Everyone's pals at the St. Louis Fed have done it again. In the July issue of the The Regional Economist, they published an article entitled "The Foreclosure Crisis in 2008: Predatory Lending or Household Overreaching" by William Emmons (a Fed economist) along with Kathy Fogel, Wayne Lee, Liping Ma, Deena Rorie and Timothy Yeager of the Sam M. Walton College of Business at the University of Arkansas. This article attempts to answer the seemingly age-old question; was the increase in the number of foreclosures and the resulting collapse in housing prices due to stupid consumers or stupid lending practices by banks? As a rather voracious reader of newspapers from around the world and the comments from readers that follow articles that discuss the collapsing housing markets in the United Kingdom, the United States and Eurozone countries, I see a strong divide between those who believe that consumers are to blame for their own poor decisions and those who believe that the banks in these countries did what they could to dupe unsophisticated consumers into overleveraging themselves. Fortunately for all of us, the St. Louis Fed is doing the heavy lifting and will answer the question for us and point the fickle finger of blame at the party that created the Great Recession. Thank goodness for all that! Please remember, that this data and its accompanying conclusions apply only to foreclosures that occurred in 2008, however, as I’ll note later, I think that the conclusions still apply.
Let's open this posting with a quote from the article:
"The answer (to fixing blame for the foreclosure crisis) is difficult to ascertain because it ultimately depends on the intentions of the borrower and the lender. After the fact, a lender would hardly admit to deceiving a borrower, and the borrower would be more than willing to place at least some of the blame for the foreclosure on the lender."
The authors then go on to state that:
"...certainly, both predatory lending and household overreaching occurred during the subprime housing bubble. But it is important to identify the primary reason for the foreclosure crisis because the policy implications are vastly different..."
If it was over-borrowing by households that created the foreclosure crisis, then it is quite possible that another round of house price appreciation like that experienced in the early- to mid-2000s could result in another housing price bubble that would, once again, result in borrowers mortgaging themselves for more than they can afford. The solution to this problem would require central bank intervention to recognize and prevent the development of real estate asset bubbles among others. While the sentiment of this solution seems nice, in fact, the easy money policies of the Fed's zero interest rate policy was at least partly to blame for the formation of more than one asset bubble over the past decade (i.e. tech stocks, housing and now probably commodities); one would think that the central bankers would learn from past mistakes but apparently, things aren't quite as simple as that in the rarified air of the Federal Reserve.
On the other hand, if the foreclosure crisis was created by the predatory lending practices of the banking establishment, consumer protection laws like those found in the Dodd-Frank law would act to prevent Wall Street banks from making millions of risky loans that consumers had no possibility of repaying so that Wall Streeters can pack their bank accounts with millions of dollars in bonuses and salaries.
In order to understand the impact of both over-borrowing and predatory lending, Emmons et al used two sources of data. The first is the RealtyTrac database that compiles nationwide data on all homes in foreclosure. The second is the Acxiom database which compiles nationwide data on millions of United States households every quarter and divides these households based on income, demography and consumption. The Acxiom database divides the population into "Life Stage Segments" as described here. Each household is segmented into one of 70 segments within 21 life stage groups based on specific consumer behaviour and demographic composition. For example, there are five main PersonicX Earnings Lifestages including Youth, Career Builder, Earning Years, Late Career and Retirement. Each of these Lifestages is then subdivided into one of 21 Lifestage Groups. The authors of the study combined the RealtyTrac and Acxiom databases and the resulting combined database had 40 million records with 200,000 foreclosures for the third quarter of 2008 alone. The authors also noted that since they really had no idea what motivated households to borrow for their mortgages, they would make one of two assumptions:
1.) Households with low income and educational levels would be most vulnerable to predatory lending practices since they likely had a poorer understanding of the mortgage contract that they were signing.
2.) Households with high educational and income levels were more likely to have high economic aspirations relative to their net worth and income and would be more likely to overreach when borrowing to purchase a home.
Now, on to the conclusions of the study.
1.) Value of foreclosed homes: The authors found that defaulted homes, on average, were more expensive than those owned by households not in default. The median market value of homes in foreclosure was $242,400 compared to $199,129 for those homes not in foreclosure. Homes in foreclosure had a median age of 30 years compared to 34 years for those not in foreclosure. As well, homes in foreclosure had a median size of 1526 square feet, substantially smaller when compared to 1907 square feet for those not in foreclosure. The median loan-to-value ratio for foreclosed homes was 96 percent compared to 65 percent for homes not in foreclosure. My suspicion is that the loan-to-value ratio for foreclosed homes today would be far worse than 96 percent with millions of homeowners currently underwater as shown here.
2.) Foreclosed Household Demographics: Households in foreclosure tended to be smaller (median size of 2.0 people compared to 3.0 people for homes not in foreclosure) with an average of 56.2 percent of foreclosure households being married compared to 70.8 percent of those not in foreclosure. As well, 36.9 percent of households in foreclosure were owned by singles compared to 25.7 percent of households not in foreclosure. Households in foreclosure also had a median length of residency that was substantially shorter than those not in foreclosure; 4.0 years compared to 9.0 years. When the data is looked at as a whole, it appears to show that that households in foreclosure purchased their homes later in the bubble, paying far more for far less house and that they were at an earlier stage of their careers. Interestingly enough, the data also shows that households in foreclosure had markedly less education with only 12 years of schooling compared to 16 years for households not in foreclosure.
