Real Estate Research

January 14, 2015

The Effectiveness of Restrictions of Mortgage Equity Withdrawal in Curtailing Default: The Case of Texas

As an economist who has studied the causes of the recent mortgage default and foreclosure crisis, I am often asked how to design policies that will minimize the likelihood of another crisis. My typical response to such a question is that one of the most effective ways of lowering mortgage defaults would be to limit borrower leverage by either increasing down payment requirements at the time of purchase or limiting home equity withdrawal subsequent to purchase.

The reason behind my belief is twofold. First, economic theory tells us that being in a situation of negative equity (where the remaining balance of the mortgage is greater than the market value of the property) is a necessary condition for default and foreclosure. Homeowners with positive equity will almost always have a financial incentive to sell their homes instead of suffering through the foreclosure process, while borrowers who are “under water” have a difficult time refinancing or selling (since they would need to have enough cash at closing to cover the difference between the outstanding balance of the mortgage and the sale price/appraisal of the house) and have less of a financial incentive to continue paying the mortgage. Second, numerous empirical studies in the literature have confirmed the theory by documenting a strong positive correlation between the extent of negative equity and the propensity to default on one’s mortgage.

New evidence on preventing defaults

An important new paper by Anil Kumar, an economist at the Federal Reserve Bank of Dallas, provides new evidence that shows just how effective restricting leverage can be in preventing mortgage defaults. His paper confirms many of the findings in previous studies that have shown a positive relationship between negative equity and default. However, it goes a step further by using plausibly random variation in home equity positions created by a government policy that placed explicit restrictions on home equity withdrawal.

Kumar's paper is a significant contribution to the literature because it seems to overcome a serious identification issue that has plagued most empirical studies on the topic. The major challenge is that a homeowner can partially control his or her equity position through decisions about initial down payments on purchase mortgages and decisions about cash-out refinancing and home equity loans or lines of credit subsequent to purchase. As a result, it's unclear whether homeowners with more negative equity are more likely to default because of their worse equity positions or because of other reasons (unobserved by the researcher) that happen to be correlated with the decision to put less money down at purchase or to extract more equity over time.

Both theory and empirical evidence tell us that more impatient individuals tend to borrow more and are more likely to default on their debts. Thus, it might simply be the case that more impatient borrowers who are less likely to repay any type of debt choose to put less money down and extract more equity over time, creating the observed correlation between negative equity and the propensity to default. To put it in the language of econometrics, there are both selection and treatment effects that could be driving the correlation that we see in the data, and the policy implications of restricting borrower leverage are likely very different depending on which cause is more important.

Do home equity restrictions cause lower default rate?

The paper focuses on a policy enacted in the state of Texas that placed severe restrictions on the extent of home equity withdrawal. The Texas constitution, enacted in 1876, actually prohibited home equity withdrawal. The prohibition was eventually lifted in 1997 and the restrictions were further relaxed in 2003, but even in the post-2003 period, Texas law placed serious limits on equity withdrawal, which remain in effect today.¹ Subsequent to purchase, a borrower cannot take out more than 50 percent of the appraised value of the home, nor exceed 80 percent of total loan-to-value (LTV). For example, if a borrower owned a home worth $200,000 and had an outstanding mortgage balance of $140,000, the borrower would be allowed to take out only $20,000 in a cash-out refinance. It is important to note that this LTV restriction does not bind at the time of purchase, so a homebuyer in Texas could take out a zero-down-payment loan, and thus begin the homeownership tenure with an LTV ratio of 100 percent (we will come back to this issue later).

Here's a nice quote in the April 4, 2010, issue of the Washington Post crediting the cash-out restriction for Texas weathering the foreclosure crisis better than many areas of the country.

But there is a broader secret to Texas's success, and Washington reformers ought to be paying very close attention. If there's one thing that Congress can do to help protect borrowers from the worst lending excesses that fueled the mortgage and financial crises, it's to follow the Lone Star State's lead and put the brakes on "cash-out" refinancing and home-equity lending.

