Leverage and the Foreclosure Crisis
70 Pages Posted: 17 Aug 2013
Date Written: August 2013
How much of the recent rise in foreclosures can be explained by the large number of high-leverage mortgage contracts originated during the housing boom? We present a model where heterogeneous households select from a set of mortgage contracts and choose whether to default on their payments given realizations of income and housing price shocks. The set of mortgage contracts consists of loans with high downpayments and loans with low downpayments. We run an experiment where the use of low downpayment loans is initially limited by payment-to-income requirements but then becomes unrestricted for 8 years. The relaxation of approval standards causes homeownership rates, high-leverage originations and the frequency of high interest rate loans to rise much like they did in the US between 1998-2006. When home values fall by the magnitude observed in the US from 2007-08, default rates increase by over 180% as they do in the data. Two distinct counterfactual experiments where approval standards remain the same throughout suggest that the increased availability of high-leverage loans prior to the crisis can explain between 40% to 65% of the initial rise in foreclosure rates. Furthermore, we run policy experiments which suggest that recourse could have had significant dampening effects during the crisis.
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