UCLA Housing Voice

Highlights: Ep. 106. Mortgage Lending Standards with Kevin Erdmann

• UCLA Lewis Center for Regional Policy Studies • Season 5 • Episode 11

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This is the shortened "highlights" version of episode 106. You can listen to the full interview here.

Was the housing market really oversupplied in the mid-2000s? Kevin Erdmann says no, and he explains how this misunderstanding is at the root of present-day affordability problems. This is part 8 of our series on misaligned incentives in housing policy.

Show notes:

Shane Phillips 00:00:00
Hello, party people. I wanted to try out something new, so I took our most recent episode and cut it down to a third its original length. I suspect most of our listeners appreciate our hourlong format and the depth that it allows, but I also know it can be a barrier. If you think this truncated format has some value, or if it could with some revisions, let us know. And if it's not your cup of tea, not to worry, because if we make these shorter episodes a regular feature then it'll be alongside the longer ones, not replacing them. They take a lot of time to put together though — As the saying goes, "I would have written a shorter letter, but did not have the time." — so I want to be sure it's an investment our listeners get something out of. Tell me what you think. Listen for my email and our Substack url up ahead.

Kevin Erdmann 00:00:57
...because we collapsed construction across the country through mortgage regulation, so that the supply conditions changed uniformly across the country, now every city looks a little bit more like Los Angeles. In 2005, we completed about 2 million homes, and by 2012 it was down to 600,000. For the past decade, we basically have been a country that needs 2 million homes a year that was only capable of completing 1 million.

Shane Phillips 00:01:29
Hello! This is the UCLA Housing Voice podcast, and I'm your host, Shane Phillips. This is episode 8 in our ongoing Incentives Series, supported by UCLA's Center for Incentive Design. Kevin Erdmann is joining us this time to do some mythbusting about the mid-2000s housing market leading up to the crash and the Global Financial Crisis, the policy response in terms of federal mortgage lending standards, and its catastrophic effect on homeownership, rental affordability, and housing production. As we discuss, tightening of lending standards leading up to and following the crash ended up shutting out roughly a third of the conventional mortgage borrowers, people with good credit scores and low borrower risk. Worse, we shut out these borrowers as a response to perceived overlending and oversupply of housing in the mid-2000s, a perception which Kevin shows quite persuasively to be false, pulling together data on housing prices, rents, mortgages, and other data from across the country. The result was a post-2008 crash that was much deeper and longer-lasting than it had to be, that decimated the construction industry even as it kept growing in peer countries like Canada and Australia, that dramatically shrank the market for new construction, that drove up rents, and that disproportionately hurt lower and middle-income households and communities. Throughout this series we've been talking about the costs of being overly cautious, and restricting mortgage credit to this degree deserves to go right to the top of the list. The Housing Voice Podcast is a production of the UCLA Lewis Center for Regional Policy Studies, with production support from Claudia Bustamante, Brett Berndt, and Tiffany Lieu. You can reach me at shanephillips@ucla.edu, or on Bluesky and LinkedIn. You can also comment on this and other episodes on our Substack, uclahousingvoice.substack.com. With that, lets get to our conversation with Kevin Erdmann.

Shane Phillips 00:03:45
Kevin Erdmann writes at a Substack called the Erdmann Housing Tracker, and he's the author of two books — Shut Out and Building From the Ground Up — and he's also a senior affiliated scholar at the Mercatus Center at George Mason University. Today he's joining us to talk about how we came out of the global financial crisis of 2007 to 2008 with much tighter mortgage lending standards and how those changes have influenced housing production, affordability, and home ownership in the years since. Kevin, thanks for joining us and welcome to the Housing Voice Podcast.

Shane Phillips 00:04:04
If Kevin is known for one thing, it is probably his argument that the thing we call the housing bubble of the mid-2000s was not really a bubble at all, but in fact, a housing shortage. It was a housing shortage, we failed to appreciate because it was limited to just a few metro areas across the country, but the impacts did not stay contained to those places, and they spread to other metros over time...

Kevin Erdmann 00:04:27
The motivating core of the story is that there were two very different types of cities during that housing boom. There were what I call the Closed Access cities, which is a very specifically New York City, Boston, San Francisco, Los Angeles, and San Diego. And San Jose, of course, along with San Francisco. And those cities are, basically across the board, just have such clamps on housing supply throughout the metropolitan area that they've effectively stopped growing. You know, we naturally tend to want to spend a given percentage of our incomes on housing. And so even with a flat population, if our real incomes go up, say 1%, people want to consume 1% more housing per capita, but the thing is, when growth is higher than that — and these cities are really only capable of growing their housing stock, by about 1% — then it actually creates this weird countercyclical population and migration trend where the better off we are, the more people have to move away from those cities to settles the housing market there. The Contagion cities — which are cities in Florida, Arizona, and Nevada — those were the destinations for those displaced families. So the shortage in the Closed Access cities is what creates the demand boom in the Contagion cities. When we're growing, the rest of the country actually has to sort of overproduce housing and overproduce economic growth to take in all these housing refugees from the Closed Access cities. So basically what happens in Arizona and Nevada and Florida is they had this surge of inmigration that they actually weren't able to keep up with. They were building houses for fundamental reasons that thousands of people were moving in.

