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1 

Interim Report to Congress on the Root 

Causes of the Foreclosure Crisis1 

U.S. Department of Housing and Urban Development 

Office of Policy Development and Research 

March 2009 

Based on a report prepared for the Office of Policy Development and Research of the U.S. Department of Housing and 

Urban Development under contract by Christopher E. Herbert and William C. Apgar, Jr., of Abt Associates Inc. 
Foreword 

Section 1517 of the Housing and Economic Recovery Act (HERA) of 2008 (P.L. 110-289) mandated 

preliminary and final reports to Congress on the root causes of the foreclosure crisis. This interim 

report contains a review of the academic literature and industry press on the root causes of the current 

foreclosure crisis and a preliminary discussion of potential policy responses to the crisis. The final 

report, due by the anniversary of the enactment of HERA, will expand upon this interim report with 

additional data and analysis of trends in the market as well as a more detailed review of policy 

responses and recommended actions to mitigate the current crisis and to help prevent similar crises 

from occurring in the future. 

As we move forward, better understanding of the root causes of this crisis will support informed 

choices among the many policy options available to address the laws and institutions that will govern 

the origination of residential mortgages in the future. As we have seen from the current crisis, 

successful outcomes from these policy debates are critical to the health of the overall economy and to 

the well being of American families. 

 

Jean Lin Pao 

General Deputy Assistant Secretary for Policy 

 Development and Research 
Contents 

Executive Summary .............................................................................................................................. vii

Introduction ............................................................................................................................................. 1

1. Trends in Delinquencies and Foreclosures................................................................................... 2

2. Literature Review .......................................................................................................................... 12

2.1 General Literature on Causes of Foreclosures and Delinquencies .................................... 12

2.2 Literature Assessing Causes of the Current Foreclosure Crisis ........................................ 15

2.2.1 Contribution of House Price Declines ................................................................ 16

2.2.2 Contribution of Weak Economic Conditions ..................................................... 17

2.2.3 Contribution of Growth in Risky Loans ............................................................. 18

2.2.4 Overall Conclusions on Precipitating Causes of Crisis...................................... 25

2.3 Factors Enabling Expanded Risky Lending....................................................................... 27

2.3.1 Key Market Developments in the 1980s and 1990s ........................................... 27

2.3.2 Failure of the Regulatory Environment to Adapt to Market Changes ............... 29

2.3.3 Factors Fostering Surge in Risky Lending in the 2000s .................................... 35

2.3.4 Contribution of Mortgage Fraud, the Community Reinvestment Act, and the 

GSEs ........................................................................................................................... 37

3. Plan for the Final Report: Potential Policy Responses to the Foreclosure Crisis.................. 43

3.1 Efforts to Address Rising Foreclosures.............................................................................. 43

3.1.1 Efforts to Enhance the Ability of Households to Remain in their Homes......... 43

3.1.2 Efforts to Enable More Aggressive Loan Modifications ................................... 46

3.1.3 Efforts to Reduce the Negative Impact on Communities................................... 48

3.1.4 Efforts to Protect Renters Affected by Foreclosures .......................................... 49

3.2 Efforts to Reduce the Risk of Unacceptably High Rates of Mortgage Foreclosures in the

Future ................................................................................................................................. 51

3.2.1 Expanding the Ability of Consumers to Make Wise Choices............................ 51

3.2.2 Legal and Regulatory Efforts to Ban Deceptive Lending Practices .................. 52

3.3 Comprehensive Mortgage Market Reform ........................................................................ 53

3.3.1 Efforts to Promote Uniform Regulations in the Primary Market....................... 53

3.3.2 Secondary Market Reform Initiatives................................................................. 54

Bibliography .......................................................................................................................................... 56

v 
vi
Executive Summary 

This study of the root causes of the current extremely high levels of defaults and foreclosures among 

residential mortgages represents the interim report to Congress by the Secretary of the Department of 

Housing and Urban Development (HUD) pursuant to Section 1517 of the Housing and Economic 

Recovery Act (HERA) of 2008 (P.L. 110-289). The problems in the mortgage market are routinely 

referred to as a “foreclosure crisis” because the level of defaults and foreclosures greatly exceed 

previous peak levels in the post-war era and, as a result, have drawn comparisons to the levels of 

distress experienced in the Great Depression. This interim report contains a review of the academic 

literature and industry press on the root causes of the current foreclosure crisis and a plan for further 

discussion of policy responses to the crisis. A final report will expand upon this interim report with 

additional data and analysis of trends in the market as well as a more detailed review of policy 

responses and recommended actions to mitigate the current crisis and to help prevent similar crises 

from occurring in the future. 

Trends in Delinquencies and Foreclosures 

To help define the nature of the foreclosure crisis, the report begins by presenting basic information 

on trends in mortgage delinquencies and foreclosure starts, relying largely on data from the Mortgage 

Banker’s Association National Delinquency Survey. According to this survey, between late 2006 and 

mid 2007 the share of loans that were seriously delinquent or beginning the foreclosure process 

reached their highest levels since the survey was begun in the late 1970s. Since then, these rates have 

continued to rise sharply, and by mid-2008 had more than doubled the previous record highs. Most of 

the initial increase in foreclosures was driven by subprime loans, both due to the fact that these 

inherently risky loans had come to account for a much larger share of the mortgage market in recent 

years and because the foreclosure rates among these loans was rising rapidly. In addition, “Alt-A” 

loans, another fast growing segment of the market, also began experiencing higher delinquency and 

foreclosure rates.1

 In both the subprime and Alt-A market segments, foreclosures have grown most 

rapidly among adjustable-rate loans. But as the economy has deteriorated in 2008 the level of 

foreclosures among prime fixed-rate loans has also risen, further exacerbating the crisis. 

Literature Review 

The literature review begins by assessing the factors that have most commonly been associated with 

rising delinquencies and foreclosures in the past. There is a rich economics literature examining the 

cause of mortgage foreclosures, generally referred to as “default” in the literature.2 Since the 1980s 

this literature has been dominated by an option-based theory of mortgage default, where the mortgage 

contract is viewed as giving homeowners an option to “put” the home back to lenders by defaulting 

1 The term Alt-A refers to loans made to borrowers that require little or no documentation of borrowers’ 

income or assets and entail other features that may expose borrowers to large increases in loan payments 

over time. 

2 Generally, mortgage “default” occurs when a borrower has missed three payments and a fourth is due. The 

default leads lenders to initiate the foreclosure process, but historically a majority of defaults are resolved 

without a foreclosure occurring. 

Executive Summary 

vii 
on their mortgage.3 In an option-theoretic view, the primary factor driving defaults is the value of the 

home relative to the value of the outstanding mortgage—when the home value falls substantially 

below the mortgage debt, owners are better off by ceding the home to the lender (a so-called 

“ruthless” default). However, while a lack of equity in a home is strongly associated with 

foreclosures, most borrowers become delinquent due to a change in their financial circumstances that 

make them no longer able to meet their monthly mortgage obligations. These so called “trigger 

events” commonly include job loss or other income curtailment, health problems, or divorce. As a 

result, foreclosures are most accurately thought of as being driven by a two-stage process—first a 

trigger event reduces the borrower’s financial liquidity, then a lack of home equity makes it 

impossible for the borrower to either sell their home to meet their mortgage obligation or refinance 

into a mortgage that is affordable given their change in financial circumstances. In this view, a lack 

of home equity is an important determinant of foreclosures as it precludes other means that borrowers 

can take to resolve an inability to meet their mortgage obligations, but defaults are most commonly 

triggered by some other event that makes borrowers financially illiquid. 

But while softening housing prices were clearly an important precipitating factor in the present crisis, 

it seems clear from the literature that the sharp rise in mortgage delinquencies and foreclosures is 

fundamentally the result of rapid growth in loans with a high risk of default—due both to the terms of 

these loans and to loosening underwriting controls and standards.4 Mortgage industry participants 

appear to have been drawn to encourage borrowers to take on these riskier loans due to the high 

profits associated with originating these loans and packaging them for sale to investors. While 

systematic information on borrowers’ motivations in obtaining these loans is not available, existing 

evidence suggests that some borrowers did not understand the true costs and risks of these loans, 

while others were willing to take on these risks to tap accumulated home equity or to obtain larger 

homes. 

The current crisis is unusual in that general economic weakness did not play a significant role in 

producing delinquencies and foreclosures in most market areas—at least not initially. Instead, it was 

a slowdown in house price growth that removed the primary safety valve for the high volume of 

unaffordable mortgages that had been made. These loans had allowed borrowers to take advantage of 

robust house price growth to avoid foreclosure by refinancing into a new loan or selling the property 

for a profit. In fact, several studies have found an association between increases in high-cost lending 

that enabled borrowers to obtain larger mortgages than they could otherwise afford and more rapid 

house price growth than would be predicted by other fundamental measures of housing demand. 

Thus, the slowdown and then decline in house price growth that precipitated the foreclosure crisis is 

itself a product of the inevitable end to the ability of lenders to keep extending more credit to 

borrowers. 

3 Quercia and Stegman (1992) and Vandell (1995) provide detailed reviews of the literature researching the 

option-based theory of mortgage defaults. 

