hud's report to congress on the root causes of the foreclosure crisis

8/14/2019 HUD's Report to Congress on the Root Causes of the Foreclosure Crisis

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Repor t to Congress on the Root Causes of the Foreclosure Crisis 1

U.S. Department o Housing and Urban DevelopmentO ce o Policy Development and Research

January 2010

1 Based on a dra t report prepared by Christopher E. Herbert and William C. Apgar, Jr., o Abt Associates Inc. undercontract with the O ce o Policy Development and Research o the U.S. Department o Housing and Urban Development.


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Foreword

Section 1517 o the Housing and Economic Recovery Act o 2008 (P.L. 110-289) mandated preliminary andnal reports to Congress on the root causes o the oreclosure crisis. This nal report responds to that mandate

by analyzing data and trends in the residential housing market and reviewing the academic literature andindustry press on the root causes o the current oreclosure crisis. The report also provides a review o policyresponses and recommended actions to mitigate the crisis and help prevent similar crises rom occurring in the

uture.

As we move orward, better understanding o the root causes o this crisis will support in ormed choicesamong the many policy options available to address the laws and institutions that will govern the originationo residential mortgages in the uture. As we have seen rom the current crisis, success ul outcomes rom thesepolicy debates are critical to the health o the overall economy and to the well-being o American amilies.

Raphael W. Bostic, Ph.D.Assistant Secretary or PolicyDevelopment and Research


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Report to Congress on the Root Causes of the Foreclosure Crisis

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Contents

Executive Summar y . .......................................................................................................................................... viIntr oduction . .........................................................................................................................................................1

1. Tr ends in Delinquencies and Foreclosures . ................................................................................................2Regional Trends in Foreclosures .....................................................................................................................9

2. Literature Review . ......................................................................................................................................152.1 General Literature on Causes o Foreclosures and Delinquencies .....................................................152.2 Literature Assessing Causes o the Current Foreclosure Crisis ..........................................................18

2.2.1 Contribution o House Price Declines .................................................................................192.2.2 Contribution o Weak Economic Conditions ......................................................................202.2.3 Contribution o Growth in Risky Loans ..............................................................................212.2.4 Overall Conclusions on Precipitating Causes o Crisis .......................................................29

2.3 Factors Enabling Expanded Risky Lending .. ......................................................................................302.3.1 Key Market Developments in the 1980s and 1990s .. ..........................................................302.3.2 Failure o the Regulatory Environment To Adapt to Market Changes................................322.3.3 Factors Fostering the Surge in Risky Lending in the 2000s . ...............................................372.3.4 Contribution o Mortgage Fraud, the CRA, and the GSEs ..................................................39

3. Policy Responses to the Foreclosure Cr isis .. .............................................................................................443.1 E orts To Address Rising Foreclosures ..............................................................................................44

3.1.1 E orts To Enhance the Ability o Households To Remain in Their Homes .......................443.1.2 E orts To Enable More Aggressive Loan Modi cations ....................................................47

3.1.3 E orts To Reduce the Negative Impact on Communities ...................................................493.1.4 E orts To Protect Renters A ected by Foreclosures ..........................................................503.2 E orts To Reduce the Risk o Unacceptably High Rates o Mortgage Foreclosures in the Future ...52

3.2.1 Expanding the Ability o Consumers To Make Wise Choices ............................................523.2.2 Legal and Regulatory E orts To Ban Deceptive Lending Practices ...................................53

3.3 Comprehensive Mortgage Market Re orm .........................................................................................543.3.1 E orts To Promote Uni orm Regulations in the Primary Market .......................................543.3.2 Secondary Market Re orm Initiatives ..................................................................................55

References .. .........................................................................................................................................................56Additional Reading .......................................................................................................................................64

Appendix ... ...................... ........................ ....................... ........................ ........................ ........................ .......... A-1


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Executive Summary

This study o the root causes o the current extremely high levels o de aults and oreclosures among residentialmortgages represents the nal report to Congress by the Secretary o the Department o Housing and Urban

Development (HUD) pursuant to Section 1517 o the Housing and Economic Recovery Act (HERA) o 2008(P.L. 110-289). The problems in the mortgage market are routinely re erred to as a oreclosure crisis becausethe level o de aults and oreclosures greatly exceed previous peak levels in the post-war era and, as a result,have drawn comparisons to the levels o distress experienced in the Great Depression. This report contains areview o the academic literature and industry press on the root causes o the current oreclosure crisis, data andanalysis o trends in the market, and policy responses and recommended actions to mitigate the current crisisand help prevent similar crises rom occurring in the uture.

Trends in Delinquencies and ForeclosuresTo help de ne the nature o the oreclosure crisis, the report begins by presenting basic in ormation on trends inmortgage delinquencies and oreclosure starts, relying largely on data rom the Mortgage Bankers Association

National Delinquency Survey . According to this survey, between late 2006 and mid-2007, the share o loansthat were seriously delinquent or beginning the oreclosure process reached their highest levels since the surveywas begun in the late 1970s. Since then, these rates have continued to rise sharply, and, by mid-2008, had morethan doubled the previous record highs. Most o the initial increase in oreclosures was driven by subprimeloans, both due to the act that these inherently risky loans had come to account or a much larger share o themortgage market in recent years and because the oreclosure rates among these loans were rising rapidly. Inaddition, Alt-A loans, another ast-growing segment o the market, began experiencing higher delinquencyand oreclosure rates.1 In both the subprime and Alt-A market segments, oreclosures have grown most rapidlyamong adjustable-rate loans. But, as the economy deteriorated in 2008 and into 2009, the level o oreclosuresamong prime xed-rate loans also rose, urther exacerbating the crisis.

Given the magnitude o this crisis, it is perhaps not surprising that the increase in oreclosures is evident acrossthe country, a ecting most areas. Nonetheless, there are signi cant di erences in the extent o the oreclosurecrisis across market areas. The report analyzes the regional patterns comparing the most recent years oreclo-sure start rates and increases in oreclosure start rates since the start o the crisis by state.

Consistent with popular press accounts, one group o states stands out as having been most severely impactedby the crisisthese states not only had the highest rates o oreclosure starts in 2008, they also experiencedthe highest increase in oreclosure starts since 2005. This group has been re erred to in the press as the sandstates as it includes Arizona, Cali ornia, Florida, and Nevada. The sand states all had a high incidence o high-cost (subprime) lending in 2006, coupled with a much larger run-up in home prices be ore the crisis hit.Perhaps because o this robust house price growth, these states enjoyed some o the lowest oreclosure startrates in the nation in 2005. However, the all in house prices rom 2005 to 2008 was most dramatic in the sandstates. Further exacerbating problems in these our states has been a sharp rise in unemployment since 2005,with unemployment rates rising rom below the national average to among the highest rates in the country.

1 The term Alt-A re ers to loans made to borrowers that require little or no documentation o borrowers income orassets and entail other eatures that may expose borrowers to large increases in loan payments over time.


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It is noteworthy to contrast the experience o the sand states with a second group o states that were also se-verely impacted by the crisis, but in a di erent way. This second grouping comprises states that had relativelyhigh oreclosure rates even be ore the crisis began due to weaknesses in local economies, although the gainin oreclosure rates was less dramatic than in the sand states. Prominent among these states are the industrialstates rom the Midwest, including Illinois, Indiana, Michigan, and Ohio. House prices ell in these states a ter

2005, but not by as much as in states that experienced higher price increases prior to the crisis. In 2005, theindustrial states had much higher unemployment rates than other states. Since 2005, economic conditions havedeteriorated urther, with alling housing prices and rising unemployment contributing to oreclosure rates in2008 and 2009 nearly as high as those in the sand states.

