Joshua Abel* and Joseph Tracy
The foreclosure crisis in America continues to grow, with more than 3 million homes foreclosed since 2008 and another 2 million in the process of foreclosure. President Obama, in his speech of February 2, 2012, argued for expanded refinancing opportunities for homeowners and programs to expedite the transition of foreclosed homes into rental housing. In this post, we document the changing face of foreclosures since 2006 and the transformation of the crisis from a subprime mortgage problem to a prime mortgage problem owing to the housing bust and persistent high unemployment. Recognizing this change is critical because the design of housing policies should reflect the types of homeowners who are at risk of foreclosure today rather than those who were at risk at the onset of the financial crisis.
It is well known that problems with nonprime lending helped to spark the housing crisis, which was a catalyst for the financial crisis and ensuing recession. Also well known is the progressive erosion of underwriting standards in nonprime lending toward the end of the housing boom. As a result, many nonprime loans were made to borrowers who did not have the ability to pay for them, especially if house prices did not continue to increase. Not surprisingly, then, as house prices began to flatten and decline in 2006, foreclosure starts were dominated by nonprime borrowers. As shown in our first chart, nonprime borrowers accounted for about 65 percent of foreclosure starts in 2006. However, as the financial crisis led to the Great Recession (indicated in grey), the composition of borrowers entering foreclosure shifted quite dramatically. By 2009, prime borrowers had eclipsed nonprime borrowers as the dominant source of new foreclosures. In fact, from 2009 until the present, prime borrowers have accounted for the majority of all new foreclosure starts. A fairly steady 10 percent of foreclosure starts were associated with mortgages guaranteed by the Federal Housing Administration or the Department of Veterans Affairs.
What accounts for the dramatic change in the composition of foreclosure starts since 2006? Our next chart shows two important economic factors that have affected homeowners over this period—house prices and unemployment. For each mortgage that enters foreclosure, we calculate the percentage change in metropolitan area house prices from the time that the mortgage was originated to the time it entered foreclosure. We report average changes across all new foreclosures by year and quarter. From 2006 through 2008, as the share of new foreclosures was shifting from nonprime to prime borrowers, we see that initially foreclosures involved properties that were on average still increasing in value
(as measured by the positive cumulative change in the metro area house price index defined above), but then shifted to properties with declining house prices (in 2008), and eventually to properties where on average house prices had declined by 20 percent (in 2009). In fact, since 2009, properties entering foreclosure have continued to face a 20 percent decline in value on average.
We also calculate the change in the local (defined as the metropolitan area) unemployment rate. Just as foreclosure starts were initially associated with properties whose value was still rising, so foreclosures in 2006 and 2007 were linked to local labor markets where the unemployment rate was still declining. In 2008, however, foreclosures shifted to markets where unemployment was beginning to rise and, in 2009, to markets where unemployment had increased on average by more than 2 percentage points. In 2010, foreclosure starts occurred in markets where the increase in the local unemployment rate exceeded 5 percentage points on average since the mortgages were originated. The shift in the composition of new foreclosures from borrowers with nonprime mortgages to those with prime mortgages reflects the fact that falling house prices and rising unemployment tend to impact all borrowers in a local housing market, not just nonprime borrowers. As a result, traditionally safe borrowers began falling behind on their payments as they felt the severe effects of the housing bust and high unemployment.
In the design of housing policy, an important consideration is the extent to which foreclosures result from situations where borrowers cannot afford their mortgage from the outset. In these circumstances, foreclosures can be viewed as the market process for removing borrowers who should not have been approved for a mortgage in the first place or who cannot sustain their mortgage going forward. When affordability is the key determinant of foreclosures, policies aimed at reducing the flow into foreclosure run the risk of slowing an adjustment process necessary for an eventual housing market recovery. A useful metric for the ability of a borrower to afford a mortgage is the “debt-to-income” (DTI) ratio. This measures the cost of the mortgage (monthly payments, property taxes, and homeowner’s insurance) relative to the borrower’s income. Unfortunately, because the data that we use from Lender Processing Services do not consistently report the DTI ratio, we cannot assess this affordability measure across time for foreclosure starts.
However, we provide an alternative indirect measure of affordability. The basic idea is that in cases where a borrower cannot afford a mortgage from the outset, payment problems are likely to materialize sooner rather than later. In the chart below, we look at the time between the origination of a mortgage and the beginning of the string of missed payments that ultimately led to foreclosure. We show the 25th percentile (25 percent of the times were shorter, P25), the median (50 percent of the times were shorter, P50), and the 75th percentile (75 percent of the times were shorter, P75). Initially, when most foreclosure starts were associated with nonprime mortgages, 25 percent of the borrowers had been in the house fewer than eight months before falling behind on their payments, and 50 percent fewer than eighteen months. However, more recently, as the composition of foreclosures shifted to prime borrowers, 75 percent had been in the house more than three years, and 50 percent more than four years. This suggests that as the recession hit, foreclosures shifted from borrowers who often could not afford their houses to borrowers who had demonstrated that they could (by virtue of making payment for several years) but began to fall behind on their payments when they were hit by the dual crises of house price declines and high unemployment.
This change in the face of foreclosures is mirrored in many other dimensions. Our last chart shows the evolution in the distribution of origination credit (FICO) scores over time for new foreclosures. In 2006, 25 percent of foreclosure starts were associated with borrowers who had a credit score of 580 or below at the time they took out the mortgage, and 50 percent had credit scores of 620 or below. However, by 2009, as the recession set in and shifted the mix of foreclosures to prime borrowers, 50 percent of new foreclosures had origination credit scores of nearly 680, and 25 percent had credit scores of 720 or higher.
Nonprime lending during the housing boom was concentrated in what were called “exotic” mortgages with little down payment, initial “teaser” rates and, in some cases, negative amortization. However, since 2010, 65 percent of foreclosure starts have been associated with borrowers who took out thirty-year fixed-rate amortizing mortgages (viewed by consumer advocates as the “safest” mortgage product)—up from 40 percent early in the crisis. Similarly, the prime borrowers who have entered foreclosure in the past several years have on average made a meaningful down payment of 20 percent.
A large foreclosure pipeline hangs over U.S. housing markets, creating headwinds for housing market recovery. What began as a nonprime mortgage problem has evolved into a prime mortgage problem with the onset of the recession. The inability to afford a home has been replaced by declining house prices and high unemployment as the primary driver of new foreclosures. Clearly, these changes have implications for the design of housing policy: By recognizing the shifting face of foreclosures, policymakers can make more informed choices about the most effective forms of intervention and the groups of borrowers that could best be served by them.
*Joshua Abel is a research associate in the Research and Statistics Group.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.