The MIT Sloan School of Business recently published an article that examines the role of middle-class borrowers in the 2008 housing collapse.
Sloan professor of finance Antoinette Schoar, along with Duke’s Manuel Adelino and Dartmouth’s Felipe Severino, took a long, hard look in her research for “Loan Originations and Defaults in the Mortgage Crisis: The Role of the Middle Class,” a new paper due for publication in Oxford Journals-The Review of Financial Studies.
Schoar’s research has already begun to propel a new narrative about the crisis, with many high-profile reassessments from economists. “A lot of the narrative of the financial crisis has been that this [loan] origination process was broken and therefore a lot of marginal and unsustainable borrowers got access to funding. In our opinion, the facts don’t line up with this narrative.”
The paper illuminates that “credit and defaults expanded proportionally across borrowers of every income level and every credit rating.” But when the bad got ugly, she and her colleagues discovered that “there was a sharp increase in delinquencies” for so-called “prime” borrowers. In fact, 13 percent of debt in 2003 and 23 percent in 2006 could be traced back to this prime segment of borrowers, while so-called “subprime” borrowers saw their “debt drop from 22 percent in 2003 to 11 percent in 2006.”
Post-crisis, subprime borrowers defaulting “increased from 6 to 12 percent” while prime borrowers went from “0 to 5-6 percent,” with “the latter defaulting on bigger loans.” It’s understandable now why Schoar publicly refers to it as a prime, rather than subprime crisis.
Schoar attributes this disparity to the exponential growth of house flipping between 2002 and 2006. “It points to the fact that households as well as banks really believed in this house price appreciation and thought that it was sustainable. And they acted on this feeling that they were richer because their home was worth more. This was a house price bubble that you could say most people in the economy seem to have bought into.”
She believes policymakers should develop effective strategies to insulate the banking industry from “a decline in housing prices” by being prepared to “absorb these types of losses” and “increase the burden on creditors.”
She believes that contingent convertible bonds (CoCos), which “convert to equity in the event of impending bank failure” and are currently “undergoing a test in the European markets,” could be one successful way to stabilize a bank before bankruptcy can occur.