Foreclosure Crisis in the U.S

The Foreclosure Crisis in the United States, occurring primarily between 2006 and 2012, was a significant economic event characterized by a dramatic increase in home foreclosures. The number of homes in foreclosure surged from just over one million in 2006 to nearly four million in 2010. This crisis was rooted in a combination of factors, including predatory lending practices, where banks issued mortgages to individuals who were often ill-equipped to manage the financial responsibilities of home ownership. The crisis was exacerbated by the housing market bubble that developed leading up to the financial downturn, as inflated property values lured more investors into the market.

Many homeowners faced challenges due to adjustable-rate mortgages and balloon payments, which initially seemed manageable but later became unaffordable as payments increased. Communities of color and lower-income individuals were disproportionately affected by subprime lending practices, which offered enticing but ultimately misleading opportunities for home ownership. The crisis ultimately revealed stark disparities in socioeconomic status and opportunity, as those targeted by predatory loans often lacked the financial literacy to navigate complex mortgage products. The fallout from the crisis not only led to widespread job losses and economic recession but also raised critical questions about the fairness and transparency of the banking industry in America, underscoring vulnerabilities in the housing market that have continued relevance today.

Published in: 2021

By: Scott Zimmer, JD

Subject Terms

Foreclosure Crisis in the U.S.

Abstract

The United States foreclosure crisis was a period running approximately from 2006 until 2012, during which the annual number of homes in foreclosure more than tripled, going from slightly more than one million homes in 2006 to almost four million homes in 2010. Many different factors contributed to this crisis, from predatory lending practices by banks that gave mortgages to people who clearly could not afford them, to home owners who continued to pull more and more equity out of their homes by taking on additional mortgage debt, seemingly without regard for the need to eventually pay it back.

Overview

The origins of the foreclosure crisis in the United States can be traced back to the development of what is known as a bubble in the housing market prior to 2008. A bubble occurs when a variety of financial factors combine to cause the value of a particular asset to rise dramatically in a relatively short period of time. Bubbles are often seen in real estate markets, both commercial and noncommercial, because the assets in question are relatively fixed, compared with other more fungible commodities. Usually, a real estate bubble develops because an initial wave of investment in housing reaps substantial earnings. Other investors see this and want to acquire similar returns, so they begin investing in housing as well. With increased investment, house prices naturally begin to climb upward in response to the increased demand for real estate. This cycle continues for a time, with rising prices producing greater returns for investors, drawing in additional investors, and further driving up prices. Eventually, prices reach a level that is no longer sustainable, and investors begin to pull away from the housing market, seeking other investment vehicles. Once this begins to occur, there is the possibility of the housing market bubble bursting—a majority of investors may try to pull out of the housing market at more or less the same time. With so many people selling or otherwise pulling out of the market, housing prices and the assessed value of homes that are not on the market can both experience rapid declines, as falling demand causes valuations to fall as well (Zandi, 2013).

This would all be little more than an interesting exercise in economics if everyone owned their own homes outright and if selling one’s old house and buying another house was an infrequent occurrence. However, such is not the case. A house is usually the single largest purchase an individual or family will ever make, and in the modern global economy, people often find it necessary to move between cities, between states, and between countries, with each such relocation potentially requiring another house purchase. Few people have available the hundreds of thousands of dollars needed to purchase a house, so the vast majority of home buyers must borrow most of the money from a bank or credit union, by taking out a mortgage (Blinder, 2013). In simplest terms, prospective buyers first locate a house that they wish to purchase, and then approach their bank for a loan. The bank will assess the current market value of the property (such assessments are performed regularly by local governments in order to collect property taxes) and will then determine whether or not the buyer has enough income and a satisfactory credit history to be able to reliably make the mortgage payments.

Ideally this should be an objective decision for the bank, but because mortgage lending is a source of profit for financial institutions, their profit being derived from the interest they charge on the loan, these institutions sometimes have an incentive to reach a determination that the loan will be repaid, even when there is substantial evidence to the contrary. In the years leading up to the economic downturn in 2008, however, there were a large number of lending decisions made that were based on the certainty of immediate profit rather than on a rational assessment of the long-term economic consequences. It was, therefore, only a matter of time until these mortgages began to fail, and the natural consequence of mortgage failure is foreclosure by the bank on the loan. Rampant lending, followed rampant mortgage defaults, resulting in a crashing real estate market, produced the foreclosure crisis (Mian & Sufi, 2014).

Viewpoints

Several categories of home owners were caught up in the foreclosure crisis. The first were those with subprime mortgages. Many of these home owners were in lower income brackets than is typical for home buyers, and a disproportionate number were people of color. As the housing market had heated up, some financial institutions sought to carve out new markets for home ownership among communities that previously would have more than likely been turned down by a mortgage lender. These banks specifically targeted those with lower incomes and people of color, tempting them with the promise of the American dream: owning a home. Brokers and lenders made the idea of home ownership not only seem possible for the first time in their lives, but even easy.