Literature ReviewThe literature review begins by assessing the actors that have most commonly been associated with risingdelinquencies and oreclosures in the past. There is a rich economics literature examining the cause o mort-gage oreclosures, generally re erred to as de ault in the literature.2 Since the 1980s, this literature has beendominated by an option-based theory o mortgage de ault, where the mortgage contract is viewed as givinghomeowners an option to put the home back to lenders by de aulting on their mortgage.3 In an option-theo-retic view, the primary actor driving de aults is the value o the home relative to the value o the outstandingmortgage; when the home value alls substantially below the mortgage debt, owners are better o by ceding thehome to the lender (a so-called ruthless de ault). However, while a lack o equity in a home is strongly as-sociated with oreclosures, most borrowers become delinquent due to a change in their nancial circumstancesthat makes them no longer able to meet their monthly mortgage obligations. These so called trigger eventscommonly include job loss or other income curtailment, health problems, or divorce. As a result, oreclosuresare most accurately thought o as being driven by a two-stage process: rst a trigger event reduces the bor-rowers nancial liquidity, and then a lack o home equity makes it impossible or the borrower to either selltheir home to meet their mortgage obligation or re nance into a mortgage that is a ordable given their changein nancial circumstances. In this view, a lack o home equity is an important determinant o oreclosures asit precludes other means that borrowers can take to resolve an inability to meet their mortgage obligations, butde aults are most commonly triggered by some other event that makes borrowers nancially illiquid.

But, while so tening housing prices were clearly an important precipitating actor in the present crisis, it seemsclear rom the literature that the sharp rise in mortgage delinquencies and oreclosures is undamentally theresult o rapid growth in loans with a high risk o de aultdue both to the terms o these loans and to looseningunderwriting controls and standards. 4 Mortgage industry participants appear to have been drawn to encourageborrowers to take on these riskier loans due to the high pro ts associated with originating these loans andpackaging them or sale to investors. While systematic in ormation on borrowers motivations in obtaining

2 Generally, mortgage de ault occurs when a bor rower has missed three payments and a ourth is due. The de aultleads lenders to initiate the oreclosure process, but historically a majority o de aults are resolved without a

oreclosure occurring.3 Quercia and Stegman (1992) and Vandell (1995) provide detailed reviews o the literature researching the option-

based theory o mortgage de aults.4 Reeder and Comeau (2008) and Demyanyk and Van Hemert (2008) provide evidence o weakening credit quality

o loan originations. Other research nds denial rates declined in recent years at the metropolitan-area level(DellAriccia, Igan, and Laeven, 2008) and at the ZIP-Code level (Mian and Su , 2008).


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these loans is not available, existing evidence suggests that some borrowers did not understand the true costsand risks o these loans while others were willing to take on these risks to tap accumulated home equity or toobtain larger homes.

The current crisis is unusual in that general economic weakness did not play a signi cant role in producingdelinquencies and oreclosures in most market areasat least not initially. Instead, it was a slowdown inhouse price growth that removed the primary sa ety valve or the high volume o una ordable mortgages thathad been made. These loans had allowed borrowers to take advantage o robust house price growth to avoid

oreclosure by re nancing into a new loan or selling the property or a pro t. In act, several studies have oundan association between increases in high-cost lending that enabled borrowers to obtain larger mortgages thanthey could otherwise a ord and more rapid house price growth than would be predicted by other undamentalmeasures o housing demand. Thus, the slowdown and then decline in house price growth that precipitated the

oreclosure crisis is itsel a product o the inevitable end o the ability o lenders to keep extending more creditto borrowers.

Given the signi cant role that an increase in risky lending appears to have played in causing this crisis, a keyquestion is what were the actors that made it possible or the mortgage market to make so many risky loansin recent years? McCoy and Renuart (2008) outline a variety o developments in the mortgage markets duringthe 1980s and 1990s that helped set the stage or the rapid growth o subprime lending a ter 2003. Theseinclude legislative changes that removed interest rate ceilings on mortgages and allowed lenders to o er loanswith variable interest rates, balloon terms, and negative amortization. The authors suggest that, when used inappropriate circumstances, these nontraditional loan terms can be use ul or both lenders and borrowers toprovide loans that address borrower needs or market circumstances. But, as recent experience has shown, whenused inappropriately, these loan terms can signi cantly raise the risk o borrower de ault.

While these legislative changes enabled the risk-based pricing that lies at the heart o subprime lending, thistype o lending was given a substantial spur by technological developments in the 1990s that allowed lendersto use statistical models and credit scores to create more ne-grained estimates o borrower risk. Another

important development over this period was the growth o the asset-backed securities market, which shi ted theprimary source o mortgage nance rom ederally regulated institutions to mortgage banking institutions thatacquired unds through the broader capital markets and were subject to much less regulatory oversight.

Numerous authors have argued that the regulatory structure may not have changed rapidly enough to keepup with the pace o undamental change that was trans orming the mortgage market.5 Borrowers protectionslargely consisted o disclosure rules, which proved to be insu cient protection against consumers makingpoor choices given the new markets much greater variation both in loan costs and in loan terms. 6 The HomeOwnership and Equity Protection Act (HOEPA) o 1994 was intended to provide greater consumer protectionagainst predatory loan terms, but, in practice, applied to less than 1 percent o all loans and so protected very

ew borrowers. In the absence o more stringent ederal regulations, a large majority o states passed their own

versions o HOEPA. But the O ce o Thri t Supervision and the O ce o the Comptroller o the Currency,the primary regulators o ederal depository institutions, issued regulations preempting these state laws rom

5 For example, Gramlich (2007), Essene and Apgar (2007), McCoy and Renaurt (2008), and Barr (2008).6 GAO (2004) also describes the inadequacy o the mortgage lending disclosure system.


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applying to the institutions these agencies regulated. Importantly, this preemption also applied to the mortgagebanking operating subsidiaries o these institutions, which greatly reduced the number o lenders coveredby these state laws. While ederal regulators concern with the sa ety and soundness o banking institutionsprovides a check against risky lending activities by these institutions, an increasing number o mortgage loanswere made by independent mortgage banking institutions subject to less ederal oversight than depository

institutions and their mortgage banking subsidiaries.Another important hole in the regulatory ramework was the lack o signi cant ederal oversight o the rat-ing agencies.7 These agencies played a key role in opening the markets or mortgage-backed securities andcollateralized debt obligations to a wide range o institutional investors and regulated nancial rms seekingAA- or AAA-rated investments. In hindsight, it is clear that the rating agencies were excessively optimistic intheir assessment o the risks associated with subprime mortgages and the securities built on these loans. Theratings compensation structureunder which the agencies were paid by the very rms that sold the securitiesto investorslikely played an important role in the agencies ailure to more soundly assess these securities.

The actors cited previously helped set the stage or the mortgage market problems that developed in recentyears, but several other actors precipitated the rapid growth o subprime and Alt-A lending and the substantialdeterioration in underwriting controls that began around 2003. One commonly cited actor is the increasingdemand or high-yield, investment-grade securities rom both domestic and oreign investors.8 The strongdemand or these securities was evident in the shrinking risk premiums demanded by investors in asset-backedsecurities through 2006. In part, the willingness o investors to purchase risky mortgages with relatively littlerisk premium also refects the belie that innovations in nancial market instruments were shielding them romde ault risk.

The surge in subprime lending was also driven by the high pro ts participants earned at each stage o the pro-cess rom loan origination through bond issuance. As housing a ordability worsened a ter 2003, lenders begano ering new mortgage products intended to stretch borrowers ability to a ord ever more expensive homes asa means o keeping loan origination volumes high. E orts to keep origination volumes high also appear to have

contributed to loosened underwriting standards during this period.

The naland perhaps most importantingredient that ostered the surge in risky lending was the rapidincrease in housing prices in large swaths o the country through 2006. The quickening pace o house priceappreciation papered over the increasing risks o mortgage origination in the years leading up to the emergenceo the oreclosure crisis in 2007. In act, the growth in risky lending seems likely to have ueled the dramaticrise in house prices. In short, market developments since 2000 helped create a sel -perpetuating cycle. Inpursuit o high pro ts, lenders and investors poured capital into ever riskier loans, particularly a ter 2003. Thisfood o capital helped to spur rising home prices that masked the riskiness o the loans being made, leading tocontinued loosening o underwriting standards. When house price growth nally slowed in late 2006, the truenature o these risky loans was exposed and the house o cards came tumbling down.

7 Rating agencies only began registering with the Securities and Exchange Commission in September 2007 asmandated under the Credit Agency Re orm Act o 2006.

