What's the No. 1 reason for foreclosure?

Foreclosure Factors: Subprime Mortgages or Home Values?

Some evidence indicates that falling home prices are a big factor in foreclosure.
Some evidence indicates that falling home prices are a big factor in foreclosure.
© iStockphoto.com/Pete Stopher

In Massachusetts, homeownerships made possible by subprime mortgages ended up in foreclosure almost 20 percent of the time, more than six times as often as loans made with prime mortgage rates [source: Gerardi, Shapiro, Willen]. It might seem then, that eliminating subprime lending might go a long way to stemming the tide of foreclosures.

This is the federal government's current approach. In March 2008, U.S. Secretary of the Treasury Henry Paulson unveiled a financial reform plan that would change bank regulation to provide stronger limits on subprime mortgages. The plan calls for a federal oversight committee to monitor mortgage origination; it's an attempt to prevent people from getting stuck in loans they can't afford in the first place.

Yet a 2007 study released by the Federal Reserve Bank of Boston indicates that home values might be a bigger factor than how the home was purchased. For one, the study noted that many people who defaulted on a subprime mortgage initially financed their mortgage with a prime mortgage. The study then turned to home values, finding that homeowners who suffered a loss in home value of 20 percent or greater were about 14 times more likely to go into foreclosure than those who had a 20 percent increase in the value of their home. The Boston Reserve, then, attributed the dramatic rise in Massachusetts foreclosures in 2006 and 2007 to a decline in home prices that began in 2005 [source: Gerardi, Shapiro, Willen].

The study suggests that while subprime lending played a role in foreclosure, the driving factor was not an outrageous reset payment. It was losing equity in the home, so that the value of the home was less than the amount owed on it. A person in a subprime mortgage is likely cash-poor to begin with; the home may be the only real asset to that person's name. With a low house value, that person has nothing to bargain with or refinance. Subprime lending may not have placed people in bad mortgages so much as it created homeowners who couldn't afford for the value of their home to drop.

But what came first? Foreclosures or dropping home values? The Office of Federal Housing Enterprise Oversight (OFHEO) says it's a two-way street. A 2007 study released by this office also found a high correlation between falling house prices and rising foreclosure rates. Homeowners are more likely to default on their mortgage when the value of the property is less than the loan balance, suggesting that lower prices drive foreclosures. But foreclosures can also lead to lower values because there's an oversupply of houses on the market [source: OFHEO].

While California has the country's largest rate of subprime mortgages, it is also suffering from an oversupply of houses due to a popped housing bubble. Investors moved in during a housing boom and built houses while home values were at a high. Now, home values are dropping, and those once optimistic investors can't sell properties or make their reset payment from the adjustable mortgage. They have to walk away. But will the federal government's plans help people in this situation?

It's hard to say. Tightening up subprime lending standards might cause a vicious cycle of falling house prices and foreclosures. If fewer people are approved, fewer homes will be sold and home values drop further. Those applicants trying to refinance a subprime loan may not be able to qualify under the tightened standards, and they're left with a loan they can't afford and possible foreclosure. Prices continue to fall as more foreclosed homes land on the market [source: Christie].

Some places that have high rates of foreclosures may not even have many subprime mortgages. Read on to find out how economic factors can lead to foreclosure.