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A Foreclosure Crisis Postmortem: Nontraditional Mortgages Were a Key Factor

The Real Estate Connection: February 2012
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Erwan Quintin Erwan Quintin


Dean Corbae Dean Corbae

By Bill Shepard

Like a devastating tsunami, the real estate crisis that swept the U.S. in recent years has left millions of victims in its wake, most notably, those who lost their homes to foreclosures.

Looking back at the tragic unfolding of events, nontraditional mortgages involving no interest, interest only, or low down payments often are cited among the biggest culprits in the foreclosure boom.

But the question is, how big of a role did these nontraditional mortgages play?

According to two Wisconsin School of Business faculty members, mortgage "innovation" played a significant role.

Erwan Quintin, assistant professor of real estate and urban land economics, and his colleague Dean Corbae, a professor of finance who recently came to the Wisconsin School of Business from the University of Texas-Austin, determined that nontraditional mortgages accounted for more than 40 percent of the foreclosures between 2003 and 2006. The two published these and other research findings in a paper titled "Mortgage Innovation and the Foreclosure Boom."

"Dean and I started collaborating a few years ago when he served as a consultant at the Federal Reserve Bank of Dallas, where I worked as an economist," Quintin explains. "In 2007, it became evident that understanding the root causes of the crisis would be a research priority for the profession for many years to come. We set out to build a dynamic model of the U.S. economy that could account for key features of housing markets prior to the collapse. Then we used our model to perform an autopsy of the crisis."

Specifically, their model simulated three transitional stages. The first stage reflected key characteristics of the U.S. economy before 2003, when homebuyers only had access to traditional fixed-rate mortgages with 20 percent down payments. The next stage introduced nontraditional mortgages as an option for a four-year period. At this stage, the model predicted that one third of the homebuyers would choose nontraditional mortgages, mirroring the real-life originations in nontraditional mortgages from 2003 to 2006. The third phase introduced an unanticipated 25 percent drop in home prices, in turn projecting a 148 percent surge in foreclosures closely paralleling the actual 150 percent spike in foreclosures between the first quarters of 2007 and 2009.

But, what would have happened to foreclosure rates if nontraditional mortgages weren't part of the picture in the second stage of the simulation? Quintin and Corbae used their model to run this counterfactual experiment, and the results were telling: foreclosure rates increased by only 86 percent.

Bottom line, their research provides compelling evidence that nontraditional mortgages accounted for 42 percent of the foreclosures.

"A natural question which we often face when presenting our work is 'Why lay out such a computationally demanding model when traditional, simpler empirical methods may have given a much quicker answer?'" says Quintin. "The low down payment option magnified the crisis both by lowering equity levels across the board and by enabling borrowers more prone to default to participate in mortgage markets. Taking the second effect into account requires a model of how people change their housing choices when the mortgage menu changes."

What are the lessons governmental policymakers can learn from these research findings?

"Our work provides direct quantitative evidence that mortgages with low initial payments greatly magnify the impact of house price shocks," says Quintin. "Encouraging them is clearly not a prudent way to accomplish home-ownership goals. We also provide strong support for the view that default is typically caused by a combination of negative equity and income shocks. This means foreclosure relief should focus on providing payment support to homeowners with documented income difficulties."

Quintin and Corbae ran an additional "what if" experiment designed to evaluate the potential role of recourse, or broadening borrower liability, in mitigating the crisis. In this counterfactual scenario, all the borrower's assets would be seized in the event of foreclosure. As a result, the model projected that foreclosure rates would be reduced by as much as 28 percent.

"In many parts of Western Europe, households that default on mortgages run a high risk of seeing their future income garnished by creditors, and this could be one reason why the foreclosure crisis has been more limited over there," says Quintin. "Understanding the impact of recourse policies requires a model like ours, and this is one application we plan to explore further going forward."

Given their culpability in the recent crisis, some may call for more draconian measures severely restricting or even outlawing nontraditional mortgages, in order to avoid repeating another foreclosure crisis in the future.

"My view is that nontraditional mortgages, in and of themselves, are not the problem," Quintin explains. "In our model and, I believe, in reality, lenders originated them because they attached little weight to the possibility that prices could fall significantly."

If and when mortgages with nontraditional features make a return, he adds, lenders will have a better understanding of the worst-case scenarios, and will underwrite mortgages more reasonably.

"As for other future crises, recent research has shown that booms and busts are quite common across time, and across countries," Quintin says. "House price collapses will happen again. We should focus on making sure that the next housing event doesn't cause a full-blown, global financial crisis."

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