Most policymakers that talk about helping the housing market have been focusing on slowing down foreclosures. I have argued that there a number of foreclosures that are just inevitable. But to make that claim, or to make the alternate claim that we can reverse the foreclosure trend, there needs to be a clear framework for what causes foreclosures?
A quartet of NYU and New York Fed authors put together a paper published earlier this summer that asked the question: what happens to distressed mortgage borrowers? Their answer in short:
We find that the outcomes of the foreclosure process are significantly related to: the terms of the loan; the borrower’s credit history; current loan-to-value and the presence of a junior lien; the borrower’s post-default payment behavior; the borrower’s participation in foreclosure counseling; neighborhood characteristics such as foreclosure rates, recent house price depreciation and median income; and the borrower’s race and ethnicity.
So... everything causes foreclosures.
Digging into the paper a bit more, here is what the paper points out as the most prominent causes of foreclosure after looking at a robust data set of mortgages following them from delinquency through their result.
- Mortgages with riskier loan terms are significantly more likely to receive a lis pendens (foreclosure notice).
- Borrowers with worse credit scores at origination are less likely to receive lis pendens and go to auction, and more likely to receive modifications or refinance the loan on their own. This seemingly surprising result may signal that after controlling for loan terms, non-prime borrowers with higher credit scores are adversely selected in ways that are unobservable to the researcher, but are observable to servicers and underwriters so that lenders avoid giving these borrowers modifications, and the borrowers find it difficult to obtain a new refinance loan elsewhere.
- Borrowers with higher current LTVs are much less likely to avoid foreclosure by refinancing their mortgage or selling their homes, but are more likely to receive a modification. This likely reflects both the lower likelihood that the lender will be able to recoup losses by going through the foreclosure process when LTV is high, as well as the probability that lower LTV borrowers who cannot refinance are adversely selected and would not be able to repay, even with a modification.
- Having a junior lien is correlated both with a lower likelihood of modification, and increased likelihoods that the borrower will receive a lis pendens and that the property will go to auction.
- Borrowers who make some payments post-default are more likely to get a modification, but the effect is non-monotonic: the chance of a modification declines as the fraction of payments exceeds one half, presumably because these borrowers have demonstrated an increased ability to cure the loan on their own.
- We also find that borrowers who received foreclosure counseling are more likely to receive a modification, although we are not able to discern what part of this effect is due to selection.
- There is a positive association between the likelihood of modification and whether the community district in which the property securing the loan is located has suffered recent house price depreciation. Foreclosure rates may be acting as leading indicators for further house price depreciation or may reflect greater depreciation than is captured in the community district level house price indices. If that is the case, while modifications are more likely in depreciating areas, lenders may be reluctant to modify loans in neighborhoods with high rates of foreclosure for fear that prices in those neighborhoods may be especially likely to decline further.
- Hispanic and Asian borrowers are much more likely to end up at a foreclosure auction, possibly reflecting language barriers faced by these borrowers. Both black and Hispanic borrowers have a greater likelihood of modification.
The reality is that to prevent delinquent homes from going into foreclosure, you essentially have to reduce the loan term on a mortgage while increasing the value of the property and eliminating second mortgage claims, as long as the borrower has not made a few payments since initially defaulting. Changing the neighborhood or race of the borrower is basically out of the question (though don't doubt creative minds if the incentive is right). But if a public policy aims to increase home values and the problems with a mortgage are more about payment capacity and a lack of equity then, just avoiding the LTV issue is only a temporary measure. And that is why trying to prop up housing prices has not been the big fix.
Of course you could take the whole thing a step further back and ask what causes delinquencies in the first place. John Y. Campbell (Harvard), João F. Cocco (London Business School) wrote a paper published last month arging that mortgage defaults are triggered by negative home equity, which results from declining house prices in a low inflation environment with large mortgage balances outstanding. They find that once in delinquency, high loan-to-value ratios at mortgage origination increase the probability of negative home equity. High loan-to-income ratios also increase the probability of default in the first place by tightening borrowing constraints. According to Campbell and Cocco:
- Adjustable-rate mortgage defaults occur when nominal interest rates increase and are substantially affected by idiosyncratic shocks to labor income.
- Fixed-rate mortgages default when interest rates and inflation are low, and create a higher probability of a default wave with a large number of defaults.
- Interest-only mortgages trade off an increased probability of negative home equity against a relaxation of borrowing constraints, but overall have the highest probability of a default wave.
Again, policymakers are thus faced with a paradox if they want to try and game the system. Downward pressure on mortgage rates—which is the current goal of the Fed and Treasury—means more fixed-rate mortgages will wind up in delinquency than might with rising mortgage rates. But it also helps to support overall housing prices, which is another (delusional) aim of the government.
The takeaway—you can not stop mortgages from slipping into delinquency. And once there, for mortgages heading towards foreclosure there are a number paths the mortgage could take, but no stopping them all. So we see quarterly bank statements hinting hard that the mortgage delinquency problem is not slowing down, despite record low mortgage rates for refinancing or purchasing a home from a family that needs to sell.