[PULSE] How should we think about foreclosures?

Part 1: Lessons we learned from the last crisis

The current economic collapse raises pressing questions about what lessons we learned from the last one. No two crises are ever the same. Although they have many common elements, which flow directly from an extended plunge in economic activity, they have distinct causes and hence different trajectories. At a minimum, the reform measures that were put in place to address aspects of the prior crisis will alter the course of the next one.

Richard Cordray
Guest Author

The Great Recession, which lasted from December of 2007 to June of 2009, is of special interest here because it was an economic collapse brought about specifically by failures in the housing and mortgage markets. Some blame government policy for those failures, and it bears some share of the responsibility. Yet the greater weight of the evidence has shown that rampant Wall Street financial speculation was the core of the problem. The traditional approach to housing and mortgage financing became distorted by new mortgage-based investment instruments, leveraged lending, and lax underwriting, all of which turned out to be grounded in ill-founded assumptions.

Two of those assumptions were especially problematic in leading to the Great Recession. The first was the glib view that residential property values would always hold steady or rise over time, as had been largely the case since World War II. Putting aside the isolated tragedy of setbacks for individual families, or localized conditions of economic weakness, the “national” market for residential real estate was regarded as steady and enduring. When we first began to see elevated levels of foreclosures in Michigan, Ohio, and Indiana in 2004, 2005 and 2006, they were initially written off as a “Rust Belt” phenomenon. In the rest of the country, the home itself, which serves as the essential collateral for a mortgage loan, continued to be regarded as the solid keystone of the entire edifice.

This assumption, in turn, led to dangerous developments in mortgage underwriting practices. Those seeking to expand the market were not content to make safe, conventional loans; they wanted to widen the pool by bringing in new swathes of customers. And many shared what they saw as a key insight – that looser underwriting to a wider pool of individuals was not overly risky because the underlying collateral could always be counted on to rescue even a failed loan. Although government policy played some role in these developments, the unshackled creativity that spawned exotic new mortgage instruments was astounding. No-documentation loans, underwriting that was deceptively pegged to teaser rates, and broader use of negatively amortizing loans were just some of the novel approaches that many lenders adopted to qualify borrowers from outside the traditional mainstream. These innovations were met with little resistance, and even open encouragement, from most regulators.

In all these instances, lenders (and those who bought or financed their loans) were able to tell themselves that the financial condition of the borrower didn’t really matter, because the ultimately surety for the loan was the residential property itself. And with the assumption that the value of this collateral would be unfailingly sound, more venturesome loans could be made.

The problem with this approach is a basic common-sense point: any economic axiom that contains the word “always” is inherently unreliable and, at some point, will be proved wrong. When real estate values plummeted across many geographic markets at once, dragged down by irresponsible lending that disregarded the borrower’s ability to repay, the transmission of this cataclysm through new and sophisticated financial channels led to the credit freeze and the financial crisis. One central reform that Congress and the Consumer Financial Protection Bureau put in place in the wake of this disaster is that nobody can now make a home loan without first making a reasonable assessment of whether the borrower will be able to repay the loan.

But the second casual assumption that helped precipitate the Great Recession was the related notion that the process for realizing the collateral that underpins a home loan, to recapture its market value, can be counted on to work effectively. The assumption had less to do with the sustainability of home values, and more to do with the nuts-and-bolts functionality of how a jilted loan-holder can go about getting its money back. The mortgage market relies on the foreclosure process as the ultimate means of recovering the loan-holder’s collateral, and those involved in the market were willing simply to assume that the process would function capably to backstop their investments. This too was an error, and the reasons why are worthy of further consideration.

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