Current Regulations Failing to Address Biggest Foreclosure Driver

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Current regulatory policy is not addressing the primary
cause of foreclosures
.  CoreLogic’s deputy
chief economists Sam Khater says, in an article on the company’s blog, that,
while lack of equity has long been known to play an important role in loan
defaults in general, CoreLogic is the first to specifically examine leverage in
the residential lending sector.  The study
comes at a time, he says, that policy makers have been attempting to loosen
lending by reducing the price and expanding the quantity of low down payment
real estate credit. 

The company looked back over five decades to examine the
role leverage plays in mortgage foreclosures
They found:

  • Homeownership rates are the same today as five
    decade ago but foreclosure risk is two to three times higher.
  • The primary driver of default risk over this
    period has been leverage; so dominant as to make changes in income and savings insignificant
    drivers from a long-term macro perspective.
  • The stabilization of foreclosures rates in the
    1970s and 1980s was driven by high inflation rates which increased nominal home
    prices and reduced aggregate loan-to-value (LTV) rates.
  • The centerpiece of government efforts to make
    mortgages safer for consumers, the ability-to-repay rule, manages delinquency
    risk but somewhat neglects foreclosure risk.

Therefore,
Khater says, the most important driver of foreclosures over the last 50 years
remains unaddressed by current regulations.

The
creation of the Federal Housing Administration (FHA) and Fannie Mae in the
1930s dramatically expanded homeownership rates which rose from 44 percent in
1940 to 62 percent by 1960 staying in that range until the mid-1990s.  Then pro-homeownership policies led to an
expansion in mortgage credit and homeownership peaked in 2004 a 69 percent
before declining through the recession to a Q4 2014 rate of 64 percent.

However, foreclosure rates have
followed a very different pattern
Between 1960 and 1965 conventional loan foreclosures averaged 0.6
percent and FHA foreclosures 1.4 percent. 
In 2014, with virtually the same homeownership rate, the respective foreclosures
rates were 1.5 percent and 2.6 percent.  Thus
the convention rate was 2.5 times its early 1960’s counterpart and the FHA rate
almost doubled it.  Khater points to
Figure 1 and says these much higher rates are not a function the ongoing
recovery from the recession because, “even as of 2004, well before foreclosure
rates spiked, the level of risk for both conventional and FHA mortgage was
three times higher than during the 1960s.

 

 

CoreLogic modeled foreclosure rates as
a function of savings, unemployment, inflation, aggregate LTV for all
outstanding mortgage loans, and real median household income and found that
only unemployment and the LTV ratio noticeably influenced foreclosure rates
with LTV being “by far the most important variable.”

Khater calls with finding consistent
with the “dual trigger theory” which holds that lack of equity and economic
shocks, typically unemployment, tip a household into foreclosure.  Lack of equity leaves homeowners vulnerable
to economic shocks.  If sufficient equity
is there and a borrower faces economic problems they will typically try to sell
the home.  But if they are close to or
actually underwater they will be able to sell and pay the mortgage which may
tip them into foreclosure.

 

 

He says it is also consistent with
emerging theoretical literature on leverage cycles.  Mortgage leverage increased in the early
1950s when downpayment requirements were lowered.  This increased homeownership rates but also
foreclosures.  Leverage would have
continued to increase but for high rates of inflation and rising home prices in
the two decades between the mid-1960s and mid-1980s.  The resulting stable leverage cycle also
featured low foreclosure rates.  Moreover
inflation led to higher nominal incomes which made pre-existing mortgage payments
easier to meet.  The savings rate and
household income were not at all important; surprising Khater says, given that
traditional underwriting focuses on affordability.

Then in the early to mid-1990 the
emphasis on homeownership led to lower down payment lending, increasing
leverage again and this picked up speed after the millennium due to cash out
refinancing and home equity lending. 
Then came the crash, leverage spiked as did unemployment and
foreclosures soared.  Once prices started
to rise again the process reversed and aggregate LTV rates have increased by 29
percent since March 2011, from 61 percent to 46 percent in November 2014.

Between 2011 and 2014 Khater says the
foreclosure rate fell by 1.5 percentage points and the rise in home prices as
accounted for 1.4 points of the decline. 
“In other words,
91 percent of the drop in the foreclosure rate is due
to the drop in leverage via higher home prices. Unemployment and the remaining
variables accounted for the small remaining portion of the decline.”

One tool the Federal Reserve did not
utilize to guide the economy through the recent recession and recovery was a
leverage target.  This has been used
successfully, Khater says, in over 20 other counties.  The Qualified Mortgage (QM) rule is focused
on ability to repay and this will lead to better performing mortgages but the
QM also lacks a leverage standard.  “That
means,” Khater says, “that the most important driver of mortgage performance
over the last five decades has remained unaddressed for the market and will
likely need to be addressed in the future.”

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