10 years after the financial crisis, is the housing market still at risk?

The economy is booming. The stock market regularly hits new all-time highs. Unemployment is at record lows. Aside from a small recent downturn, the housing market is as hot as ever.

In many ways, the world has moved on from the cataclysmic 2008 financial crisis, triggered when sloppy mortgage lending popped the massive U.S. housing bubble. But the scars of the crisis are still visible in the American housing market, which has undergone a pendulum swing in the last decade.

In the run-up to the crisis, a housing surplus prompted mortgage lenders to issue loans to anyone who could fog a mirror just to fill the excess inventory. But lending today is stricter. It is so strict, in fact, that some in the real estate industry believe it’s contributing to a housing shortage that has pushed home prices in most markets well above their pre-crisis peaks, turning younger millennials, who came of age during the crisis, into a generation of renters.

“We’re really in a hangover phase,” said Jonathan Miller, CEO of Miller Samuel, a real estate appraisal and consulting firm. “Just because prices are rising doesn’t mean we’ve recovered. [The market] is still distorted, and that’s because of credit conditions.”

How did this happen? Start with shady mortgages

When lenders and banks extend a mortgage to a homeowner, they usually don’t make money by holding that mortgage over time and collecting interest on the loan. After the savings-and-loan crisis of the late 1980s, the originate-and-hold model turned into the originate-and-distribute model, where lenders issue a mortgage and sell it to a bank or to the government-sponsored enterprises Fannie Mae, Freddie Mac, and Ginnie Mae. Then, they use the proceeds from the sale to originate another mortgage.

Fannie, Freddie, Ginnie, and investment banks buy thousands of mortgages and bundle them together to form bonds called mortgage-backed securities (MBSs). They sell these bonds to investors—hedge funds, pension funds, insurance companies, banks, or simply wealthy individuals—and use the proceeds from selling bonds to buy more mortgages. A homeowner’s monthly mortgage payment then goes to the bondholder.

This “mortgage securitization chain” keeps money flowing into the mortgage market, making credit available to anyone who wants to purchase their piece of the American dream. But in the mid-2000s, lending standards eroded, the housing market became a huge bubble, and the subsequent burst in 2008 impacted any financial institution that bought or issued mortgage-backed securities.

That burst had no single cause, but it’s easiest to start with the homes themselves. Historically, the home-building industry was fragmented, made up of small building companies producing homes in volumes that matched local demand.

But in the 1990s, the industry started to consolidate, and by 2005, one in three homes was built by a large public home-building company. These companies built homes so quickly they outpaced demand. The result was an oversupply of single-family houses for sale.

Mortgage lenders, which make money by charging origination fees and thus had an incentive to write as many mortgages as possible, responded to the glut by trying to put buyers into those homes.

But mortgage lenders ran out of qualified buyers—who, in most cases, make a 20 percent down payment and have a high enough income to cover the monthly mortgage payments, with an interest rate determined by the borrower’s credit score—and still had a ton of homes to fill, so they started cutting corners. Subprime mortgages, or mortgages to people with low credit scores, exploded in the run-up to the crisis. Down payment requirements gradually dwindled to nothing. Lenders began turning a blind eye to income verification. Soon, there was a flood of risky types of mortgages designed to get people into homes who couldn’t typically afford to buy them.

The most notorious of these loans was the 2/28 subprime adjustable-rate mortgage (ARM). It gave borrowers a below-market “teaser” rate for the first two years. After two years, the interest rate “reset” to a higher rate, which often made the monthly payments unaffordable. The idea was to refinance before the rate reset, but many homeowners never got the chance before the crisis began and credit became unavailable.

Home flippers and real estate investors helped inflate the housing bubble by buying houses, holding them for a brief period, and then flipping them for a tidy profit. One study concluded that real estate investors with good credit scores had more of an impact on the crash because they were willing to give up their investment properties when the market started to crash. They actually had higher delinquency and foreclosure rates than borrowers with lower credit scores.

Other data, from the Mortgage Bankers Association, examined delinquency and foreclosure starts by loan type and found that the biggest jumps by far were on subprime mortgages—although delinquency rates and foreclosure starts rose for every type of loan during the crisis.

Early-stage mortgage delinquencies started piling up in 2006, with the delinquency rate on subprime ARMs going from roughly 12 percent at the beginning of 2006 to well over 20 percent by 2008. It peaked later, in 2010, at almost 30 percent.

Cash-out refinances, where homeowners refinance their mortgages to access the equity built up in their homes over time, left homeowners little margin for error. When the market started to drop, those who’d taken money out of their homes with a refinancing suddenly owed more on their homes than they were worth. Instead of making their monthly payments, these people defaulted on their mortgages.

When homeowners stop making payments on their mortgage, the payments also stop flowing into the mortgage-backed securities. The securities are valued according to the expected mortgage payments coming in, so when defaults started piling up, the value of the securities plummeted.

By early 2007, people who worked in MBSs and their derivatives—collections of debt, including mortgage-backed securities, credit card debt, and auto loans, bundled together to form new types of investment bonds—knew a calamity was about to happen. That July, two prominent hedge funds at the investment bank Bear Stearns imploded due to heavy exposure to MBSs and derivatives backed by MBSs, and the bank was purchased in March 2008 by JPMorgan Chase for a bargain-basement price of $2 per share.

Panic swept across the financial system. Financial institutions were afraid to make loans to other institutions for fear they’d go under and not be able to pay back the loans. Like homeowners who took cash-out refis, some companies had borrowed heavily to invest in MBSs and could quickly implode if the market dropped, particularly if they were exposed to subprime.