At first glance, the data suggest that such a sentiment may be correct. In the figure below, we display subprime mortgage serious delinquency rates (defined as loans that are at least 90 days delinquent) for Texas and its neighbors (Arkansas, Louisiana, New Mexico, and Oklahoma). We focus on the subprime segment of the market because these are the borrowers who are more likely to be credit-constrained and thus more likely to extract home equity at any given time. It is apparent from the figure that Texas had the lowest subprime mortgage delinquency rates over most of the sample period. While the paper uses a slightly different data set, a similar pattern holds (see Figure 1 in the paper). The figure is certainly compelling and suggests that the home equity withdrawal restrictions in Texas had an important effect on default behavior, but a simple comparison of aggregate default rates across states really doesn’t tell us whether the policy had a causal impact on behavior. There could be other differences between Texas and its neighboring states that are driving the differences in default rates. For example, house price volatility over the course of the boom and bust was significantly lower in Texas compared to the rest of the country, which could also explain the differences in default rates that we see in the figure.

The paper uses a relatively sophisticated econometric technique called "regression discontinuity" to try to isolate the causal impact of the Texas policy on mortgage default rates. We won't get into the gory details of the methodology in this post, so for anyone who wants more details, this paper provides a nice general overview of the technique. Essentially, the regression discontinuity approach implemented in the paper compares default rates over the 1999–2011 period in Texas counties and non-Texas counties close to the Texas borders with Louisiana, New Mexico, Arkansas, and Oklahoma while controlling for potential (nonlinear) trends in default rates that occur as a function of distance on each side of the Texas border. The paper also controls for other differences across counties that are likely correlated with mortgage default rates (such as average house price appreciation, average credit score, and more). The idea is to precisely identify a discontinuity in default rates at the Texas border caused by the restrictions on home equity withdrawal in Texas. This strikes us as a pretty convincing identification strategy, especially in light of the fact that information on actual home equity withdrawal is not available in the data set used in the paper.

The estimation results of the regression discontinuity specification show that the equity restriction policy in Texas lowered overall mortgage default rates over the 13-year period by 0.4 to 1.8 percentage points depending on assumptions about sample restrictions (including counties within 25, 50, 75, or 100 miles of the border) and functional form assumptions for the “control function” (that is, whether distance to the border is assumed to be a linear, quadratic, or cubic polynomial). At first glance, this may not seem like a large effect, but keep in mind that the average mortgage default rate over the entire sample period was only slightly above 3 percentage points in Texas and 4 percentage points in the neighboring states. The paper also restricts the sample to subprime mortgages only and finds significantly larger effects (2 to 4 percentage points), which makes sense. We expect subprime mortgage borrowers to be affected more by the equity restriction since they are more likely to withdraw home equity.² The paper implements a battery of robustness checks to make sure that the results aren’t overly sensitive to functional form assumptions and adds controls for other types of state-level policy differences. Based on the results of those tests, the findings appear to be quite stable.

But is it a good policy?

So the paper appears to confirm what previous research on the relationship between equity and mortgage default has found, although it uses methods that aren’t quite as clean as the regression discontinuity approach employed in this analysis. However, it doesn’t mean that such a law change is necessarily good policy. While it seems to be effective in reducing defaults, it may also have some real costs. The most obvious one is the decrease in the volume of low-cost secured credit that many borrowers used to improve their circumstances during the housing boom. An unintended consequence of the policy might have been to push financially distressed households into higher-cost credit markets like credit cards or payday loans. A second drawback of the policy may have been that it increased homeowner leverage at the time of purchase. As there were no restrictions on LTV ratios at the time of purchase, many homebuyers may have decided to make lower down payments, knowing that their access to equity would be restricted in the future. It’s also possible that this may have resulted in a larger volume of subprime mortgage lending in Texas. Households with relatively high credit scores who could have obtained a prime mortgage with significant down payments (say, 20 percent), may have turned to the subprime segment of the market, where they could obtain loans with low down payments but with much more onerous contract terms.

