decoding the foreclosure crisis: causes, responses, and consequences

Journal of Policy Analysis and Management, Vol. 30, No. 2, 381–400 (2011)© 2011 by the Association for Public Policy Analysis and Management Published by Wiley Periodicals, Inc. View this article online at wileyonlinelibrary.com/journal/pamDOI: 10.1002/pam.20562

THE FORECLOSURE CRISIS: CAUSES AND CONSEQUENCES

Ashlyn Aiko Nelson, Guest Editor

This Point/Counterpoint addresses the causes and consequences of the foreclosurecrisis. Here, we feature a lively debate between two teams comprised of nationallyrenowned housing and mortgage policy experts. The first panel is comprised ofKristopher Gerardi, Research Economist and Assistant Policy Advisor at the FederalReserve Bank of Atlanta; Stephen L. Ross, Professor of Economics at the Universityof Connecticut; and Paul Willen, Senior Economist and Policy Advisor at the Fed-eral Reserve Bank of Boston. The second panel is comprised of Vicki Been, BoxerFamily Professor of Law and Director of the Furman Center for Real Estate andUrban Policy at New York University; Sewin Chan, Associate Professor of PublicPolicy at New York University’s Wagner Graduate School of Public Service; IngridGould Ellen, Professor of Urban Planning and Public Policy at New York Univer-sity’s Wagner Graduate School of Public Service and Co-Director of the FurmanCenter for Real Estate and Urban Policy; and Josiah Madar, Research Fellow at

Kenneth A. Couch,Editor

Point/Counterpoint

Submissions to Point/Counterpoint, Kenneth A. Couch, University of Connecticut,341 Mansfield Road, U-1063, Storrs, CT 06269-1063.

The collapse of an overheated real estate market backed by poorly documentedmortgages both precipitated and worsened the severity of the current foreclosurecrisis. In this Point/Counterpoint exchange, Guest Editor Ashlyn Aiko Nelsonarranges a discussion between prominent scholars of the factors that caused theforeclosure crisis, the scope of the federal response, and likely repercussions inmortgage markets. Professor Nelson is an Assistant Professor in the School of Pub-lic and Environmental Affairs at Indiana University. Her research focuses on mort-gage markets, racial disparities in access to housing, and educational policy.

New York University’s Furman Center for Real Estate and Urban Policy. Each ofthe Point/Counterpoint teams addressed the following set of questions:

1. In your opinion, what were the main factors that caused the foreclosure cri-sis? Did any factors exacerbate its effects over time?

2. Was/is the federal policy response to the foreclosure crisis appropriate interms of scale, scope, and direction? Has it been effective? How could thepolicies be improved?

3. Looking ahead, how will the future of mortgage lending change in responseto the crisis?

In our opinions, the foreclosure crisis that began in the subprime mortgage marketin mid-2007 was a direct consequence of the slowdown and decline in house priceappreciation that began in late 2006 in most areas of the country. For a number ofreasons, the equity positions of many borrowers in the period before the crisis wererelatively weak. By 2005 and 2006, homebuyers, especially in the subprime segmentof the market, were putting very little money down at the time of purchase. Accord-ing to our data, the median borrower who purchased a home with a subprime mort-gage in 2005 and 2006 in the states of Massachusetts, Connecticut, and RhodeIsland put zero money down. But high leverage was not only a characteristic ofrecent home purchasers. Many borrowers, who had been in their homes for manyyears before the crisis, had withdrawn extraordinary amounts of equity during the years of rapid house price appreciation. As a result, they were left with extremelysmall equity positions when house prices began to fall. These weak equity positionsput large numbers of borrowers at risk of default and foreclosure as housing pricesfell, as evidenced by rising foreclosure rates in all sectors of the mortgage market(prime, subprime, and loans originated by the Federal Housing Administration[FHA]) throughout 2007. Although such an argument may have been debatable atthe beginning of the mortgage crisis, as many commentators were arguing that theinherent characteristics of subprime mortgages themselves, such as resetting inter-est rates, were to blame, I think most of us now agree that those were only second-or third-order problems compared to the effect of decreasing house prices.

Therefore, in understanding the crisis, we must consider both the relatively dra-matic increase in housing prices prior to the crisis and the erosion of housing equityover the period. In terms of housing prices, the common wisdom has clearly shiftedfrom a somewhat benign view of housing prices in the period leading up to the cri-sis to a view that a nationwide housing price bubble existed that burst, precipitat-ing the crisis. However, as noted in our earlier work (Foote, Gerardi, & Willen,2011), little evidence of a housing bubble was available during the run-up in hous-ing prices. Many economists were skeptical that a bubble existed and attempted tojustify the historic run-up in housing prices based on housing fundamentals. Even

382 / Point/Counterpoint

Journal of Policy Analysis and Management DOI: 10.1002/pamPublished on behalf of the Association for Public Policy Analysis and Management

UNDERSTANDING THE FORECLOSURE CRISIS

Kristopher Gerardi, Stephen L. Ross, and Paul Willen1

1 The views expressed in this paper are those of the authors and do not necessarily represent those of theFederal Reserve Bank of Atlanta, the Federal Reserve Bank of Boston, or the Federal Reserve System.

Point/Counterpoint / 383


economists who were uncertain only acknowledged the possibility of bubble-likebehavior in certain regional housing markets. The small number of economists whoargued forcefully for a bubble often did so years before the housing market peaklosing a fair amount of credibility. Further, many of their arguments were funda-mentally at odds with the data, even ex post. For example, some economists suggestedthat cities where new construction was limited by zoning regulations or geographywere particularly “bubble-prone,” yet the data shows that the cities with the biggestgyrations in house prices were often those at the epicenter of the new constructionboom. Optimistic forecasts by many market participants in 2005 were inaccurate,but it is very difficult to know whether they were unreasonable ex ante.

Although we will not take a position on whether a bubble existed, we believe thatthe current level of housing prices at least in part reflects changes in housing mar-ket fundamentals from the pre-crisis period. For example, it is our belief that thecurrent price level reflects some of the dramatic economic developments over the past few years, such as the decline in economic activity, the large increase in theunemployment rate, and the extreme tightening of underwriting standards by mort-gage originators. Although traditional measures of housing price overvaluation arebased on current rents, actual housing prices are fundamentally determined by thediscounted value of all future rents and are intrinsically linked to anticipatednational and regional growth rates. Rapidly growing cities in the Southwest like LasVegas experienced rapid growth in all real estate sectors, as well as population, dur-ing the housing boom, not just a boom in owner-occupied housing, suggesting thatinvestors might have anticipated substantial demand growth over time, leading tolarge increases in rents for interior properties as the urban fringe continued to shiftoutward. A softening of growth and the associated revision of expectations down-ward would have lowered property values and might have contributed to the initialdeclines in housing prices in 2006 and early 2007 even in the absence of a housingbubble. Further, demand for owner-occupied housing and therefore housing pricesat least in the short run is, in part, driven by access to and the price of mortgagecredit. Therefore, even preceding the financial crisis in late 2008, further declinesin the price of owner-occupied housing were completely reasonable without a bub-ble because interest rates on subprime mortgages rose appreciably with the widen-ing spread between the London Interbank Offered Rate (LIBOR) and treasury rates.

Finally, the crisis itself led to declines in asset values across all sectors of the econ-omy as firms and individuals were forced to dramatically reassess their expecta-tions concerning economic growth, both in terms of lower average growth and ahigher probability of extreme adverse economic events. In housing, this generaldecline in asset values was almost certainly exacerbated by the dramatic decline inthe availability of mortgage credit. Significantly, the period preceding the financialcrisis had been referred to as the “Great Moderation,” when the U.S. and manydeveloped economies appeared to have entered a period of relative economic sta-bility, with sustained growth, low interest rates, little threat of inflation, and fairlyshallow economic slowdowns.2 The dramatic end to the Great Moderation likelyhad substantial impacts on the fundamental value of all assets including housing.

