Home foreclosure crisis causes, Part I of II

What do Ed McMahon and Eric Rosengren, president of the Federal Reserve Bank of Boston, have in common? They've both faced foreclosure on their homes. It’s an interesting tale as told by Paul Willen, senior economist at the Boston Fed, who presumably had his boss’ permission when he recounted his story during the Governmental Research Association’s annual conference.

Mr. Willen’s story illustrates the results of his research into the causes of the mortgage crisis. A dataset of all mortgage loans in Massachusetts revealed some interesting findings.

Finding 1: Most of the defaulted subprime loans are not the purchase loan, but a refinance or a piggyback loan. The crisis isn’t solely the result of new homebuyers going after a house they can’t afford with an unwise purchase loan, as is often contended.

Finding 2: The rate adjustments after the initial lower-interest period, called resets, aren’t the sole problem either. The definition of a subprime loan is one in which the initial interest rate is already above the market rate; the reset didn’t push the rate too much higher. Resets on subprime loans are not like the interest rate resets on those cheap credit cards you can sign up for at Summerfest.

Finding 3: Housing prices are a contributing problem. In Massachusetts less than 0.1% of all homebuyers in 2002 went into default on their mortgage within 24 months; but 0.4% of all 2005 buyers went into default during that timeframe. Mr. Willen applied the home price appreciation experienced by the homebuyers of 2002 to those of 2005 and found the 24-month default rate would have gone down to 0.1% had 2005 buyers seen their home values go up as the 2002 buyers did.

It may be that the Federal Reserve Bank’s monetary policies, particularly the low interest rates of the early 00’s and the decision not to cut rates in 2007, had an impact on housing demand and thus housing prices. Even so, the bank's finding that declining home values are a source of the crisis is significant. It means the crisis is not acute—it will not be a sharp spike of defaults that will soon pass through the system, but a continuing problem until home values eventually start to recover.

For Southeastern Wisconsin, this may mean we’ll be insulated from the worst of the crisis, as the housing bubble here was never as expansive as in other metro areas. By never reaching the peak of the bubble, we may have been saved from experiencing the depths of the crisis.

And Mr. McMahon's and Mr. Rosengren's story? While they’ve both faced foreclosure on their homes, the outcomes were very different. When Mr. Rosengren became “upside down” on his home loan in the 90’s, he did not default, but tightened his belt and stayed in the home, waiting for home prices to increase.

Mr. McMahon, in default in 2008, entered foreclosure—for him, and thousands of others, the market turnaround is too far off. Luckily for Mr. McMahon, Donald Trump came to the rescue, buying the house and leasing it back to him. That’s a rather unlikely scenario for any other homeowner facing foreclosure.

(Part II, tomorrow: How can state and local policies blunt the impact of the crisis?)