Uncertainty over the housing market sent stock prices for Fannie Mae and Freddie Mac plummeting in the summer of 2008. The Bush administration felt it had no choice but to take over the companies in September to keep them from going under, but this only caused more hysteria in financial markets.

As the world waited to see which bank would be next, suspicion fell on the investment bank Lehman Brothers. Companies stopped doing business at the bank, and while the government helped broker the sale of Bear Stearns to JPMorgan, it let Lehman Brothers fail. On September 15, 2008, the bank filed for bankruptcy. The next day, the government bailed out insurance giant AIG, which in the run-up to the collapse had issued staggering amounts of credit-default swaps (CDSs), a form of insurance on MBSs. With MBSs suddenly worth a fraction of their previous value, bondholders wanted to collect on their CDSs from AIG, which sent the company under.

The implosions of these “too big to fail” financial institutions sent the equity and housing markets into free fall, with major institutions selling assets to gain the liquidity they lost when credit locked up at the beginning of the crisis. And because foreign entities did business with and parked their wealth in American financial institutions, the crisis dominoed across the world economy.

What began as ill-advised American mortgage lending became an unprecedented global financial crisis.

How has mortgage finance changed—or not—since the crisis?

Deregulation of the financial industry tends to be followed by a financial crisis of some kind, whether it be the crash of 1929, the savings and loan crisis of the late 1980s, or the housing bust 10 years ago. But though anger at Wall Street was at an all-time high following the events of 2008, the financial industry escaped relatively unscathed.

In fact, much of the mortgage securitization chain remains intact today. Lenders still sell their mortgages to Fannie Mae and Freddie Mac, which still bundle the mortgages into bonds and sell them to investors. And the bonds are still spread throughout the financial system, which would be vulnerable to another American housing collapse.

While this understandably elicits alarm in the news media, there’s one key difference in housing finance today that makes a financial crisis of the type and scale of 2008 unlikely: the riskiest mortgages—the ones with no down payment, unverified income, and teaser rates that reset after two years—are simply not being written at anywhere close to the same volume. It is much harder to get a mortgage today.

The “qualified mortgage” provision of the 2010 Dodd-Frank reform bill, which went into effect in January 2014, gives lenders legal protection if their mortgages meet certain safety provisions. Qualified mortgages can’t be the type of risky loans that were issued en masse prior to the crisis, and borrowers must meet a certain debt-to-income ratio.

Fannie Mae and Freddie Mac, which have been under government conservatorship since the federal takeover in September 2008, will only buy qualified mortgages for mortgage bonds. At the same time, banks aren’t issuing MBSs at anywhere close to the same volume as they did prior to the crisis, because investor demand for private-label MBSs has dried up.

In 2006, at the height of the housing bubble, banks and other private institutions—meaning not Freddie Mac, Fannie Mae, or Ginnie Mae—issued more than 50 percent of MBSs, compared to around 20 percent for much of the 1990s. According to the Urban Institute, a Washington, D.C., think tank focused on economic and social policy, MBS issuance for these institutions is not even 5 percent of the total market today, meaning Freddie Mac, Fannie Mae, and Ginnie Mae are issuing 95 percent of mortgage bonds.

And because those agencies will only buy qualified mortgages, the mortgages in the bonds adhere to much higher lending standards than many of the bonds issued in the run-up to the collapse in 2008. That’s not to say they’re risk free; a borrower can always lose their job, get a divorce, or go through a life event that causes them to miss mortgage payments.

Macroeconomic events like a recession would certainly impact the bonds just as they would any financial instrument, but the mortgage market itself is more stable because of the qualified mortgage provision. As a result, serious mortgage delinquency rates and foreclosure rates have dwindled to practically nothing since the crisis.

Subprime mortgage bonds, the most toxic of the MBSs during the financial crisis, are virtually nonexistent in the market today (although there is still roughly $400 billion in outstanding subprime MBSs issued before the crisis). In 2006, subprime MBS issuance topped out at $933 billion. There’s been a slight uptick in subprime mortgage bond issuance in the last two years, but in 2017 it was still just $5.6 billion.

The MBS derivative instruments received their fair share of the blame for the crisis, as repackaging mortgage bonds into opaque and unregulated financial instruments made the crisis harder to see coming. Those instruments went extinct almost overnight after the crisis; versions of them still exist, but they typically don’t contain mortgage bonds.

The financial industry’s absence from mortgage bond issuance and the Dodd-Frank qualified mortgage provision have made mortgage credit much tighter, a needed change after the freewheeling days of the mid-2000s. But some in the housing industry believe lending standards have swung from one extreme (lending to anyone and everyone) to the other (lending only on the terms of the qualified mortgage), needlessly keeping some qualified buyers out of the market.

Homeownership in the U.S. peaked in 2004 at 69 percent. Today, despite a recent uptick, homeownership remains at 64 percent. Laurie Goodman of the Urban Institute argues that more “reasonable lending standards”—she points to the early 2000s, prior to the explosion of subprime lending—would bring the industry back to a comfortable middle ground.

With MBSs behind them, Wall Street players have found new ways to capitalize on housing. Private equity firms bought foreclosed single-family homes in bulk after the crisis and formed companies like Invitation Homes and American Homes 4 Rent to rent them out. While these companies currently own a fraction of the total number of single-family rental units in America, they have eyes on expansion by buying homes or even entire neighborhoods from home builders.

Having a single-family home with a white picket fence has been the image of American success since the GI bill sought to increase homeownership in the aftermath of World War II. But tight mortgage credit, skyrocketing student loan debt, and a housing shortage have caused a fundamental shift toward renting. Homeownership, once deemed a requirement for economic mobility in the U.S., may no longer be an attainable part of the American dream.