You need ‘skin in the game’

Stan Liebowitz, an economics professor at the University of Texas at Dallas, has examined more than 30 million mortgages to determine the factors affecting mortgage foreclosure activity since 2007. (Wall Street Journal, July 3, 2009)

His major finding? The single most important factor associated with the 4.3 million of residential foreclosures has been whether there is zero or negative equity associated with the properties.  In fact, he found that the 12 percent of homes that had negative equity comprised 47 percent of all foreclosures.

The implications of these results fly in the face of much of the governmental policy intended to mitigate the foreclosure crisis.  As Liebowitz notes, the Federal government has thrown $2 trillion at mortgage borrowers under the guise of solving this crisis in a variety of programs: reducing interest rates, extending repayment schedules, subsidizing mortgages, delaying proceedings, and so forth.

If falling house prices that produced so much negative equity is the problem, these other remedies are misdirected.  President Obama’s administration (much like the Bush administration which too had its unsuccessful programs) produced plan after plan such as “Making Homes Affordable,” which subsidizes mortgage payments when they are higher than 31 percent of household income. 

In real estate finance classes, we emphasize the importance of the down payment (compared with the mortgage) as the traditional foundation for real estate lending. Borrowing less than 100 percent of the property’s value gives the owner a real stake in the property. (Indeed, the self-amortizing feature of fixed-rate mortgages created by FHA in the early 1930s was the fundamental reason why residential mortgage lending exploded in this country.) Having equity in the property ensures that the owner will care about what happens to the property since her own money is on the line; it is her own skin in the game.

But fingers are typically pointed elsewhere: subprime lenders and their aggressive mortgage instruments, “no doc” or “liar loans,” resetting ARMs at higher interest rates, teaser-rate loans, etc.  While some other characteristics also explain foreclosures (such as FICO scores and whether the purchase was for speculation), the overwhelming result of this large statistical study is that without equity in the property, one’s attitude toward the property changes.  Negative equity is often the first step toward foreclosure.  Alternatively, owing more than the asset is worth encourages the borrower to exercise her option to default.

Leibowitz advocates stronger mortgage underwriting rules to require sufficient down payments so negative equity positions are much less likely in the future, however, he is not very optimistic: “But to do so political leaders must face up to the actual causes of the mortgage crisis, not fictitious causes that fit political agendas and election strategies.” 

Ah, yes, the real world!

Related posts:

1. Negative equity critical threat to health of real estate market

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Tags: mortgages

This entry was posted on Thursday, July 9th, 2009 at 1:37 pm and is filed under Economics. You can follow any responses to this entry through the RSS 2.0 feed.