ARMs, Not Subprimes, Caused the Mortgage Crisis

STAN J. LiEBowiTz

he origins of the financial crisis have been repeated so often that it isnt much of a stretch to suggest that even school children can provide the outline which goes like this: the housing price bubble burst causing subprime mortgages to go bad at unprecedented rates causing major ratings downgrades for assets based on these mortgages. Panic set in on Wall Street and around the world as institutions worried that the losses from these subprime loans might land on them. In response, governments have been trying to figure out how to protect the financial system from these toxic assets. More recently
Stan J. Liebowitz is the Ashbel Smith Professor of Managerial Economics at the University of Texas at Dallas.
The Berkeley Electronic Press

other classes of mortgages have gone bad as the subprime contagion spread to Alt-As and then even to prime mortgages. In spite of its constant repetition, there is a major problem with this story. The mortgage data do not suggest that subprime loans went bad first, followed by Alt-As and then prime loans. Instead, the data suggest that adjustable rate mortgages (ARMs) went bad first, with the rise occurring at about the same to for both prime and subprime ARMs. Foreclosure rates on fixed rate mortgages (FRMs), both prime and subprime, barely participated in the foreclosure outbreak, having much smaller and much later increases in foreclosures. As we contemplate financial market regulatory reform it is crucial that we understand the fundamental empirics of the recent

outbreak in mortgage foreclosures if these reforms are to have any reasonable chance at success. If the distinguishing characteristic of defaulted loans is whether the mortgage rate was adjustable, and not whether the loan was classified as subprime, we are likely to have very different economic explanations for the defaults and very different remedies.
subprime vs. prime foreclosures

he quarterly National Delinquency Survey from the Mortgage Bankers Association (MBA), based on information reported by over 120 mortgage lenders, is considered the gold standard for measuring defaults. It covers (in 2007) about 45 million firstlien, conventional mortgages, which is a very large share of the 48.7 million housing units
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5.0 4.5
Share of Mortgages (%)

Figure 1: Share of Subprimes Starting Foreclosure

Share of Mortgages (%)

Figure 2: Share of Primes Starting Foreclosure

1.20 1.00 0.80 0.60 0.40 0.20 0.00

4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

Q2_1998 Q2_1999 Q2_2000 Q2_2001 Q2_2002 Q2_2003 Q2_2004 Q2_2005 Q2_2006 Q2_2007 Q2_2008 Q2_2009

Q2 1998

rates were just beginning to match the previous peaks in foreclosure rates that had occurred in late 2000 and mid 2002, although foreclosure rates have been at all-time highs since the end of 2007. Now look at foreclosure rates for prime mortgages, as shown in figure 2. Here, the foreclosure rate was very stable until the recent increase began. The rise in foreclosure rates occurs in the third quarter of 2006, just as was the case for subprimes. It is
The Economists Voice www.bepress.com/ev November 2009

Q2 2009

Q2_1999

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that have mortgages according to the 2007 American Housing Survey conducted by the U.S. Census. Figure 1, based on MBA data, provides the history of foreclosure rates for subprime loans, starting in 1998, which is when the MBA first separated out data on subprime loans. The numbers on the vertical axis represent the share of outstanding mortgages that go into foreclosure in each quarter. Typically, foreclosures were in the range of 1 percent to 3 percent of

the stock of mortgages each quarter, meaning that annual subprime foreclosure rates tended to run between 4 percent and 12 percent. Several facts are readily apparent from the chart. First, foreclosures for subprimes have been highly variable over time. Second, the recent rapid climb in foreclosures would seem to begin in the third quarter of 2006. Third, during the second and third quarter of 2007, when the subprime crisis was becoming daily grist for the news mills, the subprime foreclosure --

8.0 7.0 6.0

Figure 3: Fixed and Adjustable Subprime Foreclosures Started

3.0 2.5
Share of Mortgages (%)

Figure 4: Fixed and Adjustable Prime Foreclosures Started

Suprime Fixed Rate Subprime Adjustable

Prime Adjustable Mortgages Prime Fixed-Rate Mortgages

Share of Mortgages (%)

5.0 4.0 3.0 2.0 1.0

2.0 1.5 1.0 0.5 0.0

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0.0
Q2_2006 Q2_1998 Q2_1999 Q2_2000 Q2_2001 Q2_2002 Q2_2003 Q2_2004 Q2_2005 Q2_2007 Q2_2008 Q2_2009

possible to suggest that visually, the rise from the 2nd quarter of 2006 to the 2nd quarter of 2007 does not appear to be much of an increase. In fact, the latter value is 56 percent higher than the former value and is almost identical to the increase between the same two quarters for subprime loans (58 percent). The increase from Q2 2006 to Q2 2007 looks smaller in Figure 2 because the top of the vertical axis is approximately 6 times the Q2 2006 value in

Figure 2, whereas it is only slightly more than 3 times the Q2 2006 value in Figure 1. Also, and of notable importance, the Q3 2007 prime foreclosure rates are far beyond any previous readings, unlike the Q3 2007 subprime foreclosure rates. Finally, foreclosure levels during the mortgage meltdown have about a five-fold increase for prime loans, which is larger than the approximately threefold increase for subprime loans. --

