From Boom to Bust

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Alarm bells are ringing loudly on Wall Street amid rising late payments and delinquencies on sub­prime home mortgages across the country, which are adding further worries to an already slowing economy and labor market. The spike in foreclosures is delivering substantial losses to some home mortgage lenders, shaking investor confidence in the subprime loan market and possibly even prime home loan industry. A slumping housing market and the threat of higher mortgage payments are also raising fears that more homeowners will find themselves unable to service their mortgages or sell their homes, threatening mortgage lenders with further foreclosures and saddling homeowners with ruined credit ratings that cripple their ability to access loans in the future.

All these worrisome trends are adding to concerns that an increase in home mortgage foreclosures could interact with other (sometimes related) macro-economic trends to further harm the broader U.S. economy, reducing the growth in incomes and job opportunities. Yet at the same time, a sad crisis is quietly unfolding for an untold number of families in neighborhoods across the country. Per­haps as many as 2.2 million families face the prospect of losing their homes in the coming years. This follows in the wake of more than 1.2 million foreclosure filings3 in 2006, up 42 percent from 2005. That’s one home mortgage foreclosure filing for every 92 households.

Nor are the filings slowing down. The number of homeowners who entered into some stage of foreclosure in December 2006 was up 35 percent from December 2005 after a slight decrease in foreclosures in the late summer and fall of 2006. At the same time, states all around the coun­try are reporting an increase in foreclosures, with some states reporting as much as a 700 percent increase in 2006 over 2005.

A slowing housing market and sometimes dramatically higher mortgage payments almost guarantee that many more families will be unable to refinance their mortgages as they did during the housing boom. Nor will many families be able to sell their homes for enough money to pay off their mort­gages now that housing prices have gone down in many locations across the country. These trends suggest there are more foreclosures to come.

What’s fueling these problems in the home-lending marketplace? The widespread use of non-tradi­tional mortgage products such as hybrid adjustable-rate mortgages with complex interest rate terms and conditions—originally created for wealthy individuals with fluctuating incomes—were increas­ingly sold to middle- and lower-income families over the past 10 years amid the nationwide housing boom. These hybrid ARMs, which offer easy lending terms but the possibility of hefty rate increases in a few short years, were often peddled to less sophisticated consumers alongside minimal under­writing requirements that allowed many borrowers to purchase homes without assessing their ability to handle payments over the life of the mortgage. The result is that many such homeowners today are vulnerable to much higher mortgage payments than they were probably able to afford when the loans were originated. The threat of higher payments is especially serious at a time when economic and employment growth is slowing and families’ incomes may not rise as fast as they have in the past.

The problem is exacerbated in the subprime mortgage market, where borrowers generally have weaker credit histories, lower incomes, and fewer assets to support their loans, requiring them to pay higher interest rates than in the prime mortgage lending market. What’s worse, many of these bor­rowers had to pay costly origination fees on their mortgages, which left them with little cash left to invest in their new homes or to service their mortgages when their adjustable interest rates rise.

But it is not just poor credit that plagues borrowers in the subprime marketplace. Recent studies suggest that the growth of subprime borrowers with non-traditional loans is due to some lenders’ use of unscrupulous and predatory practices. While it is difficult to assess the exact impact of predatory lending on the proliferation of these loans, the Center for Responsible Lending highlights certain trends that are common in the subprime market as evidence of predatory lending practices.

CRL cites the lack of solid underwriting documentation by lenders, which allowed many prospective homeowners to borrow well beyond their ability to service their debts, as well as costly up-front fees and pre-payment clauses that make it difficult for borrowers to refinance their mortgages.  Because of the combination of these lending practices and other factors, CRL estimates that one in five sub­prime loans originated over the last two years will end in foreclosure.

That’s a scary prospect for those homeowners who will see their dreams of homeownership dashed and the once-promising accumulation of wealth in their homes destroyed. Moreover, foreclosures tend to cascade across poorer communities where aspiring homeowners could only access subprime mortgage products, with detrimental long-term consequences for some communities. As foreclosure signs go up, lenders shy away from financing other properties in these neighborhoods, leading to a vicious downward spiral that can ruin neighborhood home values.

While policymakers examine the causes of the current crisis and consider legislative and policy-based solutions to prevent such a trend in the future, it is also critically important to consider ways to stem this rising tide of foreclosures. Given the crisis that may affect communities, policymakers should consider swiftly strengthening state and federal programs that help prevent home foreclosures.

While all states have homeownership and foreclosure prevention counseling, only a handful of states sponsor mortgage assistance programs that help qualifying families in danger of falling too far behind on their mortgage payments due to a sudden loss of income, illness or death in the family. Increased federal assistance could expand these programs and enhance those foreclosure prevention programs that do not provide loans. Among the steps policymakers should consider are:

• Federal grants to expand and enhance current mortgage assistance and foreclosure prevention programs and low-interest mortgage assistance to eligible borrowers.
• Federal funds to target key cities and states facing the highest risk of mass foreclosure.
• Provisions to ensure federal agencies assess the effectiveness of each program every three years.
• Strengthen programs that aid families while their mortgage contracts are renegotiated or the property is sold on the market so that the homeowners’ credit ratings are salvaged, allowing for the possibility of future homeownership.

This paper details why the steps briefly outlined above would help ameliorate the current rise in foreclosures. The paper will first examine the causes of the crisis and then look at the structure of state-funded foreclosure prevention programs to illustrate how cost-effective federal support for these programs—particularly in key states—could help families facing foreclosure stay in their homes.

While foreclosures are sometimes unavoidable, it is in the best interests of our communities and overall economy to support those who have embraced homeownership and work to prevent foreclo­sure. After all, homeownership is an important step in the creation of stable and secure communities. Yet, homeownership is also a step that is especially difficult to take for those without access to tradi­tional home lending products. When assets and wealth are better distributed and families are more financially secure, this, in turn, enhances opportunities for everyone and contributes to the country’s overall economic security.

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For Christian Weller’s take on the housing market, see:

• The End of the Great American Housing Boom