Decomposing the Foreclosure Crisis: House Price Depreciation versus Bad Underwriting

Abstract

Abstract: We estimate a model of foreclosure using a data set that includes every residential mortgage, purchase-and-sale, and foreclosure transaction in Massachusetts from 1989 to 2008. We address the identification issues related to the estimation of the effects of house prices on residential foreclosures. We then use the model to study the dramatic increase in foreclosures that occurred in Massachusetts between 2005 and 2008 and conclude that the foreclosure crisis was primarily driven by the severe decline in housing prices that began in the latter part of 2005, not by a relaxation of standards on which much of the prevailing literature has focused. We argue that relaxed standards did severely aggravate the crisis by creating a class of homeowners who were particularly vulnerable to the decline in prices. But, as we show in our counterfactual analysis, that emergence alone, in the absence of a collapse, would not have resulted in the substantial foreclosure boom that was experienced. JEL classification: D11, D12, G21 Key words: foreclosure, mortgage, house prices 1. Introduction There are two competing theories to explain the explosion of foreclosures in the United States in 2007 2009. The first focuses almost entirely on standards, and attributes the crisis to loans that borrowers had trouble repaying, either because they had bad credit and little income to begin with, or because the loans were unrealistically generous at the time of origination and later became unaffordable. There is persuasive prima facie evidence that is consistent with this theory. For example, subprime loans, which expanded credit by offering loans to borrowers who previously could not obtain any mortgage credit, and by offering large loans to those who previously could only obtain small loans, account for a disproportionate number of foreclosures. Subprime lending emerged as a major force in mortgage markets shortly before foreclosures began to accelerate, and were concentrated in communities that later became foreclosure hotspots. An alternative explanation focuses on house prices and points to the precipitous decline in prices that started in 2005 or 2006, depending on where in the country one looks, as an explanation for the crisis. There is prima facie evidence that is consistent with this theory as well. For example, until house prices began falling, subprime mortgages performed very well. In addition, states where house prices began declining sooner experienced foreclosure waves sooner than in states where prices began later. In this paper, we assess the merits of the poor underwriting and falling house price theories. We argue that, in a sense, both explanations are true, but that prices have primacy. We find that had prices not fallen, we would simply not have had a major foreclosure crisis, regardless of whether lenders had lowered standards in 2003 and 2004. By contrast, the observed fall in prices would have generated a substantial increase in foreclosures, even if lenders had retained the standards that prevailed in 2002. To be sure, the increase in foreclosures would have been substantially smaller without subprime lending because as we show that subprime loans are far more sensitive to a decline in house prices than prime loans, but the foreclosure rate would still have been very large relative to historical levels, and would have been still considered a major public policy problem. The central issue that any researcher must address in such an analysis is how to identify the effect of house prices on foreclosures. One natural explanation for the observed relationship is that the increase in foreclosures caused prices to fall. If that were the case, then the observed relationship between prices and foreclosures becomes evidence for the bad theory not the prices theory. The first contribution of this paper is to use a novel identification strategy to test this explanation of the crisis. …