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The Mortgage Crisis Todd J. Zywicki George Mason University Foundation Professor of Law Senior Scholar, Mercatus Center. Homeownership Rose. Housing Bust: Foreclosures. Theories of Foreclosure. Distress: Local Macroeconomic Problems Payment Shock and ARMs
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The Mortgage Crisis Todd J. Zywicki George Mason University Foundation Professor of Law Senior Scholar, Mercatus Center
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 can’t from those who could but don’t want to
Macroeconomic Problems • Michigan, Ohio, Indiana • Post-Natural Disasters • Historically foreclosures rise a bit in recessions
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
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
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
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 Washington’s 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
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
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