4 Reeder and Comeau (2008) and Demyanyk and Van Hemert (2008) provide evidence of weakening credit 

quality of loan originations. Other research finds denial rates declined in recent years at the metropolitanarea level (Dell’Ariccia, Igan, and Laeven, 2008) and at the ZIP-code level (Mian and Sufi, 2008). 

Executive Summary 

viii 
Given the significant role that an increase in risky lending appears to have played in causing this 

crisis, a key question becomes: what were the factors that made it possible for the mortgage market to 

make so many risky loans in recent years? McCoy and Renuart (2008) outline a variety of 

developments in the mortgage markets during the 1980s and 1990s that helped set the stage for the 

rapid growth of subprime lending after 2003. These include legislative changes that removed interest 

rate ceilings on mortgages and allowed lenders to offer loans with variable interest rates, balloon 

terms, and negative amortization. The authors suggest that when used in appropriate circumstances, 

these non-traditional loan terms can be useful for both lenders and borrowers to provide loans that 

address borrower needs or market circumstances. But, as recent experience has shown, when used 

inappropriately, these loan terms can significantly raise the risk of borrower default. 

While these legislative changes enabled the risk-based pricing that lies at the heart of subprime 

lending, this type of lending was given a substantial spur by technological developments in the 1990s 

that allowed lenders to use statistical models and credit scores to create more fine-grained estimates 

of borrower risk. Another important development over this period was the growth of the asset-backed 

securities market, which shifted the primary source of mortgage finance from federally-regulated 

institutions to mortgage banking institutions that acquired funds through the broader capital markets 

and were subject to much less regulatory oversight. 

Numerous authors have argued that the regulatory structure may not have changed rapidly enough to 

keep up with the pace of fundamental change that was transforming the mortgage market.5 

Borrowers’ protections largely consisted of disclosure rules, which proved to be insufficient 

protection against consumers making poor choices given the new market’s much greater variation 

both in loan costs and in loan terms.6 The Federal Home Ownership and Equity Protection Act 

(HOEPA) of 1994 was intended to provide greater consumer protection against predatory loan terms, 

but in practice applied to less than one percent of all loans and so protected very few borrowers. In 

the absence of more stringent federal regulations, a large majority of states passed their own versions 

of HOEPA. But the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the 

Currency (OCC), the primary regulators of federal depository institutions, issued regulations 

preempting these state laws from applying to the institutions these agencies regulated. Importantly, 

this preemption also applied to the mortgage banking operating subsidiaries of these institutions, 

which greatly reduced the number of lenders covered by these state laws. While federal regulators’ 

concern with the safety and soundness of banking institutions provides a check against risky lending 

activities by these institutions, an increasing number of mortgage loans were made by independent 

mortgage banking institutions subject to less federal oversight than depository institutions and their 

mortgage banking subsidiaries. 

Another important hole in the regulatory framework was the lack of significant federal oversight of 

the rating agencies.7 These agencies played a key role in opening the markets for mortgage backed 

securities and collateralized debt obligations to a wide range of institutional investors and regulated 

5 For example, Gramlich (2007), Essene and Apgar (2007), McCoy and Renaurt (2008), and Barr (2008). 

6 GAO (2004) also describes the inadequacy of the mortgage lending disclosure system. 

7 Rating agencies only began registering with the Securities and Exchange Commission in September 2007 

as mandated under the Credit Agency Reform Act of 2006. 

Executive Summary 

ix 
financial firms seeking AA- or AAA-rated investments. In hindsight, it is clear that the rating 

agencies were excessively optimistic in their assessment of the risks associated with subprime 

mortgages and the securities built on these loans. The ratings compensation structure – under which 

the agencies were paid by the very firms that sold the securities to investors – likely played an 

important role in the agencies’ failure to more soundly assess these securities. 

The factors cited above helped to set the stage for the mortgage market problems that developed in 

recent years, but several other factors precipitated the rapid growth of subprime and Alt-A lending 

and the substantial deterioration in underwriting controls that began around 2003. One commonly 

cited factor is the increasing demand for high-yield, investment-grade securities from both domestic 

and foreign investors.8 The strong demand for these securities was evident in the shrinking risk 

premiums demanded by investors in asset-backed securities through 2006. In part, the willingness of 

investors to purchase risky mortgages with relatively little risk premium also reflects the belief that 

innovations in financial market instruments were shielding them from default risk. 

The surge in subprime lending was also driven by the high profits participants earned at each stage of 

the process from loan origination through bond issuance. As housing affordability worsened after 

2003, lenders began offering new mortgage products intended to stretch borrowers’ ability to afford 

ever more expensive homes as a means of keeping loan origination volumes high. Efforts to keep 

origination volumes high also appear to have contributed to loosened underwriting standards during 

this period. 

The final—and perhaps most important—ingredient that fostered the surge in risky lending was the 

rapid increase in housing prices in large swaths of the country through 2006. The quickening pace of 

house price appreciation papered over the increasing risks of mortgage origination in the years 

leading up to the emergence of the foreclosure crisis in 2007. In fact, the growth in risky lending 

seems likely to have fueled the dramatic rise in house prices. In short, market developments since 

2000 helped create a self-perpetuating cycle. In pursuit of high profits, lenders and investors poured 

capital into ever riskier loans, particularly after 2003. This flood of capital helped to spur rising home 

prices that masked the riskiness of the loans being made, leading to continued loosening of 

underwriting standards. When house price growth finally slowed in late 2006, the true nature of these 

risky loans was exposed and the “house of cards” came tumbling down. 

There is a general recognition that fraud on the part of mortgage brokers and borrowers may have 

made a significant contribution to the foreclosure crisis.9 Ultimately, examinations of the growing 

incidence of fraud conclude that the fundamental cause can be traced back to the lack of adequate 

underwriting controls by lenders to oversee brokers’ activities. The most commonly cited information 

on trends in mortgage fraud is derived from Suspicious Activity Reports (SARs) which are filed by 

financial institutions, including federally-insured depository institutions, and are utilized by several 

Federal agencies, including the FBI, the Financial Crimes Enforcement Network (FinCEN), HUD, 

amongst others in their efforts against mortgage fraud. Importantly, with significant shares of loans 

8 Zandi (2008) discusses how the U.S. trade deficit left international investors with a flood of dollars to 

invest. 

9 See Bitner (2008); BasePoint Analytics (2006); Mortgage Asset Research Institute (2008); and Pendley, 

Costello, and Kelsch (2007). 

Executive Summary 

x 
10 

made by non-federally insured institutions, this reporting system leaves out a significant portion of 

the mortgage industry. But even with a large segment of the market excluded from this system and 

with strong housing price growth potentially masking many cases of fraud, the number of SARs grew 

sharply beginning in 2004. In 2003 a total of 6,939 SARs were filed; by 2007 this number had 

increased nearly 7-fold to 46,717. Nonetheless, the number of SARs was still fairly small relative to 

the number of loans originated annually. However, the low share undoubtedly reflects both the 

difficulty of identifying fraud as well as the limited scope of institutions reporting SARS. BasePoint 

Analytics, a private firm specializing in detecting mortgage fraud, has estimated that 9 percent of loan 

delinquencies are associated with some form of fraud. Thus, while mortgage fraud is certainly not a 

trivial issue, it is estimated to account for only about 1 in 10 delinquencies. 

In terms of the nature of fraud, the Federal Bureau of Investigation (FBI) distinguishes between two 

types of fraud: “for profit,” mostly perpetrated by brokers and others to generate profits; and “for 

housing,” perpetrated by homebuyers with the goal of purchasing or retaining a home. The FBI 

estimates that roughly 80 percent of fraud is “for profit” and conducted by brokers and other 

professional parties to the transaction. Consistent with this conclusion, BasePoint Analytics has 

concluded that most fraud is driven by mortgage brokers in their efforts to earn profits by originating 

loans. Existing information further suggests that the vast majority of fraud involves the 

misrepresentation of information on loan applications related to income, employment, or occupancy 

of the home by the borrower. The growth in no- and low-documentation loans appears to be highly 

related to the growth in fraud. Another significant share of cases of fraud involve appraisal 

misrepresentations, where property conditions are materially different than presented in the appraisal 

or information that is typically outside of accepted parameters used to derive the property value. 

Another common factor alleged in the popular press to have contributed to the foreclosure crisis is the 

Community Reinvestment Act (CRA).10 CRA was passed by Congress in 1977 with the goal of 

encouraging banks to meet the credit needs of the communities in which they have branches, with a 

specific emphasis on low- and moderate-income neighborhoods. Some critics of the CRA claim that 

the wave of risky lending was generated in no small part by banks having been pushed into making 

these loans to meet their CRA requirements. However, a variety of empirical evidence supports the 

view that CRA’s requirements played little or no role in producing the foreclosure crisis. To begin 

with, only a very small share of the high-priced loans that have been a key driver of the crisis can be 

linked to efforts to meet CRA’s lending requirements. Furthermore, while CRA lending requirements 

have been in force for over three decades, the foreclosure crisis is a recent phenomenon. In fact, the 

rise of the foreclosure crisis came after a period of sustained decline in the share of mortgage lending 

activity covered under the CRA. Finally, there is also some evidence that loans made to low- and 

moderate-income homebuyers as part of banks efforts to meet their CRA obligations have actually 

performed better than subprime loans. CRA loans were about half as likely to go into foreclosure as 

loans made by independent mortgage companies not covered by CRA, suggesting that CRA may have 

helped to ensure responsible lending even during a period of overall declines in underwriting 

standards. 