This evidence indicates very little temporal distinction between prime and subprime loans, in terms of when they began their recent increase.
fixed rate vs. adjustable rate foreclosures

dditional information is revealed by separating mortgages into FRMs and ARMs, as shown in Figures 3 and 4. For subprime
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mortgages, shown in Figure 3, the foreclosure have foreclosure rates far beyond the levels Q2 2006 rose by 47 percent which is roughly rates for ARMs have a much larger increase found in previous years. twice as great as that for subprime ARMs over than is the case for FRMs. Further, it is only The additional information available the same period. The key point is that when the increase in ARM foreclosures that appears when ARMs are separated from FRMs also alcomparing prime ARMs to subprime ARMs, capable of causing havoc in financial marlows somewhat more refined examination of whether an earlier or later date is chosen as kets because only the ARM foreclosure rates the claim that subprime and primes loans bethe beginning of the ascent, there is very little are far beyond any historical precedent that gan their foreclosure ascent at different times. difference in timing between prime and subcould conceivably been unanticipated by the In particular, perhaps subprime ARMs, the prime. markets. By contrast, the foreclosure rates for largest category of subprimes, began their inFinally, let us look at when foreclosure subprime FRMs still have not surpassed their crease before other categories of loans. Might rates reached unprecedented levels that previous highs set in 2000 and 2002. this resurrect the subprime hypothesis in a might cause financial instruments based on As something of an aside, I should note somewhat different form? The answer is no. historical foreclosure rates to blow up. This that although subprime adjustable forecloThe more refined data might indicate a someis done in Table 1. I employ three simple sures appear to have peaked, 90-day delinwhat earlier increase in foreclosures: prime rules of thumb for what we can label as unquencies for subprime ARMs have continued and subprime ARM foreclosure rates were precedentedness: foreclosure rates as high to rise and show no evidence of a slowdown. rising as early as Q2 of 2005. But the prime as the previous historical high; foreclosure This deviation between 90-day defaults and ARM foreclosure rate between Q2 2005 and rates 50 percent higher than previous rates; foreclosures is presumably the impact Table 1 of government attempts to keep banks Dates that Crisis Foreclosure Rates Exceeded Previous Extreme Values (Post 998) from foreclosing on delinquencies. Overall Prime Subprime Subprime ARM Subprime FRM Prime ARM Prime FRM Figure 4 separates out ARMs from Date when previous high Q4 2006 Q4 2006 Q3 2007 Q1 2007 not yet Q1 2007 Q3 2007 FRMs for prime loans. Once again, was surpassed ARM foreclosure rates increase much Date when previous high Q3 2007 Q3 2007 Q1 2009 Q3 2007 not yet Q3 2007 Q1 2008 more than FRM foreclosure rates afwas surpassed by 50% ter the two series had virtually identiDate when previous high Q3 2007 Q1 2008 not yet Q1 2008 not yet Q4 2007 Q4 2007 was surpassed by 100% cal foreclosure rates during 2004 and 2005. Once again, it is the ARMs that
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foreclosure rates twice as high as previous foreclosure rates. Table 1 indicates that, contrary to common beliefs, foreclosure rates for prime loans went into territory with unprecedentedly high values earlier and more completely than was the case for subprime loans. Foreclosure rates for ARMs went into unprecedented territory earlier and more completely than was the case for FRMs.
why the confusion?

Q2 2009), analysts simplemindedly rounded the subprime share up to one and rounded the prime share down to zero. The truth is probably a combination of these factors although, being of a cynical bent, I put more weight on the first possibility.
moral

resets were not responsible for any but a small portion of foreclosures. That leaves the playing field open for alternative explanations that fit the facts such as the possibility that adjustable rate mortgages were more attractive to housing speculators, which is an explanation I find rather intriguing. Letters commenting on this piece or others may be submitted at http://www.bepress.com/cgi/ submit.cgi?context=ev.
references and further reading

hy then did virtually everyone report that the mortgage crisis began with subprime loans? One possibility is that the subprime story provided an easy scapegoat: subprime lenders. Another is that markets with private securitization of mortgages tended to have a disproportionately large share of subprime loans and that these were the securities being downgraded by the ratings agencies and receiving most of the attention. A third possibility is that because the total number of subprime foreclosures was larger than the number of prime foreclosures early in the mortgage crisis (the subprime share peaked at 58 percent in Q2 2007 although it was down to 33 percent in

he evidence seems clear and compelling: prime and subprime loans both experienced increased foreclosure levels at about the same time. The important distinction in terms of the timing and size of foreclosure increases is whether loans were ARMs or FRMs, with ARMs rising earlier and much more dramatically, suggesting that if you had to choose whether to blame the mortgage crisis on ARMs or subprimes, ARMs seem the better bet. The question to be answered, then, is why ARMs had such a dramatic increase in foreclosures when FRMs did not. The answer to this question should provide the key to the larger question of the major cause of the foreclosure crisis. Although interest rate resets are one possible answer, my ongoing research (discussed in the Wall Street Journal using loan level data from McDash), indicates that such --

Liebowitz, Stan J. (2008) Anatomy of a Train Wreck, The Independant Institute, October 3. Available at: http://www.indepen dent.org/publications/policy_reports/detail. asp?type=full&id=30. (Later published in Housing America: Building Out of a Crisis, edited by Benjamin Powell and Randall Holcomb, 2009. New Jersey: Transaction Publishers.) Liebowitz, Stan J. (2009) New Evidence on the Foreclosure Crisis, Wall Street Journal, July 3. Available at: http://online.wsj.com/article/ SB124657539489189043.html.

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November 2009