While it’s not clear whether the actual Texas policy of restricting home equity extraction is welfare-improving, it might seem from the research that restricting borrower leverage is an effective way to reduce mortgage default rates. But limiting borrower leverage is very unpopular. In fact, it probably isn’t too much of an exaggeration to say that the vast majority of market participants are adamantly opposed to such policies. After all, it is perhaps the only policy upon which both the Center for Responsible Lending (CRL) and the Mortgage Bankers Association (MBA) share the same negative view.³ Thus, while such policies have been adopted in other countries, don’t expect to see them adopted in the United States any time soon.⁴ To the contrary, policy is more likely to go in the opposite direction as evidenced by the Federal Housing Finance Agency’s announcement to relax down payment requirements for Fannie Mae and Freddie Mac.

By Kris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta

_______________________________________

¹ Before 1998, both home equity lending (loans and lines of credit) and cash-out refinancing were explicitly prohibited in Texas. A 1997 constitutional amendment relaxed this ban by allowing for closed-end home equity loans and cash-out refinancing as long as the combined LTV ratio did not exceed 80 percent of the appraised value (among a few other limitations that are discussed in the paper). In 2003, another constitutional amendment passed that further allowed home equity lines of credit for up to 50 percent of the property’s appraised value, although still subject to a cap on the combined LTV ratio of 80 percent.

² The effects are actually smaller for the subprime sample when compared to the average default rate over the entire sample period, since the average rate is significantly higher in the subprime segment of the market (10 percent subprime default rate compared to the 3 percent overall default rate in Texas).

³ See the CRL's view of increased down payment requirements and the MBA's perspective.

⁴ In the post-crisis period, Canada, Finland, Israel, New Zealand, and Norway have all placed restrictions on borrower leverage. For an overview, see Rogers (2014).

• January 14, 2015 in
  • Financial crisis
  • Housing crisis
  • Mortgage crisis
  • Mortgage default
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July 1, 2013

Misrepresentation, or a Failure in Due Diligence? Another Argument

In the last post we wrote together, we discussed a paper on the role of misrepresentation in mortgage securitization by Tomasz Piskorski, Amit Seru, and James Witkin (2013, henceforth PSW).¹ That paper argues that the people who created mortgage-backed securities (MBS) during the housing boom did not always tell the truth about the mortgages backing these bonds. Today, we discuss a second paper on misrepresentation, this one by John M. Griffin and Gonzalo Maturama (2013, henceforth GM).² The two papers have a similar research approach, and the two sets of authors interpret their results in the same way—namely, in support of the hypothesis that misrepresentation was an important cause of the mortgage crisis. We offer an alternative interpretation.

We believe that the evidence shows that investors were not fooled and that deception had little or no effect on investor forecasts of defaults. Consequently, deception played little or no role in causing the crisis (see the post on PSW for details). We do think, however, that some results in the GM paper have significant implications for our understanding of the crisis, although GM does not focus on these particular results.

We argue that one can interpret their evidence on misreporting as a measure of due diligence on the part of lenders. Many—including most notably the New York Attorney General's office in a lawsuit against JP Morgan—allege that the dismal performance of securitized mortgages made after 2005 relative to those made before 2005 reflects a precipitous drop in due diligence among lenders starting in that year. But GM's paper implies that there was no such decline. In fact, for most measures of due diligence, there is almost no time series variation over the housing cycle at all.

Before we discuss the paper's implications for underwriting standards, it is important to outline GM's basic research approach with regards to misrepresentation. As with PSW, GM's fundamental idea is to compare two sets of loan-level mortgage records to see if the people marketing MBS misrepresented what they were selling. Specifically, GM compare information about mortgages supplied by MBS trustees with public records data from deed registries, as well as data on estimated house prices from an automated valuation model (AVM). PSW, by contrast, compare MBS trustees' data with information from a credit bureau. In general, GM's choice to use public records data as the comparison data set is probably more functional.