8 Zandi (2008) discusses how the U.S. trade de cit le t international investors with a food o dollars to invest.


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There is a general recognition that raud on the part o mortgage brokers and borrowers may have made asigni cant contribution to the oreclosure crisis.9 Ultimately, examinations o the growing incidence o raudconclude that the undamental cause can be traced back to the lack o adequate underwriting controls by lendersto oversee brokers activities. The most commonly cited in ormation on trends in mortgage raud is derived

rom Suspicious Activity Reports (SARs), which are led by nancial institutions, including ederally insured

depository institutions, and are utilized by several ederal agencies, including the Federal Bureau o Investiga-tion (FBI), the Financial Crimes En orcement Network, and HUD, amongst others, in their e orts againstmortgage raud. Importantly, with signi cant shares o loans made by institutions not regulated or insured bythe ederal government, this reporting system leaves out a signi cant portion o the mortgage industry. Evenwith a large segment o the market excluded rom this system and with strong housing price growth potentiallymasking many cases o raud, the number o SARs grew sharply beginning in 2004. In 2003 a total o 6,939 SARswere led; by 2007, this number had increased nearly seven old to 46,717. Nonetheless, the number o SARswas still airly small relative to the number o loans originated annually. However, the low share undoubtedlyrefects both the di culty o identi ying raud as well as the limited scope o institutions reporting SARS.BasePoint Analytics, a private rm specializing in detecting mortgage raud, has estimated that 9 percent o loan delinquencies are associated with some orm o raud. Thus, while mortgage raud is certainly not a trivial

issue, it is estimated to account or only about 1 in 10 delinquencies.In terms o the nature o raud, the FBI distinguishes between two types o raud: (1) or pro t, mostlyperpetrated by brokers and others to generate pro ts, and (2) or housing, perpetrated by homebuyers withthe goal o purchasing or retaining a home. The FBI estimates that roughly 80 percent o raud is or pro tand conducted by brokers and other pro essional parties to the transaction. Consistent with this conclusion,BasePoint Analytics has concluded that most raud is driven by mortgage brokers in their e orts to earn pro tsby originating loans. Existing in ormation urther suggests that the vast majority o raud involves the misrepre-sentation o in ormation on loan applications related to income, employment, or occupancy o the home by theborrower. The growth in no- and low-documentation loans appears to be highly related to the growth in raud.Another signi cant share o cases o raud involve appraisal misrepresentations, where property conditions arematerially di erent than presented in the appraisal or in ormation that is typically outside o accepted param-eters is used to derive the property value.

Another common actor alleged in the popular press to have contributed to the oreclosure crisis is the Com-munity Reinvestment Act (CRA). 10 CRA was passed by Congress in 1977 with the goal o encouraging banksto meet the credit needs o the communities in which they have branches, with a speci c emphasis on low- andmoderate-income neighborhoods. Some critics o CRA claim that the wave o risky lending was generated inno small part by banks having been pushed into making these loans to meet their CRA requirements. However,a variety o empirical evidence supports the view that CRAs requirements played little or no role in producingthe oreclosure crisis. To begin with, only a very small share o the high-priced loans that have been a keydriver o the crisis can be linked to e orts to meet CRAs lending requirements. Furthermore, while CRA lend-ing requirements have been in orce or over three decades, the oreclosure crisis is a recent phenomenon. In

act, the rise o the oreclosure crisis came a ter a period o sustained decline in the share o mortgage lending

9 See Bitner (2008); BasePoint Analytics (2006); Mortgage Asset Research Institute (2008); and Pendley, Costello, andKelsch (2007).

10 One source o this claim is in The New York Times by Husock (2008). Counter editorials include The New York Times (October 15, 2008) and The Los Angeles Times (October 25, 2008).


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activity covered under the CRA. Finally, there is also some evidence that loans made to low- and moderate-income homebuyers as part o banks e orts to meet their CRA obligations have actually per ormed betterthan subprime loans. CRA loans were about hal as likely to go into oreclosure as loans made by independentmortgage companies not covered by CRA, suggesting that CRA may have helped to ensure responsible lendingeven during a period o overall declines in underwriting standards.

Many o the same voices raising questions about CRAs role in producing the oreclosure crisis have alsoargued that ederal regulations requiring the government-sponsored enterprises (Fannie Mae and Freddie Mac,or the GSEs) to devote a sizeable share o their lending to low- and moderate-income homeowners also playeda signi cant role in ostering the growth o risky lending. The serious nancial troubles o the GSEs that led totheir being placed into conservatorship by the ederal government provides strong testament to the act that theGSEs were indeed overexposed to unduly risky mortgage investments. However, the evidence suggests thatthe GSEs decisions to purchase or guarantee nonprime loans was motivated more by e orts to chase marketshare and pro ts than by the need to satis y ederal regulators. Another argument is that the GSEs helped uelthe growth o subprime lending by purchasing a signi cant share o subprime mortgage-backed securities tomeet their low- and moderate-income housing goals. While the GSEs did purchase just under one-hal o allsubprime securities in 2004, and were allowed by ederal regulators to count quali ying loans in these securitiestoward their goals, their purchases o these securities dropped sharply in subsequent years even as the growthin the subprime market took o . In short, while the GSEs certainly contributed to the growth o the subprimemarket, there was clearly substantial demand or these securities rom a wide variety o investors.

Potential Policy Changes or Addressing Rising ForeclosuresOne important category o policy options are those options designed to address problems associated with rising

oreclosure. Rising mortgage delinquency and oreclosure rates exact a tremendous toll on individual borrow-ers and their communities. Foreclosures also exert downward pressure on home prices, urther exacerbatingproblems in the housing market and the broader economy. Concerns about the impacts o rising oreclosureshave led to a variety o e orts aimed at helping owners to remain in their homes, including substantial support

or oreclosure prevention counseling and expanded loan modi cation and re nancing options.

One prominent early e ort launched in late 2007 by HUDs Federal Housing Administration (FHA) was theFHASecure program, which was intended to use FHA insurance to replace risky subprime and high-cost loans,including those that became delinquent due to a payment reset, with xed-rate, long-term nancing. However,there was limited use o this program in part due to eligibility criteria that prevented participation or manyborrowers. In July 2008, Congress authorized FHA, under the Housing and Economic Recovery Act o 2008,to insure up to $300 billion in loans via a new program: HOPE or Homeowners. Although some lenders haveexpressed interest in the program, as o July 2009 the program had insured only one loan. Amendments havebeen made to increase program participation, including a reduction in the amount o principal lenders arerequired to write down in order to place a borrower in the program. Additional legislative changes that were

enacted in May 2009 urther modi y HOPE or Homeowners with the goal o helping additional amilies.

Another prominent e ort is the HOPE NOW Alliance, ormed in 2007 to help keep borrowers in their homesby increasing their access to counseling and in ormation and creating a uni ed private industry plan to acilitateloan workouts. Initially, the majority o these workouts consisted o repayment plans, accounting or more thantwo-thirds o all workouts in the rst year o operations. While workouts can help some households meet theirmortgage payment obligations, or many subprime borrowers repayment plans o er limited relie as they place


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additional debt repayment obligations on households already struggling to make mortgage payments. Givencontinued increases in oreclosures and deepening economic distress, public pressure has been rising on inves-tors and servicers to engage in more aggressive loan modi cations through interest rate and principal reductionsin order to keep more borrowers in their homes. Since mid-2008, HOPE NOW has reported an increasingnumber o loan modi cations by its participating servicers. From July through December 2008, nearly one-hal

o the loan workouts reported were loan modi cations rather than repayment plans.Even as the number o modi cations increases, larger numbers o recently modi ed loans are now rede aulting.In large part, this per ormance refects the act that most loan modi cations to date do not reduce monthly pay-ments. White (2008) ound that voluntary loan modi cations o subprime borrowers completed through August2008 typically increased a borrowers principal debt and virtually none involved a reduction in principal owed.While servicers did seem willing to lower mortgage interest rates, a recent assessment o the HOPE NOW Al-liance program by the Center or Responsible Lending estimated that only one in ve o all subprime workoutplans actually lowered monthly mortgage payments or nancially distressed borrowers.

Most recently, the ederal government announced a new e ort to encourage loan modi cations as part o itsMaking Home A ordable plan on February 18, 2009.11 This plan is designed to o er assistance to 7 to 9 millionhomeowners making good- aith e orts to stay current on their mortgage payments. It provides access tolow-cost re nancing that will reduce monthly payments or homeowners who owe more than 80 percent o their home value and whose mortgages are owned or guaranteed by Fannie Mae or Freddie Mac. The planalso commits $75 billion through the Treasury Department, working with the GSEs, FHA, the Federal DepositInsurance Corporation, and other agencies, to undertake a comprehensive multipart strategy to achieve loanmodi cations or 3 to 4 million at-risk homeowners to help them stay in their homes.