By using the Acxiom PersonicX Life Stage Segments as noted above, the researchers were able to define more accurately the households that were responsible for a share of foreclosures that was out of proportion to what would be expected. To observe which Life Stage Segments were responsible for a disproportionate share, the authors calculated the share of the total number of foreclosures for each Life Stage and then compared that to the share of the total number of households for each Life Stage. For example, the Cash and Careers Group accounted for 5.52 percent of all households however, they accounted for 11.3 percent of all foreclosures. The excess share of foreclosures is therefore 11.32 minus 5.52 which gives us an excess foreclosure rate of 5.78 percentage points. For your information, on the following graph, the Group codes ending in B represent Baby Boomers, the Groups ending in X and Y represent Generations X and Y, the Group ending in M represents the Mature generation (50 and 60 year olds) and the Group ending S represents seniors.
Here is the graph showing the excess foreclosure percentages for some of the Life Stage Groups:
Let's look at the group that tended to overreach first. Right away, it is apparent that the young, relatively affluent households of Generation X Cash and Careers Group (born in the mid-1960s to early 1970s) were responsible for an excessive number of foreclosures with 5.52 percentage points more foreclosures than their share of the population. This group had the highest average household income ($59,500) and the highest number of years of education (14.8 years). Next in line for an excessive number of foreclosures compared to their share of the population was the Generation Y Taking Hold Group of households with 3.66 percentage points more foreclosures than would be expected. This group has an average age of 27.8 years, has the second highest average income ($55,500), third highest net worth (I'm assuming that's net worth prior to the foreclosure) and fifth highest education level (14.1 years).
Now let's look at the group that was most likely the victim of predatory lending practices because they had they either had lower educational levels or lower net worth and income. The Generation Y Group Beginnings and Generation X Group Mixed Singles ranked in ninth or tenth place in income, education and net worth yet ranked seventh and eighth in terms of the number of foreclosures with 2.67 percentage points of excess foreclosures. Note that these two less “sophisticated” groups accounted for an excess of only 2.67 percentage points compared to their better educated and affluent counterparts in the previous paragraph who were responsible for a combined 9.44 percentage point excess.
The researchers then looked at the geographic distribution of the foreclosures in the early stage of the Great Recession. In general, the areas with the greatest price appreciation between 2000 and 2007 (think bubble) were in Florida and the Southwest and Northeast states. Now let's look at a map that shows the concentration of foreclosures by state for the third quarter of 2008:
The concentration of foreclosures in Florida and the Southwest states tells us that these were likely a result of overreaching as households bid endlessly higher prices for their homes. Note the disproportionately large number of foreclosures in the north-central states (Indiana, Michigan, Ohio and Illinois). These states did not see massive price appreciation but the disproportionate number of foreclosures is likely due to the shuttering of the America’s manufacturing heartland. When the foreclosure rates are compared to price appreciation at the state level, it is quite apparent that overreaching seems to be the cause of most of the foreclosures, that is, for those states that are outside of the states in the manufacturing heartland. While I realize that this data is nearly three years old, it is interesting to see that the RealtyTrac foreclosure map still more or less shows foreclosure hotspots in the same bubblicious areas of the United States as were seen in the second half of 2008:
The researchers conclude that most of the foreclosures in the early part of the downturn were due to overreaching by young, affluent and highly educated households. The existence of the housing bubble in certain parts of the United States followed by its collapse led to an elevated number of foreclosures. It was in these areas that consumers tended to ignore the risk involved in purchasing a home because it appeared that prices would always rise. Of course, the willingness of lenders to loan money to households that would clearly not be able to repay the debt in the future is at least part of the problem that is facing America's real estate market today and in the third quarter of 2008. While the researchers for this paper seem to give them a pass, when one is dealing with tens of millions of mortgages, I would suspect that more than a few of them had a predatory aspect to them.
In conclusion, I'll close with the last paragraph of the article since it summarize the issue facing policymakers:
"If capitalist economies are subject to periodic asset price bubbles, Hyman Minsky (an economist who wrote that prolonged periods of economic stability lead to speculative lending) suggested that policymakers take steps to eliminate bubbles that threaten to become systemically important. This, of course, requires the ability to 1) recognize an asset bubble, 2) classify the bubble as a systemic risk to the economy and 3) curb the formation of the bubble either through monetary policy actions or through more-targeted interventions, such as higher bank capital requirements or more stringent mortgage underwriting criteria." (my bold)
As I said at the beginning, one would wonder just how long it will take the Federal Reserve to recognize that their policies are, at least in part, responsible for the formation of asset bubbles in the economy? As well, giving a pass to the actions of their Wall Street banking buddies for their creative lending practices during the formation of the real estate bubble is hardly reasonable but I guess it is simpler to blame consumers for overreaching their credit than it is to blame your future employer.
That said, it is at least interesting to see where the great minds at the Federal Reserve point their fickle finger of blame at when assessing America’s housing crisis. Apparently, it’s all Main Street’s fault. For shame, for shame!