While PSW refer to their credit bureau data as "actual" data, it is well known that credit bureau data also contain errors, a fact that complicates any study of misrepresentation. For example, PSW often find that the credit bureau reports a second lien for a particular mortgage borrower while the MBS trustees report no such lien. The implication in such instances is that the MBS trustees misrepresented the loan. But PSW must also acknowledge that the reverse discrepancy turns out to be equally likely. Just as often, second liens appear in MBS data and not in the supposedly pristine data from the credit bureau. No data set is perfect, but GM's public records data is no doubt much cleaner than the credit bureau data. For a purchase mortgage, the records filed at a deed registry are not only important legal documents, they are also recorded on or very close to the day that the mortgage is originated. As a result, the public records data come closer to being "actual" data than data from a credit bureau.

GM measure four types of "misreporting" with their data: 1) unreported second liens; 2) investors incorrectly reported as owner-occupants; 3) unreported "flipping," in which the collateral had been sold previously; and 4) overvaluation of the property, which is defined to occur when the AVM reports a valuation that is more than 10 percent below the appraised house value appearing on the loan application. To us, neither 3 nor 4 seem like reasonable definitions of misreporting. For point 3, issuers never reported anything about whether the house was flipped. This issue turns to be a moot point, however, as Figure 1 from GM (reproduced below) shows that flipping almost never occurred. Regarding point 4, it's not surprising that AVMs often report substantially different numbers than flesh-and-blood appraisers do, for the same reason that two people guessing the number of jelly beans in a jar are likely to disagree. Estimating the right value exactly is not easy, even for people (and automated computer models) with the best of intentions.

More consequential are GM's findings relating to misrepresentations of the types identified in points 1 and 2. Here, GM's findings are essentially the same as PSW's, though GM report much higher rates of misrepresentation than do PSW. However, GM acknowledges that the difference stems almost entirely from their decision to ignore refinance loans. According to Table IA.VIII in GM's appendix, refinances have dramatically lower misrepresentation rates. But just as the central findings of GM are similar to those in PSW, so is our critique. The historical evidence indicates that investors were properly skeptical of the data provided by MBS issuers. Moreover, deception did not prevent investors from making accurate forecasts about default rates among securitized loans. We direct the reader to our post on PSW for more details.

Though we do not believe that GM can persuasively link misrepresentation of MBS data to massive investor losses, an alternative interpretation of their data has the potential to shed light on the mortgage crisis. One way to interpret the level of misreporting—in particular, for occupancy—is as a measure of due diligence on the part of lenders. Neither PSW nor GM suggest that for any particular loan, the MBS issuer knew that the borrower was an investor and did not plan to occupy the property. Instead, these authors claim that someone along the securitization chain failed to do the necessary due diligence to determine if the borrowers who claimed to be owner-occupiers were in fact investors. This due diligence was certainly possible. A sufficiently motivated loan officer could have done exactly what GM did: match loan files with public records to figure out that a potential borrower did not intend to live in the house he was buying.³ As a result, we would expect that when due diligence goes down, occupancy misreporting would go up.

Obtaining a proxy measure of due diligence is useful, because many commentators have argued that the poor performance of subprime loans made after 2005 as compared to loans made before 2005 (see Figure 3 from Foote, Gerardi, and Willen, 2012) resulted from a precipitous drop in due diligence. For example, in the recent complaint against JP Morgan, the New York Attorney General's office writes that:

[Subprime lenders], as early as February 2005, began to reduce the amount of due diligence conducted "in order to make us more competitive on bids with larger sub-prime sellers."

So what does GM's proxy measure of due diligence show? With respect to occupancy, there is little or no change in the incidence of occupancy misreporting in 2005. Indeed, looking across the entire sample, we see that occupancy misreporting rose smoothly from about 11 percent in 2002 to a peak of about 13 percent in 2006. In other words, at the peak of the boom, the incidence of sloppy underwriting was almost the same as it was four years earlier. In fact, all four series reported by GM show the same pattern or lack thereof. With the exception of the first quarter of 2006, second-lien misreporting was uniformly lower during what commentator Yves Smith refers to as the "toxic phase of subprime" lending than it was in 2004 and 2003 when loans performed dramatically better.

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By Paul Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston, with help from

Chris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston, and

Kris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta

• July 1, 2013 in
  • Mortgage crisis
  • Mortgage default
  • Subprime MBS
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April 26, 2012

Can home loan modification through the 60/40 Plan really save the housing sector?

