The Mortgage Crisis

1

• The Mortgage Crisis
• Todd J. Zywicki
• George Mason University
• Foundation Professor of Law
• Senior Scholar, Mercatus Center

2
Homeownership Rose
3
Housing Bust Foreclosures
4
Theories of Foreclosure

• Distress
• Local Macroeconomic Problems
• Payment Shock and ARMs
• Negative Equity and the Put Option
• Distinguish those who want to keep their home but
  cant from those who could but dont want to

5
Macroeconomic Problems

• Michigan, Ohio, Indiana
• Post-Natural Disasters
• Historically foreclosures rise a bit in recessions

6
Monetary Policy
7
Impact of Low Interest Rates
8
Rise In ARMs
9
ARMs Follow Spread
10
Subprime ARM Resets
11
Prime ARM Resets
12
Are ARMs the Problem?

• Consumers Respond to Interest Rate spread
  Problem was monetary policy, not necessarily ARMs
  per se
• Home buyers self-select for ARMs Risk aversion
• Consumers with ARMs benefited a lot between
  2000-2004
• Percentage of ARMs higher in past
• Very Common in Rest of World

13
The Option Model
14
Factors Affecting Option Value

• As value of option rises or cost of exercise
  falls, homeowners have stronger incentives to
  respond
• Speculator v. Non-Speculator Continuum (put and
  call option)
• State Antideficiency/Nonrecourse Law
• California, Arizona
• Impact increases as expected wealth and income
  increases
• Downpayment, Piggyback Loans, interest only,
  refi, Skin in the Game
• Lenders underestimated both decline in home
  prices and propensity of new homeowners to
  default when prices fall

15
What Happened?

• Two Phases of Subprime Bust-out
• Phase 1, 2001-2004 Loans performed well even
  with unusual terms, but riskier terms offset
• Phase 2, 2005-2007 (1) risk-layering was
  explosive, (2) low equity especially bad
  (interest-only, no down, cash-out refinancing,
  piggybacks, home equity loans) all of which rose
  in Phase 2
• Mistakes versus corruption ex., lo\w-doc refi
• Other factors may have exacerbated others
  probably not
• Probably Yes Fannie/Freddie, tax code, rating
  agencies
• Maybe securitization, brokers
• Probably No hybrids, CRA
• 3 Housing Markets (1) Traditionally volatile,
  (2) steady growth, (3) late-boomers
• Foreclosure problem now centered on late-boomers
• Speculators and attitudes of new homeowners

16
What Next?

• Foreclosure Mitigation Type I v. Type II Errors
  
• How many unworthy homeowners are we willing
  help?
• If problem is negative equity, has negative
  externality leveled off? Just supply and demand?
• If a function of state laws, why is that
  Washingtons problem?
• Can we separate categories practically? Refi
  problem
• Beware unintended consequences Ex., prepayment
  penalties and cash-out refinance
• Protect innovation Boom and Bust Cycles
• Reforms to incentives for housing overinvestment
  and speculation

17
Cramdown and Bankruptcy

• Cramdown unintended consequences
• Higher interest rates costs
• Contagion to other types of consumer credit
• Helping worthy borrowers? Interest rates v.
  Principal
• MBS and Worsen Credit Freeze

18
Consumer Financial Products Safety Commission

• Loans are not toasters
• Loans generally are not inherently dangerous
• U.S. standard mortgage an outlier
• Examples
• Low-doc loans refi versus purchase
• Prepayment penalties Cash-out refinance
• Adjustable-rate mortgages