Shane Phillips 00:06:05
I don't remember if I saw this in something I read of yours but is there another city? Is there like a Open Access city? How do you classify the places like Texas, and what was their experience? Because I think most people's understanding of the housing bubble, the housing crisis through the 2000s or the end of 2000s was that everywhere saw prices shooting up at roughly equal levels. And that's not true at all, right? There actually was not a huge run up in prices in some markets.

Kevin Erdmann 00:06:36
Yeah. In fact, most of the country. In Shut Out, I had three categories, Open Access, Closed Access, and Contagion. And Open Access was probably close to two-thirds of the country. Closed access is probably about 25%, and then about 15% would be in the Contagion areas. it's very easy to tell those markets apart because during the boom times the Open Access cities construction rates were basically flat. They were just building at the same rate. They didn't have a big boom and prices and rents were relatively stable.

Shane Phillips 00:07:11
So we had these Closed Access cities — like Los Angeles, San Francisco, New York, et cetera — that... demand was increasing. People were earning more money, but they were not building much more housing. And so we had this flow of people who just made the decision, or the decision was made for them in some cases, they just could not continue to afford the Closed Access. Someone had to leave given the rising demand, and the lack of supply to compensate. And a lot of those people went to places like Nevada and Arizona and Florida. And I think the key point for these Contagion metros is we see places like Las Vegas and Phoenix as having overbuilt during, the 2000s, and that was a problem we needed to solve. But what your research shows is, in fact, relative to the migration that was happening into those places, they were, for a while, just barely keeping up with demand. And for a very short time, they actually fell behind. And so even in these places we think of as building the most housing, being the most oversupplied, they were kind of holding steady at best. Whereas the highest demand places like Los Angeles were not keeping up at all. You don't see a boom in production at all during the 2000s in places like LA and New York. And so, you know, when you put all that together, you have some places barely keeping up, other places, not even trying to keep up. That is a housing shortage. It just looked a lot different than the one we've been more familiar with the past 10 years or so. So I think that because we have this idea of the housing crash being driven by lending too much for mortgages, and in particular lending to people who shouldn't have been getting mortgages — subprime lending. Some people might hear this explanation that you're offering and interpret it as dismissing concerns about lending to people who shouldn't have been borrowing, which did screw over a lot of people. But I think that's not your message, right? Subprime lending was a serious problem, and we were right to restrict it. It's just that too much lending in general does not stand up to scrutiny as the cause of the housing crash, and the recession, because we weren't actually overbuilding overall. Is that right?

Kevin Erdmann 00:09:23
So, yeah, there was definitely reckless lending that created a number of problems, and probably had a marginal effect of increasing the average home price by maybe 8% or so before 2008. So I would say that's all true, and then I would surround that with a number of caveats. The first caveat is that real home prices have increased by more than 50%. The other 42% has been broadly blamed on loose lending when it was really due to these fundamental causes.

Shane Phillips 00:09:49
So, summarizing here. Basically, we misdiagnosed housing supply booms in these Contagion metros as an oversupply driven by excessively lax mortgage borrowing standards, when in fact there were an entirely rational and, and really appropriately sized response to a huge wave of migration out of the Closed Access metros. And once we decided that loose lending was the cause, the obvious solution was to tighten those lending standards, which we did starting in 2008 or so to great effect. I pulled some stats from a few of your papers that help illustrate the effect of those stricter standards on borrowers — that I'm gonna share here really quickly. so these refer to credit scores, and a score in the mid-700s or above is considered very good to excellent. 670ish to 740ish is good. And below that, you're in fair to poor territory. And from 1999 to 2007, about two-thirds to three-quarters of the value of mortgage originations was for borrowers with credit scores under 760. This is the total value of new mortgages taken out in a given year. So most of that value was people with good, but not very good, not excellent credit. The rest of borrowers had scores of 760 or above. Since 2008, the ratio shifted from around 70/30 in favor of borrowers with lower credit scores to more like 50/50 or even 40/60 in favor of borrowers with higher scores. You could see a shift like that if borrowers with excellent credit just started taking out more mortgages, but that is not what happened. The shift was caused by people with average to good credit taking out many fewer mortgages. there are a lot of other stats I can point to from various posts and publications by Kevin and others, but the takeaway here is just that the average American has a much tougher time getting a mortgage today than they did in decades past. It's not really disputed as an idea, but part of what makes Kevin's work important is that it shows that these heightened mortgage standards were not a reasonable reaction to too much lending to people who shouldn't have been borrowing. It hit a whole lot of people who were perfectly capable of paying back this debt if they have the opportunity to get it. So Kevin, What caused this big rise in the average credit score of mortgage borrowers and the big drop in the share of borrowers with scores under 760? What changed both in the realm of public policy and in the private sector?