In a recent article in the Federal Reserve Bank of St. Louis Review, Manuel Santos, a professor at the University of Miami, claims to offer a simple solution to "save the housing sector." Called the "60/40 Plan," his proposal is the centerpiece of a business called 60/40 The Plan Inc. Santos’s article is, in our opinion, written less like an academic article and more like promotional material.

The developer of the 60/40 Plan, Gustavo Diaz, is seeking a patent for the proposal. Unfortunately for the stressed mortgage market, his idea is simply a specific variant of a long-standing mortgage-servicing practice known as "principal forbearance." In general, principal forbearance occurs when the mortgage lender grants a temporary reduction of a borrower’s monthly mortgage payment, often reducing the payment by a significant fraction, with the stipulation that the borrower repay this benefit, with interest, at a later date.

Principal forbearance is a loss-mitigation tool that mortgage lenders and servicers have been using for decades. In fact, Fannie Mae and Freddie Mac are currently using this technique as a loss mitigation tool and alternative to principal forgiveness (which Federal Housing Finance Agency Acting Director Edward DeMarco discussed here). Private mortgage lenders have also widely used principal forbearance, especially in the first few years of the recent foreclosure crisis.

As articulated in Diaz’s 60/40 Plan, principal forbearance simply splits a distressed borrower’s current principal balance into two parts: a 60 percent share that will fully amortize over 30 years and be subject to interest payments at market rates, and a 40 percent share that is treated as a zero-interest balloon loan due at the time of sale.

Of course, in practice, the optimal shares and other terms of a principal forbearance program should be, and often are in practice, based on a given household’s financial situation. One size does not fit all. Professor Santos advocates the 60/40 Plan in large part because it is, in the language of economists, "incentive compatible." What this means is that borrowers who need assistance with their mortgage payments will find the program helpful and borrowers who do not need assistance will not find the program very appealing and thus will have little incentive to pretend to be a borrower in need of help in order to qualify for the program.

He writes: "It is important to understand that the 60/40 Plan builds on financial postulates and incentive compatible mechanisms that can be firmly implemented. It is designed as a first-best contract between the homeowner and the lender by holding onto some basic principles of incentive theory."

We agree completely with this sentiment. In fact, one of us wrote an article almost five years ago that advocated a policy of principal forbearance over principal forgiveness for exactly these reasons. Thus, the 60/40 Plan is not a novel concept, as Professor Santos seems to believe. But even more problematic, principal forbearance, as we have come to realize over the past few years, is not a panacea for the housing market for several reasons. First, it is really only helpful and appealing to borrowers that have temporary cash-flow problems who do not wish to move. This is because under the 60/40 Plan and principal forbearance in general, a borrower remains in a position of negative equity, which makes it virtually impossible to sell, since the borrower would need to come up with the amount of negative equity in cash to repay the entire principal balance of the mortgage at closing. For example, in the numerical example that Professor Santos works through to illustrate how the 60/40 Plan would work in practice, the borrower remains in a position of negative equity for 15 years. Thus, if a cash-strapped borrower needs to move immediately, or even a few years down the road, default (or re-default) is very likely.

Second, carrying 40 percent of the mortgage at a zero (or below market) interest rate imposes significant costs on the lender or investor. (These costs are viewed as being offset by savings from avoiding foreclosure.) Nevertheless, principal forbearance is not always going to be a positive net-present-value proposition; this depends on the share being protected (40 percent is quite high), the amortization schedule (30 years is very long), the discount rate, and the re-default rate. Indeed, Professor Santos seemingly assumes no re-default despite the fact that under the plan a borrower would remain in negative equity for a very long time, as we discussed above.

Third, most distressed mortgages are not held by depository institutions as whole loans. Fannie Mae and Freddie Mac have been able to selectively employ principal forbearance because they make investors whole in terms of the original promised principal and interest payments. This is not true for private-label securitizations, and there have been ongoing disagreements between investors and servicers as to optimal loss-mitigation strategies. (And there is no reason to think this proposal would not be similarly controversial.) The 60/40 Plan also seemingly ignores the significant complications posed by existing second liens and mortgage insurance policies.

