A great many things have been blamed for causing foreclosures. Having purchased more than 150 foreclosures, talked with hundreds of owners in foreclosure, and having read every study I come across on the subject, there seem to be just a couple of root causes: declining prices, which leave homeowners with negative equity and unable to sell, and certain life events like death or divorce which can cause foreclosures in even the best housing markets. We'll look briefly at each below.
There is strong evidence to suggest that negative equity, meaning that an owner owes more on their loans than the house is worth, is the leading cause of foreclosure. As lenders rarely loan more on a property than it is worth, this primarily occurs after prices drop.
Why is having negative equity, also referred to as being underwater, such an important factor? Because homeowners with equity have options—they can refinance or sell if they run into trouble making their payment. Underwater homeowners lack these options, leaving foreclosure as the only way out, unless the lender is willing to take less then they are owed in a short sale, or modify the loan terms.
Typically, the leading cause of price declines is economic downturn. While this is still the primary issue in certain parts of the country which are losing jobs or entire industries; the housing bubble that occurred from 2000-2007 has led to wide scale price declines, after prices reached unsupportable levels using risky loans. These loans put buyers in homes they could not otherwise afford. As these loan offerings were removed from the market, prices were forced to return to levels that buyers could afford, using more traditional financing. This caused prices to drop by 50% or more in the hardest hit areas. As prices declined, foreclosures rose.
Five D's of Foreclosure
Despite the fact that the vast majority of foreclosures are driven by negative equity from price declines, there is a base rate of foreclosure that happens during even the best economic times and housing markets. This base rate can largely be explained by the Five D's of Foreclosure:
- Death—The passing of a head of household can very quickly result in foreclosure.
- Divorce—Even in the most amicable of divorces, spousal support and house payments are missed. More common is one refusing to leave, and the other refusing to pay.
- Drugs—Drug use and abuse impairs judgment, and fixes become a higher priority than house payments.
- Disease—Catastrophic illness, chronic disease, lack of health insurance coverage, or a primary provider falling ill; any of these can significantly impact a homeowner’s ability to make mortgage payments.
- Denial—A home is a person’s castle, their security. Individuals often refuse to acknowledge that their home can actually be taken from them, if they fail to meet their financial obligations.
What about Subprime?
Despite many blaming defaulting subprime loans for the latest downturn, there is little evidence pointing to subprime foreclosures as the primary cause. For example, a study done by the Boston Fed looked at various factors, including credit score, income, job loss and other factors typically blamed for foreclosure; and found that while these factors contributed, foreclosure was unlikely unless there had also been price declines leading to negative equity. It makes sense—if a house is worth more than is owed, it can be sold even if the person has bad credit or loses their job. Now, that's not to say that loose lending standards did not play a role in this crisis. They did. Together with pay option ARMs, and other exotic loans, they clearly helped push prices too high, and thus ultimately led to the price declines that are at the root of the foreclosure crisis.