One source of this claim is in The New York Times by Hussock (2008). Counter editorials include The New 

York Times (October 15, 2008) and The Los Angeles Times (October 25, 2008). 

Executive Summary 

xi 
Many of the same voices raising questions about CRA’s role in producing the foreclosure crisis have 

also argued that federal regulations requiring the Government Sponsored Enterprises (Fannie Mae 

and Freddie Mac, or the GSEs) to devote a sizeable share of their lending to low- and moderateincome homeowners also played a significant role in fostering the growth of risky lending. The 

serious financial troubles of the GSEs that led to their being placed into conservatorship by the 

Federal government provides strong testament to the fact that the GSEs were, indeed, overexposed to 

unduly risky mortgage investments. However, the evidence suggests that the GSEs’ decisions to 

purchase or guarantee non-prime loans was motivated much more by efforts to chase market share 

and profits than by the need to satisfy federal regulators. Another argument is that the GSEs helped 

fuel the growth of subprime lending by purchasing a significant share of subprime mortgage-backed 

securities. But while the GSEs did purchase just under half of all subprime securities in 2004, their 

purchases of these securities dropped sharply in subsequent years even as the growth in subprime 

market took off. In short, while the GSEs certainly contributed to the growth of the subprime market 

there was clearly substantial demand for these securities from a wide variety of investors. 

Potential Policy Changes for Addressing Rising Foreclosures 

One important category of policy options are those designed to address problems associated with 

rising foreclosure. Rising mortgage delinquency and foreclosure rates exact a tremendous toll on 

individual borrowers and their communities. Foreclosures also exert downward pressure on home 

prices, further exacerbating problems in the housing market and the broader economy. Concerns 

about the impacts of rising foreclosures have led to a variety of efforts aimed at helping owners to 

remain in their homes, including substantial support for foreclosure prevention counseling and 

expanded loan modification and refinancing options. 

One prominent early effort launched in late 2007 by HUD’s Federal Housing Administration (FHA) 

was the FHA Secure program, which was intended to use FHA insurance to replace risky subprime 

and high-cost loans, including those which became delinquent due to a payment reset, with fixed rate, 

long term financing. However, there was limited use of this program in part due to eligibility criteria 

that prevented participation for many borrowers. In July 2008, Congress authorized FHA, under the 

Housing and Economic Recovery Act (HERA) to insure up to $300 billion in loans via a new 

program: HOPE for Homeowners (H4H). Although some lenders have expressed interest in the 

program, as of late 2008 the program had not insured any loans. Amendments have been made to 

increase program participation, including a reduction in the amount of principal lenders are required 

to write down in order to place a borrower in the program. Additional changes have been proposed in 

legislation that will give the FHA important flexibility in operating the program and should encourage 

more interest. 

Another prominent effort is the Hope Now Alliance, formed in 2007 to help keep borrowers in their 

homes by increasing their access to counseling and information and creating a unified private industry 

plan to facilitate loan workouts. Initially, the majority of these workouts consisted of repayment 

plans, accounting for more than two-thirds of all workouts in the first year of operations. While 

workouts can help some households meet their mortgage payment obligations, for many subprime 

borrowers repayment plans offer limited relief as they place additional debt repayment obligations on 

households already struggling to make mortgage payments. Given continued increases in 

foreclosures and deepening economic distress, public pressure has been rising on investors and 

Executive Summary 

xii 
servicers to engage in more aggressive loan modifications through interest rate and principal 

reductions in order to keep more borrowers in their homes. Since mid-2008, Hope Now has reported 

an increasing number of loan modifications by its participating servicers. From July through 

December 2008, nearly half of the loan workouts reported were loan modifications rather than 

repayment plans. 

Even as the number of modifications increases, larger numbers of recently modified loans are now 

redefaulting. In large part this performance reflects that most loan modifications to date do not 

reduce monthly payments. White (2008) found that voluntary loan modifications of subprime 

borrowers completed through August 2008 typically increased a borrower’s principal debt and 

virtually none involved a reduction in principal owed. While servicers did seem willing to lower 

mortgage interest rates, a recent assessment of the Hope Now Alliance program by the Center for 

Responsible Lending (CRL) estimated that only 1 in 5 of all subprime workout plans actually lowered 

monthly mortgage payments for financially distressed borrowers. 

Most recently, the federal government announced a new effort to encourage loan modifications as 

part of its Homeowner Affordability and Stability Plan (HASP) on February 18, 2009. This plan is 

designed to offer assistance to seven to nine million homeowners making good-faith efforts to stay 

current on their mortgage payments. It provides access to low-cost refinancing that will reduce 

monthly payments for four to five million homeowners who owe more than 80 percent of their home 

value and whose mortgages are owned or guaranteed by Fannie Mae or Freddie Mac. The plan also 

commits $75 billion through the Treasury Department, working with the Government Sponsored 

Enterprises (GSEs), FHA, the Federal Deposit Insurance Corporation (FDIC) and other agencies, to 

undertake a comprehensive multi-part strategy to achieve loan modifications for three to four million 

at-risk homeowners to help them stay in their homes. 

This homeowner stability initiative aims to reduce mortgage payments to 31 percent of income to 

help those borrowers in imminent danger of default. HASP aims to achieve this goal primarily 

through subsidizing interest rate reductions, though the program does provide servicers and investors 

with the option of reducing outstanding principal balance as a means of achieving the 31 percent 

payment-to-income target. To date, many servicers have been reluctant to offer interest rate and 

principal write downs even when such modifications could avoid lengthy and costly foreclosure costs. 

In part this reflects concerns that existing pooling and servicing agreements (PSAs or the legal 

agreements that govern the servicer’s authority to engage in loan modifications on behalf of the 

collection of investors with interests in any single mortgage backed security pool) may limit ability of 

servicers to engage in loan modification activities. Yet at the same time, many of these agreements 

contain inconsistent, and arguably not enforceable, language as to what actions are permissible under 

the contract. HASP offers substantial interest rate subsidies and bonus payments for success to 

borrowers and servicers and creates clear industry-wide standards on how best to interpret these 

PSAs; thus, the expectation is that HASP will encourage wider use of loan modification tools. 

Some question whether the HASP approach is sufficient to address all situations. For some 

borrowers, the subsidies provided through HASP will not be sufficient to allow them to stay in their 

homes. Some of these borrowers may be helped through an improved Hope for Homeowners 

Program. But many have argued that bankruptcy reform is needed to allow bankruptcy judges to 

modify mortgages for families who have run out of other options. 

Executive Summary 

xiii 
11 

Potential Policy Changes to Reduce the Risk of Future Foreclosure Crises 

A fundamental cause of the foreclosure crisis was the substantial increase in loans made to borrowers 

with insufficient willingness or ability to meet their payment obligations. As a result, there is a 

growing consensus regarding the need for policy changes to improve the functioning of both the 

primary and secondary mortgage markets to help reduce the number of foreclosure-prone loans before 

they are made. To begin with, there is a clear need to enhance the ability of consumers to make 

appropriate choices in the mortgage market. Recent research on consumer behavior provides growing 

evidence that many consumers took out mortgages that they did not understand or that were not 

suitable for their needs. In particular, there is ample evidence that consumers are often overwhelmed 

by aggressive mortgage sales and marketing efforts that exploit various consumer decision-making 

weaknesses. 

One potential approach to aide consumers is to expand consumer awareness campaigns to warn 

against abusive lending practices. Unfortunately, even the best designed education and outreach 

efforts can be easily swamped in a marketplace characterized by aggressive marketing by lenders. In 

the face of this marketing onslaught many community groups and counseling organizations are 

expanding their capacity to act as a ‘buyer’s broker’ to help clients search for the best mortgages, 

while earning a small fee for offering this service like any other mortgage broker. Building on this 

concept, there have been calls for the government to help establish a national network of “trusted 

advisors,” independent of mortgage providers who are available on-demand to review loan 

documents, educate borrowers and advise them of the suitability of their loan to their circumstances. 

Another potential approach to help consumers make better choices is to apply the “opt-in/opt-out” 

principle identified in the consumer behavior literature to structure more effective mortgage 

marketing of “good loans” – that is, loans that are fairly priced and that consumers understand and 

can afford to repay over the life of the loan.11 For example, many programs first offer a prospective 

consumer a “safe,” level-payment fixed rate mortgage priced in an affordable manner. By starting 

with the default option of offering a simple and safe product, this approach builds on the observations 

that consumers often latch onto the first option for which they qualify. 

While expanding the range of consumer counseling and assistance efforts is likely to be helpful, it 

may also be important to more forcefully counteract aggressive marketing practices and to consider 

banning inherently deceptive loan features. Moreover, since the mortgage market will continue to 

create new products, efforts to ban specific loan terms or mortgage products may not keep pace with 

these innovations. A number of initiatives have been enacted or proposed to enhance existing 

consumer protections, including recently released protections for subprime borrowers under the Truth 

in Lending Act (TILA), which requires lenders to evaluate both a borrower’s income and ability to 

repay prior to originating a subprime loan, and 2008 HUD revisions to the Real Estate Settlement 

Procedures Act (RESPA) regulations. 

