Goldman Sachs Fraud Charge: U.S. Home Ownership: Background, Part 3

The last two posts have covered (1) the policies advanced by the Clinton and Bush administrations to increase homeownership, and how effectively they worked in a short period of time, increasing the proportion of Americans homeowners from the low-to-mid 60 percent range to 69 percent by 2005, and (2) the flow of mortgage lending into that increase, and the resulting surge in home prices.

The factor that kept home ownership so steady was the nature of mortgage lending. Borrowers had to have verifiable jobs, loans were limited to twice their income, and they had to produce substantial down payments. Those were prime mortgages.

To make loans to the new layer of homeowners, the credit standards had to be eased. Higher risk, subprime mortgages had been around, but weren't a big force until the mid-2000s. Below is a chart from a Fed paper showing the share of subprime mortgages, note how the rise in subprimes coincides with the surges in lending, prices and home ownership in the small graphs from yesterday's Part 2:

As we know, making lower quality loans did not work out. Or at least not when their numbers grew so fast. Here's what Fed Chairman Ben Bernanke said about credit quality in an address to the Federal Reserve Bank of Chicago's 43rd Annual Conference on Bank Structure and Competition, in May 2007. Things had started to turn, but it was still possible to make a positive case:

In general, mortgage credit quality has been very solid in recent years. However, that statement is no longer true of subprime mortgages with adjustable interest rates, which currently account for about two-thirds of subprime first-lien mortgages or about 9 percent of all first-lien mortgages outstanding. For these mortgages, the rate of serious delinquencies -- corresponding to mortgages in foreclosure or with payments ninety days or more overdue -- rose sharply during 2006 and recently stood at about 11 percent, about double the recent low seen in mid-2005. The rate of serious delinquencies has also risen somewhat among some types of near-prime mortgages, although the rate in that category remains much lower than the rate in the subprime market. The rise in delinquencies has begun to show through to foreclosures... Subprime mortgages accounted for more than half of the foreclosures started in the fourth quarter.

...

How will developments in the subprime market affect the evolution of the housing market? We know from data gathered under the Home Mortgage Disclosure Act that a significant share of new loans used to purchase homes in 2005 ... were nonprime (subprime or near-prime). In addition, the share of securitized mortgages that are subprime climbed in 2005 and in the first half of 2006. The rise in subprime mortgage lending likely boosted home sales somewhat, and curbs on this lending are expected to be a source of some restraint on home purchases and residential investment in coming quarters. Moreover, we are likely to see further increases in delinquencies and foreclosures this year and next as many adjustable-rate loans face interest-rate resets.

All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well. Past gains in house prices have left most homeowners with significant amounts of home equity, and growth in jobs and incomes should help keep the financial obligations of most households manageable. (Emphasis added.)

More to the point, his comments provided a ready-made thesis for investors wanting to play the subprime market. Depending on whether your glass was half-full or half-empty, investing in subprime mortgages would either be a sound investment with higher yields in a growing economy, or a way to take advantage of the cyclical drop, amplified by the subprime excesses, sure to come in U.S. housing.

Stay tuned for Part 4 where I will finally get to what's up with Goldman and the fraud charges.