Underlying the recent turmoil in the banking industry are the rising level of foreclosures and the apparent spread of the foreclosure contagion from the subprime to the prime market. Presidential candidates and economists alike have come forward with a variety of proposals to respond to the crisis, yet all share two underlying assumptions—first, that rising foreclosures can be explained by a single cause; second, that Washington can and should act to reduce the number of foreclosures. Both assertions are contestable, and in fact, acting aggressively to reduce foreclosures could be counterproductive and even worsen current economic problems.
Concerns about widespread foreclosures are indeed justified. Rampant foreclosures threaten the stability not only of financial markets but also of neighborhoods. Foreclosures depress the values of neighboring homes (although studies disagree about the full extent and duration), and this externality effect can set off a vicious circle that spawns further foreclosures and imperils local governmental services.
On the other hand, it is not obvious what Washington can or should do to reduce foreclosures.
Three basic causes have dovetailed to contribute to the extraordinary foreclosure rates we now see, yet each of them suggests different, and even contradictory, policy responses. More important, the foreclosure problem is not uniform throughout the country but rather is the aggregation of several foreclosure “hot spots,” thus adding a geographic dimension to the problem that complicates any uniform national solution.
Cause No. 1: Adverse “trigger events.” A foreclosure can be caused by a job loss, divorce, illness, or something else that leads to an unexpected, dramatic drop in household income or increase in expenses. Although many of these are chronic and universal features of the human condition, others can cause foreclosure spikes in particular places at particular times. Major natural disasters, such as Hurricane Katrina, can leave a trail of foreclosures in their wake. Foreclosures today are unusually high in economically struggling areas with major job loss, such as Michigan, Ohio, and Indiana.
Where foreclosures are the result of local macroeconomic conditions, staving off foreclosures may prove counterproductive. Research shows that negative home equity limits labor-market mobility by locking home owners into their investment and making them disinclined to move. Although a bitter pill to swallow, foreclosure may do involuntarily what these home owners are reluctant to do on their own: surrender their homes and move to more prosperous parts of the country. Policies that discourage foreclosure also discourage these home owners from moving, reinforcing this lockin effect at the very moment when greater labor-market flexibility is needed.
Cause No. 2: Mortgage payment shock. Foreclosure can also result from an unexpected increase in a household’s monthly payment obligations. In recent years, many foreclosures have resulted from the proliferation of adjustable-rate and “hybrid” ARM loans, with an initial fixed period followed by adjustable rates. The easy-money policies followed by the Federal Reserve in the wake of the September 11, 2001, terrorist attacks opened up a substantial gap in market interest rates between shortterm and long-term mortgages. Tightening the Fed monetary policy closed this gap, triggering resets on mortgage payments at higher rates. Borrowers who took ARMs initially were able to qualify for much larger principal amounts than was possible at long-term interest rates. Many of the states with the greatest percentage of ARMs (especially California and Florida) also saw the fastest run-ups in housing prices—and now the highest foreclosure rates.
But the popularity of ARMs in recent years is not unprecedented, and fixed-rate mortgages are not necessarily a better option. In 1984, ARMs made up 61 percent of the conventional mortgage market; in 1988, the figure was 58 percent. Moreover, ARMs (with average loan terms substantially shorter than the thirty-year term in the United States) are standard fare in the rest of the world, where efforts to introduce the American thirty-year fixed-rate mortgage have generally failed. And, of course, the risk that ARMs will cause one’s mortgage payments to rise is offset by the automatic downward ratchet when interest rates fall. Fixed-rate mortgages provide home owners with insurance against fluctuations in interest rates, but this insurance is far from free: borrowers pay about 100 basis points on average to avoid bearing this risk. This insurance can turn out to be a bad bet when interest rates fall, as during the Fed’s easy-money days. As then–Fed chairman Alan Greenspan noted in 2004, those who had ARMs during the preceding several years saved tens of thousands of dollars in reduced interest rates over those with fixed-rate mortgages. Hybrid loans and ARMs also can benefit those who expect to move within a few years.
The relative popularity of ARMs in the market tends to closely track the relative spread between short- and long-term interest rates, and the past several years were no different. This also meant that ARMs are not merely a subprime phenomenon—in fact, the foreclosure rate on prime ARMs has been rising faster than that of subprime ARMs (from a smaller percentage base). Foreclosures on both prime and subprime fixed-rate mortgages, by contrast, have risen more slowly.
Efforts to address the adjustment problem by refinancing ARMs as fixedrate mortgages raise questions of fairness. Those who locked in fixed-rate mortgages in the past have paid for this insurance against rate changes with higher rates, even as those with ARMs benefited from low interest rates for several years.
Cause No. 3: Negative home equity. Foreclosure can also result from negative home equity. Economists model the decision to default and allow foreclosure as a “put option” held by the home owner. When the home is underwater (worth less than what is owed on it), the home owner has an incentive to default and give the home to the bank. This option is especially attractive to those who may have purchased the home for its investment value—either to “flip” it rapidly or to occupy it as an alternative to renting, hoping its value will rise—rather than for the amenities of living there.
Other factors may increase the value of the home owner’s put option, such as state laws that deem home mortgages to be nonrecourse debts. These laws limit the lender to foreclosure of the property in the event of default and prohibit the bank from recovering any shortfall from the debtor personally. Fewer than a dozen states have full-blown nonrecourse, or antideficiency, laws, but those that do are among those with the highest levels of foreclosure (California is the most notorious example). Empirical studies have documented the dramatic effect that a nonrecourse law has on encouraging rational default by borrowers when home prices fall.
Other factors may also increase the value of the foreclosure put option, such as the length and formality of state foreclosure processes. The borrower is relieved of the obligation to make loan payments when the home is in foreclosure, and thus in states with extended foreclosure processes (again, such as California) the home owner can live essentially rent-free for up to a year. In fact, in some markets, entrepreneurs are expert at buying homes in foreclosure and then renting them out for the period that they are in foreclosure, using legal and other processes to extend that period as long as possible.
Lenders take account of state antideficiency laws and foreclosure processes at the time they extend credit. Borrowers in states with antideficiency protections pay higher interest rates and are more likely to be rejected for loans than those in other states.
Economists refer to this decision to allow foreclosure of an underwater property as ruthless default. The home owner could continue to make payments but decides voluntarily and rationally to allow foreclosure instead. In that sense, the occupants are more like renters than home owners, and the case for bailing them out is more difficult to justify than for those who would like to keep their homes but are unable to because of payment shock.
Moreover, to the extent that variation in foreclosure rates results from differences in state laws (such as antideficiency laws), the problem seems as if it should be addressed in Sacramento or Phoenix, not Washington. Lenders were compensated for the increased riskiness of loans in states where borrowers have the option of defaulting with minimal pain. It is not clear why taxpayers in the rest of the country should pay again to bribe those borrowers to stay in their homes rather than walk away.
There is no one-size-fits-all explanation for the rise in foreclosures or a single response to the problem. Because many of the causes of the problems lie in state and local laws and economic conditions, perhaps many of the solutions lie there as well.