With the nation’s homeownership rates similar to those of 50 years ago, the foreclosure rate is significantly higher compared to the early 1960s. The main reason for the increase in foreclosure risk while the homeownership rate remains little changed is leverage, according to CoreLogic chief economist Sam Khater.
The economist noted that leverage remains unaddressed by those responsible for initiating housing policy, and he recommended in his study that they may want to consider the ability to manage leverage in order to obtain financial stability in the residential housing market.
“Leverage is known to play an important role in loan default, but while theoretical research on leverage exists; to our knowledge there has been virtually no long-term data driven empirical analysis on the impact of leverage on residential foreclosure,” Khater wrote on CoreLogic’s blog. “We assembled data from various sources to fill that void and examine the role leverage plays in mortgage foreclosures over the last five decades. This is an especially timely topic given that policy makers have recently attempted to thaw the tight lending environment by reducing the price and expanding the quantity of low down payment real estate credit.”
Khater said the CoreLogic research on the relationship of leverage to residential foreclosures revealed four main findings: 1) Foreclosure risk is two to three times higher than it was 50 years ago despite homeownership rates being close to their 1960s levels; 2) leverage has been a primary driver of foreclosures during the last 50 years, and that the strong role of leverage has rendered savings and income changes insignificant drivers of default; 3) high inflation rates in the 1970s and 1980s propelled nominal home prices, resulting in reduced aggregate LTV and lowering default risk – thus stabilizing foreclosures during those decades; and 4) government regulations aimed at making the mortgage market safer for consumers center on an income-based ATR rule that manage the risk of delinquency, but are not so much focused on foreclosure risk.
“Therefore, leverage as the most important driver of foreclosure performance over the last five decades remains unaddressed for the market,” Khater wrote. “In the future, policy makers may need to consider exploring their ability to manage the leverage cycle to promote residential financial stability.”
Homeownership stood at just 40 percent in the 1930s, but jumped to 62 percent by 1960 with the help of expanded credit access with the creation of the Federal Housing Administration and Fannie Mae. Homeownership has largely stabilized between 62 percent and 65 percent since then, peaking at 69 percent in 2004; it was reported at 64 percent for Q4 2014, according to CoreLogic. The conventional foreclosure rate was 0.6 percent in the early 1960s, while it was 1.4 percent for FHA loans; by 2014, the conventional foreclosure rate had more than doubled up to 1.5 percent and the foreclosure rate on FHA loans had swelled to 2.6 percent.
Khater said the higher foreclosure rates are not necessarily due to the recession and subsequent foreclosure peak experienced in 2010, citing the fact that the higher foreclosure risk for both conventional and FHA mortgage loans was still three times higher than in during the 1960s in 2004, four years prior to the recession.
A model comparing the different drivers of foreclosure rates (savings, unemployment, inflation, aggregate current LTV, real median household income) revealed only two primary factors and one secondary factor that noticeably influenced foreclosure rate: LTV ratio and unemployment rate were the most important, with LTV ratio “by far being the most important variable,” Khater said.
The findings in the model were consistent with the “dual trigger theory of foreclosures” that states that combination of a lack of equity (with a high LTV ratio) and economic shocks, such as unemployment or job loss, tip a home into foreclosure.
The model’s findings were also consistent with emerging theories that point to leverage as a major driver of default and foreclosures. Increased mortgage rates in the early 1950s combined with lower down payments drove homeownership rates higher but also drove foreclosure rates higher. Leverage stabilized from the mid-early 1960s to the mid-1980s, causing foreclosure rates to stabilize. In the early 1990s, leverage increased when housing policy began to focus on increasing homeownership via lower down payment; in the early 2000s, cash out refinances and home equity lending caused leverage to rise even faster. Foreclosures soared due to a spike in both leverage and unemployment rate when home prices crashed; in the last four years, the process has reversed and leverage has declined, according to Khater.
“CoreLogic findings illustrate how important leverage has been both historically and in today’s recovery. While leverage is the dominant driver of foreclosure trends, the unemployment rate captures the impact of short-term economic cyclical fluctuations,” Khater wrote. “A less important but still influential factor has been periods of accelerating inflation, which ease the burden of the monthly mortgage payment and masked the rise in leverage via higher nominal home prices. Interestingly, the savings rate and household income were not at all important, which was a surprise given that traditional underwriting focuses on affordability.”