But even while applauding these initial efforts, many consumer advocates argue that additional 

reform is needed. They recommend limiting or banning yield spread premiums, which provide 

A detailed discussion of opt-in/opt-out loans is provided in Barr, Mullainathan, and Shafir (2008). 

Executive Summary 

xiv 
12 

brokers and loan officers with incentives to sell borrowers higher priced loans, and prepayment 

penalties, which lock borrowers into high priced loans and expose them to high fees if they need to 

refinance or sell their homes. There are also proposals to develop new standards for truth in lending 

so that mortgage brokers and lenders do not have incentives to get around disclosure rules. Under 

this approach, federal regulators would evaluate whether a creditor’s disclosure was objectively 

unreasonable, in that the disclosure would fail to communicate effectively the key terms and risks of 

the mortgage to the typical borrower. 

Finally, the recent mortgage crisis has exposed a range of shortcomings with the approaches that have 

been used in the past by many mortgage servicers, including the tendency to push less costly (to the 

servicer) repayment plans and short-term modifications rather than aggressively pursue options that 

may benefit both borrowers (by helping them stay in their homes with an affordable monthly 

payment) and investors (by finding resolutions that have a higher expected return than a foreclosure). 

This has led to proposals, such as the federal government’s HASP plan, that seek to better align 

mortgage servicer incentives with those of both consumers and investors and set standards for loan 

modifications. Some have also called for imposing a duty to engage in loss mitigation efforts before 

initiating foreclosure actions. 

In addition to greater consumer protections, many also argue that improvements are needed in the 

general regulatory structure overseeing the origination and financing of mortgages. The failure of 

federal regulation to adapt to the rapid changes in both the primary and secondary market was a key 

element in the explosion of high risk lending and resulting surge in mortgage delinquency and 

default. 

In the primary market, federal oversight has largely focused on federally-insured depository 

institutions. But since the boom and bust of the subprime market was led by non-bank institutions 

and less fully regulated affiliates and subsidiaries of banks, in large measure the nation’s regulatory 

mechanisms have been focused on the wrong parts of the system. To realign regulation with today’s 

organization of financial services, uniformity of regulation is needed across the lending practices of 

all segments of the mortgage industry and its regulators.12 Reforms could reduce the incidence of 

nonbanks or affiliates and subsidiaries of banks playing by different rules, and they could encourage 

hands-on oversight to improve fair lending enforcement and improve compliance monitoring. An 

example of harmonizing the rules for all loan originators could be reform of the Community 

Reinvestment Act (CRA). Such reform applied to the CRA would involve expanding the current 

onsite reviews and detailed file checks now performed on assessment area lending of CRA-regulated 

entities to all mortgage lending activities. Most importantly, CRA could be expanded to cover 

independent mortgage banking operations and other newly emerging non-bank lenders. 

Lack of uniformity is also a problem in the regulation of secondary market participants. The two 

housing GSEs, Fannie Mae and Freddie Mac, are subject to extensive federal oversight; however, 

most of the funds flowing into the subprime market come through the lightly regulated private label 

mortgage-backed securities markets. Though the Securities and Exchange Commission (SEC) is 

charged with the responsibility of monitoring the wide range of security transactions linked to the 

Uneven regulation and supervision left what one former Governor of the Federal Reserve Board described 

as a “gigantic hole in the supervisory safety net” (Gramlich, 2007). 

Executive Summary 

xv 
subprime sector, the degree of due diligence in this sector falls short of the oversight review of the 

GSEs. The development of a new and comprehensive regulatory structure for the non-GSE segment 

of the market will represent a critical piece of the coming mortgage market reforms. 

In considering how best to regulate the GSEs or other secondary market participants, it is important to 

place these issues in the broader context of how the capital markets channel investment dollars into 

the subprime mortgage market. Just as is the case in the primary market, development of detailed 

secondary market regulations that apply to only one segment of the marketplace can be both 

counterproductive and unfair. Considering how best to reduce the tendency for capital used to fund 

higher-priced mortgages to flow through less regulated capital market channels is a worthy addition 

to the current debate on GSE reform in particular, and capital markets in general. 

Executive Summary 

xvi 
Introduction 

This study of the root causes of the current extremely high levels of defaults and foreclosures among 

residential mortgages represents the interim report to Congress by the Secretary of the Department of 

Housing and Urban Development (HUD) pursuant to Section 1517 of the Housing and Economic 

Recovery Act (HERA) of 2008 (P.L. 110-289). The problems in the mortgage market are routinely 

referred to as a “foreclosure crisis” because the level of defaults and foreclosures greatly exceed 

previous peak levels in the post-war era and, as a result, have drawn comparisons to the levels of 

distress experienced in the Great Depression. This interim report contains a review of the academic 

literature and popular and industry press on the root causes of the current foreclosure crisis, and a 

plan for further discussion of policy responses to the crisis. A final report will expand upon this 

interim report with additional data and analysis of trends in the market as well as a more detailed 

review of potential policy responses and recommended actions to mitigate the current crisis and to 

help prevent similar crises from occurring in the future. 

Since HERA was passed in July 2008, the problems in the mortgage market have triggered a more 

general crisis in global financial markets as first the securitization market for broad classes of assets 

seized up and then a broader credit crunch ensued as a shortage of capital held by banks and other 

lenders cut off lending generally (Gorton, 2008). Although the broader financial crisis has roots in 

the mortgage market turmoil, there are many aspects of the financial market problems that go beyond 

issues in the mortgage markets. Thus, while this paper will touch on some of the causes of problems 

in the broader financial markets, much of this broader topic is beyond the scope of this report. 

To help define the nature of the foreclosure crisis, Section I presents basic information on trends in 

mortgage delinquencies and foreclosure starts based on the Mortgage Banker’s Association National 

Delinquency Survey. 

Section II then presents a detailed review of the literature on the causes of the foreclosure crisis. This 

section is divided into three parts. First, it reviews the general academic literature over the last two 

decades analyzing the general causes of mortgage delinquencies and foreclosures. Second, it reviews 

studies that have specifically examined the causes of the recent spike in delinquencies and 

foreclosures to levels not seen since the Great Depression. Finally, Section II concludes by reviewing 

both the academic literature and articles in the popular press that shed light on factors that fostered 

significant growth in the origination of the highly risky loans that were the root cause of the current 

crisis. 

Section III then focuses on potential policy responses to the crisis. This section draws upon articles 

and reports by academics and advocacy groups. There are three main parts to this section. The first 

part discusses potential efforts to remedy the high levels of delinquencies and foreclosures among 

current homeowners. The second part then presents policy options to help reduce the risk of high 

foreclosure rates in the future. The last part outlines potential approaches for more comprehensive 

reform of regulation of the primary and secondary mortgage markets. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

1 
1. Trends in Delinquencies and Foreclosures 

Arguably, the first tremors of the national mortgage crisis were felt in early December 2006 when two 

sizeable subprime lenders, Ownit Mortgage Solutions and Sebring Capital, failed. The Wall Street 

Journal described the closing of these firms as “sending shock waves” through the mortgage-bond 

market.13 The failure of these firms was triggered by high levels of early payment defaults—newly 

originated loans on which borrowers quickly miss several payments. Under the terms of sales 

agreements with investors, lenders can be forced to buy back loans with early payment defaults. 

Since mortgage banking firms are not highly capitalized, a significant number of forced mortgage 

buybacks can quickly lead to insolvency. By late 2006, the volume of early payment defaults was 

rising rapidly, spurring a spike in the volume of mortgage buybacks, and pushing more and more 

subprime lenders into untenable financial positions.14 

Yet, when the Mortgage Banker’s Association (MBA) released the results of its National 

Delinquency Survey for the third quarter of 2006 on December 14, 2006, there was not yet a sense of 

panic (see Exhibit 1). While the survey showed that delinquency and foreclosure start rates were 

rising, particularly among subprime borrowers, the tone surrounding this news was still cautiously 

optimistic, with the MBA predicting that there would only be a ‘modest increase’ in delinquencies 

over the next several quarters as the housing market bottomed.15 At the same time, a very different 

assessment was presented in a report released on December 19th by the Center for Responsible 

Lending (CRL), which estimated that more than 1 million subprime loans originated in recent years 

would end in foreclosure, producing the worse foreclosure crisis in the modern mortgage era 

(Schloemer et al., 2006). CRL’s foreclosure outlook was based on forecasts by Moody’s 

Economy.com showing that house prices were likely to fall in many market areas in the wake of 

recent record levels of housing price growth. 

By late February 2007 when the number of subprime lenders shuttering their doors had reached 22, 

one of the first headlines announcing the onset of a “mortgage crisis” appeared in the Daily Telegraph 

of London.16 By March, it was clear that a mortgage crisis had begun and was worsening.17 When 

the MBA released the results of its delinquency survey for the 4th quarter of 2006 in March 2007, the 

foreclosure start rate was found to have hit a record level.18 

Exhibit 1 presents trends in two key measures of mortgage distress from the MBA’s National 

Delinquency Survey: the share of mortgages that were 90 or more days behind in their payments and 

13 “Mortgage Sector Withstands Subprime’s Fallout,” Danielle Reed and Anusha Shrivastava, The Wall Street 

Journal, December 9, 2006. 

