Rate Resets v. Falling Home Values?

The Wall Street Examiner has a post which draws the correct conclusion about the Bush Administration modification plan and which identifies a great source of data (the GAO's "Home Mortgage Defaults and Foreclosures briefing). But, the payoff line of the post is, "The main driver of foreclosures is the change in real estate prices." I think that's wrong. The main driver of foreclosures is income curtailment. Falling real estate prices are a condition which sometimes leads to foreclosure when the driver is in effect.

I've written a previous post discussing research identifying causes of foreclosure, with Income Curtailment (most commonly loss of employment) #1 on the list. I do think there is some fuzzy thinking in the research, the surveys, and/or the minds of the people answering the surveys when it comes to other items on most of the lists. For example, #2 is typically Illness/Medical. I doubt in and of itself illness causes a whole lot of defaults ("Sorry, lender, I'm too sick to mail in my payment"). I think it's more likely people got sick and lost their job (income curtailment), had to get by on reduced disability payments (income curtailment), or they or a dependent incurred major medical expenses (income curtailment again, in the broader sense of less net income available to service debt). Similarly, #3 on most lists is Divorce. The most likely scenario here is there were two incomes available to service the debt, and post-split there's only one (income curtailment). These three causes account for 80% of defaults. Rate Resets in the research referred to in my previous post are #7 (clearly not a driver).

Where do falling home values come in? During the happy days if your income was curtailed and the value of your house was up you could refinance and pull out the cash you needed (those no doc loans were a boon for the unemployed borrower), or you could sell your house. Either way, foreclosure was avoided. As teaser rates climbed and underwriting standards tightened, the refinance option went away, but you could still sell. As home values fall to the point there's no equity the sale option goes away for more and more people, which leaves foreclosure. Two additional points:

1) Income curtailment happens to everyone in the socioeconomic spectrum; what distinguishes those who default from those who don't is whether or not they have resources (savings, insurance, etc.) to tide them over. It's a lot easier and cheaper to tweak the rate reset features of subprime loans than it is to provide an income safety net to support those whose income has been curtailed. But, don't expect big results from the tweak when the real driver is more fundamental.

2) Income curtailment is more widespread and prolonged during a recession. If we slip into a recession foreclosures will go up significantly and home values will fall faster and farther.