As mandated by the Housing and Economic Recovery Act of 2008, HUD recently released a report to Congress addressing the root causes of the foreclosure crisis and made recommendations on actions that should be taken to mitigate the crisis and help prevent similar crises from occurring in the future.
In its report, HUD said most of the initial increase in foreclosures was driven by subprime loans. These inherently risky loans have accounted for a much larger share of the mortgage market in recent years, and foreclosure rates among these loans have grown rapidly. In addition Alt-A loans, another fast-growing segment of the market, have experienced higher delinquency and foreclosure rates, HUD said.
In both subprime and Alt-A market segments, foreclosures have grown most rapidly among adjustable rate loans. However, as the economy deteriorated in 2008 and 2009, the level of foreclosures among prime fixed-rate loans also rose, “further exacerbating the crisis,” HUD said.
In an option-theoretic view, the primary factor driving defaults is the value of the home relative to the value of the outstanding mortgage. While a lack of equity in a home is strongly associated with foreclosures, HUD said most borrowers become delinquent due to a change in their financial circumstances that makes them unable to meet their monthly mortgage obligations. These so called “trigger events” commonly include job/income loss, health problems, or divorce.
As a result, foreclosures are most accurately thought of as being driven by a two-stage process. First, a trigger even reduces the borrower’s financial liquidity, and then a lack of home equity makes it impossible for the borrower to either sell their home to meet their mortgage obligation or to refinance into a mortgage that is affordable given their change in financial circumstances.
From its analysis of literature, HUD also concludes that the sharp rise in mortgage delinquencies and foreclosures is fundamentally the result of rapid growth in loans with a high risk of default. Mortgage industry participants appear to have encouraged borrowers to take on these “riskier” loans due to the high profits associated with originating these loans and packaging them for sale to investors, and existing evidence suggests that some borrowers did not understand the true costs and risk associated with these loans.
In addition, HUD said there is a general recognition that fraud on the part of mortgage brokers and borrowers may have had a significant contribution to the foreclosure crisis. BasePoint Analytics, a private firm specializing in detecting mortgage fraud, has estimated that 9 percent of loan delinquencies are associated with some form of fraud.
Another common factor alleged to have contributed to the foreclosure crisis is the Community Reinvestment Act (CRA), passed by Congress in 1997 with the goal of encouraging banks to meet the credit needs of the communities in which they have branches. Critics of the CRA claim that the wave of risky lending was generated in no small part by banks being pushed into taking these loans to meet their CRA requirements. However, HUD said a variety of empirical evidence supports the view that CRA’s requirements played little or no role in producing the foreclosure crisis.
Many of the same critics raising questions about CRA’s role in producing the foreclosure crisis also argue that federal regulations requiring the government-sponsored enterprises (GSEs) to devote a sizeable share of their lending to low- and moderate-income borrowers played a significant role in fostering the growth of risky lending. HUD said the GSEs certainly contributed to the growth of the subprime market, but there was clearly substantial demand for these securities from a wide variety of investors.
The causes of the foreclosure crisis are numerous, and as a result, there is a growing consensus regarding the need for policy changes to mitigate the current crisis and help prevent a similar predicament in the future.
To begin with, HUD said there is a need to enhance the ability of consumers to make appropriate choices in the mortgage market. This would include expanding the range of consumer counseling and assistance efforts. While this is likely to be helpful, HUD said it may also be important to more forcefully counteract aggressive marketing practices and to consider banning inherently deceptive loan features.
Many consumer advocates recommend limiting or banning yield spread premiums, which provide brokers and loan officers with incentives to sell borrowers higher prices loan. They also suggest prohibiting prepayment penalties, which lock borrowers into high-priced loans and expose them to high fees if they need to refinance or sell their home.
In addition to greater consumer protections, many also argue that improvements are needed in the general regulatory structure overseeing the origination and financing of mortgages. In large measure, the nation’s regulatory mechanisms have been focused on the wrong parts of the system, and to realign regulation with today’s organization and financial services, uniformity of regulation is needed across the lending practices of all segments of the mortgage industry and its regulators, HUD said.
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