In addition to the current view that a national housing bubble existed, thereseems to be a large segment of housing market researchers who believe that the expansion of mortgage credit to subprime borrowers had a significant, direct rolein producing and sustaining a housing bubble.3 This segment cites the decline inunderwriting standards through the early to mid-2000s as their primary evidence—as loan-to-value ratios increased, credit scores decreased, and exotic or alternative

2 See Davis and Khan (2008) for a detailed discussion of the Great Moderation and a brief review of thecorresponding literature.3 Mian and Sufi (2009, in press) and Dell’Ariccia, Igan, and Laeven (2009) are a few examples from thisliterature.

mortgage products like interest-only mortgages and negative amortization mort-gages became more prevalent. There seems to be little doubt that the relaxation ofunderwriting standards and low and at times declining interest rates in this periodincreased the demand for owner-occupied housing. Again, however, the fact that theareas with the most rapidly rising prices were located in the Southwest, and weresimultaneously experiencing dramatic growth in virtually all sectors of the realestate market (owner-occupied, rental, and commercial), works against this as anexplanation for a housing bubble. In the long run, housing can be shifted betweenthe owner-occupied and rental sectors, values should be based on the present valueof future rents, and the developments in the mortgage market, other than large andpermanent technological innovations, should have little impact on housing values.In markets with growing populations and substantial new construction, developershave the greatest opportunity to shift the composition of the housing stock betweenrental and owner-occupied housing and limit the short-run impact of mortgagemarket circumstances on housing prices. Further, it is very difficult to measure thequantitative effect that declining underwriting standards had on housing pricemovements, in part because anticipated economic growth and the associated expec-tations concerning housing prices reduces a priori risk of foreclosure and so shouldbe expected to lead to a decline in underwriting standards. Thus, separating theeffect of evolving underwriting standards on house price movements from the effectof house price movements on underwriting standards, which is crucial to address-ing these issues, is an almost impossible task.

A related theory that has gained popularity among researchers is that mortgagesecuritization played a direct role in causing the crisis.4 Basically, the argument isthat securitization separated the mortgage origination process from the mortgageholders or investors. Because the originators were not holding the mortgages ontheir own balance sheets, they didn’t have any incentive to diligently analyze creditrisk (i.e., they didn’t have any “skin in the game”) and instead sold risky mortgagesto mortgage-backed security (MBS) investors who were unaware of the risk.5 Thus,securitization, in large part, facilitated the decline in underwriting standards. Thosewho believe this theory cite the large increase in private-label (non-agency) securi-tization that began in the early 2000s and continued up until the crisis in 2007.Although this theory sounds very intuitive, it has some serious flaws that shouldmake one skeptical. First, the separation of the mortgage origination process fromthe actual mortgage investor, or the originate-to-distribute model, is not a new phe-nomenon. The originate-to-distribute model has been around for decades, and certainly predates the rise of private-label securitization.6 In fact, the originate-to-distribute model is used in the process of securitization and by large institutionsthat hold significant mortgage portfolios. It isn’t clear why it could create problemsin the private-label securitization process, but not in other segments of the mort-gage market. As for the rise in private-label securitization that occurred simultane-ously with the rise in house price appreciation, again it is difficult to distinguish thedirection of causality. Although it may have been the case that increased securiti-zation led to increased credit supply, which in turn increased the demand for hous-ing, it could also have been the case that house price appreciation and increased



4 Keys et al. (2009) is perhaps the most widely cited paper in this literature, as many interpret the empir-ical findings in the paper as direct evidence linking securitization to the mortgage crisis. However, Bubband Kaufman (2009) offer a significant critique and alternative interpretation of their results.5 Purnanandam (in press) is an example of this literature. The author finds evidence that loans sold toMBS issuers were of worse credit quality compared to those not sold and interprets this as evidence oflax screening and adverse selection. However, we note that the study used Home Mortgage DisclosureAct (HMDA) data, which does not contain detailed loan-level characteristics used in the underwritingprocess. In addition, the study does not contain the prices that the loans were sold for, making itextremely difficult to infer anything about the effects of asymmetric information.6 See the discussion and references in Ross and Yinger (2002, pp. 15–17).



collateral values made securitization a more profitable enterprise. Again, we wouldargue that up to this point, no one has been able to effectively distinguish betweenthe two potential effects.

In our opinion, the most significant aspect of mortgage market evolution in termsof explaining the mortgage crisis is the willingness of mortgage lenders to issuemortgage-secured (often subordinate) debt on homes in which the owner had littleor no equity. This placed large numbers of American homeowners in a negativeequity position and at risk of a foreclosure from negative income shocks after onlymoderate declines in housing prices. The financial crisis and the resulting deeprecession then forced large numbers of homeowners into delinquency and foreclo-sure. Many of the issues raised above can directly help explain the phenomenon ofdeclining homeowner equity. Expectations of future growth and a recent history of rapidly appreciating housing prices led lenders and investors to assign a very lowprobability to housing value declines, which reduced the importance of a bor-rower’s current equity stake in explaining future default.7 Securitization, especiallyprivate-label securitization, may have facilitated the ability of lenders to extend sub-ordinate mortgage credit to borrowers with no equity position in their homebecause a substantial fraction of the income stream expected to be generated by thedebt could be placed in primary tranches and sold as moderately low-risk securi-ties. Finally, the credit enhancements offered by AIG and other market playersallowed much of this debt to be securitized as AAA-rated securities and thereforesold to pensions funds, the Government Sponsored Enterprises (GSEs), and otherregulated investors.

In terms of the response to the crisis, we see government efforts being divided intothree specific areas. Stepping back from broader attempts to stabilize the financialsystem and the macroeconomy, the first set of policies involves efforts to stabilize themortgage market. The most important legislative step was the expansion of lendinglimits of FHA and the GSEs, Freddie Mac and Fannie Mae. This legislation allowedthe GSEs to step into the jumbo market for prime and alt-A credit and allowed FHAto provide both expanded home purchase and refinance options for traditional sub-prime borrowers as the availability of other securitized mortgage credit was col-lapsing. Further, as the financial crisis worsened and the GSEs became threatened,the federal government took these institutions into conservatorship and continued tooperate the GSEs’ mortgage securitization business.8 With a few minor exceptions,such as the very small jumbo mortgage market, the GSEs and FHA constitute nearlythe entire U.S. mortgage market, and regardless of one’s opinion concerning thelong-run role of the GSEs, it is hard to imagine what the state of U.S. housing mar-kets or the macroeconomy more generally would be if those institutions were notcurrently operating under the full faith and credit of the U.S. government.

The second area of government policy involved efforts to stimulate the housingmarket by encouraging homeownership. One of the administration’s centerpiece pro-grams, the homebuyer tax credits, certainly led to a dramatic increase in home salesduring the period that the credit was in effect, but the end of the credit was followedby a substantial decline in home sales, raising concerns that the program simplymoved home purchases forward in time in order to qualify for the credit rather thanincreasing the population of homebuyers. Second, the Federal Reserve’s efforts topurchase mortgage-backed securities (MBSs) during the financial crisis are thoughtto have substantially lowered mortgage interest rates and may have made homeown-ership more attractive. However, our recent work (Fuster & Willen, 2010) suggeststhat this program only increased the rate of mortgage refinances and had no impacton the number of home purchase mortgages being originated. The program may have

7 See Gerardi et al. (2008) for evidence on the importance of the role of house price expectations in themortgage crisis.8 Frame (2008) contains a detailed discussion of the conservatorship of the GSEs.

had important benefits for the macroeconomy by reducing long-term interest rates,but it does not appear to have increased the demand for owner-occupied housing.