Kevin Erdmann 00:12:19
It's sort of a tough question to answer. So there's a few things, like in October 2006, the Fed published what they call the interagency guidance on non-traditional mortgage product risks. And that probably had a lot to do with the subprime markets collapsing. But again, in my point of view, the subprime markets weren't that important to the crisis. That led to that whole market basically disappearing, and it probably lowered home prices a few percentage points across 2007. So then you get to 2008. In early 2008, there's a change in the fair lending standards, what they call Regulation Z, and regulators started making changes to what they call ability to repay. Now, what gets a little bit tricky is a lot of that doesn't necessarily get codified, written down and officially made as part of lawmaking until... Dodd-Frank really happens in the summer of 2010, and the Consumer Financial Protection Bureau is created to manage all these regulations. But the change had happened before Dodd-Frank was passed, you see it very distinctly from the end of 2007 to early 2009, whether it's at Fannie Mae or whether it's across the market more broadly. There was just a steep one time spike in the average, credit score of a borrower getting a new mortgage over the course of 2008. And I think a lot of it is informal... But it's hard to pin it down because there was sort of a thousand straws thrown on the camel's back at once, and there was not a single person in this country that was gonna make a peep about it. So I just think a lot of that is sort of in the details and the informalities in the back rooms of Fannie and Freddie, where the underwriting rules are getting made up, it doesn't necessarily draw itself from some bill that Congress has passed that lays out what credit score should be approved, or what kind of income should be approved for a mortgage. And I think you could just see it so universally in the way people were acting then and the way people look back on it now. Even to this day when I suggest that we should or could have tried to avoid any of that collapse, the most common response is very much a sort of, how dare you, "oh want the NINJA loans back again." People still have a very strong reaction to interpreting the entire thing as one big bubble and bust, and they don't even want to think about it more carefully.

Shane Phillips 00:14:46
Something that I did not appreciate is how much of mortgage policy is... I guess not informal necessarily, but not enacted through law. It's decisions by different agencies that don't require Congressional approval or that kind of thing. So thinking about alternative explanations here, I think a likely one you might hear is that what has caused this change in the distribution of who is getting a mortgage is less about lending standards and more about housing prices. So higher credit scores are correlated with higher incomes, and I would guess that people with lower credit scores are also less likely to own a home already, meaning they have less wealth through that channel, and may be just less wealthy generally. And most importantly, housing has gotten a lot more expensive over the years. So how do we know that this is not just a matter of— or at least primarily a matter of housing prices rising past a level that a lot of people who don't have great credit can afford.

Kevin Erdmann 00:15:47
Yeah, actually I think the answer to that question is really key to understanding all of this, because home prices are higher because rents are higher, and those families that you're talking about are spending more of their income on rent to stay in the same old houses than they used to. And I don't think there's a mechanism other than being locked outta mortgage access and not having enough homes that would lead people to, inflate the rents they're spending on the homes they're living in. I think the short answer to your question is that you take a typical house, somewhere in a random city in the country, that was renting for $1,000 a month in 2007... adjusted for inflation, rents on that house are probably up to say $1,400 a month by 2019. And we're probably taking a larger portion of that family's income to stay in that same house. That same house in 2007 was selling at a price that would require a mortgage payment of say, $1,200 a month, and by 2019 it had a mortgage payment of maybe $600 a month. So over that period of time, the rental versus ownership price of the homes that are on the margin where people were locked outta mortgages was much more favorable to owning than it was to renting.

Shane Phillips 00:17:00
Okay. So you're saying especially in that six-ish year period after 2008, if you could get a mortgage, in many markets, you were much better off owning. And so the fact that people did not do that is a pretty strong indication that they could not.

Kevin Erdmann 00:17:16
Yeah, yeah. And of course a lot of investors came into those markets and made a killing during those years.

Shane Phillips 00:17:46
Right. Okay, so let's just take it as a fact that it has gotten much harder for people with merely good credit to get a mortgage, and therefore buy a home. I think that's pretty well established. That clearly sucks for them, and I think it's also just stupid policy at some level because there's no indication that many— most of these people are risky borrowers. They're just being excluded because we're being overly cautious, essentially, because we're overcompensating for the looser lending standards that had been in place before the financial crisis. But let's say you don't care about those people. Maybe simply because they're not you, and you've got great credit. Or maybe you think this actually benefits you because it means less competition and possibly a lower price when it comes time for you to buy a home for yourself. Tell us why even a selfish person like that should care about the impact of these overly restrictive lending standards. Connect some of these dots for us and tell us what all this means for housing production and affordability.

