Most Mortgage Remedies Miss Real Causes of Foreclosure Crisis

Published August 31, 2009

What is really behind the mushrooming rate of mortgage foreclosures since 2007?

The evidence from a huge national database containing millions of individual loans strongly suggests the single most important factor is whether the homeowner has negative equity in a house—that is, the balance of the mortgage is greater than the value of the house. This means that most government policies being discussed to remedy woes in the housing market are misdirected.

Many people blame the rise of foreclosures on subprime mortgage lenders who presumably misled borrowers into taking out complex loans at low initial interest rates. Those hapless individuals were then supposedly unable to make the higher monthly payments when their mortgage rates reset upwards.

Prime Loans More Trouble

But the focus on subprimes ignores the widely available industry facts, reported by the Mortgage Bankers Association, that 51 percent of all foreclosed homes had prime loans, not subprime, and that the foreclosure rate for prime loans grew by 488 percent compared to a growth rate of 200 percent for subprime foreclosures. Those percentages are based on the period since the steep ascent in foreclosures began—the third quarter of 2006—during which more than 4.3 million homes went into foreclosure.

Sharing the blame in the popular imagination are other loans where lenders were largely at fault—such as “liar loans,” where lenders never attempted to validate a borrower’s income or assets.

This common narrative also appears to be wrong, based on my analysis of loan-level data from McDash Analytics, a component of Lender Processing Services Inc. It is the largest loan-level data source available, covering more than 30 million mortgages.

Positive Equity Major Factor

The analysis indicates that, by 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). Although only 12 percent of homes had negative equity, they comprised 47 percent of all foreclosures.

Further, because it is difficult to account for second mortgages in this data, my measurement of negative equity and its impact on foreclosures is probably too low, making my estimates conservative.

What about upward resets in mortgage interest rates? I found interest rate resets did not measurably increase foreclosures until the reset was greater than four percentage points. Only 8 percent of foreclosures had an interest rate increase of that much. Thus the overall impact of upward interest rate resets is much smaller than the impact from equity.

Although the government is throwing money—almost $2 trillion and counting—at the mortgage markets with the intent of stabilizing house prices, its methods are poorly targeted. While Federal Reserve actions have succeeded in reducing mortgage interest rates, low interest rates induce refinancings more than they do home purchases. And the suggestions being put forward by the administration and most media outlets—more stringent regulation of subprime lenders—would not have prevented the mortgage meltdown regardless of their merit otherwise.

Need for Stronger Underwriting

Rather, stronger underwriting standards are needed—especially a requirement for relatively high down payments. If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell.

A further beneficial regulation would be a strengthening, or at least clarifying at a national level, of the recourse that mortgage lenders have if a borrower defaults. Many defaults could be mitigated if homeowners with financial resources know they can’t just walk away.

We are at a crossroads where we can undo the damage to the housing market by strengthening underwriting standards in a reasonable way. But to do so, political leaders must face up to the actual causes of the mortgage crisis, not fictitious causes that fit political agendas and election strategies.

Stan Liebowitz ([email protected]) is professor of economics and director of the Center for the Analysis of Property Rights and Innovation at the University of Texas-Dallas and a Heartland Institute policy advisor. An earlier version of this article appeared in the July 3 edition of The Wall Street Journal. Used with permission.