This homeowner stability initiative aims to reduce mortgage payments to 31 percent o income to help thoseborrowers in imminent danger o de ault. The Home A ordable Modi cation Program aims to achieve thisgoal primarily through subsidizing interest rate reductions, although the program does provide servicers andinvestors with the option o reducing outstanding principal balance as a means o achieving the 31-percent

payment-to-income target. To date, many servicers have been reluctant to o er interest rate and principalwrite-downs even when such modi cations could avoid lengthy and costly oreclosure costs. In part thisrefects concerns that existing pooling and servicing agreements (PSAs, or the legal agreements that govern theservicers authority to engage in loan modi cations on behal o the collection o investors with interests in anysingle mortgage-backed security pool) may limit ability o servicers to engage in loan modi cation activities.Yet, at the same time, many o these agreements contain inconsistent, and arguably not en orceable, languageas to what actions are permissible under the contract. The expectation is that the Home A ordable Modi cationProgram will encourage wider use o loan modi cation tools because it o ers substantial interest rate subsidies,o ers bonus success payments to borrowers and servicers, and creates clear industrywide standards on howbest to interpret these PSAs.

Some question whether the Home A ordable Modi cation Program approach is su cient to address allsituations. For some borrowers, the subsidies provided through the program will not be su cient to allow themto stay in their homes. Some o these borrowers may be helped through the improved HOPE or Homeowners

11 The February 18, 2009, announcement was originally entitled the Homeowner A ordability and Stability Plan andhas since become known as Making Home A ordable.


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Program. But many have argued that bankruptcy re orm is needed to allow bankruptcy judges to modi ymortgages or amilies who have run out o other options.

Potential Policy Changes To Reduce the Risk o Future Foreclosure CrisesA undamental cause o the oreclosure crisis was the substantial increase in loans made to borrowers withinsu cient willingness or ability to meet their payment obligations. As a result, there is a growing consensusregarding the need or policy changes to improve the unctioning o both the primary and secondary mortgagemarkets to help reduce the number o oreclosure-prone loans be ore they are made. A June 2009 report bythe Treasury Department presenting a comprehensive plan or re orm o regulatory oversight o the nancialsystem has identi ed a series o detailed proposals that has provided a ramework or this ongoing policydebate (U.S. Department o the Treasury, 2009).

To begin with, there is a clear need to enhance the ability o consumers to make appropriate choices in themortgage market. Recent research on consumer behavior provides growing evidence that many consumerstook out mortgages that they did not understand or that were not suitable or their needs. In particular, there isample evidence that consumers are o ten overwhelmed by aggressive mortgage sales and marketing e orts that

exploit various consumer decision making weaknesses.

One potential approach to aide consumers is to expand consumer awareness campaigns to warn against abusivelending practices. Un ortunately, even the best-designed education and outreach e orts can be easily swampedin a marketplace characterized by aggressive marketing by lenders. In the ace o this marketing onslaught,many community groups and counseling organizations are expanding their capacity to act as a buyers brokerto help clients search or the best mortgages while earning a small ee or o ering this service like any othermortgage broker. Building on this concept, there have been calls or the government to help establish a nationalnetwork o trusted advisors, independent o mortgage providers who are available on demand to review loandocuments, educate borrowers, and advise them o the suitability o their loan to their circumstances.

Another potential approach to help consumers make better choices is to apply the opt-in/opt-out principleidenti ed in the consumer behavior literature to structure more e ective mortgage marketing o good loans;that is, loans that are airly priced and that consumers understand and can a ord to repay over the li e o theloan.12 For example, many programs rst o er a prospective consumer a sa e, level-payment xed-rate mort-gage priced in an a ordable manner. By starting with the de ault option o o ering a simple and sa e product,this approach builds on the observation that consumers o ten latch onto the rst option or which they quali y.

While expanding the range o consumer counseling and assistance e orts is likely to be help ul, it may alsobe important to more orce ully counteract aggressive marketing practices and to consider banning inherentlydeceptive loan eatures. Moreover, since the mortgage market will continue to create new products, e orts toban speci c loan terms or mortgage products may not keep pace with these innovations. A number o initia-tives have been enacted or proposed to enhance existing consumer protections, including recently releasedprotections or subprime borrowers under the Truth in Lending Act, which requires lenders to evaluate botha borrowers income and ability to repay prior to originating a subprime loan, and 2008 HUD revisions to theReal Estate Settlement Procedures Act regulations.

12 A detailed discussion o opt-in/opt-out loans is provided in Barr, Mullainathan, and Sha r (2008).


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But even while applauding these initial e orts, many consumer advocates argue that additional re orm isneeded. They recommend limiting or banning yield spread premiums, which provide brokers and loan o -

cers with incentives to sell borrowers higher priced loans, and prepayment penalties, which lock borrowersinto high-priced loans and expose them to high ees i they need to re nance or sell their homes. A proposedrevision to Regulation Z, the regulation which implements the Truth In Lending Act, would ban yield spread

premiums and lender loan o cer compensation related to loan terms. There are also proposals to developnew standards or truth in lending so that mortgage brokers and lenders do not have incentives to get arounddisclosure rules. Under this approach, ederal regulators would evaluate whether a creditors disclosure wasobjectively unreasonable, in that the disclosure would ail to communicate e ectively the key terms and riskso the mortgage to the typical borrower.

Finally, the recent mortgage crisis has exposed a range o shortcomings with the approaches that have beenused in the past by many mortgage servicers, including the tendency to push less costly (to the servicer)repayment plans and short-term modi cations rather than aggressively pursue options that may bene t bothborrowers (by helping them stay in their homes with an a ordable monthly payment) and investors (by ndingresolutions that have a higher expected return than a oreclosure). This has led to proposals, such as the ederalgovernments Making Home A ordable plan, that seek to better align mortgage servicer incentives with thoseo both consumers and investors and set standards or loan modi cations. Some have also called or imposing aduty to engage in loss mitigation e orts be ore initiating oreclosure actions.

A key aspect o the Treasury Departments proposals with regard to consumer protections include the establish-ment o a new Consumer Financial Protection Agency, which would have broad jurisdiction to protect consum-ers across the nancial sector rom un air, deceptive or abusive practices. In addition, the Treasury Departmentrecommends that this new agency develop stronger regulations governing consumer disclosures to ensure thatthey are transparent, simple, and air.

In addition to greater consumer protections, many also argue that improvements are needed in the generalregulatory structure overseeing the origination and nancing o mortgages. The ailure o ederal regulation

to adapt to the rapid changes in both the primary and secondary market was a key element in the explosion o high-risk lending and resulting surge in mortgage delinquency and de ault.

In the primary market, ederal oversight has largely ocused on ederally insured depository institutions. Butsince the boom and bust o the subprime market was led by nonbank institutions and less ully regulateda liates and subsidiaries o banks, in large measure, the nations regulatory mechanisms have been ocused onthe wrong parts o the system. To realign regulation with todays organization o nancial services, uni ormityo regulation is needed across the lending practices o all segments o the mortgage industry and its regulators.13 Re orms could reduce the incidence o nonbanks or a liates and subsidiaries o banks playing by di erentrules, and they could encourage hands-on oversight to improve air lending en orcement and improve compli-ance monitoring. An example o harmonizing the rules or all loan originators could be re orm o the CRA.

Such re orm applied to CRA would involve expanding the current onsite reviews and detailed le checks nowper ormed on assessment area lending o CRA-regulated entities to all mortgage lending activities. Most impor-tantly, CRA could be expanded to cover independent mortgage banking operations and other newly emergingnonbank lenders.

13 Uneven regulation and supervision le t what one ormer governor o the Federal Reserve Board described as agigantic hole in the supervisory sa ety net (Gramlich, 2007).


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The Treasury Departments recommendations address these concerns by calling or the Federal Reserve tooversee and set stronger capital requirements or all nancial rms even i they do not own banks. In addition,these recommendations also call or the creation o a single National Bank Supervisor to oversee all ederallychartered banks as well as the elimination o loopholes that allow some depositories to avoid bank holdingcompany regulation by the Federal Reserve.

