The Real Cause of Foreclosures: No Skin in the Game

This is an opinion piece in the Wall Street Journal, but with a lot of data behind it, so I thought it worthwhile to share. What it does is show the causes of a large ream of foreclosures and dispels some of the myths of what is causing it. We've discussed since 2007 the "walk away" situation happening at first 1 in 6 [Oct 9, 2008: WSJ - Nearly 1 in 6 Homes Underwater], then 1 in 5 [Mar 9, 2009: One in Five Houses Underwater], and now approaching my long term prediction that 1 in 4 Americans will be underwater on their mortgages.

• What is really behind the mushrooming rate of mortgage foreclosures since 2007? The evidence from a huge national database containing millions of individual loans strongly suggests that the single most important factor is whether the homeowner has negative equity in a house -- that is, the balance of the mortgage is greater than the value of the house.
• A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures. Further, because it is difficult to account for second mortgages in this data, my measurement of negative equity and its impact on foreclosures is probably too low, making my estimates conservative.

So you can see the commonly portrayed reason for foreclosure, "rates spiking in bad mortgages to bad borrowers" is really not the main issue at all. In fact this made up less than 10% of the foreclosures in 2nd half 2008.

• What about upward resets in mortgage interest rates? I found that interest rate resets did not measurably increase foreclosures until the reset was greater than four percentage points. Only 8% of foreclosures had an interest rate increase of that much. Thus the overall impact of upward interest rate resets is much smaller than the impact from equity.

The real cause? No skin in the game. This goes to what I've been saying for a long time - we even were posting stories in 2007 how people were paying off credit cards ahead of their home mortgages; something never seen before in the history of the U.S. Why? If you have no skin in the game, why bother trying to hold onto your home? We also see clear evidence of this in Europe - the countries who followed "innovative" US approaches saw housing bubbles and crashed - Ireland, UK, Spain. Those who never budged off their 20% down (skin in the game) ideals, never saw the bubbles - but never saw this sort of bust in their housing markets.

Effectively, we've transferred a whole batch of 2004-2007 "renters" into "pseudo" homeowners... really with many of these mortgage programs they were in the same (or better!) terms than as a renter. That's right, it cost less up front to be an owner than a renter! At least a renter had to put a security deposit down, but in this new-fangled era of financial innovation, we let people put 0% down, and finance the closing costs. EVEN BETTER THAN RENTING. And when the loans go bad, the responsible people are asked to send checks to bail many of these folks out. (Yes I realize regular people who just bought at a bad time also got caught in this trap, but I am sorry if I don't have sympathy as I speak from a state where home prices are back to 1995 levels)

So what's our current solution? We are driving almost all American loans through Fannie and Freddie, and using FHA... which has (wait for it) 3.5% down programs - lessened by the 1st time federal tax credit of $8K and similar figures from many states. Even "IOU" California was offering a $10K tax credit. So if you have a $160K house (roughly the US median), 3.5% down is about $6K. All covered by federal or state programs and *POOF* people can walk in with nothing down again. Only this time we'll cut out the middleman and instead of bailing out the banks we'll just be bailing out Fannie, Freddie, and de facto FHA for the next 4-8 years as this crop of loans goes bad.

It is almost laughable at this point, but I long have since thrown up my hands in the air. Our money supply is endless so really, just print more and send it to the people in all forms of handouts that require no one to save. Then when the loans go bad, despite handing out money to borrowers, just print another batch to subsidize Fannie, Freddie, FHA. Rinse. Wash. Repeat. Why bother learning from the past when your money trees are endless you do not need to?

