Foreclosure Levels Unlikely To Fall | Mark A. Calabria | Cato Institute: Commentary

Foreclosure Levels Unlikely To Fall | Mark A. Calabria | Cato Institute: Commentary: "The vast majority of mortgage defaults are being driven by the same factors that have always driven mortgage defaults: being 'underwater,' that is, you owe more on the mortgage than the home is worth, combined with a life event that results in a substantial income decline, such as a job loss. Until both of these pieces are addressed, foreclosure levels are unlikely to fall.

All efforts addressing the foreclosure crisis implicitly assume that the current wave of foreclosures is almost exclusively the result of predatory lending practices and "exploding" adjustable rate mortgages, where upward shocks on the rate reset cause mortgage payment to become unaffordable. This was true of former Treasury Secretary Paulson's HOPE NOW and of FDIC Chairwoman Sheila Bair's IndyMac models. The Obama administration's current foreclosure efforts are based on the same mistaken belief.

If payment shock were driving the defaults, then we would observe most defaults occurring around the reset of the mortgage rate, specifically just after the reset. But that is not the case. The vast majority of defaults occurred long before the reset. It could be that this is due to such loans being "unaffordable" from the time of origination. According to analysis done at the Boston Federal Reserve, though, the borrower's initial debt-to-income had almost no impact in terms of predicting subsequent default. Additionally, if payment shock were the driver of default, fixed-rate mortgages, where payments did not change, would display default rates significantly below that of adjustable rate mortgages. Differences in performance between these different mortgage products largely disappears once differences in owner equity and credit score are taken into account."

"The question then is, what exactly it is that homeowners with no equity are losing in the event of a foreclosure?"

"According to Freddie Mac, speculators make up about 40 percent of those foreclosed upon. An additional 50 percent of foreclosures are likely due to job loss, eliminating the income a borrower would need to put forth a repayment plan under Chapter 13 of the bankruptcy code. Combining speculators and the unemployed reveals that cramdown will do little to help at least 90 percent of borrowers currently in foreclosure."