Lack o uni ormity is also a problem in the regulation o secondary market participants. The two housing GSEs,Fannie Mae and Freddie Mac, are subject to extensive ederal oversight; however, most o the unds fowinginto the subprime market come through the lightly regulated private-label mortgage-backed securities markets.Although the U.S. Securities and Exchange Commission is charged with the responsibility o monitoring thewide range o security transactions linked to the subprime sector, the degree o due diligence in this sector

alls short o the oversight review o the GSEs. The development o a new and comprehensive regulatorystructure or the non-GSE segment o the market will represent a critical piece o the coming mortgage marketre orms. With regard to the secondary markets, the Treasury Departments recommendations call or enhancedregulation o securitization markets, including greater oversight o credit rating agencies and a requirement thatoriginators and security issuers retain a nancial interest in securitized loans.

In considering how best to regulate the GSEs or other secondary market participants, it is important to placethese issues in the broader context o how the capital markets channel investment dollars into the subprimemortgage market. Just as is the case in the primary market, the development o detailed secondary marketregulations that apply to only one segment o the marketplace can be both counterproductive and un air.Considering how best to reduce the tendency or capital used to und higher priced mortgages to fow throughless-regulated capital market channels is a worthy addition to the current debate on GSE re orm in particular,and capital markets in general.


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Introduction

This study o the root causes o the current extremely high levels o de aults and oreclosures among residentialmortgages represents the nal report to Congress by the Secretary o the Department o Housing and Urban

Development (HUD) pursuant to Section 1517 o the Housing and Economic Recovery Act (HERA) o 2008(P.L. 110-289). The problems in the mortgage market are routinely re erred to as a oreclosure crisis becausethe level o de aults and oreclosures greatly exceed previous peak levels in the post-war era and, as a result,have drawn comparisons to the levels o distress experienced in the Great Depression. This report contains areview o the academic literature and popular and industry press on the root causes o the current oreclosurecrisis and a discussion o initial ederal policy responses to the crisis. The report expands upon the earlierinterim report submitted to Congress on this subject with additional data and analysis o trends in the market aswell as an updated review o policy responses and recommended actions to mitigate the current crisis and helpprevent similar crises rom occurring in the uture.

Since HERA was passed in July 2008, the problems in the mortgage market have triggered a more general

crisis in global nancial markets as rst the securitization market or broad classes o assets seized up and thena broader credit crunch ensued as a shortage o capital held by banks and other lenders cut o lending generally(Gorton, 2008). Although the broader nancial crisis has roots in the mortgage market turmoil, there are manyaspects o the nancial market problems that go beyond issues in the mortgage markets. Thus, while this reportwill touch on some o the causes o problems in the broader nancial markets, much o this broader topic isbeyond the scope o this report.

To help de ne the nature o the oreclosure crisis, section 1 presents basic in ormation on trends in mortgagedelinquencies and oreclosure starts based on the Mortgage Bankers Associations (MBAs) National Delin-quency Survey .

Section 2 then presents a detailed review o the literature on the causes o the oreclosure crisis. This sectionis divided into three parts. First, it reviews the general academic literature over the last two decades analyzingthe general causes o mortgage delinquencies and oreclosures. Second, it reviews studies that have speci callyexamined the causes o the recent spike in delinquencies and oreclosures to levels not seen since the GreatDepression. Finally, section 2 concludes by reviewing both the academic literature and articles in the popularpress that shed light on actors that ostered signi cant growth in the origination o the highly risky loans thatwere the root cause o the current crisis.

Section 3 then ocuses on potential policy responses to the crisis. This section draws upon articles and reportsby academics and advocacy groups. There are three main parts to this section. The rst part discusses potentiale orts to remedy the high levels o delinquencies and oreclosures among current homeowners. The secondpart then presents policy options to help reduce the risk o high oreclosure rates in the uture. The last partoutlines potential approaches or more comprehensive re orm o regulation o the primary and secondarymortgage markets.


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1. Trends in Delinquencies and Foreclosures

Arguably, the rst tremors o the national mortgage crisis were elt in early December 2006 when two sizeablesubprime lenders, Ownit Mortgage Solutions and Sebring Capital, ailed. The Wall Street Journal described the

closing o these rms as sending shock waves through the mortgage-bond market.14

The ailure o these rmswas triggered by high levels o early payment de aultsnewly originated loans on which borrowers quicklymiss several payments. Under the terms o sales agreements with investors, lenders can be orced to buy back loans with early payment de aults. Since mortgage banking rms are not highly capitalized, a signi cantnumber o orced mortgage buybacks can quickly lead to insolvency. By late 2006, the volume o early pay-ment de aults was rising rapidly, spurring a spike in the volume o mortgage buybacks and pushing more andmore subprime lenders into untenable nancial positions. 15

Yet, when the MBA released the results o its National Delinquency Survey or the third quarter o 2006 onDecember 14, 2006, there was not yet a sense o panic (see Exhibit 1). While the survey showed that delin-quency and oreclosure start rates were rising, particularly among subprime borrowers, the tone surrounding

this news was still cautiously optimistic, with the MBA predicting that there would only be a modest increasein delinquencies over the next several quarters as the housing market bottomed. 16 At the same time, a verydi erent assessment was presented in a report released on December 19 by the Center or Responsible Lend-ing (CRL), which estimated that more than 1 million subprime loans originated in recent years would end in

oreclosure, producing the worse oreclosure crisis in the modern mortgage era (Schloemer et al., 2006). CRLsoreclosure outlook was based on orecasts by Moodys Economy.com showing that house prices were likely toall in many market areas in the wake o recent record levels o housing price growth.

By late February 2007, when the number o subprime lenders shuttering their doors had reached 22, one o therst headlines announcing the onset o a mortgage crisis appeared in The Daily Telegrap h o London.17 By

March, it was clear that a mortgage crisis had begun and was worsening. 18 When the MBA released the resultso its delinquency survey or the ourth quarter o 2006 in March 2007, the oreclosure start rate was ound tohave hit a record level.19

Exhibit 1 presents trends in two key measures o mortgage distress rom the MBAs National DelinquencySurvey: the share o mortgages that were 90 or more days behind in their payments and the share that startedthe oreclosure process. As shown, the oreclosure start rate or all mortgages exhibited a airly sizeable increaseo 0.08 percentage points in the ourth quarter o 2006, pushing the rate to the new record high o 0.54 percent.While the 90-day delinquency rate was also trending strongly upward at this point, it would not reach a newrecord high until two quarters later, in mid-2007. The act that the rate o oreclosure starts was already at

14 Mortgage Sector Withstands Subprimes Fallout, Danielle Reed and Anusha Shrivastava, The Wall Street Journal ,December 9, 2006.

15 Tremors at the Door, Vikas Bajaj and Christine Haughney, The New York Times , January 26, 2007.16 Late Mortgage Payments and Foreclosures Rise, The New York Times , December 14, 2006.17 US Mortgage Crisis Goes into Meltdown, The Daily Telegraph , February 24, 2007.18 Mortgage Crisis Spirals, and Casualties Mount, Julie Creswell and Vikas Bajaj, The New York Times , March 5,

2007.19 Record Foreclosures Hit Mortgage Lenders, USA Today , March 13, 2007.


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record levels 6 months ahead o when the 90-day delinquency rate would set a new record is an indication o the importance o early payment de aults in the early stages o the crisis, with many loans going straight romdelinquency to the start o oreclosure proceedings.

In hindsight, the increases in delinquency and oreclosure rates experienced in early 2007 were still somewhatmild compared to what was to come. Both o these measures o distress experienced large and steady increasesinto 2008, shattering previous records or both. Prior to 2006, the highest rate o oreclosure starts had been0.50 percent, reached in the a termath o the economic recession that started the decade. By the second quartero 2008, this rate was more than twice as high, at 1.08 percent. Similarly, the 90-day delinquency rate, whichhad reached a new record o 1.00 percent in 2005, had more than doubled to 2.09 percent by the third quarter o 2008. Most recently, oreclosure starts declined in the third quarter o 2008, but the MBA speculated that thisrefected some lenders temporary moratoria on oreclosures and increased e orts by lenders to increase thevolume o workouts with borrowers short o oreclosure.20 But, with serious delinquencies continuing to surgeinto new records each quarter, there does not appear to be any sense that the growth in the magnitude o thecrisis is slowing. Indeed, oreclosure starts increased sharply in the rst quarter o 2009 to reach yet a new high.

