NCPA - National Center for Policy Analysis


December 11, 2007

The excuse for getting the government involved in helping a few politically-favored borrowers is based on false assumptions that subprime mortgages were usually used to buy a house, that a huge percentage of subprime loans face foreclosure, and that the main reason for foreclosure is rising interest rates, says Alan Reynolds, a senior fellow with the Cato Institute, is the author of "Income and Wealth" (Greenwood Press, 2006).

All three conventional assumptions were undone by a new study from the Federal Reserve Bank of Boston:

  • Its research shows that "most subprime loans are refinances of a previous mortgage," and estimates that "about 18 percent of people who finance home purchases with subprime mortgages will eventually experience foreclosure" within a 12-year period.
  • It found that most foreclosures do not result from adjustable rates going up, but from local house prices going down.
  • The Boston Fed economists "attribute most of the dramatic rise in foreclosures in 2006 and 2007 in Massachusetts to the decline in house prices that began in the summer of 2005.
  • Subprime lending played a role but that role was in creating a class of homeowners who were particularly sensitive to declining house price appreciation, rather than, as is commonly believed, by placing people in inherently problematic mortgages."

If you owe more money on a house than the house is worth, foreclosure can be a perfectly rational choice, says Reynolds:

  • Suppose Mr. Smith bought a house for $300,000 with no money down, but the value of that house has now fallen to $270,000.
  • If he refinances or sells the house, he would still owe the mortgage servicer an extra $30,000.
  • Falling home prices in many areas provide a powerful incentive to default on the loan, live rent-free for many months, and then hand the keys to the bank.

Source: Alan Reynolds, "Dissecting the Bailout Plan," Wall Street Journal, December 10, 2007.

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