Given that these programs should lower the cost of homeownership, a reasonablequestion to ask is, Why didn’t they substantially expand the demand for owner-occupied housing? In our opinion, the problem relates to the stock of potentialhomeowners in the current economic environment. During the housing market andmortgage credit expansion that preceded the crisis, underwriting and down pay-ment constraints were relaxed, substantially expanding the population of house-holds that could qualify to purchase their desired home. The current retrenchmentin access to mortgage credit likely leaves very few households who are renting whocan both qualify for mortgage credit and be swayed by these moderate declines inthe cost of homeownership. Given recent history, these programs are likely infra-marginal in terms of tenure choice for most U.S. households.

The final policy area involves efforts to remediate mortgage delinquencies andminimize foreclosures. In our opinion, many policymakers thought that they couldhave a large impact on foreclosure rates without expending many resources. Therationale behind programs like the Home Affordable Modification Program(HAMP), for example, was that there were institutional frictions that prevented effi-cient levels of modifications from taking place, and thus an inefficiently high num-ber of foreclosures as a result. Securitization was thought to be the main culprithere, with the relationship between the holders of the mortgages, the MBSinvestors, and the companies that handle the day-to-day administrative tasks asso-ciated with servicing the mortgages, the mortgage servicers, the primary focus.9 Forvarious reasons, including explicit modification caps in the servicing contracts(pooling and servicing agreements), or tranch warfare, and the threat of subsequentlawsuits by one set of investors who had a financial interest in foreclosure overmodification, it was believed that servicers of MBS pools could not perform “prof-itable” modifications. Thus, the government, via HAMP, believed that withoutspending many resources, it could simply solve these frictions and prevent a lot offoreclosures (initial estimates were somewhere between 3 and 4 million foreclo-sures). However, given the extremely small number of permanent modificationsthat HAMP and similar state programs ended up producing, it is hard to continueto argue for the institutional story.

In fact, there is considerable existing research that argued against the institutionalstory, pointing out that modification rates between securitized mortgages and mort-gages held and serviced by a single institution (like a bank) were not that different(Adelino, Gerardi, & Willen, 2009). Instead, this line of research supported a morefundamental economic issue behind the difficulty in modifying loans instead of fore-closing on them, which policymakers largely ignored. This fundamental economicissue was asymmetric information. Basically, modification is very costly because itis very difficult to identify borrowers who are at risk of defaulting. Lenders and ser-vicers do not know a borrower’s detailed financial situation or preferences and thusdo not know the borrower’s willingness to repay the mortgage. Admittedly, financialinstitutions have varied substantially in their execution of delinquency remediationand loan modification programs, and the government likely had a role to play infacilitating this process as the industry grappled with unprecedented numbers ofdelinquencies and foreclosures. Given the limited resources spent by the governmenton mortgage modification efforts, these may well have been an effective allocationof resources in spite of the low rate of successful mortgage modifications.

However, policymakers need to realize that most borrowers experiencing mort-gage delinquencies are unlikely to avoid foreclosure without a substantial infusionof resources. As has been made clear in earlier work, the decline in housing prices



9 See Mayer, Morrison, and Piskorski (2009) for a nice summary of these ideas.



and resulting decline in equity positions puts households experiencing financial dis-tress at extreme risk of foreclosure because it reduces the set of viable alternativeslike selling or refinancing. Although it is impossible to know for sure, given the lackof detailed data, we believe that in the current severe economic downturn most peo-ple are entering foreclosure due to job loss and a substantial reduction in familyincome.10 Furthermore, given the very slow recovery, many of those borrowersexpect the negative income shock to persist for a relatively long period of time. Suchborrowers are unlikely to be able to avoid foreclosure without relatively dramaticand sustained reductions in their mortgage payments. Accordingly, mortgage mod-ification is likely to continue to be a very small part of any successful federalresponse to the housing crisis.

Finally, in terms of the future of the mortgage market, we are actually quite sup-portive of several of the innovations and trends in the mortgage market over the lasttwo decades. In our opinion, automated underwriting, risk-based pricing, and theexpansion of mortgage securitization reduced the cost of credit, other things equal,and expanded access to credit for millions of Americans. We also believe that con-cern about the array of exotic mortgage products that were either developed orexpanded in usage during the run-up to the crisis is a bit of a red herring. Our mainconcerns arise from the dramatic relaxation of down payment and equity require-ments during this period and the accompanying increase in household leverage.Individual households that expect increasing income and wealth over time havestrong economic reasons to prefer low levels of housing equity in order to bothincrease current consumption and increase leverage in their investment portfolio.However, in aggregate, this high level of demand for leverage among homebuyersappears to have placed the entire economy at risk from a housing market downturnand economic slowdown, and likely played a substantial role in precipitating thefinancial crisis. Going forward, policymakers need to carefully examine the trade-off between allowing financial institutions to satisfy household demands for lever-age and the risk to the macroeconomy created by the resulting aggregate demandfor leverage.

REFERENCES

Adelino, M., Gerardi, K., & Willen, P. (2009). Why don’t lenders renegotiate more home mort-gages? The effect of securitization. Federal Reserve Bank of Atlanta Working Paper 2009-17. Atlanta, GA: Federal Reserve Bank of Atlanta.

Bubb, R., & Kaufman, A. (2009). Securitization and moral hazard: Evidence from a lendercutoff rule. Federal Reserve Bank of Boston Public Policy Discussion Paper Series No. 09-05. Boston: Federal Reserve Bank of Boston.

Davis, S., & Kahn, J. (2008). Interpreting the Great Moderation: Changes in the volatility ofeconomic activity at the macro and micro levels. Journal of Economic Perspectives, 22,155–180.

Dell’Ariccia, G., Igan, D., & Laeven, L. (2009). Credit booms and lending standards: Evidencefrom the subprime mortgage market. European Banking Center Discussion Paper No.2009-14S. Tilberg, Netherlands: Tilberg University.

Foote, C., Gerardi, K., & Willen, P. (2011). Reasonable people did disagree: Optimism andpessimism about the U.S. housing market before the crash. In M. Smith & S. Wacheter(Eds.), Reinventing the American mortgage system: Rethink, recover, rebuild (pp. 36–78).Philadelphia: University of Pennsylvania Press.

Foote, C., Gerardi, K., Goette, L., & Willen, P. (2009). Reducing foreclosures: No easyanswers. NBER Macroecomics Annual, 24, 89–138.

10 See Foote et al. (2009) for a more detailed discussion and analysis.

Frame, S. (2008). The 2008 federal intervention to stabilize Fannie Mae and Freddie Mac.Journal of Applied Finance, 18, 124–133.

Fuster, A., & Willen, P. (2010). $1.25 trillion is still real money: Some facts about the effectsof the Federal Reserve’s mortgage market investments. Federal Reserve Bank of BostonPublic Policy Discussion Paper Series No. 10-04. Boston: Federal Reserve Bank of Boston.

Gerardi, K., Lehnert, A., Sherland, S., & Willen, P. (2008). Making sense of the subprime cri-sis. Brookings Papers on Economic Activity, Fall, 69–145.

Keys, B., Mukherjee, T., Seru, A., & Vig, V. (2009). Did securitization lead to lax screening?Evidence from subprime loans. Quarterly Journal of Economics, 125, 307–362.

Mayer, C., Morrison, E., & Piskorski, T. (2009). A new proposal for loan modifications. YaleJournal on Regulation, 26, 417–429.