The MBA data provide a number o use ul insights into the nature o the mortgage crisis. As is well known,subprime loans have accounted or a signi cant share o troubled loans during the current crisis. Exhibit 2shows trends in oreclosure starts by major market segment as categorized in the MBA dataprime, subprime,

Exhibit 1: 90-Day Delinquency and Foreclosure Start Rates

Source: Mortgage Bankers Association, National Delinquency Survey

20 Mortgage Troubles Rise to Record Levels, Renae Merle, The Washington Post , December 6, 2008.


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Exhibit 2: Foreclosure Start Rate by Mortgage Market Segment

Source: Mortgage Bankers Association, National Delinquency SurveyNote: Annual fgures are average o quarterly data.

and Federal Housing Administration (FHA)-insured loans. Since 1998, when the MBA rst began reporting sepa-rately on the prime and subprime sectors, oreclosures rates in the subprime sector had been many multiples therate o oreclosure starts in other market segmentsroughly nine times the rate o prime loans and two-and-a-hal times the rate in the FHA-insured sector. As shown in Exhibit 2, since 2006, when the oreclosure start ratebegan to rise sharply, the increase in the rate in the subprime sector has been particularly dramatic.

The much higher risk o oreclosure among subprime loans is also made evident when 90-day delinquencyrates are compared across market segments (Exhibit 3). While subprime loans have always had a much higher

oreclosure start rate than other segments, there was little di erence in the 90-day delinquency rates betweensubprime and FHA-insured loansuntil these trends diverged drastically in 2007. The much larger di erencein oreclosure start rates among subprime loans relative to di erences in 90-day delinquency rates refects the

act that once subprime loans became delinquent, they were much more likely to enter oreclosure than othermarket segments.

The high oreclosure risk among subprime loans was no secret even be ore 2006. As early as 1998, the Na-tional Training and In ormation Center (NTIC) in Chicago highlighted a sharp rise in oreclosures in minority

neighborhoods in Chicago and linked these increases to the growth o subprime lending in these areas (NTIC,1998). In the wake o NTICs work, a number o other studies revealed similar trends in other market areasaround the country (Bunce et al., 2000). As will be discussed in more detail at the end o this section, histori-cally high oreclosure rates were evident among 20 states in 2002 in the wake o the 2001 recession.

But, while the subprime oreclosure risk was well documented, the overall market share o subprime loans wasstill low enough that the high rates o oreclosure starts were not pushing up overall oreclosure rates to record


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levels. As shown in Exhibit 3, the oreclosure start rate among subprime loans was higher in 2001 at the timeo the last recession than it was in 2006, when the current oreclosure crisis began. But whereas subprime loansonly accounted or 2.6 percent o all loans in MBAs survey in 2001, by 2006 this share had increased morethan ve old to 13.5 percent (see Exhibit 4).21

In act, because the MBA data show the share o alloutstanding mortgages by market segment, these data donot adequately illustrate the growing importance o subprime and other riskier loan segments among loansoriginated during this period. Using data rom Inside Mortgage Finance , Exhibit 5 shows the share o mort-gage originations in dollars accounted or by subprime, Alt-A, and home equity loans rom 2001 through 2006.The Alt-A market segment consists o loans made to borrowers with prime credit histories, but incorporatesother loan terms that make these loans riskier than standard prime mortgagesmost commonly entailing theuse o limited or no documentation requirements or borrowers income and/or assets as well as interest-onlyor optional monthly payment levels. 22 Home equity loans are second mortgages, most commonly originated

21 In part, the sharp rise in the subprime market share reported in the Mortgage Bankers Association data may refect

changes in reporting practices among lenders participating in the National Delinquency Survey to include moresubprime loans that were previously excluded rom the survey. Nonetheless, the sharp rise in market share rom 2003to 2005 is consistent with data rom Inside Mortgage Finance showing the subprime markets share o mortgageoriginations more than doubling to 20 percent over this period. When this high share o new originations is coupledwith a huge wave o re nancing in 2003 due to historically low mortgage rates, it is not improbable that the subprimeshare o all outstanding mortgages could have doubled over this period.

22 Option adjustable-rate mortgages give the borrower several options or each monthly payment during the earlyyears o the loan: a ully amortizing payment, an interest-only payment, or a payment that is less than the interestowed that month, leading to an increase in the outstanding loan balance.

Exhibit 3: 90-Day Delinquency Rate by Mortgage Market Segment



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Exhibit 4: Subprime Share of Mortgages in Mortgage Bankers Association National Delinquency


Exhibit 5: Subprime, Alt-A, and Home Equity Loan Share of All Mortgage Originations

Source: Inside Mortgage Finance


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during this period in tandem with a rst mortgage or 80 percent o the homes value. These simultaneous homeequity loans, known as piggy-back loans, would be or up to 20 percent o the home value, allowing theborrower to obtain a prime rst mortgage without mortgage insurance while paying much higher interest rateson the home equity loan. Between 2001 and 2003, these three segments together accounted or about 15 percento all mortgage originations. Beginning in 2004, all three o these market segments grew rapidly, achieving a

combined market share o 48 percent in 2006. In reviewing data rom the MBAs National Delinquency Survey,it is important to bear in mind that the Alt-A segment is likely to be reported in the prime market segment whilehome equity loans are not covered by the MBA survey.

With subprime mortgages accounting or such a large share o outstanding loans, the relatively modest risein the oreclosure starts rate among subprime loans in 2006 had a much larger impact on the market than thespike in oreclosure rates in 2001. Exhibit 6 shows the trends in the number o loans starting oreclosure bymarket segment rom 1998 through 2008. In 2006, as the oreclosure crisis rst became evident, the volume o subprime oreclosures increased by more than 100,000, accounting or much o the increase o about 120,000in oreclosure starts in the overall market. This sharp increase in the volume o oreclosure starts occurred eventhough the subprime oreclosure start rate was still below peak levels rom 2001 (see Exhibit 2). In 2007, thevolume o subprime oreclosure starts increased by nearly 300,000, accounting or more than one-hal o theoverall increaseeven though subprime loans only accounted or about one in eight o all outstanding mort-gages. In part, the sharp increase in 2007 refects the much higher oreclosure start rateup more than a ullpercentage point rom 2006as well as the act that the number o subprime loans reported in the MBA surveywas nearly seven times the volume reported in 2001.

However, in 2007 and 2008, the volume o prime oreclosure starts also increased sharply. In 2007, the number o prime loans entering oreclosure nearly doubled to about 500,000. The increase in prime oreclosure starts waseven larger in 2008, reaching more than 850,000 loans. While still less than the roughly 900,000 oreclosure

Exhibit 6: Numbers of Loans Starting Foreclosure by Market Segment



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starts among subprime loans, in 2008 the prime market has come to account or an increasingly large share o all oreclosures. Across all market segments, oreclosure starts reached nearly 2 million loans in 2008greatlyexceeding the levels predicted by CRL in 2006 as representing the worst mortgage crisis in the modern era. 23

While the MBA data do not identi y subsegments o the prime market, based on in ormation rom othersources, much o the increase in prime market oreclosures is occurring among Alt-A loans.24 The MBA dataalso highlight the act that much o the oreclosure crisis can be linked to adjustable-rate mortgages (ARMs)in both the prime and subprime sectors. Exhibit 7 shows annual trends in the number o prime and subprimemortgages starting oreclosure by whether the loan has a xed or adjustable rate. At the start o the mortgagecrisis in 2006, the rise in oreclosure starts occurred only among adjustable-rate prime and subprime mortgages.There have continued to be sharp increases in oreclosures among both subprime and prime ARMs; in 2008,these two categories o loans accounted or a large majority o all oreclosure starts. However, oreclosurestarts have also increased substantially among xed-rate loans, particularly in 2008 as economic conditionshave deteriorated.

The high percentage o prime oreclosures accounted or by ARMs is out o proportion to the share o all primeloans that are ARMs. While ARMs only accounted or 18 percent o prime loans reported in the MBA data in2008, these loans accounted or 52 percent o all prime oreclosure starts. The disparity is also evident among

23 Delinquencies Increase, Foreclosure Starts Flat in Latest MBA National Delinquency Survey, Mortgage BankersAssociation, December 5, 2008.

24 See, or example, Alt-A Credit: The Other Shoe Drops, David Liu, Shumin Li, The MarketPulse , December 2006,LoanPer ormance; Mortgage Crisis Spreads Past Subprime Loans, The New York Times , February 12, 2008; andFannie Having Debt Woes, National Mortgage News , November 17, 2008.