Finally, Professor Santos claims that the 40 percent zero-coupon balloon shares—typically nonrecourse loans to severely distressed homeowners—will have a deep secondary market to pull liquidity back into the housing market. This seems far-fetched given that these assets have little or no yield and will have high default rates with no recourse. However, reading further, it appears that the proposal assumes a Federal Deposit Insurance Corporation (FDIC) insurance wrap for these assets to facilitate their sale. The cost of this insurance would likely be expensive and require a controversial new program, with premiums expected to cover losses or a congressional appropriation. However, it also ignores the fact that FDIC-insured depository institutions only hold about 25 percent of all mortgages.

Principal forbearance can be a useful loss-mitigation tool, although its value depends on economic circumstances. The 60/40 Plan that Professor Santos advocates is an example of principal forbearance and not a novel concept. Moreover, the 60/40 Plan does not consider a number of important institutional factors that have hampered loss-mitigation activities since the onset of the mortgage foreclosure crisis. Simply put, the 60/40 Plan will not save the housing market.

By Scott Frame, financial economist and senior policy adviser, and

Kris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta

• April 26, 2012 in
  • Foreclosure contagion
  • Loan modifications
  • Mortgage crisis
  • Mortgage default
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November 17, 2011

Taking on the conventional wisdom about fixed rate mortgages

The long-term fixed rate mortgage (FRM) is a central part of the mortgage landscape in America. According to recent data, the FRM accounts for 81 percent of all outstanding mortgages and 85 percent of new originations.¹ Why is it so common? The conventional wisdom is that the FRM is a great product created during the Great Depression to bring some stability to the housing market. Homeowners were defaulting in record numbers, the story goes, because their adjustable rate mortgages (ARMs) adjusted upward and caused payment shocks they could not absorb.

In a Senate Committee on Banking, Housing, and Urban Affairs hearing on October 20, some experts presented testimony that followed this conventional wisdom. As John Fenton, president and CEO, Affinity Federal Credit Union, who testified on behalf of the National Association of Federal Credit Unions, laid out in his written testimony:

Prior to the introduction of the 30-year FRM, U.S. homeowners were at the mercy of adjustable interest rates. After making payments on a loan at a fluctuating rate for a certain period, the borrower would be liable for the repayment of the remainder of the loan (balloon payment). Before the innovation of the 30-year FRM, borrowers could also be subject to the "call in" of the loan, meaning the lender could demand an immediate payment of the full remainder. The 30-year FRM was an innovative measure for the banking industry, with lasting significance that enabled mass home ownership through its predictability.

Of course, this picture of the 30-year FRM as bringing stability to the housing market has profound implications for recent history. Many critics attribute the problems in the mortgage market that started in 2007 to the proliferation of ARMs. According to the narrative, lenders, after 70 years of stability and success with FRMs, started experimenting with ARMs again in the 2000s, exposing borrowers to payment shocks that inevitably led to defaults and the housing crisis. Indeed, one of the other panelists at the hearing, Janis Bowdler, senior policy analyst for the National Council of La Raza, argued in her written testimony that "when the toxic mortgages began to reset and brokers and lenders could no longer maintain their refinance schemes, a recession ushered in record-high foreclosure rates."

I argue, on the other hand—both in my testimony at the hearing and in this post—that the narrative of the fixed rate mortgage as an inherently safe product invented during the Depression that would have mitigated the subprime crisis because it

eliminated payment shocks does not fit the facts.

Parsing the myths around the fixed rate mortgage
First, the FRM has been around far longer than most people realize. Most people attribute the FRM's introduction to the Federal Housing Administration (FHA) in the 1930s.² But it was the building and loan societies (B&Ls), later known as savings and loans, that created them, and they created them a full hundred years earlier. Starting with the very first B&L—the Oxford Provident Building Society in Frankfort, Pennsylvania, in 1831—the FRM accounted for almost every mortgage B&Ls originated. By the time of the Depression, B&Ls were not a niche player in the U.S. housing market. They were, rather, the largest single source of funding for residential mortgages, and the FRM was central to their business model.

