This is the second part of an article summarizing the chapter on Mortgages from a Center for Responsible Lending (CRL)research paper titled The State of Lending in America and its Impact on U.S. Households.  Part one reviewed the role of the government in housing finance and looked at major players in that market.

The authors estimate that 12 million homes went into foreclosure between January 2007 and June 2012, doubling and sometimes tripling the historic foreclosure rate during any given previous quarter.  Millions of homes that started the process have not yet completed it.  CRL estimates that 3.3 million of owner-occupied loans originated between 2004 and 2008 completed the foreclosure process as of February 2012, with an additional 3.2 million of these loans 60 days or more delinquent or in some stage of the foreclosure.

Foreclosures have touched almost every geographic and demographic U.S. community but have hit hardest at middle- or higher-income and white non-Hispanics.  However, while the foreclosure crisis has been widespread and the majority of affected borrowers have been white, the crisis has disproportionately affected borrowers of color. This disparate impact of the foreclosure crisis reflects that African-American and Latino borrowers were far more likely to receive higher-rate and other risky loan terms than white borrowers. For example, as the figure below shows, African-American borrowers were 2.8 times as likely to receive a higher-rate loan as a white borrower, and Latino borrowers were 2.3 times as likely to receive a loan with a prepayment penalty. As noted earlier, there is evidence that many of these borrowers could have qualified for more affordable and sustainable loans.

These racial and ethnic disparities show no signs of abating. Among Latino and African-American households an additional 11.5% and 13% of loans, respectively are seriously delinquent, compared with six percent for non-Hispanic whites. It is possible that more than 25 percent of all home loans to African-American and Latino borrowers during this time period will eventually end in foreclosure.

There has been a tremendous impact from these foreclosures which extends beyond individual families.  Some $1.95 trillion in home equity has been lost by property owners who happen to live in proximity to foreclosed homes, approximately $21,000 per property.  This "spillover" estimate includes only the marginal loss in home values from nearby foreclosures not the total equity lost to the collapse of the housing market which is estimated at $7 trillion.  This "spillover" estimate does not include non-financial negative neighborhood impacts from foreclosures, such as neighborhood blight or increased crime nor account for the direct costs to local governments related to vacant and abandoned properties, which can range from several hundred to tens of thousands of dollars per foreclosure.

The collapse of the subprime market triggered a much broader economic crisis as well. Because of mortgage securitization, subprime defaults spread throughout national and international investments, against which the financial industry was highly leveraged. As a result, more than 400 banks have failed since 2007. Despite the government bailout of the financial industry the U.S. was thrown into the deepest recession since the Great Depression, causing high and persistent unemployment that has yet to recede fully.

Although well into the fifth year of the foreclosure crisis the authors say we are nowhere near the end.  Although housing prices have stabilized in most parts of the country, overall housing prices are down 17.4% from five years ago. Despite the high volume of troubled loans, loan modifications are declining.  During the first quarter of 2012, fewer than a quarter of a million troubled home owners received a loan modification, down 31 percent from the previous year.

Since the collapse of the subprime market, mortgage credit has dried up considerably, driven by the drop in conventional (non-government- backed) lending which declined 58.3 percent between 2006 and 2010.  This decline, despite historically low interest rates, is due in part to the tighter lending standards imposed by the GSEs.  Loans have declined precipitously for borrowers with FICO scores under 700 suggesting the current conventional market may be overemphasizing the role of borrowers' credit profiles and creating an overly tight market.

These current trends in mortgage credit, which have again hit communities of color the hardest, may be temporary responses to the crisis and could abate once the market fully adjusts to the new regulations and protections of Dodd-Frank. It is critical, however, that this dynamic not result in a new, permanent "dual mortgage market," where only the highest-wealth borrowers with near-perfect credit can gain access to the conventional market, while lower-income and minority borrowers who could be successful home owners are relegated to more expensive FHA loans, or find credit largely unavailable.