Exhibit 7: Number of Loans Starting Foreclosure by Loan Type and Market Segment

Source: Mortgage Bankers Association, National Delinquency SurveyNote: Annual fgures are sums o quarterly


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subprime loans, although it is not as large. ARMs accounted or 48 percent o subprime loans in the MBA databut 73 percent o subprime oreclosure starts.

In part, the high oreclosure rates among ARMs may refect the potential or payment shock or borrowerswhen the interest rates on these loans rst reset. However, as will be discussed urther later in this report, theincidence o early payment de aults among these loans suggests that much o their poor per ormance may berelated to lax underwriting that allowed borrowers to take on monthly payments that were una ordable evenbe ore interest rate resets occurred.

In sum, data rom the MBA National Delinquency Survey highlight a ew key eatures o the oreclosure crisis.First, a substantial portion o the crisis can be traced to both the growing volume o and rising oreclosure ratesamong subprime loansparticularly in the initial phases o the crisis. Second, oreclosure starts have beenmuch higher among adjustable-rate loans in both the subprime and prime sectors, with much o the problemamong prime loans concentrated in the Alt-A segment o the market. However, as the crisis continues into itsthird year and the nations economic recession worsens, oreclosure starts are also rising sharply among prime

xed-rate loans as well.

Regional Trends in ForeclosuresAs shown earlier, data rom the MBA nd that oreclosure rates are now nearly three times higher than previ-ous peak levels rom any time over the past 30 years. Where new records or oreclosure starts rates used tobe measured in hundredths o a percent, it has not been uncommon or this measure to increase by tenths o apercent in a single quarter. Given the magnitude o this crisis, it is perhaps not surprising that the increase in

oreclosures is evident in most areas o the country. Nonetheless, there are signi cant di erences in the extento the oreclosure crisis across market areas.

Exhibit 8 shows the number o states with a oreclosure start rate exceeding 0.50 percent in a given year

beginning in 1979, when the MBA rst conducted the National Delinquency Survey . A oreclosure start rate o 0.50 percent is taken as an indicator o severe distress in the mortgage market as this was the national recordlevel prior to 2007. As shown in Exhibit 8, there were widespread problems evident at the state level as earlyas 2000. During the 1980s, the severe economic recession in the oil patch states led to signi cant oreclosurestart rates in seven to nine states each year rom 1986 through 1990. This period has been viewed as one o themost serious mortgage oreclosure episodes in the post-war era. More speci cally, oreclosure rates in Texasand surrounding states rom this time were used as the basis or the stress test o the government-sponsoredenterprises capital requirements by its regulator. But by 2000, the number o states with oreclosure start ratesexceeding 0.50 percent was already at nine. By 2002, at the height o oreclosures in the wake o the previ-ous economic recession, the number o states exceeding this rate reached 20, more than double the numberachieved in the 1980s. Most o these states were in the Midwest and the South in areas with high shares o

subprime loans. While the number o states exceeding a oreclosure start rate o 0.50 percent declined through2006, there were several states that saw the situation deteriorate even urther, experiencing very high rateso starts (in excess o 0.80 percent). These states included Indiana, Ohio, and Michigan. With the start o the national oreclosure crisis in 2007, the number o states with oreclosure start rates above 0.50 percentexploded, reaching 35 in 2007 and 46 in 2008. The number o states with very high rates o oreclosure startsalso reached unprecedented levels, with 18 states in this category in 2008. Clearly, the oreclosure crisis is notlimited to a small number o states.


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Table 1 in the appendix provides summary in ormation or all 50 states and the District o Columbia onchanges in oreclosure starts rates rom 2005, be ore the national oreclosure crisis began, to 2008. Thetable also provides selected in ormation or each state on high-cost loan shares, changes in house prices, andunemployment rates to provide some indication o the actors that may help explain variations across states in

oreclosure levels.25 States have been divided into six groups in this exhibit based on changes in the oreclosurestart rate between 2005 and 2008 as well as the level o oreclosure starts in 2008.

Exhibit 9 maps the six categories identi ed in Table 1. The rst group, shown in red, consists o the our statesthat have experienced the sharpest rise in oreclosures rom 2005 to 2008, with an increase o more than 1.00percentage points. The average oreclosure start rate among this group is 1.76 percentmore than twice thenational average. This group has been re erred to as the sand states as it includes Arizona, Cali ornia, Florida,and Nevada. There are several characteristics o this group that stand out rom the data in Table 1 in theappendix. Speci cally, these sand states all had high incidence o subprime lending based on their high shareso high-cost loans in 2006. While the average high-cost loan share across states was 27.2 percent, high-costloans averaged 33.6 percent across the sand states. The high-cost lending in theses states was also coupled witha much larger run-up in home prices be ore the crisis hit, as indicated in Table 1 by an average gain in home

prices o 24.2 percent in 2005 compared to a national average across states o 10.3 percent. Perhaps because o this robust house price growth, these states also had the lowest oreclosure start rate in 2005 o any the groups,

Exhibit 8: Number of States With Foreclosure Start Rates Above 0.50 Percent

Source: Mortgage Bankers Association, National Delinquency SurveyNote: Annual rates o oreclosures started are average o the quarterly rates.

25 High-cost loans are originated with an annual percentage rate at or above 3 percentage points plus the yield o aTreasury security o comparable maturity. Not all high-cost loans are necessarily subprime; however, high incidenceo high-cost lending is generally indicative o high incidence o subprime lending.


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Exhibit 9: State-Level Trends in Foreclosure Starts

averaging just 0.20 percent. However, the all in house prices has also been most dramatic among the sandstates, declining by an average o 20.9 percent in 2008 alone. Further exacerbating problems in these marketshas been a sharp rise in unemployment since 2005, with unemployment rates rising rom below the nationalaverage to among the highest rates in the country.

It is noteworthy to contrast the experience o the sand states with the Group 2 states, which are de ned asthose states or which the level o oreclosures starts in 2008 was high (above 1.00 percent), but the gain in

oreclosure starts rom the inception o the crisis was not as high as the gain exhibited by the sand states inGroup 1. Group 2, shaded in orange in Exhibit 9, comprises states that had high oreclosure rates even be orethe crisis began due to weaknesses in local economies. Prominent among these states are the industrial states

rom the Midwest, including Illinois, Indiana, Michigan, and Ohio. As o 2005, this group o states had thehighest average oreclosure rates in the country at 0.62 percent compared to an average across all states o 0.39percent. As o 2005, the housing problems in these areas appear related to a combination o high shares o high-cost lending (30.5 percent o all loans in 2006) and the weakest house price growth o any group o states(5.2 percent in 2005). This group also had much higher unemployment rates in 2005 than other states. Since2005, economic conditions have deteriorated even urther, with alling housing prices and rising unemploymentcontributing to increases in oreclosure rates o more than 0.50 percent on average. With high oreclosure startsrates in 2005 and worsening conditions since then, this group o states has the second highest average oreclo-sure starts rate in 2008 a ter the sand states.

The third group in Exhibit 9 consists o states that had increases in oreclosure starts rates since 2005 o morethan 0.40 but less than 1.00 percentage points. This increase is actually similar in magnitude to that o the


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second group o states, but because the third group had below-average oreclosure rates in 2005, the 2008 ratesare lower than those o the second group, averaging 0.79 percent. States in this group, shaded in yellow, aremostly located along the eastern seaboard rom Virginia to Maine but also include Wisconsin and Minnesotain the Midwest and Hawaii in the West. The most prominent characteristics o this group that seem relatedto rising oreclosure rates are above-average house price growth in 2005 (13.4 percent) ollowed by slightly

higher than average price declines in 2008 (-4.8 percent). The share o high-cost loans in 2006 was close to thenational average. Overall, the experience o this group o states has been closest to the national average.

The ourth group o states is marked by an increase in oreclosure starts since 2005 o between 0.20 and 0.40percentage points. Foreclosure starts were close to the national average in 2005 but are now below average,having had smaller than average increases since then. Still, the average oreclosure start rate among these statesis 0.69 percent, well above previous national highs. This group, shaded in light green, includes a number o states in the south-central region, the Paci c Northwest, and the Northeast. Like the third group, these stateshad an average share o high-cost loans in 2006, but they were also marked by somewhat less volatility inhouse prices, having slightly below-average gains in 2005 and smaller declines in 2008.

