Monday, July 6, 2009

WSJ: No Money Down Or Negative Equity Top Source of Foreclosures

This is an opinion piece in the Wall Street Journal but with a lot of data behind it so I thought worthwhile to share. What is does is show the causes of a large ream of foreclosures and dispels some of the myths of what is causing it. We've discussed since 2007 the "walk away" situation happening as first 1 in 6 [Oct 9, 2008: WSJ - Nearly 1 in 6 Homes Underwater], then 1 in 5 [Mar 9, 2009: One in Five Houses Underwater], and now approaching my long term prediction that 1 in 4 Americans will be underwater on their mortgage.
  • 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 that 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.
  • A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% 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.
So you can see the commonly portrayed reason for foreclosure, "rates spiking in bad mortgages to bad borrowers" is really not the main issue at all, in fact this made up less than 10% of the foreclosures in 2nd half 2008.
  • What about upward resets in mortgage interest rates? I found that interest rate resets did not measurably increase foreclosures until the reset was greater than four percentage points. Only 8% 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.
The real cause? No skin in the game. This goes to what I've been saying for a long time - we even were posting stories in 2007 how people were paying off credit cards ahead of their home mortgages; something never seen before in the history of the U.S. Why? If you have no skin in the game, why bother trying to hold onto your home. We also see clear evidence of this in Europe - the countries who followed "innovative" US approaches saw housing bubbles and crashed - Ireland, UK, Spain. Those who never budged off their 20% down (skin in the game) ideals, never saw the bubbles - but never saw this sort of bust in their housing markets.

Effectively, we've transferred a whole batch of 2004-2007 "renters" into "pseudo" homeowners... really with many of these mortgage programs they were in the same (or better!) terms than as a renter. That's right, it cost less up front to be an owner than a renter! At least as a renter that had to put a security deposit down, but in this new fangled era of financial innovation we let people put 0% down, and finance the closing costs. EVEN BETTER THAN RENTING. :) And when the loans go bad, the responsible people are asked to send checks to bail many of these folks out. (Yes I realize regular people who just bought at a bad time also got caught in this trap but I am sorry if I don't have sympathy as I speak from a state where home prices are back to 1995 levels)

So what's our current solution? We are driving almost all American loans through Fannie and Freddie, and using FHA... which has (wait for it) 3.5% down programs - lessened by the 1st time federal tax credit of $8K and similar figures from many states. Even "IOU" California was offering a $10K tax credit. So if you have a $160K house (roughly the US median), 3.5% down is about $6K. All covered by federal or state programs and *POOF* people can walk in with nothing down again. Only this time we'll cut out the middleman and instead of bailing out the banks we'll just be bailing out Fannie, Freddie, and de facto FHA for the next 4-8 years as this crop of loans goes bad. It is almost laughable at this point, but I long have since thrown up my hands in the air. Our money supply is endless so really, just print more and send it to the people in all forms of handouts that require no one to save. Then when the loans go bad, despite handing out money to borrowers - just print another batch to subsidize Fannie, Freddie, FHA. Rinse. Wash. Repeat. Why bother learning from the past? When your money trees are endless you do not need to.
  • This means that most government policies being discussed to remedy woes in the housing market are misdirected. (understatement of the year) 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. 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.
  • 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.
  • .....the important factor is whether or not the homeowner currently has or ever had an important financial stake in the house. Yet merely because an individual has a home with negative equity does not imply that he or she cannot make mortgage payments so much as it implies that the borrower is more willing to walk away from the loan.
The above point is so key - many of us in states like Michigan are very underwater on their mortgages... but we actually put down payments into our homes. Why? Because unlike many parts of the country where mostly the 2004-2007 vintage of home buyer is underwater (the height of the insane mortgages) many of the loans underwater here were made earlier before financial "innovation" took over the land. So to "walk away" you'd not only take a credit hit, you'd lose saved money you actually invested into the house. Of course, some who bought in the 2004-2007 time frame also put 5, 10, 20% down into their homes and face the same dilemma. But the man who put nothing, or 1% or 2%? Not so much of a dilemma. Sit "rent free" for 6-12 months while foreclosure proceedings happen and then go back to being... well the same thing you were the last few years, a renter (except you were effectively renting a home instead of an apartment). Or even better - wait for scrambling government agencies to send your bank money to help you on your "investment" (I use that word in the loosest way possible)....

I did not mention it here but the LATEST housing rescue plan from team Obama announced in the past 10 days now has upped the ante from "helping" people who owe 105% of what their house is worth, up to 125%. So who do you think has the greater chance of being 125% down ? Someone who actually put a 5-10-20% mortgage payment down on the home at inception? Or someone who put 0-1-2% and rolled the closing costs into the mortgage. It doesn't take much thinking to realize where your tax money is going.... all in the name of "helping those who deserve the help".

Again, it is to the point of being laughable. If you acted responsibly, you dear reader - are the fool. Political initiatives to "save those in need" are not only misguided based on what is causation, but implicitly unfair to those who tried to do the right thing. All the time the peasants are being fed political dogma about the root causes, when veering from common sense was reason #1. Even more amazing ... we are simply repeating the exact same path; outside of actual underwriting standards (at least that will stop liar loans) the same policy of little to no skin in the game is now institutionalized at the federal level. That's what happens when you have a nation of non savers.
  • 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.
  • Understanding the causes of the foreclosure explosion is required if we wish to avoid a replay of recent painful events. .....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.

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