Mian, A., & Sufi, A. (2009). The consequences of mortgage credit expansion: Evidence fromthe U.S. mortgage default crisis. Quarterly Journal of Economics, 124, 1449–1496.

Mian, A., & Sufi, A. (in press). House prices, home equity-based borrowing, and the U.S.household leverage crisis. American Economic Review.

Purnanandam, A. (in press). Originate-to-distribute model and the subprime mortgage crisis.Review of Financial Studies.

Ross, S. L., & Yinger, J. (2002). The color of credit: Mortgage discrimination, research meth-ods, and fair lending enforcement. Cambridge, MA: MIT Press.

BAD ECONOMY, BAD HOUSING MARKET, BAD LOANS

In June 2010, 4.6 percent of all loans outstanding on one- to four-family homes werein the foreclosure process, and another 9.9 percent were at least one payment pastdue (Mortgage Bankers Association, 2010). Economists predict that 8 to 13 millionhomes will have been foreclosed on before the crisis ends (Dubitsky et al., 2008;Hatzius & Marschoun, 2009; Sherlund, 2008). Americans are losing their homes atrates not seen since the Great Depression, when most borrowers held relativelyshort-term balloon mortgages and deflation made real interest rates extremely high.Today’s crisis was driven initially by risky underwriting, but now is primarily causedby job loss and falling house prices.

The recent recession has reduced income for many households and led to thehighest unemployment rates since the 1940s. As Figure 1 shows, historically, fore-closure rates are generally low and job losses bump rates up only modestly. But inthe recent downturn, unemployment spells have been unusually long—in June2010, 46 percent of the unemployed had been unemployed for 27 weeks or more(U.S. Bureau of Labor Statistics, 2010b). Few mortgage holders will have savings tomanage for more than six months without earned income.



DECODING THE FORECLOSURE CRISIS: CAUSES, RESPONSES, AND CONSEQUENCES

Vicki Been, Sewin Chan, Ingrid Gould Ellen, and Josiah R. Madar11

11 The authors would like to acknowledge that this article was a team effort by the Furman Center andthank, in particular, Sam Dastrup, Claudia Sharygin, Max Weselcouch, and Mark Willis for their manythoughtful suggestions, and Allie Curreri and Tyler Jaeckel for excellent research assistance.



Source: Mortgage Bankers Association National Delinquency Survey, Bureau of Labor Statistics.

Figure 1. Quarterly foreclosure start rate and unemployment rate, 1990Q1 to2010Q2.

Widespread negative equity has aggravated the effect falling incomes and risingunemployment have had on foreclosures. In healthy housing markets, a borrowerunable to pay her mortgage may avoid foreclosure by selling her home. Negativeequity makes that much more difficult. By one estimate, at the end of June 2010, 23percent of all residential mortgages had negative equity (CoreLogic, 2010), largelybecause of the bursting of the housing bubble, shown in Figure 2. Negative equityalso resulted from the rising popularity of zero–down payment, interest-only, andnegative-amortization financing that meant many borrowers had little equity intheir homes even at origination (McCoy, 2010). The popularity of such mortgageswas likely predicated on the expectations of homeowners and lenders alike thathouse prices would continue to rise and thereby create equity. Although the factorsunderlying the housing bubble are beyond the scope of this paper, falling houseprices have a clear effect on foreclosures: They increase default rates (Gerardi,Shapiro, & Willen, 2009).

This brings us to another factor driving foreclosures: the rise of the subprimemortgage market—and changes in lending practices more generally. Extendedunemployment combined with negative equity is the main cause of default today,but some foreclosures arise because the mortgage terms were unrealistic for theborrower even at origination. Adjustable rate mortgages, and other mortgages thatmay be affordable for only a limited period of time, can make sense to both bor-rowers and lenders when house prices are rising. For the borrower, if housing pricesare expected to rise, it is logical to buy as much house as possible, even if thatmeans using a mortgage where payments will jump. In the worst case, the borrowercan sell the house and keep the (tax-free) capital gains or refinance into a moreaffordable loan after accumulating additional equity. Similarly, for the lender it isprofitable to lend at high rates, even to borrowers with questionable ability to repay,if the lender expects to recover its capital when the property is sold or the mortgagerefinanced. The high prepayment rates for subprime mortgages during the housing

bubble indicate the prevalence of this strategy (Chomsisengphet & Pennington-Cross, 2006).

The dramatic expansion of subprime lending during the bubble years, shown inFigure 2, may have simply reflected the fact that with rapidly rising house prices,the creditworthiness of the borrower takes on less importance. But the expansionalso may have reflected (and allowed) fraud and deception—by homebuyers, bro-kers, and others within the mortgage lending and real estate industry. The ability ofmortgage originators to remove mortgages from their books through securitizationmay have also weakened originators’ incentives to carefully screen potential loansand borrowers, as they retained little exposure to the risk of the originated loans.

Despite the importance of the subprime expansion and associated lending prac-tices during the initial stages of the foreclosure crisis, prime mortgage foreclosureshave exceeded subprime foreclosures in the past year. Job losses, in combinationwith negative equity, are now the most important causes of foreclosures.

FEDERAL POLICY RESPONSES TO THE FORECLOSURE CRISIS

Many have characterized the federal response to the foreclosure crisis as “too little,too late.” Although we agree on the “too late”—a more robust set of policies at thestart of the crisis (or even before) could have moderated the forces describedabove—we do not entirely agree on the “too little.”

The federal government’s response has been quite expansive. First, the governmentembraced many anti-recessionary policies to boost the economy and increaseemployment. Congress and successive White House administrations spent billions,through the Troubled Asset Relief Program (TARP), to shore up financial institutionsand encourage them to keep lending; implemented a $787 billion economic recoveryplan to stimulate the economy; and adopted policies to keep interest rates low. It ishard to know how effective these policies have been—the recession is officially over



Source: Standard and Poor’s (2010); Inside Mortgage Finance Publications (2010).

Figure 2. Home price appreciation and subprime lending volume, 1990 to 2009.



but unemployment remains high. Ultimately, we do not know what would have hap-pened in the absence of these efforts.

Stimulating the economy is critical to combating foreclosures, but our main focusis on the policies that take direct aim at housing and lending markets. The federal gov-ernment introduced several programs to stabilize housing prices and help as manyborrowers as possible stay in their homes through refinancing or modifications.

Loan Modifications

A key focus of the federal response has been to encourage loan modifications. Thatis a seemingly straightforward goal, but modifying distressed mortgages is a com-plicated task, especially in a climate of depressed housing values. Each troubledmortgage involves a borrower who is unable or unwilling to make contracted pay-ments; a servicer (hired to collect payments for investors), who acts in self-interestand often on behalf of multiple investors with competing interests; and frequentlyadditional debt holders with claims to the mortgaged home. Moreover, any programthat promotes changes to mortgage terms must balance concerns about moral hazard,fairness, and cost. The more generous a program, the more households are encour-aged to default and use it, and the greater the burden on taxpayers. Thus, more vig-orous programs might have helped more borrowers, but they would have come attremendous cost.

The Bush Administration’s central loan modification effort was the Hope NOW Pro-gram, which aimed to coordinate servicers, loan counselors, and investors to identifydistressed borrowers, provide them with counseling, and, where appropriate, offermodifications. The Obama Administration shifted to a strategy of government-fundedfinancial incentives when it unveiled the Home Affordable Modification Program(HAMP) in February 2009. HAMP was built on the assumption that many borrow-ers could not afford their mortgage but had loans that could be modified to allowthem to keep their home while providing mortgage holders with a higher payoff thanforeclosure. Policymakers also assumed that these “Pareto-optimal” modificationswere being blocked by a set of structural incentives, including the compensation andcost structure of servicers, which tended to favor foreclosure over modifications(McCoy, 2010). HAMP sought to overcome some of these barriers by paying servicersand mortgage holders to make qualifying loan modifications.