Kevin Erdmann 00:18:19
In a way, the screw you, I got mine position is true. Ironically, the main effect of reduced mortgage access is higher rents. Increasingly I've come to the view that the 2008 American housing market is really a massive disequilibrium. In 2005, we completed about 2 million homes, and by 2012 it was down to 600,000. And it was back up to about a million homes by 2015. And I think at that point we were basically back at capacity — that we had permanently hobbled the construction industry so that now instead of a normal cyclical recovery back to the old level, it was sort of the slow grind of redeveloping capacity over time. So I think for the past decade, we basically have been a country that needs 2 million homes a year that was only capable of completing 1 million. And that's slowly been rising. We're up to about 1.6 million new homes this year. I think so now we're in this new moment of slowly rebuilding capacity. And if we don't do anything in the marketplace policy-wise, slowly over the next 10 or 15 years, we will finally get above sustainable capacity. Rents will start to moderate. Prices will start to moderate. But the thing is, if we don't change mortgage access, I think we need probably 15 million homes, at least. If we don't change mortgage access, those 15 million extra units will have to be, on net, units owned by investors for renting households.

Shane Phillips 00:19:48
One point I want to underline here and I'm not sure if we made it clear enough yet, is that in addition to people with just good credit, let's say, being unable to get a mortgage to buy a home, I think in people's minds that's mainly existing homes. A home that's 30 years old, 70 years old, whatever. But on the production side of things, these are the people who oftentimes would've bought the home in the tract development 20 or 30 miles out of town, the people who would "drive until you qualify." And that market is gone for these builders. And so I think it's important to say here that these tightening mortgage standards have very likely reduced the market — the size of the market — for these large scale home builders. And so they're just building less. And of course, because the people they're building for have higher credit, higher income, they're gonna tend toward these truly luxury homes, really large, expensive homes. And so when people complain about not building starter homes anymore, certainly a large part of that is just zoning, but aside from, in many places it just not being legal to build a starter home, the people who would've bought them 20 years ago can't get a mortgage for it anymore. And so why would you ever build that? And so I think that as an explanation for... not just less housing production overall, but a shift toward higher end housing production is really, really critical.

Kevin Erdmann 00:21:16
Yeah, yeah.

Shane Phillips 00:21:17
So what does reform look like for you? Is this as simple as going back to the way things were in the mid-2000s, except without all the lending, or is there a different and better path available to us here? If you could change things, what would be your top priorities?

Kevin Erdmann 00:21:34
Yeah, I think it is that simple. We don't need the subprime stuff. We could go back to everything else that was happening. Before 2008 was purely functional. I always just say, if people can get the subprime stuff outta their mind, that's not what we're talking about. 2004, 1998, 2002 — go get the manual off the Fannie Mae back shelf and blow off the dust, and let's try starting over again. And in fact, I'm not sure that we could get back to a functional mortgage market by trying to reverse or engineer our way a step at a time, because of that thousand straws on the camel's back issue. I think just so much was thrown at the underwriting process at once, it's gonna be hard to do it a step at a time.

Shane Phillips 00:22:17
Who has the power to make these changes? is there a role here for Congress or the president? I do imagine this is mostly a federal issue rather than a state or local one, which is kind of unusual for the things we talk about here on the podcast.

Kevin Erdmann 00:22:30
Yeah, yeah. But ironically, I think every administration from Bush on up till today probably had a lot of leeway to just single-handedly tweak things in the underwriting process, and play around and see what would work. And it's just not been on anyone's radar. So ironically, it's probably the easiest reform in housing of all the problems we're dealing with, with zoning and all the other stuff. It's probably the easiest thing to do, it's just the elephant in the room that nobody sees.

Shane Phillips 00:23:00
Yeah. It seems to me it is entirely possible to do what you're suggesting without increasing risk for very vulnerable people. But that just does not seem to be the conversation we've been having. All right, Kevin Erdmann, this has been a great, very illuminating conversation. Thank you for joining us on the Housing Voice podcast.

Kevin Erdmann 00:23:21
Yeah. Thanks for having me. It's been a pleasure.

Shane Phillips 00:23:28
You can find our show notes and a transcript of the episode on our website, lewis.ucla.edu. Talk with us and other listeners at uclahousingvoice.substack.com. The UCLA Lewis Center is on the socials, and I'm on Bluesky and LinkedIn at @shanedphillips. Thanks for listening, we'll see you next time.

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