Friday, July 17, 2009

Foreclosures Also Happen In Better times

My comment that I posted yesterday to Arnold Kling's post on the ineffectiveness of mortgage modifications, "The Worst Solution to the Financial Crisis" on Econolog.
I agree mortgage modifications are ineffective, but there is always a base rate of foreclosures, even in better economic times.

It is unfair to say about these people, "out of the homes they should never have bought in the first place."

Unplanned adverse events do happen after a home purchase, such as illness, death of wage earner, divorce, job loss, etc. These income-lowering events often happen. In fact, medical expenses, divorces and job losses are major contributors to personal bankruptcies and have been for many years. Why shouldn't they also be major factors in home defaults?

While there are lots of anecdotes about subprime and no-doc lending, second home investment properties, etc., I have not seen any research on defaults producing a number showing the relative numbers of income qualified one-home owners who had unexpected income losses and those who were overextended at time of the purchase and mortgage loan.

I suspect even some of the two-home owners were those who purchased a second home to move and then got caught in the housing slow down and could not revert to single home ownership.

While I understand the human nature of wanting to believe that there are people and processes to blame for the current housing crisis, none of the easy theories (securitization, fraud, bad incentives, no skin in the game, capital arbitrage, credit rating agencies, etc.) really make any sense when thought about critically. They just are not capable of explaining the duration, the lending volume, the international aspects, the risk that investment bank restricted shares owners took to their wealth, and the lack of investment asset diversification in the financial industry, etc. They are weak attempts to explain the high supply of mortgage lending, but do nothing to explain the high supply of demand for these loans. They are weak because in other times lenders raise their rates and cut off lending when it gets too heated. Likewise, in other times most borrowers do not continue to chase easy money for home purchases when they feel it can cause them financial harm and lenders find they cannot make mortgage loans in those periods.

A bubble mania does not adequately capture what happened because of the excessive degree of risk that both homeowners and financial institution took. When other bubbles occur, while there are many players who are caught up in the mania, a much smaller percentage actually is substantially at risk for most of their wealth. It was much more widespread this time. Too many players, both as homeowners and as lenders and investors, gambled too much of their wealth this time.

It will take a few years to sort out all the causes of this crisis, but it is certainly much more complicated than the common wisdom.

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