HAMP’s record is mixed. Although the pace of modifications has fallen far shortof goals, 468,000 borrowers had received permanent modifications by August 2010(U.S. Department of Treasury, 2010), and the re-default rate of these modifications,though still high, is lower than for modifications in the past (Office of the Comp-troller of the Currency, 2010). The program has succeeded in changing servicers’incentives to some degree and in nudging them to modify more loans in meaning-ful ways.

However, there are significant constraints on to the program’s ability to encour-age win–win modifications. First, standard accounting rules fail to require banks towrite down assets to market value on a regular basis but demand immediate write-downs for permanent modifications of interest or principal (McCoy, 2010). A sec-ond key problem has been the prevalence of junior mortgages, which a Treasuryanalysis estimates are linked to half of all loans at risk of delinquency (Office of theInspector General for TARP, 2010). Second liens significantly complicate modifica-tions because first lien holders may lose their senior status upon modification andusually will not modify unless second lien holders agree to resubordinate theirclaims, which often does not happen (McCoy 2010). The Obama Administrationintroduced a second lien modification program in August 2009, but take-up hasbeen limited (Office of the Inspector General for TARP, 2010). A third issue was theSenate’s rejection of the bankruptcy cram-down legislation. The threat that bank-ruptcy judges could order write-downs might have pushed servicers to modify more

loans. Its failure to pass weakened HAMP considerably, leaving only the carrots andno sticks. Finally, the fact that borrowers had to be delinquent or show that defaultwas imminent to qualify for HAMP limited the pool of eligible loans (and incen-tivized borrowers to become delinquent).

In addition, the number of win–win modifications left on the table may simply beshrinking. The modifications that servicers are willing to offer given the likely costsof foreclosure, expected sales price, and re-default rates are not generous enough toallow borrowers to stay in their homes, in part because the problem shifted asHAMP was being implemented. Recent foreclosures have more to do with job lossand negative equity and less to do with underwriting or loan terms, and thesebroader economic trends make it harder for servicers to justify modifications asbeing in the investors’ interests. In recognition of these trends, the UnemploymentProgram (UP) introduced in August 2010 requires HAMP servicers to reduce or for-bear mortgage payments for selected unemployed borrowers for three to sixmonths.

Underwater Borrowers

Refinancings

A number of other federal policies focus on preventing foreclosure of underwaterborrowers. The Hope for Homeowners Program, adopted in October 2008, offeredto refinance delinquent, underwater borrowers into Federal Housing Administration(FHA) loans, but only if lenders wrote down the principal. Because of unfavorableterms, and perhaps reluctance to write down mortgages, the take-up rate was mini-mal (ElBoghdady, 2008). The Obama Administration introduced several refinanceprograms designed to help borrowers who were current on their mortgages butwhose homes had fallen in value and were thus unable to refinance or sell. First, itsHome Affordable Refinance Program (HARP), introduced in March 2009, allowsborrowers with loans held or guaranteed by Fannie Mae or Freddie Mac to refinanceto lower interest rates as long as their first mortgage does not exceed 105 percent(and later, 125 percent) of the current market value of their home. Although 300,000borrowers have refinanced through the program (Federal Housing Finance Author-ity, 2010), many more have been unable to do so because their home prices havefallen too much (Helping Homeowners, 2010). The FHA Short Refinance Programlaunched in September, 2010 offers to refinance non-delinquent, underwater bor-rowers into FHA loans, but only if lien holders agree to write down principal by 10percent and new loan-to-value ratios are below specified caps. It is too early to gaugethe program’s success.

Short Sales

The Obama Administration also introduced a program in April 2010 to subsidizeand streamline short sales and to encourage more lenders to forgive the differencebetween the sale price of the property and the mortgage balance. Again, it is tooearly to evaluate whether the program is working.

Stabilization of Home Prices

The government has also adopted several strategies to stabilize home prices. In July2008, Congress passed the homebuyer tax credit, which ultimately provided an$8,000 tax credit to first-time homebuyers and a $6,500 tax credit to repeat home-buyers. The credits, which expired on May 1, 2010, may have stabilized house pricesto some degree, but they likely subsidized many people who would have purchased





homes anyway. The government also instituted a number of policies to increase liq-uidity in mortgage lending, such as increases in loan limits for FHA and govern-ment-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, FederalReserve purchases of mortgage-backed securities guaranteed by the GSEs, conser-vatorship of the GSEs to keep them in business, and support of the banking systemthrough TARP. Collectively, these policies helped to encourage government-backedlending, but purely private lending volume remains low.

Despite these efforts to stabilize home prices and encourage principal write-downs and refinancings, the number of underwater borrowers, and the amount thattheir debt exceeds their home values, remains troublingly high. However, address-ing negative equity in a more aggressive way would be enormously expensive and arguably unfair because the government would be bailing out many borrowersand lenders who took on highly risky mortgages.

Alternative Policies

Where should the government focus its resources now? First, it could allow non-delinquent borrowers with government-backed loans to refinance, even when theirloans exceed value by more than 125 percent, given that the government holds this riskanyway. Second, it could offer more generous incentives for short sales and experi-ment with models to convert the shortfall to a personal liability. Short sales shouldengender less resentment than principal write-downs because borrowers do not keeptheir homes. Finally, the government could adopt a more robust set of policies to mit-igate the collateral costs of foreclosures on children, renters, and communities. Thefederal government already has enacted legislation to protect tenants in foreclosedhomes and allocated billions of dollars to local neighborhood stabilization programs.However, it could do more, making grants to local governments to cover code enforce-ment, for example, and providing assistance to help children stay in their same schoolsor ease their transitions to new ones.

THE FUTURE OF MORTGAGE LENDING

Residential mortgage lending has already changed dramatically in response to thecrisis. Originations of subprime and junior lien home purchase loans have largelyceased (Furman Center, 2010). FHA- and Department of Veterans Affairs(VA)–backed mortgages have exploded in number, constituting a majority of allowner-occupant home purchase loan originations and a growing share of refinanceloan originations in 2009 (Furman Center, 2010). Private label securitization andportfolio lending by banks, in contrast, have halted almost completely (Krainer,2009). As a result, between FHA and VA loans and loans backed by Fannie Mae andFreddie Mac, nearly all recent-vintage mortgage debt is explicitly or implicitly guar-anteed or insured by the federal government.

Once the trauma of the crisis subsides, two additional forces will largely shape thefuture of mortgage lending: the Dodd–Frank bill and the resolution of Fannie Mae’sand Freddie Mac’s conservatorships. Several provisions in Dodd–Frank make thereturn of subprime mortgage lending in its most reckless forms unlikely. All origi-nations will require a good faith determination, based on verified income, that theborrower will be able to afford the payments. Only mortgages meeting minimumsafety standards (“qualified” mortgages) will enjoy a partial safe harbor presump-tion that the originator met this requirement. Loans with particularly high interestrates or, if issued to first-time homebuyers, negative amortization, will requiremortgage counseling. Prepayment penalties will be prohibited for adjustable ratemortgages and all non-qualified fixed rate mortgages. Securitizers of non-qualifiedloans will be required to retain a portion of the underlying credit risk, and mortgagebrokers will no longer be compensated based on the terms of an originated loan and

will be subject to other regulations against steering. The bill’s creation of a Bureauof Consumer Financial Protection should ensure greater scrutiny of mortgage lend-ing, independent of potentially conflicting safety and soundness considerations thatfocus on the health of financial institutions.