14 “Tremors at the Door,” Vikas Bajaj and Christine Haughney, The New York Times, January 26, 2007. 

15 “Late Mortgage Payments and Foreclosures Rise,” The New York Times, December 14, 2006. 

16 “US Mortgage Crisis Goes into Meltdown,” The Daily Telegraph, February 24, 2007. 

17 “Mortgage Crisis Spirals, and Casualties Mount,” Julie Creswell and Vikas Bajaj, The New York Times, 

March 5, 2007. 

18 “Record foreclosures hit mortgage lenders,” USA Today, March 13, 2007. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

2 
19 

the share that started the foreclosure process. As shown, the foreclosure start rate for all mortgages 

exhibited a fairly sizeable increase of 0.08 percentage points in the 4th quarter of 2006, pushing the 

rate to the new record high of 0.54 percent. While the 90 day delinquency rate was also trending 

strongly upward at this point, it would not reach a new record high until 2 quarters later in mid-2007. 

The fact that the rate of foreclosure starts was already at record levels six months ahead of when the 

90 day delinquency rate would set a new record is an indication of the importance of early payment 

defaults in the early stages of the crisis, with many loans going straight from delinquency to the start 

of foreclosure proceedings. 

Exhibit 1: 90 Day Delinquency and Foreclosure Start Rates 

l

0.00 

0.50 

1.00 

1.50 

2.00 

2.50 

New Record High 

New Record High 

Percent of Al Mortgages 

3rd Quarter Released Dec 2006 

1998Q11998Q31999Q11999Q32000Q12000Q32001Q12001Q32002Q12002Q32003Q12003Q32004Q12004Q32005Q12005Q32006Q12006Q32007Q12007Q32008Q12008Q3 

90 Day Delinquency Rate Forec osure Start Rate l

Source: Mortgage Bankers Association, National Delinquency Survey 

In hindsight, the increases in delinquency and foreclosure rates experienced in early 2007 were still 

somewhat mild compared to what was to come. Both of these measures of distress experienced large 

and steady increases into 2008, shattering previous records for both. Prior to 2006, the highest rate of 

foreclosure starts had been 0.50 percent, reached in the aftermath of the economic recession that 

started the decade. By the second quarter of 2008, this rate was more than twice as high at 1.08 

percent. Similarly, the 90 day delinquency rate, which as recently as 2005 had reached a new record 

of 1.00 percent, had more than doubled to 2.09 percent by the third quarter of 2008. Most recently, 

foreclosure starts declined in the third quarter of 2008, but the MBA speculated that this reflected 

some lenders’ temporary moratoria on foreclosures and increased efforts by lenders to increase the 

volume of workouts with borrowers short of foreclosure.19 But with serious delinquencies continuing 

“Mortgage Troubles Rise to Record Levels, Renae Merle, The Washington Post, December 6, 2008. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

3 
to surge into new records each quarter, there does not appear to be any sense that the growth in the 

magnitude of the crisis is slowing. 

The MBA data provides a number of useful insights into the nature of the mortgage crisis. As is well 

known, subprime loans have accounted for a significant share of troubled loans during the current 

crisis. Exhibit 2 shows trends in foreclosure starts by major market segment as categorized in the 

MBA data—prime, subprime, and government insured loans. Since 1998, when the MBA first began 

reporting separately on the prime and subprime sectors, foreclosures rates in the subprime sector had 

been many multiples the rate of foreclosure starts in other market segments—roughly nine times the 

rate of prime loans and two-and-a-half times the rate in the government-insured sector. As shown by 

Exhibit 2, since 2006 when the foreclosure start rate began to rise sharply, the increase in the rate in 

the subprime sector has been particularly dramatic. 

Exhibit 2: Foreclosure Start Rate by Mortgage Market Segment 

5.00 

4.50 

4.00 

3.50 

3.00 

2.50 

2.00 

1.50 

1.00 

0.50 

0.00 

Percent of All Mortgages by Market Segment 

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008* 

Prime Subpr me i Govt Insured 

Source: Mortgage Bankers Association, National Delinquency Survey.

Note: Annual figures are average of quarterly data; 2008 only includes first three quarters.

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

4 
The much higher risk of foreclosure among subprime loans is also made evident when 90 day 

delinquency rates are compared across market segments (Exhibit 3). While subprime loans have 

always had a much higher foreclosure start rate than other segments, there was little difference in the 

90-day delinquency rates between subprime and government-insured loans—until these trends 

diverged drastically in 2007. The much larger difference in foreclosure start rates among subprime 

loans relative to differences in 90 day delinquency rates reflects the fact that once subprime loans 

became delinquent they were much more likely to enter foreclosure than other market segments. 

Exhibit 3: 90 Day Delinquency Rate by Mortgage Market Segment 

7.00 

6.00 

5.00 

4.00 

3.00 

2.00 

1.00 

0.00 

Percent of All Mortgages by Market Segment 

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008* 

Prime Subpr me i Govt Insured 

Source: Mortgage Bankers Association, National Delinquency Survey.

Note: Annual figures are average of quarterly data; 2008 only includes first three quarters.

The high foreclosure risk among subprime loans was no secret even before 2006. As early as 1998, 

the National Training and Information Center in Chicago highlighted a sharp rise in foreclosures in 

minority neighborhoods in Chicago and linked these increases to the growth of subprime lending in 

these areas (NTIC, 1998). In the wake of NTIC’s work, a number of other studies revealed similar 

trends in other market areas around the country (Bunce et al., 2000). 

In fact, using a foreclosure start rate of 0.50 percent—the national record level prior to 2007—as an 

indicator of severe distress in the mortgage market, there were widespread problems evident at the 

state level as early as 2000. Exhibit 4 shows the number of states with a foreclosure start rate 

exceeding 0.50 percent in a given year beginning in 1979 when the MBA first conducted the National 

Delinquency Survey. During the 1980s the severe economic recession in the Oil Patch states led to 

significant foreclosure start rates in 7 to 9 states each year from 1986 through 1990. This period has 

been viewed as one of the most serious mortgage foreclosure episodes in the post-war era, with 

foreclosure rates in Texas and surrounding states from this time used as the basis for the stress test of 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

5 
the GSEs capital requirements by its regulator. But by 2000, the number of states with foreclosure 

start rates exceeding 0.50 percent was already at 9. By 2002, the height of the previous economic 

recession, the number of states exceeding this rate reached 20, more than double the number achieved 

in the 1980s. Most of these states were in the Midwest and the South in areas with high shares of 

subprime loans. While the number of states exceeding a foreclosure start rate of 0.50 percent 

declined through 2006, there were several states that saw the situation deteriorate even further, 

experiencing very high rates of starts (in excess of 0.80 percent). These states included Indiana, 

Ohio, and Michigan. With the start of the national foreclosure crisis in 2007, the number of states 

with foreclosure start- rates above 0.50 percent exploded, reaching 35 in 2007 and 44 in 2008. The 

number of states with very high rates of foreclosure starts also reached unprecedented levels, with 16 

states in this category in 2008. 

Exhibit 4: Number of States with Foreclosure Start Rates above 0.50 Percent 

50 

45 

40 

35 

30 

25 

20 

15 

10 

5 

0 

Share of 

Loans 

Initiating 

Foreclosure 

(%) 

0.80+ 

0.70-0.79 

0.60-0.69 

0.50-0.59 

197919801981198219831984198519861987198819891990199119921993199419951996199719981999200020012002200320042005200620072008 

Source: Mortgage Bankers Association National Delinquency Survey.

Note: Annual rates of foreclosures started are average of the quarterly rates. 

But while the subprime foreclosure risk was well-documented, the overall market share of subprime 

loans was still low enough that the high rates of foreclosure starts were not pushing up overall 

foreclosure rates to record levels. As shown in Exhibit 3, the foreclosure start rate among subprime 

loans was higher in 2001 at the time of the last recession than it was in 2006 when the current 

foreclosure crisis began. But whereas subprime loans only accounted for 2.6 percent of all loans in 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

6 
20 

MBA’s survey in 2001, by 2006 this share had increased more than five fold to 13.5 percent (Exhibit 

5).20 

Exhibit 5: Subprime Share of Mortgages in MBA National Delinquency Survey 

Share of All Mortgages 16%

14%

12%

10%

8%

6%

4%

2%

0%

2.4% 2.2% 2.4% 2.6% 

3.4% 

5.2% 

11.5% 

13.2% 13.5% 13.3% 

12.2% 

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008*

Source: Mortgage Bankers Association, National Delinquency Survey.

Note: Annual figures are average of quarterly data; 2008 only includes first three quarters.

