The Mortgage Crisis

Todd J. Zywicki

George Mason University

Foundation Professor of Law

Senior Scholar, Mercatus Center

Homeownership Rose

Homeownership Rates

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Housing Bust: Foreclosures

Mortgage Foreclosures Started

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Theories of Foreclosure

Distress: Local Macroeconomic Problems Payment Shock and ARMs

Negative Equity and the “Put” Option Distinguish those who want to keep their

home but can’t from those who could but don’t want to

Macroeconomic Problems

Michigan, Ohio, Indiana Post-Natural Disasters Historically foreclosures rise a bit in

recessions

Monetary Policy

Mortgage Interest Rates

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Impact of Low Interest Rates

HUD Composite Affordability Index

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Rise In ARMs

Market Share Fixed v. Adjustable Rate Mortgages

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ARMs Follow SpreadARMs and Spread

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Subprime ARM ResetsForeclosures: Subprime Mortgages

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Prime ARM ResetsForeclosures: Prime Mortgages

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Are ARMs the Problem? Consumers Respond to Interest Rate spread:

Problem was monetary policy, not necessarily ARMs per se

Home buyers self-select for ARMs: Risk aversion

Consumers with ARMs benefited a lot between 2000-2004

Percentage of ARMs higher in past Very Common in Rest of World

The Option Model

Housing Prices and Foreclosure

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ForeclosuresStarted

QuarterlyHouse PriceAppreciation

Factors Affecting Option Value As value of option rises or cost of exercise falls,

homeowners have stronger incentives to respond Speculator v. Non-Speculator: Continuum (put and

call option) State Antideficiency/Nonrecourse Law

California, Arizona Impact increases as expected wealth and income

increases Downpayment, “Piggyback Loans,” interest only,

refi, “Skin in the Game” Lenders underestimated both decline in home prices

and propensity of new homeowners to default when prices fall

What Happened? Two Phases of Subprime Bust-out:

Phase 1, 2001-2004: Loans performed well even with unusual terms, but riskier terms offset

Phase 2, 2005-2007: (1) risk-layering was explosive, (2) low equity especially bad (interest-only, no down, cash-out refinancing, piggybacks, home equity loans) all of which rose in Phase 2

Mistakes versus corruption: ex., lo\w-doc refi Other factors may have exacerbated others probably not:

Probably Yes: Fannie/Freddie, tax code, rating agencies Maybe: securitization, brokers Probably No: hybrids, CRA

3 Housing Markets: (1) Traditionally volatile, (2) steady growth, (3) late-boomers Foreclosure problem now centered on late-boomers Speculators and attitudes of new homeowners

What Next? Foreclosure Mitigation: Type I v. Type II Errors:

How many “unworthy” homeowners are we willing help? If problem is negative equity, has negative externality

leveled off? Just supply and demand? If a function of state laws, why is that Washington’s

problem? Can we separate categories practically? Refi problem

Beware unintended consequences: Ex., prepayment penalties and cash-out refinance

Protect innovation: Boom and Bust Cycles Reforms to incentives for housing overinvestment

and speculation

Cramdown and Bankruptcy

Cramdown: unintended consequences Higher interest rates & costs Contagion to other types of consumer credit Helping “worthy” borrowers? Interest rates v.

Principal MBS and Worsen Credit Freeze

Consumer Financial Products Safety Commission Loans are not toasters Loans generally are not “inherently

dangerous” U.S. standard mortgage an outlier Examples:

Low-doc loans: refi versus purchase Prepayment penalties: Cash-out refinance Adjustable-rate mortgages