This was done by structuring the loan so that the first few years of payments would be artificially small, making the house seem affordable to the buyer. After this initial period, however, the mortgage payments were designed to increase, either because the interest rate on the mortgage was tied to economic indices that rise from time to time (called an adjustable rate loan) or because the initially low payments would be offset by a scheduled but very high "balloon" payment. This was often not made clear to borrowers, and many later claimed to have been mislead by loan arrangers eager to close the deal. Before long, the home owner found that the mortgage payments that had seemed so reasonable had adjusted themselves so high that they were no longer affordable. Home owners would gradually fall behind on their payments as they tried to find out what they could do in order to stay in their homes. Eventually, they would find themselves unable to keep up with what they owed, causing the bank to begin foreclosure proceedings. Foreclosure is the legal proceeding by which a bank reclaims the property so that it can be resold as a way of recovering the bank’s investment (Garson, 2013).

Another group of home owners were not taken in by subprime mortgage offers, but they did use their home equity in a less than prudent fashion. As the housing market bubble expanded, these home owners had experienced the pleasant situation in which their homes were worth far more than they paid for them. For example, home owners who had purchased a house for two hundred thousand dollars by paying twenty thousand dollars down and borrowing the remaining one hundred eighty thousand dollars would be delighted to learn that instead of being valued at the original two hundred thousand dollars, their home was now worth two hundred and fifty thousand dollars because of the rising housing market. The increased value, added to the original down payment, is the home’s "equity." Many home owners chose to borrow against their home’s equity, that is, use the house’s new, higher assessed value as collateral. As long as housing values continued to rise or at least remain steady, the home owner might take advantage of the wealth accruing in the home’s value. However, when the real estate market fell, home equity also decreased, sometimes leaving a home owner "underwater," that is, with a larger mortgage than the home was worth.

The 2008 collapse of the mortgage-backed securities market caused shockwaves of distress to move throughout the entire economy, launching a recession that caused hundreds of thousands of people to lose their jobs in the years following. This, in turn, cut off the stream of income for many people with mortgage payments pending. Because housing prices had been driven so low, many home owners could not sell their homes for enough to pay off their mortgages. Mortgage holders who could neither sell nor make their payments wound up being foreclosed upon (Solow, 2012).

Perhaps the most distressing aspect of the U.S. foreclosure crisis is the way in which it highlighted differences in social class and opportunity in a country that has, since its inception, purported to be free from the bonds of social class (Lucy, 2010). The United States was founded upon the belief that all people in a society should have equal opportunity to fulfill their dreams through their own hard work and ingenuity. Throughout its history, citizens of the United States have struggled with differences in religion, race, and many other classifications, but there has always been a strong insistence that social class is not an issue in the United States. The contours of the foreclosure crisis, however, strongly suggest otherwise. Seen through the lens of socioeconomic analysis, the foreclosure crisis has been described as an instance of highly educated, upper class elites (the bankers and investors) with ready access to investment capital, using their privileged positions to target lower income and minority home buyers with subprime loans.

As distressing as this depiction is, there is another facet to the situation that compounds the malfeasance (Barofsky, 2012). The mortgage lenders did not simply focus on less advantaged groups when selling their products, but they also actively "bet" against subprime borrowers. They did this by using financial instruments known as credit default swaps to counterbalance the risk they were carrying by backing subprime mortgages. Credit default swaps are analogous to taking out an insurance policy on an investment one has made, so that even if the investment falls through, the credit default swap will allow one to recover some money; experts in law and finance have compared the idea of a credit default swap to a person making a wager and then making a separate wager contingent upon losing the first wager.

As confusing as it sounds, the outcome of a credit default swap is that whether the investor wins or loses, the investor still gets paid some amount of money (Jarsulic, 2010). This type of financial maneuvering is also known as "hedging" because it allows investors to protect themselves against some of the risk they are carrying. Subprime mortgage lenders have defended their use of this practice by claiming that all players in the mortgage market have access to the same information, so it is not fair for a particular lender to have to disclose to other actors that it is either adopting a high risk position by taking on questionable mortgages or that it is hedging some of this risk through the use of credit default swaps. Critics of the practices of the banking industry during and prior to the foreclosure crisis counter this proposition by pointing out that in fact not all parties to the mortgage market had access to the same information, because the average person trying to purchase a house does not have the same sophisticated understanding of complex financial instruments as does a wealthy banking executive (United States, 2011).

Indeed, in the aftermath of the foreclosure crisis and the meltdown of the mortgage-backed security market, there were a flurry of reports in the news media highlighting the fact that one of the principal causes of the economic collapse was that investment firms were trading securities and other investment vehicles that were so complex and intertwined with one another that it was not even possible to accurately explain their design to the teams of forensic accountants who were charged with understanding what had caused the collapse in order to prevent it from occurring again in the future. With teams of experts using the benefit of hindsight unable to unravel the convoluted origins of the foreclosure crisis, it is little wonder that so many prospective home buyers were convinced to participate (De & Batker, 2011).

