Foreclosure: How Big a Risk?

Peter Coy

A study out today from the Center for Responsible Lending predicts that subprime borrowers are going to lose their homes to foreclosure on a massive scale. Looking at more than 6 million subprime mortgage loans issued from 1998 through September of this year, the study calculates that 2.2 million households have either already been foreclosed on or will be foreclosed on in the next few years.

These foreclosures, it says, will cost homeowners around $160 billion in wealth, mainly in the form of lost equity. The foreclosure rate will be highest on homes that were sold at the peak of the market, it says, because prices on those homes have fallen, meaning people will have a harder time bailing out of distressed loans by refinancing or selling their homes for a profit.

Is this study accurate? How worried should we be?

The Center for Responsible Lending is an arm of the Center for Community Self-Help, a Durham (N.C.) non-profit organization operating primarily in North Carolina that makes mortgage loans as well as loans to small businesses. It serves the same kinds of clients as subprime lenders do, so you could argue that its report is just a criticism of the competition.

To their credit, the study's authors--Ellen Schloemer, Wei Li, Keith Ernst, and Kathleen Keest--aren't just plucking numbers out of the thin blue sky. Their methodology resembles one used by Anthony Pennington-Cross, a senior economist at the Federal Reserve Bank of St. Louis. Here's a link to something Pennington-Cross wrote on this topic earlier this year.

Naturally, though, the overlap in methodology doesn't mean Pennington-Cross agrees with the findings of this study.

The Mortgage Bankers Association says it thinks the study is too pessimistic. In an interview with me, Chief Economist Douglas Duncan said that he doubts that housing prices will fall considerably in 2007, which is the assumption the study uses, based on a report by Moody's Economy.com. He also said the foreclosure rates to date reported by the Center for Responsible Lending are higher than the ones that the Mortgage Bankers Association has seen, leading him to ask questions about the source of their data.

One oddity of the study is the estimate that people who get foreclosed on stand to lose over $160 billion in equity. The obvious question: If you have a lot of equity in your house and you're having trouble making payments on the mortgage, why wouldn't you just sell the house yourself, pay off the loan, and keep the equity? I asked Mike Calhoun, the president of the Center for Responsible Lending, that question. His answer:

"Yes, they should sell. But most people put that off until the last minute and hold on as long as they can. There are not that many borrowers who are able to make the rational decision to sell and go rent. Most keep refinancing as long as they can."

While acknowledging that many borrowers bear part of the blame for their own predicament, Calhoun says that subprime lenders are wrong to "push" loans with low teaser rates that borrowers don't understand. The main losers from foreclosures aren't the lenders but the borrowers, he says. "There’s a high human cost of foreclosure and in our view an unnecessarily high cost."

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