Response To Wall St. Journal Article On Foreclosure Causes

My response to a Friday, July 3, 2009, Wall Street Journal article by Stanley Liebowitz, "New Evidence on the Foreclosure Crisis." Parts were previously posted as a comment to the Wall St. Journal article, as a comment posted on Carpe Diem and on Cafe Hayek.

Liebowitz's article only explains part of the dynamics of mortgage defaults. Loss of employment, death of a wage earner, divorce, unexpected sudden large expenses, such as medical expenses, and other losses of income are the major causes of mortgage defaults.

Rate of home sales and the amount of equity in the home determines if the home goes into foreclosure, refinanced or is sold. If an income loss event happens, homeowners start defaulting and the first choices of the borrower and the lender are for a home sale or a mortgage refinance. With negative equity and a low home sales rate, homeowners have little option but to walk away from their homes and the homes are foreclosed.

Negative equity is not the cause of the need for a homeowner to cease paying the mortgage. Negative equity limits the options that a homeowner has that cannot afford to continue paying the mortgage. Positive equity allows a sale, or refinance, and payment of debt and cash in the pocket of the homeowner. Negative equity results in foreclosure because the homeowner cannot sell or refinance the home, payoff the debt and put cash in their pockets. A significant number of these homeowners walk away from their homes because they will lose them anyway.

Raising the minimum down payment to 20 percent would not have stopped foreclosures in parts of the US, such as California, Florida, and Arizona, where home prices declined by 50 percent or more. In these areas, homeowners with large down payments who cannot afford their mortgage payments would still have negative equity and those that cannot afford to continue to pay would still walk away from their homes.

Furthermore, bigger down payments would just increase the transaction costs of owning a home. Buyers would resort to other means to make the down payment, such as borrowing from relatives, credit cards, etc. If people want something, they look for ways to get it.

The article author's analysis is based on data after home prices reached their peak and started to decline. Once home prices decline, negative equity will increase and foreclosures increase among those who cannot afford their mortgages. With the advent of the recession, unemployment and partial loss of wages increased further, precipitating an increase in foreclosures in negative equity homes.

Negative equity does not cause the need for a homeowner to get out from the mortgage, but it does limit the homeowner's options once the need arises.

The house price bubble is a chicken and egg problem. Did consumers' insatiable demand for housing (even if it were to speculate and flip) cause the bubble, and lax lending standards to compete with competition, or did lax lending standards cause the insatiable demand and the bubble.

In a capitalistic market, that suppliers (banks and homebuilders) will meet demand at profit maximizing prices is much more logical then the alternative that consumer demand will meet supply and that the oversupply of lending and building caused a price bubble.

Also see Casey Mulligan's post on Supply and Demand blog.