The th group o states is marked by having oreclosure starts rates o less than 0.20 percentage points; thisgroup is among the states with the most modest increases in oreclosures since 2005. This group is distinguished

rom the sixth group, however, by having oreclosure starts rates o above 0.40 percent in 2005. These stateswere among those with the highest oreclosure rates in 2005, averaging 0.51 percentage points, and second onlyto the states in the industrial Midwest at that time. This group, shaded in green, is concentrated in the centraland southern plains states rom Nebraska down through Texas and also includes the Carolinas, Pennsylvania,and Utah. Like Groups 3 and 4, these states also had average levels o high-cost lending in 2006 but hadbelow-average house price increases in 2005, which may have contributed to the higher oreclosure rates at thattime. In 2008, house price declines were relatively small, averaging just 0.9 percent, which may explain why

oreclosure rates have risen less sharply in these areas. Like the ourth group, the average oreclosure starts rateo 0.65 percent is somewhat below the current national average but well above previous national highs.

The sixth group o states are the only states where it can be said that a oreclosure crisis has not been evident,as oreclosure starts rates have remained well below 0.50 percent. These states, shaded in dark green, includethe northern plains states o the Dakotas, Montana, and Wyoming as well as Alaska. One prominent character-istic o these states is a very low share o high-cost loans, averaging only 21.7 percent in 2006. These areas alsohad average house price growth in 2005 and generally have not experienced house price declines.

In general, there are two actors that stand out in di erentiating the six groups o states. The rst is the share o high-cost loans originated in 2006. States with the greatest increase and highest levels o oreclosures in 2008all had above-average shares o high-cost loans in 2006, while the states that have avoided the oreclosure crisisall had very low shares o these loans. The second key actor is trends in house price increases since 2004.Many states with the sharpest increases in oreclosures were marked by sharp increases in house prices through

2005, ollowed by the sharpest declines through 2008.

To illustrate how the oreclosure crisis has played out in di erent areas o the country, Exhibit 10 shows trendsin oreclosure starts rates rom 2004 through the beginning o 2009 or a sample o states rom Groups 1, 2, 5,and 6. At the beginning o the period, states rom the industrial Midwest stand out as having oreclosure ratesthat are well in excess o other parts o the country. States in the central and southern plains also had oreclo-sure rates that were consistently in excess o the national rate and close to the 0.50-percent level. In contrast,


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the sand states and upper plains states both had oreclosure rates that were well below the national average.By the end o 2006, the national oreclosure crisis begins to be evident with oreclosure starts increasing mostdramatically in the sand states. These states had a clear infuence on the national oreclosure rate, which alsomoved up markedly over this same period. Foreclosures also increased in the industrial Midwest, although theincreases were much less dramatic than in the sand states. Foreclosure rates in the central and southern plainsstates, which were consistently above the national average prior to 2006, increased relatively modestly until theend o 2008 and so are now well below the national average despite being higher than the nation prior to thecrisis. Finally, states in the upper plains have had only a mild increase in oreclosure starts, with most o thegains occurring since the beginning o 2008 when the nation entered a severe recession.

To illustrate the role that house price trends appear to have played in regional variations in the crisis, Exhibit 11presents trends in housing prices or these same groups o states since 2004. In general, the order o the lines

or the our state groups is in inverse order rom Exhibit 10. The sand states had house price increases that werewell in excess o the national level through the end o 2005. In 2006, these increases slowed substantially andby 2007 were declining. The sharp rise in oreclosure starts in Exhibit 10 or these states mirrors this dramatic

all in house prices. In contrast, the industrial Midwest states had the lowest rates o housing price appreciationprior to 2006 and have also experienced airly signi cant declines in house prices since 2006. The central andsouthern plains states had house price increases prior to 2006 that were only slightly higher than in the indus-trial Midwest, but the declines since 2006 have been airly modest. Finally, the upper plains states had houseprice increases that were about the national average through 2005 but have maintained positive growth rates ormuch longer than other regions.

Exhibit 10: Foreclosure Starts for Selected States

Source: Mortgage Bankers Association


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Exhibit 11: Annual Changes in House Prices for Selected States

Source: Federal Housing Finance Agency, State-Level House Price Index

While the data presented in this section is only illustrative, it does suggest the likely importance o bothsubprime lending shares and house price trends in contributing to the oreclosure crisis. The next section o the report presents a detailed review o the literature that examines with more rigor the relative importance o various actors in producing the crisis.


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2. Literature Review

2.1 General Literature on Causes o Foreclosures andDelinquencies

There is a rich economics literature examining the cause o mortgage oreclosures, generally re erred to asde ault in the literature.26 As noted in detailed reviews o this literature by Quercia and Stegman (1992) andVandell (1995), since the 1980s, this literature has been dominated by an option-based theory o mortgagede ault, where the mortgage contract is viewed as giving homeowners an option to put the home back tolenders by de aulting on their mortgage. In an option-theoretic view, the primary actor driving de aults is thevalue o the home relative to the value o the outstanding mortgage; when the home value alls substantiallybelow the mortgage debt, owners are better o by ceding the home to the lender.27 This type o situation hasbeen characterized in the literature as a ruthless de ault, where borrowers simply walk away rom theirmortgage obligations when it is in their nancial interest to do so.

However, as argued most prominently by Vandell (1995) and Elmer and Seelig (1999), a lack o housing equityby itsel generally does a poor job o predicting mortgage delinquencies, which are a necessary precursor to

oreclosures. As these papers point out, it is generally understood that most borrowers become delinquent dueto a change in their nancial circumstances that make them no longer able to meet their monthly mortgageobligations. These so called trigger events commonly include job loss or other income curtailment, healthproblems, or divorce. Both Vandell and Elmer and Seelig argue that oreclosures are most accurately thought o as being driven by a two-stage process: a rst trigger event that produces nancial illiquidity among borrowerswhich is then coupled with a lack o home equity that makes it impossible or the borrower to either sell theirhome to meet their mortgage obligation or re nance into a mortgage that is a ordable given their change in

nancial circumstances. In this view, a lack o home equity is an important determinant o oreclosures as itprecludes other means that borrowers can take to resolve an inability to meet their mortgage obligations, but

oreclosures are most commonly triggered by some other event that makes borrowers nancially insolvent.

For the most part, the literature provides numerous examples to support the view that most de aults are notruthlessly driven by alling house prices. One o the rst articles to put orth an option-theoretic view o mortgage de ault was Foster and Van Order (1984, 1985). However, the data on Federal Housing Administra-tion (FHA) borrowers used in their analysis show that only 4.2 percent o borrowers with estimated loan-to-value ratios o 110 percent or higher actually de aulted on their mortgage. Ambrose and Capone (1998), againexamining data on FHA borrowers, nd that loans with negative equity accounted or a small share o all loansthat became seriously delinquent and also a minority o loans that ended in oreclosure. More recently, Foote,Girardi, and Willen (2008) examine data on all homeowners in Massachusetts over a 20-year period and ound

26 Technically, mortgage de ault occurs when a borrower has missed three payments and a ourth is due. Thede ault leads lenders to initiate the oreclosure process, but historically a majority o de aults are resolved without a

oreclosure occurring.27 Option-theory also ocuses on borrowers ability to exercise a call option by prepaying the mortgage when interest

rates all. Thus, pure option-theoretic models ocus heavily on trends in house prices and interest rates to explain bothde aults and prepayments.


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that in the early 1990s only 6.4 percent o homeowners whose house values dropped below their mortgageamounts ended in oreclosure.

O course, while it may be that most de aults are not strictly ruthless, this does not preclude ruthless de aultsrom occurring. The magnitude o house price declines occurring now in many markets around the country

as well as the number o markets simultaneously experiencing house price declines are unprecedented in thepost-war era. Some owners are property investors who are purely motivated by nancial concerns and may bemore likely to pursue a ruthless de ault i it is in their nancial interest. Some owner-occupants who have theability to meet their monthly payments may decide to de ault when house values are substantially below theirmortgage debt either because o a desire to move to a new home or because they see limited nancial bene t

rom continuing to pay the mortgage given the level o prevailing rents relative to their mortgage costs and thedegree to which home prices would have to recover to make them whole. 28 But, given the h

hud's report to congress on the root causes of the foreclosure crisis

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