• This means that most government policies being discussed to remedy woes in the housing market are misdirected. (understatement of the year) Many policy makers and ordinary people blame the rise of foreclosures squarely on subprime mortgage lenders who presumably misled borrowers into taking out complex loans at low initial interest rates. Those hapless individuals were then supposedly unable to make the higher monthly payments when their mortgage rates reset upwards. Sharing the blame in the popular imagination are other loans where lenders were largely at fault -- such as "liar loans," where lenders never attempted to validate a borrower's income or assets.
• But the focus on subprimes ignores the widely available industry facts (reported by the Mortgage Bankers Association) that 51% of all foreclosed homes had prime loans, not subprime.
• .....the important factor is whether or not the homeowner currently has or ever had an important financial stake in the house. Yet merely because an individual has a home with negative equity does not imply that he or she cannot make mortgage payments so much as it implies that the borrower is more willing to walk away from the loan.

The above point is so key - many of us in states like Michigan are very underwater on their mortgages... but we actually put down payments into our homes. Why? Because unlike many parts of the country where mostly the 2004-2007 vintage of home buyer is underwater (the height of the insane mortgages) many of the loans underwater here were made earlier, before financial "innovation" took over the land. So to "walk away" you'd not only take a credit hit, you'd lose saved money you actually invested into the house.

Of course, some who bought in the 2004-2007 time frame also put 5, 10, 20% down into their homes and face the same dilemma. But the man who put nothing, or 1% or 2%? Not so much of a dilemma. Sit "rent free" for 6-12 months while foreclosure proceedings happen and then go back to being... well the same thing you were the last few years, a renter (except you were effectively renting a home instead of an apartment). Or even better - wait for scrambling government agencies to send your bank money to help you on your "investment" (I use that word in the loosest way possible)....

I did not mention it here, but the latest housing rescue plan from team Obama announced in the past 10 days now has upped the ante from "helping" people who owe 105% of what their house is worth, up to 125%. So who do you think has the greater chance of being 125% down ? Someone who actually put a 5-10-20% mortgage payment down on the home at inception? Or someone who put 0-1-2% and rolled the closing costs into the mortgage. It doesn't take much thinking to realize where your tax money is going.... all in the name of "helping those who deserve the help".

Again, it is to the point of being laughable. If you acted responsibly, you dear reader - are the fool. Political initiatives to "save those in need" are not only misguided based on what is causation, but implicitly unfair to those who tried to do the right thing. All the time the peasants are being fed political dogma about the root causes, when veering from common sense was reason #1. Even more amazing ... we are simply repeating the exact same path; outside of actual underwriting standards (at least that will stop liar loans) the same policy of little to no skin in the game is now institutionalized at the federal level. That's what happens when you have a nation of non savers.

• The difference in policy implications is enormous: A significant reduction in foreclosures will happen when and only when housing prices stop falling and unemployment stops rising. Although the government is throwing money -- almost $2 trillion and counting -- at the mortgage markets with the intent of stabilizing house prices, its methods are poorly targeted.
• Understanding the causes of the foreclosure explosion is required if we wish to avoid a replay of recent painful events. .....stronger underwriting standards are needed -- especially a requirement for relatively high down payments. If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell.

Comments

[Tony Petroski:]

I've seen a few articles on this "no skin in the game" pop up in the last couple days. Two thoughts:

1) This golden age of "20% down" is a myth and never existed in my lifetime. It was more like 5% down, and even that was often created by the trick of having the seller provide the "downpayment" in the form of a rebate at the closing.

2) The lenders were well aware of the danger of lending to those with "no skin in the game." They lent the money knowing that they could offload the mortgages to Fannie and Freddie and collect nice fees along the way until somebody pulled the plug on these transactions. The biggest fees were earned by the mortgage brokers operating on behalf of the lenders and they were fully aware of what they were doing. It's this offloading of mortgages to a government-backed entity that caused the bust.

