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Did Weak Lending Standards Really Drive the Crisis?

Many commentators assume so. But the role of declining lending standards may be overstated.

In a new Atlanta Fed paper, Kristopher Gerardi, Adam Shapiro, and Paul Willen take a look at Massachussets home prices over two housing cycles from 1989 and 2008 and conclude that falling home prices (rather than weak underwriting standards) played the key role in the crisis:

[H]ad prices not fallen, we would simply not have had a major foreclosure crisis, regardless of whether lenders had lowered underwriting standards in 2003 and 2004. By contrast, the observed fall in prices would have generated a substantial increase in foreclosures, even if lenders had retained the underwriting standards that prevailed in 2002. To be sure, the increase in foreclosures would have been substantially smaller without subprime lending because as we show that subprime loans are far more sensitive to a decline in house prices than prime loans, but the foreclosure rate would still have been very large relative to historical levels, and would have been still considered a major public policy problem.

(Gerardi and Willen also wrote the Boston Fed paper on walk-aways that I've referred to frequently.)

The following chart from the paper shows the researchers' estimates for the effects of lending standards and home prices on foreclosures:

Here's how to interpret it: People who bought in 2002 experienced much better price gains than those who bought in 2005. At the same time, the creditworthiness of borrowers declined between 2002 and 2005, since subprime had been a much smaller segment of the market earlier on.

The blue dotted line shows what would have happened if people who bought in 2002 actually experienced 2005 price changes. If foreclosure levels were high, then that would imply that declining standards were the main driver, but that's not what we see. The dotted red line shows what would have happened if the better credit quality borrowers from 2002 had actually bought homes in 2005. The fact that foreclosures are much higher in this scenario again suggests that it's house price changes and not lending standards that had the biggest impact on foreclosures:

Subprime’s contribution to the crisis, therefore, was as an accelerant but not as the root cause. Fifteen percent of buyers in 2005 had some cocktail of problematic credit history, high payments and high LTV’s which would lead to a high likelihood of cash-flow problems. However, the logic of the lenders that made the loans was that those borrowers could either sell or refinance in that event, an outcome that became problematic when house prices began to fall in 2005.