Current regulatory policy is not addressing the primary cause of foreclosures. CoreLogic's deputy chief economists Sam Khater says, in an article on the company's blog, that, while lack of equity has long been known to play an important role in loan defaults in general, CoreLogic is the first to specifically examine leverage in the residential lending sector. The study comes at a time, he says, that policy makers have been attempting to loosen lending by reducing the price and expanding the quantity of low down payment real estate credit.
The company looked back over five decades to examine the role leverage plays in mortgage foreclosures. They found:
- Homeownership rates are the same today as five decade ago but foreclosure risk is two to three times higher.
- The primary driver of default risk over this period has been leverage; so dominant as to make changes in income and savings insignificant drivers from a long-term macro perspective.
- The stabilization of foreclosures rates in the 1970s and 1980s was driven by high inflation rates which increased nominal home prices and reduced aggregate loan-to-value (LTV) rates.
- The centerpiece of government efforts to make mortgages safer for consumers, the ability-to-repay rule, manages delinquency risk but somewhat neglects foreclosure risk.
Therefore, Khater says, the most important driver of foreclosures over the last 50 years remains unaddressed by current regulations.
The creation of the Federal Housing Administration (FHA) and Fannie Mae in the 1930s dramatically expanded homeownership rates which rose from 44 percent in 1940 to 62 percent by 1960 staying in that range until the mid-1990s. Then pro-homeownership policies led to an expansion in mortgage credit and homeownership peaked in 2004 a 69 percent before declining through the recession to a Q4 2014 rate of 64 percent.
However, foreclosure rates have followed a very different pattern. Between 1960 and 1965 conventional loan foreclosures averaged 0.6 percent and FHA foreclosures 1.4 percent. In 2014, with virtually the same homeownership rate, the respective foreclosures rates were 1.5 percent and 2.6 percent. Thus the convention rate was 2.5 times its early 1960's counterpart and the FHA rate almost doubled it. Khater points to Figure 1 and says these much higher rates are not a function the ongoing recovery from the recession because, "even as of 2004, well before foreclosure rates spiked, the level of risk for both conventional and FHA mortgage was three times higher than during the 1960s.
CoreLogic modeled foreclosure rates as a function of savings, unemployment, inflation, aggregate LTV for all outstanding mortgage loans, and real median household income and found that only unemployment and the LTV ratio noticeably influenced foreclosure rates with LTV being "by far the most important variable."
Khater calls with finding consistent with the "dual trigger theory" which holds that lack of equity and economic shocks, typically unemployment, tip a household into foreclosure. Lack of equity leaves homeowners vulnerable to economic shocks. If sufficient equity is there and a borrower faces economic problems they will typically try to sell the home. But if they are close to or actually underwater they will be able to sell and pay the mortgage which may tip them into foreclosure.
He says it is also consistent with emerging theoretical literature on leverage cycles. Mortgage leverage increased in the early 1950s when downpayment requirements were lowered. This increased homeownership rates but also foreclosures. Leverage would have continued to increase but for high rates of inflation and rising home prices in the two decades between the mid-1960s and mid-1980s. The resulting stable leverage cycle also featured low foreclosure rates. Moreover inflation led to higher nominal incomes which made pre-existing mortgage payments easier to meet. The savings rate and household income were not at all important; surprising Khater says, given that traditional underwriting focuses on affordability.
Then in the early to mid-1990 the emphasis on homeownership led to lower down payment lending, increasing leverage again and this picked up speed after the millennium due to cash out refinancing and home equity lending. Then came the crash, leverage spiked as did unemployment and foreclosures soared. Once prices started to rise again the process reversed and aggregate LTV rates have increased by 29 percent since March 2011, from 61 percent to 46 percent in November 2014.
Between 2011 and 2014 Khater says the foreclosure rate fell by 1.5 percentage points and the rise in home prices as accounted for 1.4 points of the decline. "In other words, 91 percent of the drop in the foreclosure rate is due to the drop in leverage via higher home prices. Unemployment and the remaining variables accounted for the small remaining portion of the decline."
One tool the Federal Reserve did not utilize to guide the economy through the recent recession and recovery was a leverage target. This has been used successfully, Khater says, in over 20 other counties. The Qualified Mortgage (QM) rule is focused on ability to repay and this will lead to better performing mortgages but the QM also lacks a leverage standard. "That means," Khater says, "that the most important driver of mortgage performance over the last five decades has remained unaddressed for the market and will likely need to be addressed in the future."