Friday, July 03, 2009

Stronger Underwriting, Bigger Down Payments

Understanding the causes of the foreclosure explosion is required if we wish to avoid a replay of recent painful events. The suggestions being put forward by the administration and most media outlets -- more stringent regulation of subprime lenders -- would not have prevented the mortgage meltdown regardless of their merit otherwise.

Rather, stronger underwriting standards are needed -- especially a requirement for relatively high down payments. If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell. A further beneficial regulation would be a strengthening, or at least clarifying at a national level, of the recourse that mortgage lenders have if a borrower defaults. Many defaults could be mitigated if homeowners with financial resources know they can't just walk away.

We are at a crossroads where we can undo the damage to the housing market by strengthening underwriting standards in a reasonable way. But to do so political leaders must face up to the actual causes of the mortgage crisis, not fictitious causes that fit political agendas and election strategies.

Stan Liebowitz in today's WSJ


At 7/03/2009 10:05 AM, Anonymous Anonymous said...

Rather, stronger underwriting standards are needed -- especially a requirement for relatively high down payments.

The Democrats worked tirelessly for almost two decades at undermining lending standards. Recently, Barney Frank called on Fannie and Freddie to relax lending standards for condominium purchases.

The people most responsible for the crisis are now in complete control of the government. Good luck, at trying to get any rational reform.

At 7/03/2009 11:32 AM, Blogger Milton Recht said...

Chicken and egg problem. Did consumers' insatiable demand for housing (even if it were to speculate and flip) cause the bubble, and lax lending standards to compete with competition, or did lax lending standards cause the insatiable demand and the bubble.

In a capitalistic market, that suppliers (banks and home builders)will meet demand at profit maximizing prices is much more logical then consumer demand will meet supply.

Even with the lax standards and increased consumer housing demand, the home ownership rate in the US moved only a couple of percentage points.

Bigger down payments would just increase the transaction costs of owning a home. Buyers would resort to other means to make the down payment, such as borrowing from relatives, credit cards, etc. If people want something they look for ways to get it.

Is it wrong for homeowners to want to be landlords, buy a second home and rent it out for extra income? Is it wrong to want to own a vacation home?

What ever happened to self-control and living within one's means.

At 7/03/2009 12:07 PM, Blogger sethstorm said...

What ever happened to self-control and living within one's means.

What happened to relatively honest business and better perceptions of business? Both departed from existence.

To ignore that concept is to form an incomplete solution.

At 7/03/2009 1:13 PM, Anonymous Norman said...

Professor Liebowitz forgot to include the effects of negatively amortized loans which boosted the mortgage amount by 20% to 25% thus destroying equity all by itself. So, the teaser rates had a much bigger effect than he shows.

At 7/03/2009 2:45 PM, Blogger QT said...

A very good analysis highlighting the role of negative equity particularly in states with zero default.

This video echoes many of the same themes: Yale economists on the financial crisis.

Unfortunately, the present public policy approaches do not redress negative equity.

At 7/03/2009 3:57 PM, Blogger Benjamin said...

But no oh no, do not touch that sacred cow on nanny-statism, the home mortgage interest tax deduction. Even if you buy a $10 million house.

At 7/03/2009 11:07 PM, Blogger Patrick said...

I don't see how negative equity or a down payment of <3% can be a CAUSE of foreclosure. If you're original mortgage payment is affordable given your income and other debt payments simply having negative equity isn't going to cause foreclosure. Negative equity makes it hard to sell a house unless you can make up the difference out-of-pocket. Negative equity may pre-dispose you to foreclosure because inability to make payments can't be solved by selling the house, but it can't force to into foreclosure on its own.

At 7/03/2009 11:35 PM, Blogger QT said...


2 things:

1. there is no incentive for a homeowner to pay a debt that is in excess of the value of the home when they can walk away without any penalty in states that have zero default
2. negative equity makes it next to impossible to obtain financing when your mortgage comes up for renewal; the homeowner could choose to reduce the principle in order to obtain financing, but has very little incentive to put more money into an asset that is falling in value.

If you were faced with a huge debt for a house that would take years to return to its former value, wouldn't walking make the most sense particularly if there is no penalty for doing so? Incentives matter.

At 7/04/2009 12:47 AM, Blogger Robert Miller said...

There was a really good paper from the Boston Fed which showed people do not just get up and walk away when they are under water. There is a wedge where people will tolerate some negative equity but if it gets large enough, then they'll walk away. It's by Foote, Gerardi and WILLEN. They used 1991 data though. It would be interesting to see how well their predictions hold up in this market.

I think this crisis was different. There were many more speculators and much greater access to "affordable mortgages" with less than 20% down. Actually, many mortgages with 20% down are 100% leveraged because the DP was financed. Then there were low interest rates for a very long time, securitization, and secondary market activity.

I'd really like to see this paper to see how they controlled for the different variables.

Subprimes make up the majority of foreclosures in many states, even though prime outnumber them 5 to 1 in originations.

I agree with Milton. There was a coincidence of personal ambitions which fed this monstrous bubble. But I disagree that home ownership wasn't affected. It rose nealry 5% under Clinton and 2.5% under Bush. Those are enormous gains in a 10 year period. But as economist Joe Mason said, this was not home ownership. It was home living-in-ship with the option to sell for a profit.

As we sit here, the roots of the next housing crisis are spreading through the soil with speculation, foreclosure prevention, and FHA loans and incentives. Round 2 is about to begin.

At 7/04/2009 9:14 AM, Blogger Milton Recht said...

Robert Miller,

Boston Fed paper:
"Negative Equity and Foreclosure:
Theory and Evidence" by Christopher L. Foote, Kristopher Gerardi, and Paul S. Willen.

Also see St. Louis Fed paper:
"Quick Exits of Subprime Mortgages" by Yuliya S. Demyanyk

At 7/04/2009 11:32 AM, Blogger Patrick said...

As to point 1, I suppose that maybe having negative equity would make you want to walk from the obligation. However, I wouldn't want to have that on my record. I wasn't aware that there were states with a zero default policy. Does that mean that you can actually walk and have no trace of that default on your record? That would be a truly amazing policy, but I could see some state somewhere thinking that would be a good idea.

In my personal situation I probably have negative equity on my house right now as I opted to not put all of the cash I had available into the down payment on my house when I bought in March. I used the FHA financing option and got into a house that is well within my means to maintain (much cheaper than my previous rent) and didn't have to put in a lot of my free cash. I did this knowing that if I had to move suddenly I would be able to rent this easily, sell at a loss and cover the difference from cash, or pay for housing in two places. Any one of these options could work, but I realize that most people buy too much house and stretch to get there.

My point with explaining my situation is that if planned properly, a negative equity situation does not always provide an incentive to simply walk away. I am certain that sometime in the next 30 years my house will at least recover the equity that may have been lost and I'm willing and able to wait till then. A house is an investment of sorts, why dump it when it's down if you still have to live somewhere?

The second point you made is an interesting one. I've not really looked into the specifics of ARMs, but do you have to refi when the rates reset? I understand that if your plan was to start with an ARM and refi later at a low rate rather than actually let things reset you would be unable to refi since you'd have to come up with the equity difference out-of-pocket. Even in this case, the negative equity itself isn't causing the delinquency that leads to foreclosure. The negative equity only prevents a refi solution to give the homeowner a lower payment.

It still seems that the root cause is not the lack of equity in the house, but a lack of earning power to afford the debt payment. Someone who only put down 3% on a house that only took 15% of their gross income to cover the mortgage could continue paying that through a lot of different hardships regardless of what market value their house has.


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