Jul 07 08:43 AM

[winnersdon'...:]

Tony... you need to get your facts straight!
A quick rewind back to 1970, our first house. $46,990 + upgrades. $56,000. at closing. Bank requirements...$20% down minimum. We scraped up 12K, it wasn't easy, but we did it.Survived the recession that followed. the lousy stock market, and never once considered "bailing out of the mortage". That's the difference between previous generations, and what masquarades today as responsible adults.
By the way Tony... 5 years ago my younger son bought a cute little place, water view, a great starter home, guess what??? he was required to put 20% down. He's still in that house and will be for many years. In the medium to long term he'll make out just fine.
Trader Mark is absolutely right...it's all about the skin in the game"

Jul 07 09:32 AM

[cash:]

Given that we continue to elect rogues whose only goal is to perpetuate their power & influence why complain? They need votes, and free homes, cars etc... to the poorer voting masses will endear them to their base. Bailing out their rich auto/bankster friends will fetch them campaign dollars, speakerships, and revolving door positions. If you are the responsible saving kind, you need to pay for that privilege! And pay you will.

Jul 07 10:09 AM

[TraderMark:]

Tony, I don't think the "number" (20%) is so important as the actual ability to showcase you can save an extra amount over and above your monthly expense level for an extended period of time, therefore showing you can build a cushion.

If its 10% (then layered with government incentives) or 5% without incentives (i.e. 5% down of your OWN money not using other taxpayers money for 1st time home buying tax credit or state tax credit) that's fine with me. But then people would actually take this purchase seriously and have their own hard earned money in the game.

We've just come from a period where easy loans meant you had to bring nothing to your purchase and we've morphed into an era where your fellow taxpayer will subsidize you and you can enter with effectively nothing down again under FHA. Hence nothing has changed.

So does it have to be 20%? Not really. But it has to be something material. 10% with government bells and whistles would reduce your "input" to maybe 4-5%... or 5% without any government assistance would at least show the ability to save for a period of time of more than 6 months.

We seem to have been brainwashed that the "right to shelter" is now the "right to homeownership".


On Jul 07 08:43 AM Tony Petroski wrote:

> I've seen a few articles on this "no skin in the game" pop up in
> the last couple days. Two thoughts:
>
> 1) This golden age of "20% down" is a myth and never existed in
> my lifetime. It was more like 5% down, and even that was often created
> by the trick of having the seller provide the "downpayment" in the
> form of a rebate at the closing.
>
> 2) The lenders were well aware of the danger of lending to those
> with "no skin in the game." They lent the money knowing that they
> could offload the mortgages to Fannie and Freddie and collect nice
> fees along the way until somebody pulled the plug on these transactions.
> The biggest fees were earned by the mortgage brokers operating on
> behalf of the lenders and they were fully aware of what they were
> doing. It's this offloading of mortgages to a government-backed
> entity that caused the bust.

Jul 07 10:10 AM

[John Galt:]

I am glad you called it what it is. If you borrowed 100% or more of the money to "buy a house" you are not a "home owner". I worked in the business and financially conservative me would just shake my head when I saw people borrow 105% or 110% of the purchase price to buy a home. I'd just shake my head and wonder if that kind of move would ever end in tears. If you have 0% Equity in a home, you are not a a "home owner" by definition...

Where does the next crop of buyers come from? Everybody that wanted a loan and had a pulse was able to buy. How many prudent buyers with 20% down payments are waiting on the sidelines in the major cities? Ask yourself this... Are there more people looking to sell right now or more financially responsible people waiting on the sidelines looking to buy?

$

Jul 07 10:24 AM

[Charlie J:]

There's a disconnect between what I read about home loans and what I'm seeing in the real world. Someone I know was just turned down for a $400K home loan, and they have $1M cash in the bank. The broker said they could only qualify for a $200K loan (based on income from job).

So things are definitely not heading back to where they were, at least not for that person with a steady job and $1M cash.

Jul 07 11:29 AM

[Gtarras:]

dont you still have to pay with ruined credit history if you walk?

Jul 07 11:51 AM

[Gregman2:]

Also, jobs and less outsourcing might help since without jobs and with declining real wages making mortgage payments is hard.

