Causes of Foreclosure:
Easy money
4 Jul 2009 in Regulatory Economics, Regulatory Policy
The collapse of the housing bubble, with 20% to 50% reductions in home values across wide swaths of the country, has led to an extraordinary high rate of foreclosures. The federal government has responded with various programs to "help people stay in their homes." These programs have one or two typical features: (1) lower interest rates, (2) forgiveness of some portion of the loan principal, (3) forbearance of nonpayment for some period of time, or some combination thereof.
These remedies have in common a similar diagnosis: foreclosures are rising because some aspect of the mortgage changed such that borrowers suddenly found themselves unable to afford the payments. Typically, what is presumed to have changed is that a low "teaser" rate ended, and the house was no longer affordable when the interest rate reset to market levels.
New research raises doubt about that diagnosis.
Stan Liebowitz, professor of economics and director of the Center for the Analysis of Property Rights at the University of Texas at Dallas, writes in a Wall Stret Journal commentary:
[B]y far, the most important factor related to foreclosures is the extent to which the homeowner now has or ever had positive equity in a home. The accompanying figure shows how important negative equity or a low Loan-To-Value ratio is in explaining foreclosures (homes in foreclosure during December of 2008 generally entered foreclosure in the second half of 2008). A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures.
Liebowitz says the predominant cause of both the housing bubble and its bursting was lax underwriting standards. That is, lenders wrote mortgages for hundreds of thousands of borrowers who put little or none of their own money at risk -- they had "no skin in the game." This conclusion is based on empirical research Liebowitz conducted on a sample of 30 million mortgages.
The resetting of "teaser" interest rates is a small contributor, and while so-called subprime mortgages explain some of the problem they do not dominate. That leaves weakened underwriting standards: lender decisions, fully supported and indeed encouraged by legislators and regulators, to increase the rate of homeownership by offering loans with little or no money down. (The bottom bar in the graph is a secondary wave of the foreclosure crisis. It is caused by the recession, not by the bursting of the housing bubble per se.)
These loans typically were sold to Fannie Mae, which packaged them for sale to investors in mortgage-backed securities with the implicit guarantee of federal taxpayers. (With Fannie Mae now in receivership, that implicit guarantee is now explicit.)
A related paper by Liebowitz is here.
Liebowitz, Stan J., Anatomy of a Train Wreck: Causes of the Mortgage Meltdown. Available at SSRN: http://ssrn.com/abstract=1211822 (forthcoming as chapter 2 in Powell B and Holcomb R, eds: Housing America: Building Out of a Crisis, Transaction Publishers, 2009.
Abstract:
Why did the mortgage market melt-down so badly? Why were there so many defaults when the economy was not particularly weak? Why were the securities based upon these mortgages not considered anywhere as risky as they actually turned out to be? It is the thesis of this paper that, in an attempt to increase homeownership, particularly by minorities and the less affluent, an attack on underwriting standards was undertaken by virtually every branch of the government since the early 1990s. The decline in mortgage underwriting standards was universally praised as an 'innovation' in mortgage lending by regulators, academic specialists, GSEs, and housing activists. This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble. The bubble increased the number of housing speculators with estimates indicating that one quarter of all home sales were speculative sales prior to the bubble bursting. The recent rise in foreclosures is not related to the subprime/prime distinction since both markets had similar size increases in foreclosures that occurred at exactly the same time. Instead, the adjustable-rate/fixed-rate distinction is the key to understanding the rise in foreclosures. This is consistent with speculators turning and running when housing prices stopped rising. It is not consistent with the nasty-subprime-lender hypothesis currently considered to be the cause of the mortgage meltdown.
