No Money Down the Culprit

Living and working in the center of the national foreclosure crisis keeps one's interest piqued in the many theories that abound as to what happened...and what will happen next. While much of the media has focused on subprime loans, there is hard data that shows that subprime loans were just part of the sideshow.

Since I'm a numbers guy at heart, I put the most stock in the analyses that take an objective look at the numbers. In last week's Wall Street Journal, a University of Texas professor presented findings that were based on the analysis of over 30 million mortgages. While subprime loans were one of the culprits that led to this mess, negative equity was the biggest contributor to homes going into foreclosure. Here is an excerpt from the article:

Many policy makers and ordinary people blame the rise of foreclosures squarely 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.

But the focus on subprimes ignores the widely available industry facts (reported by the Mortgage Bankers Association) that 51% of all foreclosed homes had prime loans, not subprime, and that the foreclosure rate for prime loans grew by 488% compared to a growth rate of 200% for subprime foreclosures. (These 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.

He goes on to note that mortgage resets (common in subprime loans) were a minor factor and that while only 12% percent of homes had negative equity, they were 47% of all foreclosures.

The conclusion of this article should be disconcerting for our federal and state policymakers, who seem to focused on bailing out owners with bad loans. The author notes:

The difference in policy implications is enormous: A significant reduction in foreclosures will happen when and only when housing prices stop falling and unemployment stops rising.

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.

His solution is much more simple, we go back to the way residential real estate used to function:

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.

To read the article in its entirety, click here.