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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70
Perc
en
tag
e o
f H
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s O
wn
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Ho
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Housing Bust: Foreclosures
Mortgage Foreclosures Started
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0.5
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Perc
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ortg
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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
0.00%2.00%4.00%6.00%8.00%
10.00%12.00%14.00%16.00%
30 Year Fixed
Adjustable
Impact of Low Interest Rates
HUD Composite Affordability Index
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7080
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100110
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130140
150
Aff
ord
abil
ity
Ind
ex
Rise In ARMs
Market Share Fixed v. Adjustable Rate Mortgages
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100
Perc
ent
PercentARM
PercentFRM
ARMs Follow SpreadARMs and Spread
01020304050607080
Year
Perc
ent A
RM
0.00%0.50%1.00%1.50%2.00%2.50%3.00%3.50%4.00%
Spre
ad
PercentageARM
Spread
Subprime ARM ResetsForeclosures: Subprime Mortgages
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Perc
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orec
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Star
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Subprime ARM
Subprime All
Subprime FRM
Prime ARM ResetsForeclosures: Prime Mortgages
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0.5
1
1.5
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2.5
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Perc
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orec
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Star
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Prime ARM
Prime All
Prime FRM
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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Year
Fore
clos
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Sta
rted
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Qua
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ppre
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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