One key determinant of access to credit in the next decade will be down payment regulations set by regulators and the market.  Federal policymakers are working to define "Qualified Residential Mortgages" (QRMs), a category of home loans established by the Dodd-Frank Act and for reforming the GSEs.  In both instances new down-payment requirements have been suggested as a way to decrease mortgage defaults on top of Dodd-Frank reforms that will already keep the riskiest mortgages out of the secondary market.

CRL says the costs of a federally mandated down payment are unacceptably high. Not only would such requirements exclude creditworthy families from homeownership, but they would also undermine the nation's economic recovery by further depressing the housing market. Consider these facts:

Low down-payment loans are not the same as subprime loans. Paired with responsible underwriting and safe loan terms, low down payments have, for decades, proven to be a successful strategy for expanding sustainable homeownership.

Arbitrary minimum down-payment requirements would lock middle-income families out of the market and widen the wealth disparities between whites and communities of color. To save a 10 percent down payment plus closing costs would take over 20 years for non-white Hispanic families and 31 years and 26 years respectively for typical African-American and Latino families.

Excluding so many families from accessing affordable mortgages, would likely depress home prices further, decreasing the equity of families across the country, and act as a drag on economic growth and employment. In doing so, it could actually undermine its primary objective of reducing individual default rates.

CRL and the authors say that housing policy must strike the right balance between homeownership and affordable rental housing goals and that it is essential that lower-income borrowers and borrowers of color regain access to credit for homeownership and not remain blocked out of the housing market.

Federal and state policies should continue to address the true causes of the crisis-abusive loan terms and irresponsible underwriting practices-while also helping families still facing foreclosure and facilitating a stable supply of mortgage financing.

The papers strongly recommends that policymakers not weaken or undermine the mortgage reforms established in the Dodd-Frank Act.  To do so could result in future abusive lending and the possibility of a new foreclosure crisis. The mortgage reforms in the law include provisions that will limit harmful and abusive loan provisions and require that all lenders take the common-sense step of evaluating a borrower's ability to repay a mortgage.

Research has shown that mortgage defaults are strongly tied to abusive loan practices, such as having prepayment penalties, including "exploding" ARMs, and originating loans through mortgage brokers who received kick-backs for placing borrowers in riskier, more expensive mortgages than those for which they qualified. Reversing these reforms and returning to the pre-crisis status quo would have long-term costs for both the economy and individual families.

CRL also recommends that policymakers promote reasonable foreclosure prevention activities. They suggest requiring mortgage servicers give full and fair consideration to loan modifications and other cost-effective alternatives to foreclosure and specifically that servicing standards should prohibit dual tracking, where one servicing department processes a borrower for a foreclosure while another is reviewing the borrower for a loan modification.  Congress and state legislatures should also fund more housing counseling and legal-aid assistance for home owners who are at risk of foreclosure

Going forward, policymakers should support mortgage finance reform that balances both broad market access and borrower protections. In assessing this balance, the significant protections against risky lending already included as part of the Dodd-Frank Act must be taken in to account and further reforms to the GSEs and the secondary market should not add additional loan restrictions but rather must prioritize the issue of equitable access to the mortgage finance system.

Policymakers should adopt the following key principles to ensure a robust and secure secondary market:

The U.S. government should provide an explicit, actuarially sound guarantee for mortgages in a future secondary market structure. This is an appropriate role for the government to play in the event of a housing-market crash or market disruption. Discussion about the role of private capital in sharing losses is an important part of the conversation, but a catastrophic government guarantee is essential to the future of mortgage finance. Mortgage finance reform should require secondary market entities that benefit from federal guarantees to serve all qualified homeowners, rather than preferred market segments which would allow lenders to recreate the dual credit market that characterized the subprime crisis.

The future mortgage finance system should encourage competition and further broad market access to the secondary capital markets for both small and large lenders. These goals should be met by establishing a cooperative secondary market model of one non-lender entity, owned in equal shares by member-users able to issue guaranteed securities. Such a model of aligned interests will correct the shortcomings of Fannie Mae and Freddie Mac's past and also prevent a further concentrated lending marketplace in the future.