Jul 07 01:13 PM

[Moon Kil Woong:]

Every day home prices keep falling and job losses mount is just that more homes sliding into the great negitive equity pit. Tradermark is right that this is the source of the problem and that prime mortgages are falling victim as well as 0 down NINJA loans. Prime being not what is prudent but what Freddie Mac and Fannie Mae consider acceptable.

Even as we speak Fannie Mae and Freddie Mac are writing a whole new slew of bad mortgages at unjustifably low rates to the risk involved that will yield nothing but negative returns for the writers of these motrgages in which the taxpayer will inevitably have to backstop and pay for. Nothing really has changed in the home mortgage merket except that banks won't write a loan unless Fannie Mae or Freddie Mac will buy it the second they write it. That doesn't show a lot of faith in their review process does it? Probably because the mortgage market is still socialized and the review and qualification of homes mortgages still stink to high heaven.

Jul 07 01:19 PM

[Trend is No...:]

Smart people here making points, but I am frustrated with the title of this piece. When I read terms like "skin in the game", I am reminded of our treasury secretary, Tim Geithner. Why can't we say as Americans, we have a problem with money (namely debt)? Why can't we admit that individual consumers, families, state and local governments, corporations, and western economies are struggling with the same issues of systemic debt? When we come up with an all-encompassing, which was well thought out by the way, explanation for this debt phenomena we do a real disservice to individuals who do not have access to, the privilege of, or the power to confront the idea that this bubble was precisely manufactured, executed, and lamented after the fact with the people who profited from this seizing more market share and power. So, when you quote Tim Geithner' skin in the game quote; who are you serving with this explanation and who did you leave out? Respectfully, John

Jul 07 01:33 PM

[Bob 123:]

Not only that, but the amount of the owed debt you walk away from is considered taxable income, as far as Uncle Sam is concerned. The following April 15th their problems are only just beginning.
Those who walk do not get away scot-free as this author and other sources imply. They are screwed most likely for the rest of their lives.


On Jul 07 11:51 AM Gtarras wrote:

> dont you still have to pay with ruined credit history if you walk?

Jul 07 01:49 PM

[TraderMark:]

I did not imply that. I implied those getting the assistance most likely were those who put little to nothing down.

Also many we hoarded into home buying had bad credit to begin with; there was a reason no one was checking employment or FICO scores. So if you had bad credit before and bad credit after - whats the difference? Basically you were able to be in a home for a few years, make a payment for part of that, live rent free for a while and then go back to the renting world after.

Also a whole slew of people will now be entering "renting" world with tarnished credit and all can claim "look I was hit with a black swan" (not that they will use that language) - my credit was due to unforseen once in a lifetime events blah blah. When 15-20-25% of the pool of renters has the same situation, it will just become standard quo to "look over" the "episode" of 2007-2010.

I do agree on the tax treatment part though.


On Jul 07 01:49 PM Bob 123 wrote:

> Not only that, but the amount of the owed debt you walk away from
> is considered taxable income, as far as Uncle Sam is concerned.
> The following April 15th their problems are only just beginning.
>
> Those who walk do not get away scot-free as this author and other
> sources imply. They are screwed most likely for the rest of their
> lives.

Jul 07 02:08 PM

[FTAX:]

The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence.
www.irs.ustreas.gov/in...


On Jul 07 02:08 PM TraderMark wrote:

> I do agree on the tax treatment part though.

Jul 07 04:19 PM

[Jasper M:]

SO many people will be losing their homes over the next 7-8 years, that it will drastically reduce the sting of any attendant damage to their credit rating, as a significant fraction of everyone they know will be in the same boat.
c. 30% unemployment peak in last depression. I see no reason to expect less this time, and considerable reason to expect more. And that will translate into foreclosures at some point.

Jul 07 11:17 PM

[DuffBeer:]

As a realtor for over 20 yrs in the far south suburbs of Chicago I
saw the drastic changes over my career. When you have your money in the game you play the game very differently. Case in point your real portfolio investments vs a virtual trading portfolio. Play money who cares ???
Many purchasers just view homeownership as an Entitlement and used the tax payers money because they did not have any to buy the home. I could go on and on but I real think you all know that those that don not want to pay or can not pay Will Not pay!