In fact, because the MBA data shows the share of all outstanding mortgages by market segment, these 

data do not adequately illustrate the growing importance of subprime and other riskier loan segments 

among loans originated during this period. Using data from Inside Mortgage Finance, Exhibit 6 

shows the share of mortgage originations in dollars accounted for by subprime, Alt-A, and home 

equity loans from 2001 through 2006. The Alt-A market segment consists of loans made to 

borrowers with prime credit histories, but incorporating other loan terms that make these loans riskier 

than standard prime mortgages—most commonly entailing the use of limited or no documentation 

requirements for borrowers’ income and/or assets, as well as interest-only or optional monthly 

In part the sharp rise in the subprime market share reported in the MBA data may reflect changes in 

reporting practices among lenders participating in the National Delinquency Survey to include more 

subprime loans that were previously excluded from the survey. Nonetheless, the sharp rise in market share 

from 2003 to 2005 is consistent with data from Inside Mortgage Finance showing subprime’s share of 

mortgage originations more than doubling to 20 percent over this period. When this high share of new 

originations is coupled with a huge wave of refinancing in 2003 due to historically low mortgage rates, it is 

not improbable that the subprime share of all outstanding mortgages could have doubled over this period. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

7 
payment levels.21 Home equity loans are second mortgages, most commonly originated during this 

period in tandem with a first mortgage for 80 percent of the home’s value. These simultaneous home 

equity loans, known as “piggy-back” loans, would be for up to 20 percent of the home value, 

allowing the borrower to obtain a prime first mortgage without mortgage insurance while paying 

much higher interest rates on the home equity loan. Between 2001 and 2003 these three segments 

together accounted for about 15 percent of all mortgage originations. Beginning in 2004 all three of 

these market segments grew rapidly, achieving a combined market share of 48 percent in 2006. In 

reviewing data from the MBA’s National Delinquency Survey it is important to bear in mind that the 

Alt-A segment is likely to be reported in the prime market segment, while home equity loans are not 

covered by the MBA survey. 

Exhibit 6: Subprime, Alt-A, and Home Equity Loan Share of All Mortgage Originations 

Share of Annual Value of Mortgage Originations 60% 

50% 

40% 

30% 

20% 

10% 

0%

2001 2002 2003 2004 2005 2006

Subprime Alt-A Home Equity Loans 

Source: Inside Mortgage Finance 

With subprime mortgages accounting for such a large share of outstanding loans, the relatively 

modest rise in the foreclosure starts rate among subprime loans in 2006 had a much larger impact on 

the market than the spike in foreclosure rates in 2001. Exhibit 7 shows the trends in the number of 

loans starting foreclosure by market segment from 1998 through 2008.22 In 2006 as the foreclosure 

21 “Option” adjustable-rate mortgages give the borrower several options for each monthly payment during the 

early years of the loan: a fully-amortizing payment, an interest-only payment, or a payment that is less than 

the interest owed that month leading to an increase in the outstanding loan balance. 

22 The 2008 number is an estimate based on actual levels reported for the first three quarters with the fourth 

quarter estimated as the average number of loans starting foreclosure during the first three quarters. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

8 
23 

23 

crisis first became evident, the volume of subprime foreclosures increased by more than 100,000, 

accounting for much of the increase of about 120,000 in foreclosure starts in the overall market. This 

sharp increase in the volume of foreclosure starts occurred even though the subprime foreclosure start 

rate was still below peak levels from 2001 (see Exhibit 2 above). In 2007, the volume of subprime 

foreclosure starts increased by nearly 300,000, accounting for more than half of the overall increase— 

even though subprime loans only accounted for about one in eight of all outstanding mortgages. In 

part the sharp increase in 2007 reflects the much higher foreclosure start rate—up more than a full 

percentage point from 2006—as well as the fact that the number of subprime loans reported in the 

MBA survey was nearly 7 times the volume reported in 2001. 

However, in 2007 and 2008 the volume of prime foreclosure starts also increased sharply. In 2007 

the number of prime loans entering foreclosure nearly doubled to about 500,000. Based on 

foreclosure starts during the first three quarters of 2008, it seems likely that the increase in prime 

foreclosure starts will be even larger in 2008, reaching about 850,000 loans. While still less than the 

estimated 950,000 foreclosure starts among subprime loans, in 2008 the prime market has come to 

account for an increasingly large share of all foreclosures. Across all market segments, it is expected 

that foreclosure starts will exceed 2 million loans in 2008—greatly exceeding the levels predicted by 

the Center for Responsible Lending in 2006 as representing the worst mortgage crisis in the modern 

era. 

Exhibit 7: Numbers of Loans Starting Foreclosure by Market Segment 

0 

100,000 

200,000 

300,000 

400,000 

500,000 

600,000 

700,000 

800,000 

900,000 

1,000,000 Number of Loans by Market 

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008* 

Prime Subprime Government 

Source: Mortgage Bankers Association, National Delinquency Survey.

Note: Annual figures are sums of quarterly data; 2008 includes estimate for fourth quarter that is the average of volume in first three quarters.

“Delinquencies Increase, Foreclosure Starts Flat in Latest MBA National Delinquency Survey,” Mortgage 

Bankers Association, December 5, 2008. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

9 
24 

While the MBA data does not identify sub-segments of the prime market, based on information from 

other sources, much of the increase in prime market foreclosures is occurring among “Alt-A” loans.24 

The MBA data also highlights the fact that much of the foreclosure crisis can be linked to adjustablerate mortgages (ARMs) in both the prime and subprime sectors. Exhibit 8 shows annual trends in the 

number of prime and subprime mortgages starting foreclosure by whether the loan has a fixed or 

adjustable rate. At the start of the mortgage crisis in 2006, the rise in foreclosure starts occurred only 

among adjustable rate prime and subprime mortgages. There have continued to be sharp increases in 

foreclosures among both subprime and prime ARMs, so that in 2008 these two categories of loans 

accounted for a large majority of all foreclosure starts. However, foreclosure starts have also 

increased substantially among fixed rate loans, particularly in 2008 as economic conditions have 

deteriorated. 

Exhibit 8: Number of Loans Starting Foreclosure by Loan Type and Market Segment 

700,000 

600,000 

500,000 

400,000 

300,000 

200,000 

100,000 

0 

Number of Loans 

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 

Prime FRM Prime ARM Subprime FRM Subprime ARM 

Source: Mortgage Bankers Association, National Delinquency Survey.

Note: Annual figures are sums of quarterly data; 2008 includes estimate for fourth quarter that is the average of volume in first three quarters.

The high percentage of prime foreclosures accounted for by ARMs is out of proportion to the share of 

all prime loans that are ARMs. While ARMs only accounted for 22 percent of prime loans reported 

in the MBA data in 2008, these loans accounted for 55 percent of all prime foreclosure starts. The 

disparity is also evident among subprime loans, although it is not as large. ARMs accounted for 55 

percent of subprime loans in the MBA data, but 77 percent of subprime foreclosure starts. 

See, for example, “Alt-A Credit: The Other Shoe Drops,” David Liu, Shumin Li, The MarketPulse, 

December 2006, LoanPerformance; “Mortgage Crisis Spreads Past Subprime Loans,” The New York Times, 

February 12, 2008; and “Fannie Having Debt Woes,” National Mortgage News, November 17, 2008. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

10 
In part the high foreclosure rates among ARMs may reflect the potential for payment shock for 

borrowers when the interest rates on these loans first reset. However, as will be discussed further 

later in this report, the incidence of early payment defaults among these loans suggests that much of 

their poor performance may be related to lax underwriting that allowed borrowers to take on monthly 

payments that were unaffordable even before interest rate resets occurred. 

In sum, data from the MBA National Delinquency Survey highlights a few key features of the 

foreclosure crisis. First, a substantial portion of the crisis can be traced to both the growing volume 

of and rising foreclosure rates among subprime loans—particularly in the initial phases of the crisis. 

Second, foreclosure starts have been much higher among adjustable-rate loans in both the subprime 

and prime sectors, with much of the problem among prime loans concentrated in the Alt-A segment 

of the market. However, as the crisis now enters its third year and the nation’s economic recession 

worsens, foreclosure starts are also rising sharply among prime fixed-rate loans as well. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

11 
2. Literature Review 

2.1 General Literature on Causes of Foreclosures and 

Delinquencies 

There is a rich economics literature examining the cause of mortgage foreclosures, generally referred 

to as “default” in the literature.25 As noted in detailed reviews of this literature by Quercia and 

Stegman (1992) and Vandell (1995), since the 1980s this literature has been dominated by an optionbased theory of mortgage default, where the mortgage contract is viewed as giving homeowners an 

option to “put” the home back to lenders by defaulting on their mortgage. In an option-theoretic 

view, the primary factor driving defaults is the value of the home relative to the value of the 

outstanding mortgage—when the home value falls substantially below the mortgage debt, owners are 

better off by ceding the home to the lender.26 This type of situation has been characterized in the 

literature as a “ruthless default,” where borrowers simply walk away from their mortgage obligations 

when it is in their financial interest to do so. 

However, as argued most prominently by Vandell (1995) and Elmer and Seelig (1998), a lack of 

housing equity by itself generally does a poor job of predicting mortgage delinquencies, which are a 

necessary precursor to foreclosures. As these papers point out, it is generally understood that most 

borrowers become delinquent due to a change in their financial circumstances that make them no 

longer able to meet their monthly mortgage obligations. These so called “trigger events” commonly 

include job loss or other income curtailment, health problems, or divorce. Both Vandell and Elmer 

and Seelig argue that foreclosures are most accurately thought of as being driven by a two-stage 

process—a first trigger event that produces financial illiquidity among borrowers which is then 

coupled with a lack of home equity that makes it impossible for the borrower to either sell their home 

to meet their mortgage obligation or refinance into a mortgage that is affordable given their change in 

financial circumstances. In this view, a lack of home equity is an important determinant of 

foreclosures as it precludes other means that borrowers can take to resolve an inability to meet their 

mortgage obligations, but foreclosures are most commonly triggered by some other event that makes 

borrowers financially insolvent. 