Decisions about the future of Fannie Mae and Freddie Mac also have the potential totransform the mortgage market in profound ways. Proposed models range from con-tinuing the availability of a federal guarantee for securities backed by safe and sustain-able mortgages to leaving the secondary mortgage market primarily in private hands,with private guarantees (Ellen, Tye, & Willis, 2010). The outcome of this contentiouspolicy debate will affect both future mortgage rates and product offerings. Completelyprivate aggregators or securitizers, for example, may choose not to purchase or insurelong-term fixed-rate mortgages, limiting their availability to borrowers.

Future policies regarding mortgage lending should also respond to conspicuous dis-parities by race, class, and neighborhood that have long plagued mortgage lending inthe U.S. For a variety of reasons, black and Hispanic borrowers were much more likelythan white and Asian borrowers to receive subprime loans during the housing boom(Been, Ellen, & Madar, 2009). Since the disappearance of subprime lending, the num-ber of home purchase loans issued to blacks and Hispanics has declined more steeplythan the number issued to other borrowers, and black and Hispanic borrowers relymuch more heavily on FHA- and VA-backed loans (Furman Center, 2010). Futureefforts to rein in unscrupulous lending and manage federal mortgage programs mustensure that mortgage credit remains available to those groups. Reinvigorating theCommunity Reinvestment Act might be particularly vital in light of this risk.

The foreclosure crisis also has disproportionately affected black and Hispanic andlower-income neighborhoods. As a result, residents of these neighborhoods, eventhose not in mortgage distress, are more likely to be exposed to the increased crime,physical decay, lowered home values, and fractured social networks that foreclo-sures may cause (Schuetz, Ellen, & Been, 2008; Immergluck & Smith, 2006). Dis-proportionate declines in housing prices in these communities are of particularconcern because the resulting losses of wealth leave residents relatively disadvan-taged in financing education and retirement. Black and Hispanic homeowners arealso more likely than their white counterparts to experience foreclosure and sufferits direct impacts, including disruption in children’s education, moving expenses,and emotional distress (Been et al., 2010).

Finally, the future of mortgage lending will be shaped by federal policy regardinghomeownership more broadly. For those with high enough incomes to itemizedeductions for federal income tax purposes, homeownership has long been subsi-dized through the deductibility of mortgage interest. This policy encourages debt,does little to increase homeownership, and disproportionately benefits higher-income households (e.g., Glaeser & Shapiro, 2003). We hope the current crisis willprompt policymakers to consider its reform.

REFERENCES

Been, V., Ellen, I., & Madar, J. (2009). High cost of segregation: Exploring racial disparitiesin high-cost lending. Fordham Urban Law Journal, 36, 361–393.

Been, V., Ellen, I. G., Schwartz, A. E., Stiefel, L., & Weinstein, M. (2010, September). Kids and foreclosures: New York City. NYU Furman Center for Real Estate and Urban Policy. Retrieved December 27, 2010, from http://furmancenter.org/files/publications/Foreclosures_and_Kids_Policy_Brief_Sept202010.pdf.

Chomsisengphet, S., & Pennington-Cross, A. (2006). The evolution of the subprime mortgagemarket. Federal Reserve Bank of St. Louis Review, 88, 31–56.

CoreLogic. (2010, August). Negative equity report, Q2 2010. Retrieved December 27, 2010,from http://www.corelogic.com/uploadedFiles/Pages/About_Us/ResearchTrends/CL_Q2_2010_Negative_Equity_FINAL.pdf.





Dubitsky, R., Yang, L., Stevanovic, S., & Suehr, T. (2008, December). Foreclosure update:Over 8 million foreclosures expected. Retrieved December 27, 2010, from http://www.chapa.org/pdf/ForeclosureUpdateCreditSuisse.pdf.

ElBoghdady, D. (2008, December 17). HUD chief calls aid on mortgages a failure. Washing-ton Post, p. A1.

Ellen, I. G., Tye, J. N., & Willis, M. A. (2010, May). Improving U.S. housing finance throughreform of Fannie Mae and Freddie Mac: Assessing the options. NYU Furman Center forReal Estate and Urban Policy. Retrieved December 27, 2010, from http://furmancenter.org/files/publications/Improving_US_Housing_Finance_Fannie_Mae_Freddie_Mac_9_8_10.pdf.

Federal Housing Finance Agency. (2010, June). Fannie Mae and Freddie Mac loan modifica-tions and refinancings increase significantly in first quarter. Retrieved December 27, 2010,from http://www.fhfa.gov/webfiles/15861/1q20109ForeclosurePrevention62210.pdf.

Furman Center for Real Estate and Urban Policy. (2010, November). Mortgage lending dur-ing the Great Recession: HMDA 2009. Retrieved December 27, 2010, from http://furmancenter.org/files/publications/HMDA_2009_databrief_FINAL.pdf.

Gerardi., K, Shapiro, A. H., & Willen, P. (2009, September). Decomposing the foreclosure cri-sis: House price depreciation versus bad underwriting. Federal Reserve Bank of Atlanta,Working Paper No. 2009-25. Retrieved December 27, 2010, from http://www.frbatlanta.org/filelegacydocs/wp0925.pdf.

Glaeser, E. L., & Shapiro, J. M. (2003). The benefits of the home mortgage interest deduction.In J. M. Poterba (Ed.), Tax policy and the economy, Vol. 17 (pp. 37–82). Cambridge, MA:MIT Press.

Hatzius, J., & Marschoun, M. (2009, January). Home prices and credit losses: Projections andpolicy options. Goldman Sachs, Global Economics Paper No. 177. Retrieved December 27,2010, from http://media.garygreene.com/file.php/216/Global�Paper�No��177.pdf.

Helping Homeowners to Refinance. (2010, October 10). New York Times. Retrieved Decem-ber 27, 2010, from http://www.nytimes.com/2010/10/10/opinion/10sun2.html.

Immergluck, D., & Smith, G. (2006). The impact of single-family mortgage foreclosures onneighborhood crime. Housing Studies, 21, 851–866.

Inside Mortgage Finance Publications. (2010). The 2010 mortgage market statistical annual.Bethesda, MD: Inside Mortgage Finance Publications.

Krainer, J. (2009, October). Recent developments in mortgage finance. Federal Reserve Bankof San Francisco, economic letter. Retrieved December 27, 2010, from http://www.frbsf.org/publications/economics/letter/2009/el2009-33.html.

McCoy, P. (2010, August). Barriers to federal home mortgage modification efforts during thefinancial crisis. Joint Center for Housing Studies of Harvard University. Retrieved December27, 2010, from http://www.jchs.harvard.edu/publications/MF10-6.pdf.

Mortgage Bankers Association. (2010, August). Delinquencies and foreclosure starts decreasein latest MBA National Delinquency Survey. Retrieved December 27, 2010, fromhttp://www.mortgagebankers.org/NewsandMedia/PressCenter/73799.htm.

National Bureau of Economic Research. (2010, September). Business Cycle Dating Commit-tee. Retrieved December 27, 2010, from http://www.nber.org/cycles/sept2010.html.

Office of the Comptroller of the Currency and Office of Thrift Supervision. (2010, Septem-ber). OCC and OTS mortgage metrics report: Second quarter 2010. Washington, DC:Author.

Office of the Special Inspector General for the Troubled Asset Relief Program. (2010, March).Factors affecting the implementation of the Home Affordable Modification Program. SIG-TARP-10-005. Washington, DC: Author.

Schuetz, J., Ellen, I., & Been, V. (2008). Neighborhood effects of concentrated mortgage fore-closures. Journal of Housing Economics, 16, 306–319.

