Jan. 12, 2011
Research shows extent of damage to stock market by housing collapse
A new study by University of Iowa finance researchers shows that the ongoing housing market collapse rippled into the stock market in ways that previous collapses had not.
The result, they suggest, is a significantly larger amount of damage to the economy than what was caused by the previous housing bust and that will take even longer to fix .
“Our research suggests worse financial conditions for a longer spell than the earlier housing-led downturn,” Tippie College of Business finance professors Jon Garfinkel and Jarjisu Sa-Aadu conclude in their paper, “Houses, Banks and Financial Markets: Why the Crisis This Time?”
Garfinkel and Sa-Aadu compared housing prices, bank stock performance and the S&P 500 during the first two years of the current bust---from 2006 to 2008—to the 1990-91 housing market collapse. Both bank profits and the stock market tanked at the outset of the current bust, setting it apart from the 1990 bust that had little impact on bank performance or stock prices.
They said this was because of significant changes in the nature of mortgage lending between the 1980s and the 2000s. The current slump was caused in part by excessive and imprudent mortgage lending by banks using financial tools that were used less frequently in the previous decade, such as derivatives and mortgage backed securities.
In addition, lending in the most recent boom period was heavily dependent on adjustable rate mortgages, many of which required little equity from the homeowner. These mortgages gave homeowners an incentive to simply walk away from the house when they could no longer afford their monthly payments because they had little equity to lose.
This wasn’t the case during the 1980s housing boom, when banks still required customers to make down payments and build equity, discouraging homeowners from walking away from their mortgage. As a result, banks in the 1990s weren’t saddled with the ownership of thousands of empty foreclosed homes, as they are today.
Their research also showed the 1980s run-up in prices was driven by banks responding to a strong economy that improved their own financial condition. That performance prompted increased lending, which drove up housing prices.
In contrast, their research found no connection whatsoever between bank performance and housing prices in the most recent boom. “This suggests other factors, such as the subprime or non-bank real estate lending boom, drove up housing prices,” they said.
“Overall, there are real differences in the links between housing, banks and stocks across the two episodes,” said Garfinkel and Sa-Aadu. “In the recent episode, housing leads banks, whereas it did not in the prior episode. This apparently feeds into stocks, implicitly linking housing with the stock market in a way that was not evident during the prior episode.”
Ironically, they said the use of such financial tools as derivatives, mortgage backed securities and other forms of securitization were originally intended to reduce a bank’s risk in mortgage lending. Instead, they only left the banks even more highly exposed.
Garfinkel and Sa-Aadu delivered their paper in December at the Australian Finance and Banking Conference.
STORY SOURCE: University of Iowa News Services, 300 Plaza Centre One, Suite 371, Iowa City, Iowa 52242-2500