Terms & Concepts

Adjustable Rate Loans: An adjustable rate loan, or adjustable rate mortgage (ARM), is one in which the rate of interest is not fixed, but changes over time. The rate is tied to an external index such as one year Treasury securities, and periodically adjusts itself to keep pace with this index. Many home buyers accepted adjustable rate mortgages that had low rates at the outset, without understanding that after a set period (three to five years was not uncommon) the rates would then automatically adjust. When the rates adjusted upward, the home owners would suddenly find themselves with a monthly mortgage payment far higher than they expected or were able to pay.

Balloon Payments: A balloon payment is a final, large payment due at the end of a mortgage term. Mortgages with balloon payments are designed to keep payments lower for most of the duration of the mortgage term, but they accomplish this by not fully amortizing the mortgage amount. In essence, the borrower has a smaller mortgage payment, but when the mortgage ends, the last payment is much larger, as if it had "ballooned" in size.

Mortgage Backed Securities: Mortgage backed securities are a type of financial instrument that investors can put their money into. Mortgages are profitable to the financial institutions that issue them, so their capacity to produce value is something that other entities, such as governments, investment banks, insurance companies, and so forth, often include as packages or "bundles" of mortgages in their investment portfolios. This became an issue in the foreclosure crisis because some of the banks that were issuing questionable mortgages were later investing in financial instruments that would pay off if these mortgages failed—banks were betting against the people they had lent money to.

Predatory Lending: Predatory lending is a broad term that describes behavior by banks and other lenders that fails to meet even minimal expectations for good faith and fair dealing. Prior to the foreclosure crisis, some lenders would deliberately target consumers interested in home ownership but unable to afford it, and would craft loans that seemed too good to be true, often with very low introductory interest rates and payments, but with confusing or hidden clauses that would cause the rates and payments to grow dramatically later on, after the consumer was already locked into the mortgage.

Subprime Mortgage: Subprime mortgages are a category of mortgages initially used by lenders for their own internal purposes. Prime mortgages would be those sold to people with high incomes and good credit, the necessary qualifications for borrowers to receive favorable interest rates and thus lower payments. Subprime mortgages were designed for people with lower incomes and poorer credit scores, which ordinarily would have made them ineligible for a mortgage.

Underwater Mortgage: An underwater mortgage is one in which the borrower owes more on the mortgage than the home is currently worth on the market. Underwater mortgages are caused by fluctuations in the real estate market, with occasional assistance from home owners who continue to borrow against the equity in their homes.

Bibliography

Avsar, R. B. (2014). Foreclosure crisis and innovative policy responses: A constructive critique. Journal of Economic Issues (M.E. Sharpe Inc.), 48(1), 155–168. Retrieved January 3, 2016, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=95429847&site=ehost-live

Barofsky, N. M. (2012). Bailout: An inside account of how Washington abandoned Main Street while rescuing Wall Street. New York, NY: Free Press.

Blinder, A. S. (2013). After the music stopped: The financial crisis, the response, and the work ahead. New York, NY: Penguin Press.

De, G. J., & Batker, D. K. (2011). What's the economy for, anyway?: Why it's time to stop chasing growth and start pursuing happiness. New York, NY: Bloomsbury Press.

Ellen, I. G., Madar, J., & Weselcouch, M. (2015). The foreclosure crisis and community development: Exploring reo dynamics in hard-hit neighborhoods. Housing Studies, 30(4), 535–559. Retrieved January 3, 2016, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=110727693&site=ehost-live

Garson, B. (2013). Down the up escalator: How the 99 percent live in the Great Recession. New York, NY: Doubleday.

Jarsulic, M. (2010). Anatomy of a financial crisis: A real estate bubble, runaway credit markets, and regulatory failure. New York, NY: Palgrave Macmillan.

Lindblad, M. R., & Riley, S. F. (2015). Loan modifications and foreclosure sales during the financial crisis: Consequences for health and stress. Housing Studies, 30(7), 1092–1115. Retrieved January 3, 2016, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=111242547&site=ehost-live

Lucy, W. H. (2010). Foreclosing the dream: How America's housing crisis is reshaping our cities and suburbs. Chicago, IL: American Planning Association, Planners Press.

Mian, A., & Sufi, A. (2014). House of debt: How they (and you) caused the Great Recession, and how we can prevent it from happening again. Chicago, IL: University of Chicago Press.

Solow, R. M. (2012). Rethinking the financial crisis. New York, NY: Russell Sage Foundation.

United States. (2011). The financial crisis inquiry report: Final report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. Washington, DC: Financial Crisis Inquiry Commission.

Zandi, M. M. (2013). Paying the price: Ending the great recession and beginning a new American century. Upper Saddle River, NJ: FT Press.