For the most part, the literature provides numerous examples to support the view that most defaults 

are not ruthlessly driven by falling house prices. One of the first articles to put forth an optiontheoretic view of mortgage default was Foster and Van Order (1984, 1985). However, the data on 

Federal Housing Administration (FHA) borrowers used in their analysis shows that only 4.2 percent 

of borrowers with estimated loan-to-value ratios of 110 percent or higher actually defaulted on their 

mortgage. Ambrose and Capone (1998), again examining data on FHA borrowers, find that loans 

25 Technically, mortgage “default” occurs when a borrower has missed three payments and a fourth is due. 

The default leads lenders to initiate the foreclosure process, but historically a majority of defaults are 

resolved without a foreclosure occurring. 

26 Option-theory also focuses on borrowers ability to exercise a “call” option by prepaying the mortgage when 

interest rates fall. Thus, pure option-theoretic models focus heavily on trends in house prices and interest 

rates to explain both defaults and prepayments. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

12 
27 

with negative equity accounted for a small share of all loans that became seriously delinquent and 

also a minority of loans that ended in foreclosure. More recently, Foote, Girardi, and Willen (2009) 

examine data on all homeowners in Massachusetts over a twenty-year period and found that in the 

early 1990s only 6.4 percent of homeowners whose house values dropped below their mortgage 

amounts ended in foreclosure. 

Of course, while it may be that most defaults are not strictly ruthless, this does not preclude ruthless 

defaults from occurring. The magnitude of house price declines occurring now in many markets 

around the country as well as the number of markets simultaneously experiencing house price 

declines are unprecedented in the post-war era. Some owners are property investors who are purely 

motivated by financial concerns and may be more likely to pursue a ruthless default if it is in their 

financial interest. Some owner-occupants who have the ability to meet their monthly payments may 

decide to default when house values are substantially below their mortgage debt either because of a 

desire to move to a new home or because they see limited financial benefit from continuing to pay the 

mortgage given the level of prevailing rents relative to their mortgage costs and the degree to which 

home prices would have to recover to make them whole.27 But given the high cost of foreclosure to 

borrowers, these ruthless defaults are unlikely to be widespread. 

While borrower illiquidity is largely believed to be a root cause of foreclosures, the literature has 

found only an inconsistent relationship with measures of trigger events such as unemployment or 

divorce rates. On the other hand, there is always a strong association between negative home equity 

and the likelihood of foreclosure. As both Quercia and Stegman and Vandell note, in part this reflects 

the fact that there is little systematic information available on the incidence of trigger events among 

individual borrowers. Instead, the literature has relied on aggregate measures of these events at the 

metropolitan area or state level. The finding of a strong association between foreclosures and 

declines in house prices is also consistent with the view that while delinquencies are brought on by a 

trigger event, a delinquency is only likely to end in a foreclosure in cases where homeowners do not 

have sufficient equity to be able to sell their home or refinance into a more affordable mortgage. To 

the extent that the literature has largely focused on estimating the causes of foreclosures and not 

delinquencies, it is not altogether surprising that measures of declining housing prices are found to be 

much more significant predictors of these outcomes than measures of trigger events. Foote, Girardi, 

and Willen (2009) note that while Massachusetts experienced a record high level of mortgage 

delinquencies at the time of the last economic recession in 2001, this period was also marked by a 

record low level of foreclosures as steep increases in house prices offered delinquent borrowers 

options for resolving the delinquency short of foreclosure. 

While the importance of house prices as a determinant of foreclosures has continued to be evident in 

the literature since the mid-1990s, there has also been a growing emphasis on the importance of 

borrowers’ credit history and specific loan terms in contributing to foreclosure risk. During the 

1990s, as automated underwriting became more common in the prime mortgage market and as the 

subprime market developed, there was greatly expanded use of credit scores in evaluating borrowers’ 

risk of default (Gramlich, 2007). A variety of studies have confirmed the importance of credit scores 

Foote, Girardi, and Willen (2008a) present theoretical examples comparing the financial returns from 

maintaining ownership in the face of declining home prices with the alternative of renting a home of the 

same quality to show that it can be logical for homeowners to choose to default on their mortgage. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

13 
in predicting the likelihood that an individual borrower will default (see, for example, PenningtonCross, 2003, and Demyanyk and Van Hemert, 2008). Pennington-Cross finds that, all else equal, 

borrowers with low credit scores (less than 600) were two to three times more likely to default than 

borrowers with high credit scores (700 or higher). Demyanyk and Van Hemert find that even among 

subprime borrowers, credit scores were one of the strongest predictors of default, along with starting 

loan to value ratios, initial interest rates, and changes in house prices. 

A number of studies have found that a variety of loan terms common in the subprime market are 

associated with higher risk of default. While adjustable-rate mortgages (ARMs) have long been 

known to be associated with higher risk (see, for example, Cunningham and Capone, 1990), recent 

work has shown that hybrid ARMs, which are particularly common in the subprime market, exhibit a 

spike in default and prepayment risk at the time when interest rates first adjust from initially lower 

rates.28 In examining a group of hybrid loan originated in 1995-96 and tracked through mid-2000, 

Ambrose, LaCour-Little, and Huszar (2005) find that hybrid ARMs exhibited a sharp spike in the risk 

of both default and prepayment in the month when the interest rate first adjusted. Similarly, in 

examining the performance of hybrid ARMs originated between 1998 and 2005, Pennington-Cross 

and Ho (2006) find that these loans exhibited a strong spike in prepayment rates in the month when 

interest rates first adjusted, along with a mild increase in default rates. While these authors do not 

find as strong a spike in defaults as Ambrose, LaCour-Little and Huszar, the time period studied by 

Pennington-Cross and Ho was marked by significant increases in house prices which may have 

contributed to the predominance of prepayment over default at the time of interest rate resets.29 

In addition to adjustable rate features, other characteristics of subprime and Alt-A loans that have 

been found to have an independent association with higher default risk include: 

• Prepayment penalties (Quercia, Stegman, and Davis, 2005; Danis and Pennington-Cross, 

2005 (22A); and Demyanyk and Van Hemert, 2008); 

• Low or no documentation of income or savings (Danis and Pennington-Cross, 2005 

(22A); Pennington-Cross and Ho, 2006; and Demyanyk and Van Hemert, 2008); and 

• Balloon terms (Quercia, Stegman, and Davis, 2005; Danis and Pennington-Cross, 2005 

(22A); and Demyanyk and Van Hemert, 2008). 

In short, subprime mortgages have been found to be inherently associated with much higher 

foreclosure risk than prime mortgages both because they are made to riskier borrowers and because 

they frequently contain a range of loan terms that are associated with higher foreclosure risk. While 

Alt-A loans are generally made to borrowers with higher credit scores, these loans also exhibit higher 

28 Hybrid ARMs are loans where interest rates are fixed for an initial two or three year period, following 

which interest rates adjust every six months to a year based on trends in an index rate (commonly the 

London Interbank Offer Rate) plus a margin specified for each loan. 

29 In an analysis of the performance of fixed-rate subprime loans from a similar time period, Danis and 

Pennington-Cross (2005) find that delinquent loans had a very high probability of prepayment as long as 

the borrower had some positive equity in the home. This result is consistent with the finding that subprime 

ARMs from this period did not experience high defaults at the time of reset as rapidly rising house prices in 

most areas of the country would have provided most owners with a positive equity cushion. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

14 
risk than prime loans because of the risks associated with lower documentation of income and assets 

as well as the higher risk of payment shock associated with various loan terms. 

But even prime mortgages may also have been of higher risk during recent years as underwriting 

standards allowed higher loan-to-value ratios, which has been an important predictor of foreclosure 

risk in the past. The surging volume of piggy-back loans noted earlier may also have masked the 

degree to which prime mortgages were becoming riskier as relatively low loan-to-value ratio first 

mortgages were often teamed with second mortgages that brought the combined loan-to-value ratio to 

100 percent. In 2006 it is estimated that nearly one quarter of all home purchase loans reported in 

HMDA involved a piggy-back loan, suggesting that the share of prime loans where borrowers had 

essentially no equity investment was very high in recent years (Avery, et al., 2007). 

2.2 Literature Assessing Causes of the Current Foreclosure 

Crisis 

There have been a number of reviews of the fundamental causes of the sharp rise in mortgage 

delinquencies and foreclosures since 2006. Prominent among these are reviews by the Chairman of 

the Federal Reserve Board (Bernanke, 2008), the Government Accountability Office (2007), the 

Majority Staff of the Joint Economic Committee of the U.S. Senate (2007), and the Fitch Rating 

Agency (Costello, Mistretta, and He, 2007). In general, each of these sources point to three 

prominent factors underlying the current crisis: the widespread slowdown in house price growth 

followed by actual declines in prices in most areas of the country, weak economic conditions in 

selected market areas, and substantial growth in the volume of risky loans originated—made even 

riskier by loosening underwriting and lender quality control in the years leading up to the crisis. This 

section presents a review of the literature that has supported these conclusions. 