Sherlund, S. (2008). The past, present, and future of subprime mortgages. Federal ReserveBoard, finance and economics discussion series 2008-63. Washington, DC: Federal ReserveBoard.

Standard & Poor’s. (2010). S&P/Case-Shiller home price indices. Home price values.Retrieved December 27, 2010, from http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId�spusa-.

U.S. Bureau of Labor Statistics. (2010a). Employment status of the civilian noninstitutionalpopulation, 1940 to date. Retrieved December 27, 2010, from http://www.bls.gov/cps/cpsaat1.pdf.

U.S. Bureau of Labor Statistics. (2010b). Unemployed persons by duration of unemploy-ment, seasonally adjusted. Retrieved December 27, 2010, from http://www.bls.gov/web/empsit/cpseed10.pdf.

U.S. Department of Treasury. (2010). Making Home Affordable Program: Servicer perform-ance report through August 2010. Retrieved December 27, 2010, from http://www.financialstability.gov/docs/AugustMHAPublic2010.pdf.

Our views of the current crisis do not substantially differ from those of Been, Chan,Ellen, and Madar (BCEM). However, our views concerning the origins of the crisisare quite different. In noting the important role of negative equity and incomeshocks, BCEM claim that the crisis was initially driven by risky underwriting.Although we agree that underwriting standards, especially in the subprime market,eroded substantially in the period leading up to the crisis, the timing of events doesnot appear to be consistent with their view. As noted above, the decline in housingprices clearly preceded the increase in foreclosures in 2007 that helped trigger thefinancial crisis. In addition, foreclosures increased in all segments of the mortgagemarket, not just among very risky subprime loans, and this was true from the verybeginning of the crisis. Similarly, although we acknowledge the risk inherent inmany subprime products available during the run-up to the crisis, we continue toview the availability and possible abuse of these products as a second-order issuefor the foreclosure crisis, even though they may have had very important negativeimplications for individual borrowers. BCEM reference the high prepayment ratesduring the “housing bubble” as evidence of this phenomenon, but this argument isrelatively unconvincing given that subprime loans exhibited high prepayment rates forthe entire history of the industry.13

In general, we also agree with BCEM’s comments concerning the federal responseto the crisis. The exception is their belief that there is less room for policy inter-ventions today due to the changing nature of the foreclosure crisis. We believe thatthe number of large-scale modifications that would have been required in order toappreciably reduce the foreclosure crisis was never feasible at any time during thecrisis. In other words, in order to have significantly increased modification rates for



DECODING MISPERCEPTIONS: THE ROLE OF UNDERWRITING AND APPROPRIATEPOLICY RESPONSES

Kristopher Gerardi, Stephen L. Ross, and Paul Willen12

12 The views expressed in this paper are those of the authors and do not necessarily represent those ofthe Federal Reserve Bank of Atlanta, the Federal Reserve Bank of Boston, or the Federal Reserve Sys-tem.13 In addition, according to Mayer, Piskorski, and Tchistyi (2009), there was a trade-off between prepay-ment penalties and coupon rates in the subprime mortgage market. They find that subprime loans withprepayment penalties had lower interest rates on average, and this trade-off was greatest for the least



troubled mortgages, even at the start of the crisis, the government would have hadto expend significantly more resources than they did through major initiatives likethe Home Affordable Mortgage Program (HAMP). At the same time, we are sup-portive of the specific goals of mortgage remediation programs. For example, at theend of March 2010, HAMP had modified approximately 228,000 mortgages at a costof about $242 million,4 which comes to only about $1,000 per modification. Suchan investment is strikingly small even when compared to the standard 6 percentreal estate agent commission, let alone the potential costs of foreclosure. As of theend of September 2010, approximately 496,000 mortgages had been modified, with26 and 37 percent of HAMP modifications lapsing back into delinquency or defaultafter 6 and 9 months, respectively (U.S. Department of the Treasury, 2010). Fur-thermore, although a 37 percent redefault rate seems high, it is comparable to ratesobserved in the FDIC modifications of IndyMac loans during much better economiccircumstances.

We likely disagree most with BCEM in our view of the future of the mortgage mar-ket. We are certainly supportive of the aspects contained in recent mortgage regula-tory and legislative reforms that reduce the potential for predatory activities bymortgage brokers and lenders. For example, we have seen many examples of indi-vidual subprime loans in which large surpluses were extracted from borrowers onor near the day of the mortgage closing because the mortgage broker increased theinterest rate, and the associated yield spread premiums well above the good faithestimate when there had been little corresponding change in market rates. Althoughthe existence of such behavior has been well documented, we still believe thatpredatory lending practices occurred in only a small share of the transactions that were consummated in the mortgage market in the period leading up to the cri-sis, and likely played only a minor role in the dramatic rise of aggregate foreclosurerates. Therefore, in terms of limiting aggregate risk in the housing market, we believe the most important issue is to monitor and potentially regulate aggregatehomeowner leverage, including the fraction of mortgage borrowers at risk of nega-tive equity in the event of further or future declines in housing prices. Leverage isnot necessarily a bad thing, especially for borrowing-constrained households withrelatively good future income prospects, but zero down payment mortgages for bor-rowers with checkered credit histories is probably going a little too far, as evidencedby what has occurred over the past few years. However, we want to stress that inthe long run, we believe it is important that U.S. homebuyers continue to be able tobenefit from the lower cost of credit provided by securitization and the increasedaccess to credit provided by risk-based pricing. This view also suggests that manycurrent practices in the mortgage industry are counterproductive. For example,over the last year, the Government Sponsored Enterprises (GSEs) have imple-mented loan-level pricing adjustments based on credit scores over and above therisk premia implied by existing automated underwriting systems. Our research(Fuster & Willen, 2010) suggests that these pricing adjustments have a substantialnegative impact on the refinancing behavior of households. In addition, the GSEshave imposed caps on the volume of super-conforming (in excess of the permanentGSE loan limits that were relaxed earlier in the crisis) mortgages that they will pur-chase. In the current credit environment, it is very likely that these caps are signif-icantly limiting the availability of credit for purchasers of mid-priced housingthroughout much of the nation. More generally, there has been a dramatic restric-tion in the availability of credit to individuals with even small blemishes on creditreports or with somewhat volatile income flows, such as owners of small busi-nesses. Given the fundamental role of negative equity in the foreclosure crisis,

credit worthy borrowers.4 We were unable to find official numbers because the HAMP report cards just released information onmodifications and do not release any information on the associated federal expenditures. These figures

we are concerned that these lending trends, especially in the case of the GSEs,which are currently operating under the auspices of the U.S. government, may behaving a negative impact on the recovery of the housing market and the economicrecovery more generally. In cases where borrowers have reasonable equity in theirhomes, these draconian policies are not required for prudent mortgage lending.

REFERENCES

Kiel, P. (2010). Only $242 million spent so far on gov’t $75B mortgage mod program. Pro-Publica. Retrieved May 11, 2010, from http://www.propublica.org/article/only-242-million-spent-so-far-on-govt-75-billion-mortgage-mod-program.

Fuster, A., & Willen, P. (2010). $1.25 trillion is still real money: Some facts about the effects ofthe Federal Reserve’s mortgage market investments. Federal Reserve Bank of Boston Pub-lic Policy Discussion Paper Series No. 10-04. Boston: Federal Reserve Bank of Boston.

Mayer, C., Piskorski, T., & Tchistyi, A. (2009). The inefficiency of refinancing: Why prepay-ment penalties are good for risky borrowers. Retrieved November 28, 2010, fromhttp://ssrn.com/abstract�1108528.