As Table 2 of my testimony shows, B&Ls made about 40 percent of new residential mortgage originations in 1929 and 95 percent of those loans were long-term, fixed-rate, fully amortized mortgages. Importantly, B&Ls suffered mightily during the Depression, so the facts simply do not support the idea that the widespread use of FRMs would have prevented the housing crisis of the 1930s.

Source: Grebler, Blank and Winnick (1956)
Note: Market percentage is dollar-weighted. Building and loan societies were the main source of funds for residential mortgages and almost exclusively used long-term, fixed-rate, fully amortizing instruments.

To be sure, at 15–20 years, the terms on the FRMs the FHA insured were somewhat longer than those of pre-Depression FRMs, which typically had 10–15 year maturities.³ The 30-year FRM did not emerge into widespread use until later. It must be stressed that none of the arguments that Fenton made hinge on the length of the contract. Furthermore, the argument that Bowdler made in her testimony—that by delaying amortization, a 30-year maturity lowers the monthly payment as compared to a loan with shorter maturity—applies as much to ARMs as it does to FRMs.

But even though the ARMs may not have caused the Depression, FRM supporters might ask, didn't the payment shocks from the exotic ARMs cause the most recent crisis? Again, the data say no. Table 1 of my Senate testimony shows that payment shocks actually played little role in the crisis.

Source: Lender Processing Services and author's calculations.
Note: Sample is all first-lien mortgages originated after 2005 on which lenders initiated foreclosure proceedings from 2007 to 2010.

Of the large sample of borrowers who lost their homes, only 12 percent had a payment amount at the time they defaulted that exceeded the amount of the first scheduled monthly payment on the loan. The reason there were so few is that almost 60 percent of the borrowers who lost their homes had, in fact, FRMs. But even the defaulters who did have ARMs typically had either the same or a lower payment amount due to policy-related cuts in short-term interest rates.

To be absolutely clear here, my discussion so far focuses entirely on the question of whether the design of the FRM is inherently safe and eliminates a major cause of foreclosures. The data say it does not, but that does not necessarily mean that the FRM does not have benefits. As I discussed in my testimony, all else being equal, ARMs do default more than FRMs, but since defaults occur even when the payments stay the same or fall, the higher rate is most likely connected to the type of borrower who chooses an ARM, not to the design of the mortgage itself.

The difficulty of measuring the systemic value of fixed rate mortgages
One common response to my claim that the payment shocks from ARMs did not cause the crisis is that ARMs caused the bubble and thus indirectly caused the foreclosure crisis. However, it is important to understand that this argument, which suggests that the FRM has some systemic benefit, is fundamentally different from the argument that the FRM is inherently safe. This difference is as significant as that between arguing that airbags reduce fatalities by preventing traumatic injuries and arguing that they somehow prevent car accidents.

Measuring the systemic contribution of the FRM is exceedingly difficult because the use of different mortgage products is endogenous. Theory predicts that home buyers in places where house price appreciation is high would try to get the biggest mortgage possible, conditional on their income, something that an ARM typically facilitates. When the yield-curve has a positive slope (in most cases) and short-term interest rates are lower than long-term interest rates, ARMs loans offer lower initial payments compared to FRMs. Thus, it is very difficult to disentangle the causal effect of the housing boom on mortgage choice from the effect of mortgage choice on the housing boom.

In addition, there is evidence from overseas that suggests that the FRM is not essential for price stability. As Anthony B. Sanders, professor of finance at the George Mason School of Management, points out in his written testimony, FRMs are rare outside the United States. A theory of the stabilizing properties of FRMs would have to explain why Canadian borrowers emerged more or less unscathed from the global property bubble of the 2000s, despite almost exclusively using ARMs.

By Paul Willen, senior economist and policy adviser at the Boston Fed (with Boston Fed economist Christopher Foote and Atlanta Fed economist Kristopher Gerardi)

• November 17, 2011 in
  • Homeownership
  • Housing prices
  • Mortgage crisis
  • Mortgage default
  • Subprime mortgages
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