Paul's Midway neighborhood. He clerked for the U.S. Court of Appeals for the Second Circuit, has conducted research for the U.S. Senate Permanent Subcommittee on Investigations, and worked for the Minnesota House of Representatives. He is currently a lawyer in New York City.