U.S. Department of Treasury. (2010). Making home affordable program: Servicer perform-ance report through August 2010. Retrieved November 28, 2010, from http://www.financialstability.gov/docs/Sept%20MHA%20Public%202010.pdf.

We substantially agree with Gerardi, Ross, and Willen (“the Gerardi team”) onmany of the issues they discuss, though with some important differences in empha-sis, which we outline briefly as follows.

We agree, for instance, that widespread negative equity is a critical element of theforeclosure crisis. We believe that the most important contribution to the existence ofnegative equity was the bursting of the housing bubble. The Gerardi team, whilerefusing to take a position on the existence of such a bubble, makes a series ofpoints suggesting that they are dubious that a bubble existed. Of course, detectinga bubble with certainty is difficult, and we obviously agree that a price decline fol-lowing a run-up does not by itself prove that a bubble existed. Nonetheless, thecombination of a historically unprecedented run-up in housing prices; large dis-connects between house prices, rents, incomes, and construction costs; the wide-spread discussion of the existence of a housing bubble in the popular and financialpress; and academic research findings of beliefs that would underpin a bubble(Case & Shiller, 2004) are powerful evidence of a housing bubble. We agree that theexpansion of credit to the subprime sector was unlikely to have been the principalcause of the bubble, because there was a general rise in all sectors of the real estatemarket, including those unlikely to be much affected by subprime lending (Coleman,LaCour-Little, & Vandell, 2008).

Subprime lending practices and exotic loan terms, however, did play a part in thecrisis. The Gerardi team argues that the willingness of lenders to offer high loan-to-value mortgages was a central factor. We surely agree that low–down payment loansare risky, especially when house prices are volatile. But loan-to-value ratios are onlyone element of underwriting. If high loan-to-value loans are issued to borrowers



NEGATIVE EQUITY, YES, BUT NOT THE WHOLE STORY

Vicki Been, Sewin Chan, Ingrid Gould Ellen, and Josiah R. Madar



with good credit scores, documented income and assets, and low payment-to-income ratios, they can help families without many assets achieve stable home-ownership. The Federal Housing Administration (FHA), along with the Departmentof Veterans Affairs (VA), has been offering low–down payment loans for years.

Our view is that a more serious problem than high loan-to-value ratios per se wasthe presence of second liens, which led to high combined loan-to-value ratios thatwere often not disclosed to investors and sometimes were unknown to first lienholders. More than half of the loans in private label securities have second liensbehind them (Goodman et al., 2010), and borrowers with second liens have twicethe level of negative equity on average compared to other borrowers (CoreLogic,2010). Borrowers with high combined loan-to-value ratios are especially problem-atic because the presence of second liens complicates modifications should prob-lems arise. Current proposals to require the disclosure of any second liens toinvestors and first lien holders appropriately take aim at this problem.

Turning to the programs put in place to address the crisis, the Gerardi team argues that the Obama Administration was wrong to believe that institutionalfrictions prevented efficient levels of modifications from occurring and that itignored the “existing research that argued against the institutional story.” We dis-agree. There was—and continues to be—considerable evidence that the pace ofmodifications has been slowed by structural issues, including the nature of servicercompensation, the capacity of servicers, accounting rules, and perhaps most signif-icantly, the presence of second liens (McCoy, 2010). The Home Affordable Modifi-cation Program (HAMP) does appear to have accelerated the rate of modifications,and if the program failed to live up to the Obama Administration’s initial expecta-tions, that does not prove that servicer frictions are not an issue; it may simply bethat HAMP’s incentives were not generous enough to overcome all of those frictionsor that the program was rolled out too slowly, was too difficult to use, or was aimedat the problem of inappropriate loan terms rather than the growing issues of fallinghousing values and unaffordability related to job loss.

Although the Gerardi team points to its own excellent research finding little differ-ence in the modification rates of securitized mortgages versus those held in portfolio(Adelino, Gerardi, & Willen, 2010), the issue is still being debated (e.g., Piskorski,Seru, & Vig, 2010). Even if the Gerardi team is right that securitization does notaffect modification rates, it does not prove that servicer frictions are unimportant.First, incentive issues may still exist, even when loans are serviced internally,though those issues likely would be reduced. Second, servicer frictions may impedethe type of modifications that are offered to borrowers. The Adelino, Gerardi, andWillen study treats all modifications as identical, even though the re-default ratesamong modifications of securitized loans are significantly higher than those amongportfolio loans, in large part because portfolio lenders are more likely to write downprincipal, extend terms, and improve the affordability of loans (Levitin, 2009; Officeof the Comptroller and Currency, 2010). Finally, there is considerable variation inthe pace of modification across servicers (U.S. Department of Treasury, 2010).Although it is possible that underlying heterogeneity in loan pools explains thesedifferences, it seems likely that differences in servicers’ success in addressing struc-tural issues are a part of the story.

In terms of the future, it is worth underscoring the need for greater informationand transparency. Underwriting problems were exacerbated by the fact that bor-rowers and investors often understood little about terms and risks. Moreover, sen-sible policymaking during this crisis has been greatly hampered by the lack of dataand information. It is imperative that regulators—and non-governmentalresearchers as well—have access in the future to robust data, not just on loan orig-inations, but on the subsequent performance and outcomes of those loans as well.

REFERENCES

Adelino, M., Gerardi, K., & Willen, P. S. (2010, April). Why don’t lenders renegotiate morehome mortgages? Federal Reserve Bank of Atlanta, Working Paper 2009-17a. RetrievedDecember 27, 2010, from http://www.frbatlanta.org/pubs/wp/working_paper_2009-17a.cfm.

Case, K. E., Shiller, R. J. (2004). Is there a bubble in the housing market? Cowles FoundationPaper No. 1089. Retrieved December 27, 2010, from http://www.econ.yale.edu/~shiller/pubs/p1089.pdf.

Coleman, M. D., LaCour-Little, M., & Vandell, K. (2008). Subprime lending and the housingbubble: Tail wags dog? Journal of Housing Economics, 17, 272–290.

CoreLogic. (2010, May). Real estate news and trends: New CoreLogic data shows decline innegative equity. Retrieved December 27, 2010, from http://www.corelogic.com/uploadedFiles/Pages/About_Us/ResearchTrends/CL_Q1_2010_Negative_Equity_FINAL.pdf.

Goodman, L. S., Ashworth, R., Landy, B., & Yin, K. (2010). Second liens: How important?Journal of Fixed Income, 20, 19–30.

Levitin, A. (2009, July). Does securitization affect loan modifications? Retrieved December 27,2010, from http://www.creditslips.org/creditslips/2009/07/a-few-days-ago-i-wrote-a-long-and-detailed-critique-of-a-boston-federal-reserve-staff-study-that-argued-among-other-things.html.

McCoy, P. (2010, August). Barriers to federal home mortgage modification efforts during thefinancial crisis. Joint Center for Housing Studies of Harvard University. Retrieved December27, 2010, from http://www.jchs.harvard.edu/publications/MF10-6.pdf.

Office of the Comptroller of the Currency and Office of Thrift Supervision. (2010, September).OCC and OTS mortgage metrics report: Second quarter 2010. Washington, DC: Author.

Piskorski, T., Seru, A., & Vig, V. (2010). Securitization and distressed loan renegotiation: Evi-dence from the subprime mortgage crisis. Retrieved December 27, 2010, fromhttp://papers.ssrn.com/sol3/papers.cfm?abstract_id�1321646.

U.S. Department of Treasury. (2010, September). Making Home Affordable Program: Ser-vicer performance report through September 2010. Retrieved December 27, 2010, fromhttp://www.financialstability.gov/docs/Sept%20MHA%20Public%202010.pdf.



decoding the foreclosure crisis: causes, responses, and consequences

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