How Banks Inflated the Housing Bubble, and Why Some Cities Were Spared

Why have some U.S. housing markets gotten creamed during the financial crisis while others were spared? OK, that's a complicated question. But lending patterns -- specifically, the degree to which banks pushed subprime or nonprime loans in particular communities -- turn out to be a surprisingly important factor.

The hardest-hit U.S. housing markets tend to draw the most attention. (If it bleeds, it leads.) But it can be even more instructive to zero in on what have emerged as the most resilient markets. Take, say, Ithaca, New York, and Honolulu. Although these are very different communities, they have a common ingredient when it comes to housing -- relatively low levels of nonprime lending.

As in much of the U.S., home prices in both cities rose in the six years preceding the housing crash. Notably, however, Ithaca and Honolulu home values continued to climb even after housing cratered in 2007. That makes the two metropolitan areas among the lucky cities around the country that have thrived throughout the crisis.

Generally speaking, regions with lower levels of nonprime lending showed much less fluctuation in real estate prices, according to new research out of the New York Federal Reserve. By contrast, metro areas where home values rose the fastest and which had the most nonprime borrowers during the preceding economic boom tended to see the greatest price drop after the bust. In other words, aggressive lending amplified the unusually large boom-and-bust cycle witnessed during the housing collapse.

For instance, many parts of California and Florida saw real estate prices soar 15 to 20 percent -- per year! -- between 2000 and 2006. When the dam broke a couple years ago, home values fell by roughly the same margin.

Metro areas that saw the highest peaks and valleys in home prices -- places like Las Vegas, Punta Gorda, Fla., and Stockton, Calif. -- had the highest penetration of nonprime lending, at roughly 82 loans per 1,000 households, compared with a national average of 55.

Conversely, areas like upstate New York and Hawaii that had relatively little nonprime lending experienced virtually no bust. By the same token, they also saw little boom when home values in other parts of the country were soaring.

Put another way, areas with many weaker borrowers were a good place to buy property if you were looking for rapid appreciation. But once the bottom fell out, prices plunged.

Despite all the headlines during the housing crisis, that's been the prevailing trend across most U.S. metro areas. Other cities that mostly proved immune to the boom-bust epidemic are found along the Eastern coastline, in the Pacific Northwest (especially around Portland and Seattle) and in a handful of other states (see map at bottom).

Now for a trickier question -- what accounts for that link between nonprime lending and home prices? Here's the researchers' explanation:

... the availability of nonprime loans would have expanded the supply of credit by providing �nancing opportunities to those unable to obtain prime mortgages. This trend in turn would have brought more buyers into the housing market, driving up the demand for housing and, all else equal, increasing home prices.

Now, of course, we know better. Among the many myths shattered during the financial crisis was that our homes, sweet, homes are perpetual money machines. As this latest research shows, the picture is far more complicated.

Images courtesy of Flickr and the Federal Reserve Bank of New York