The Foreclosure Crisis
February 3rd, 2011
The U.S. housing market bubble burst in the latter half of 2007 and three years later, the housing industry is still recovering. Lenders across the country are foreclosing on mortgaged homes and according to Brent Ambrose, Smeal Professor of Real Estate and director of the Institute for Real Estate Studies, it’s going to take a long time to get ourselves out of this mess.
“In order to stabilize the housing market, we need to work through the mortgage foreclosure process as quickly as possible to get the houses out from the banks, let them clear, and let the market set the price,” he says.
He and his coauthors Sumit Agarwal of the Federal Reserve Bank of Chicago, Souphala Chomsisengphet of the Office of the Comptroller of the Currency, and Anthony Sanders of George Mason University, are exploring the crisis on a micro-level.
They examine whether negative spillover effects from subprime mortgage originations result in higher default rates in the surrounding area.
Their study, “Thy Neighbor’s Mortgage: Does Living in a Subprime Neighborhood Affect One’s Probability of Default,” forthcoming in Real Estate Economics, takes this notion into account and analyzes the local housing market in Arizona’s Maricopa County. With Phoenix being one of the epicenters of the subprime crisis, Maricopa County was natural setting for the study.
A Cascade Effect
Ambrose and his coauthors note that there was an increase in the use of alternative, or hybrid, mortgages around the same time the housing bubble burst. These mortgages were given to people will low credit histories and because of it, became known as subprime mortgages.
They observed that subprime mortgages tend to be clustered in metropolitan areas where there was also an increase in home prices.
This clustering led them to think that there may be a cascade effect in the neighborhoods with high rates of foreclosures, assuming that a foreclosure sale acts as a public signal of a declining property market.
“One homeowner’s decision to default may start a default cascade by causing the remaining homeowners to reevaluate their property values downward,” they write.
But after controlling for individual borrower risk characteristics and foreclosures in the area, the researchers find that the concentration of subprime lending in the neighborhood does not increase the risk of borrower default. In fact, they found the opposite.
However, they find that higher concentrations of the more aggressive mortgage products, like hybrid-ARMS (adjustable-rate mortgages) and no- or low-documentation loans, did increase the probability of borrower default.
Ambrose explains that a popular hybrid-ARM is the 2/28, which is what led to many defaults. The 2/28 is a two-year fixed-rate mortgage that converts to an adjustable-rate mortgage for the next 28 years. When the payment resets after two years, it is known as payment shock.
“When the payment shock hit, the borrowers couldn’t make the new payments,” says Ambrose. “Couple that with a decline in house prices and the fact that they didn’t show documentation of any income to support the payments to begin with, you have a recipe for a problem.”
He hopes the findings are going to help policy-makers identify whether or not there needs to be more regulation in the market.
“You don’t want to make blanket rules and say no subprime loans because they have helped people get homes. Some of these people are still making their mortgage payments,” says Ambrose, who adds that the no-documentation loans or the interest-only, no-documentation loans are really damaging. “Now we can target regulations toward the really bad products.”
Ambrose admits that we have a long way to go to get things back on track.
“We’re in for an extended period of very low to negative price appreciation in housing,” he says. “We have to let the market take its course and set prices. As long as we’re intervening through policies that are trying to keep prices propped up, it’s just going to prolong the agony.”
- Brent Ambrose