Remember the last time you were waiting to pay for your goods standing behind some one who brings out credit card after credit card until they find one that works !!!
How about the family member who you gave a million dollars to
and gives you a call ," hey brother can you spare me some cash for my mortgage ?"
If I played the game I would still be in that business but I could not morally play the game . I left the real estate business. Hey anybody out there know what happened to the CEO of Country Wide ? Did they come up with this 110 % mortgage, no moeny down and all the other gizmos or was it that foolish looking barney guy ?
Cheers DuffBeer

Jul 08 10:59 AM

[rm:]

Negative equity: Is this causation or correlation?

Hasn't anyone had any statistics here?

Just because there's a strong correlation doesn't mean it's a cause.

Thus far, nobody's been able to document a significant number of borrowers who are able to make their payments that choose to walk away.

Probably because it's not happening on a large scale.

What *is* happening is that those who fall behind because they CANNOT afford the payments- whether due to a temporary or permanent change- ARE looking at the LTV before deciding what to do.

That's not the same thing... although it's a much less interesting story.

Jul 08 11:23 AM

[ariesl:]

Speaking of having "no skin in the game", isn't that true of most lenders from 2004-2006? After dispursing money to almost anybody willing to sign up for a mortgage, they sold it to Fanni, Freedy, Mers, or Wall Street money barrons who packaged the mortgages up into MBS packages, CDO's, etc. Thus, neither they nor the original lenders had any "skin in the game"! They didn't care if the mortgages ever got paid. By the way all of those bastards are still holding the dollars they made from those deals.Shouldn't they be held liable for the damage they did? They nearly crashed the entire world's financial system. It was probably the biggest fraud ever committed. Worse, the crime has gone unpunished. Worse yet, Bush, Paulson, and Bernanke gave the crooks even more of the citizen's money.

Of course now that prices are low, you can bet those individuals who made obscene profits selling and reselling all those bad loans and CDO's are in there (like vultures) picking up the bargains.

We are all witnesses to the most massive transfer (read robbery) of wealth from the Middle Classes the the very rich that has ever occured. Moreover, it doesn't end soon or even in our lifetimes. Sadly, our grandchildren will still be paying on the government debt incurred to pay for TARP.

Here in South Florida, most of the forclosured homes going for 60% or more off of 2006 prices are being bought with CASH! No Government programs needed.

Jul 08 12:09 PM

[TeresaE:]

Yet one more time the true culprits are trying to shift blame to the victims.

Yes, there are a plethora of POS in our country. People that don't understand what being a man of your word is.

BUT, there are also millions of hard working, tax paying citizens, who believed the propaganda that the banks, builders, government and real estate industry were selling.

So, they bought high. Then, when times started to get a little tough, they lost their jobs.

Once you have lost your income AND your home is underwater, HOW would YOU come up with the cash to pay off your home?

Any takers?

I hate that we are so quick to blame the victim in America. The rape victim asked for it by being out after dark.

A huge portion of our middle class is being raped, and the best those that haven't been hurt (yet-it's coming) can come up with is stoning the victims.

Jul 09 09:48 AM

[nova:]

It is very clear that government imposed "social engineering" using hard-earned taxpayer money is a road to hell. It never worked before and never will work in a future. The only thing it does is promoting a parasitic, government dependency way of life.

It is time for people to take responsibility for their lives and their actions. I know it is very difficult.

I am convince that "real" socialism is coming to America. It will not be a "welfare socialism" promoted by intellectually bankrupt intelligencia but rather some brand of fascist socialism: "one who does not work does not eat".

Jul 09 10:28 AM

[The Caring ...:]

Scary stuff - I am glad Im a renter

Jul 09 08:40 PM