The literature provides fairly strong evidence that slowing growth and then decline in house prices 

played a significant role in precipitating the foreclosure crisis in many market areas. On the other 

hand, weak economic conditions have been a much less important factor than in previous times of 

high foreclosure rates. Taken as a whole, the literature suggests that the more fundamental cause of 

the foreclosure crisis was the surge beginning in 2003 in the origination of loans that were at high risk 

of foreclosure due to a combination of unaffordable initial payment levels relative to borrower 

incomes coupled with loan terms that would make these loans even more unaffordable over time. 

The riskiness of these mortgages was masked by rapid house price appreciation through 2006 that 

allowed many—but certainly not all—borrowers to avoid foreclosure by either refinancing into a new 

mortgage or selling their home for more then they had originally financed. In fact, as described 

below, there is evidence that the surge in risky lending itself fed the rapid house price growth that 

occurred since 2003. Once the limit of extending risky mortgage credit was reached in 2006, house 

price growth slowed. 

House price declines were further exacerbated by an oversupply of new homes, particularly in 

markets where rapid house price growth had spurred significant housing demand by investors and 

borrowers that were aided by the ready availability of mortgage financing. As house prices softened, 

demand by both investors and owner-occupants dropped sharply, leaving an excess supply of new 

housing that further added to downward pressure on prices (Joint Center for Housing Studies, 2008). 

Foreclosures themselves also undoubtedly add to this downward pressure. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

15 
As a result, declining house prices can be viewed as an inevitable result of the surge in risky lending 

rather than a cause of the resulting foreclosure crisis. As the crisis matures, however, a downward 

spiral can take hold as declining house prices could exert their own influence to increase foreclosures 

which, in turn, depress prices further. 

2.2.1 Contribution of House Price Declines 

Given the central role that has long been assigned to home price declines in explaining foreclosure 

trends, it is perhaps not surprising that most reviews of the current crisis begin by pointing to the 

slowdown in house price growth that began in 2006 as the main factor precipitating the sharp rise in 

delinquencies and foreclosures. There have been several studies by researchers in the Federal 

Reserve System that are commonly cited as evidence of the importance of house price trends in the 

current crisis. 

The most prominent of these studies is an analysis of foreclosure rates in Massachusetts from 1989 

through mid-2007 by researchers from the Federal Reserve Bank of Boston (Gerardi, Shapiro, and 

Willen, 2008).30 A key conclusion of the study is that the decline in house price appreciation that 

began in Massachusetts in 2005 accounts for much of the dramatic rise in foreclosures in the state in 

2006 and 2007. Specifically, they find that a one standard deviation decrease in house price 

appreciation is associated with a doubling of foreclosure risk. However, the study also finds that 

homeownership spells that begin with a mortgage originated by a subprime lender are six times more 

likely to end in foreclosure than homeownership spells that begin with a prime mortgage. One 

limitation of this study is that it only includes data on Massachusetts, and so may not be 

representative of other areas of the country. For example, Massachusetts has experienced fairly 

volatile house prices over this period compared to other areas of the country (such as the Midwest) 

and did not have the same degree of subprime or Alt-A lending as other areas (such as California or 

the South Central regions). Another limitation is that the study did not have any information on loan 

terms other than whether the loan was originated by a lender on a list of subprime lenders compiled 

by HUD. 

Another commonly cited source of evidence of the importance of house price declines is a study by 

researchers from the Federal Reserve Bank of San Francisco (Doms, Furlong, and Krainer, 2007), 

which points to changes in house price appreciation rates as the single most important factor in 

explaining variation in serious delinquency rates in subprime mortgages across 309 metropolitan 

areas in 2005 and 2006. This study finds that variations in house price appreciation rates by itself 

explains about two-thirds of the variation in serious delinquency rates. While the study does find 

some association between delinquency rates and measures of borrower risk (proxied by high cost loan 

shares and the median interest on high cost loans as reported in HMDA) and economic conditions 

(measured both by employment growth and unemployment rates), these factors are largely 

insignificant when house price appreciation rates are taken into account. 

30 There are several interesting features of this study. First, the data analyzed cover a period of nearly two 

decades from 1987 to 2007 that span two periods of substantial decline in nominal home prices. Second, 

the data comes from public real estate records that track spans of property ownership rather than just the 

lifespan of an individual loan. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

16 
Finally, Yuliya Demyanyk of the Federal Reserve Bank of St. Louis and Otto Van Hemert of New 

York University also find that declines in metropolitan-area house price appreciation rates were the 

single most important factor contributing to very high rates of early delinquency (60 days or more late 

within 12 months of origination) among subprime loans originated nationally in 2006 and 2007 

(Demyanyk and Van Hemert, 2008). This study pools loans originated from 2001 through 2007 and 

predicts early delinquency as a function of loan characteristics and house price appreciation rates over 

the 12-month period after origination. For the entire pool of loans, the study finds that borrower 

FICO score, the combined loan-to-value ratio of all loans, the original mortgage interest rate, and the 

rate of house price appreciation all have similarly large associations with early default rates. 

However, when they further examine deviations in underlying explanatory factors across cohorts of 

loans by the year of origination, they find that the very high rates of early payment default among 

loans originated in 2006 and 2007 are almost entirely due to lower rates of house price appreciation 

and not due to higher incidence of any specific loan terms or borrower credit scores. 

Yet, while there is significant evidence that softening house prices played a prominent role in 

precipitating the crisis, it is also remarkable that the rise in mortgage delinquencies and foreclosure 

starts began as the growth in house prices slowed—and generally before house prices actually began 

to drop. Between the second quarter of 2006 and the second quarter of 2007 47 states experienced an 

increase in the foreclosure start rate in the MBA National Delinquency Survey, with an average 

increase of 47 percent. Over this same period OFHEO’s house price index indicates that 44 states 

experienced declines in the rate of house price growth, but only 5 states had actual price declines over 

this period. In many states the rise in foreclosures appears to have been brought on by slowing house 

price growth as much as outright declines.31 

2.2.2 Contribution of Weak Economic Conditions 

While reviews of the foreclosure crisis generally point to weak economic conditions in some regions 

of the country as a contributing factor, most studies actually find only a weak association between 

variations in economic conditions and subprime delinquency rates. Gerardi, Shapiro, and Willen 

(2008) do find a statistically significant association between town-level unemployment rates and 

foreclosure rates in Massachusetts over a period from 1989 through mid-2007, but the association is 

much weaker than that for either house price appreciation or the use of a subprime lender. While they 

find that a one standard deviation increase in unemployment rates raises foreclosure risk by 10 

percent, the same change in house price appreciation rates is associated with a 200 percent change in 

foreclosure risk. However, given this study’s focus on foreclosure incidence rather than delinquency, 

31 A plausible explanation is that growth in the values of individual properties is distributed around the 

measured market area index, which represents the mean growth for the market area. Even with a positive mean 

growth in a market, there will be some properties in that market that experience negative growth. When the 

mean for the market grows less rapidly, there are likely to be a higher number of individual properties with 

negative growth. According to Calhoun (1996), “it is now standard practice in the housing research literature to 

characterize individual house prices as arising from a stochastic process in which the average rate of change or 

drift in housing values is represented by a market index and the dispersion and volatility of values around the 

market average are modeled as a log normal diffusion process. In this approach, one assumes that the price, Pit, 

of an individual house i at time t, can be expressed in terms of a market price index βt, a Gaussian random walk 

Hit, and white noise Nit, such that ln(Pit) = βt + Hit + Nit.“ 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

17 
it would be expected that house price changes would play a much more important role than 

employment trends. 

Doms, Furlong, and Krainer (2007) find that variations in employment growth and unemployment 

rates by themselves explain about a third of the variation in subprime delinquency rates in 2005 and 

2006, but this association is either statistically insignificant or much smaller in magnitude once 

variations in house price appreciation are taken into account. The GAO review (2007) cites work by 

researchers from Moody’s noting that weaker employment growth accounts for about 20 to 32 

percent of elevated delinquency rates in selected Midwestern markets, but the Moody’s study is also 

reported to have found that employment growth trends had little impact on delinquencies nationally. 

In keeping with this conclusion, Demyanyk and Van Hemert (2008) indicate that they dropped the 

unemployment rate from their model due to statistical insignificance. 

In fact, what may be most unique about the current crisis in mortgage delinquencies and foreclosures 

is that weak economic conditions were not a significant factor in precipitating these events although 

after the crisis began, they have contributed to worsening the crisis. This view is aptly summarized in 

a review of the drivers of high delinquencies among subprime loans originated in 2006 by Fitch 

Ratings (2007) which concludes that “the 2006 subprime vintage performance is remarkable for the 

magnitude of early mortgage defaults given a benign economic environment apart from home prices.” 

As an indication of the lack of importance of weak economic conditions in producing the mortgage 

crisis, it is notable that 48 states had an increase in the foreclosure start rate between 2006 and 2007 

in the MBA’s National Delinquency Survey, but over this period only 16 states had an increase in the 

unemployment rate, and in 10 of these states the increase was 0.2 percentage points or less. 

2.2.3 Contribution of Growth in Risky Loans 

Investor Loans 

One reason why there may have been such a significant rise in mortgage delinquencies and 

foreclosures in the wake of merely softening home prices in 2006 is that there was much greater 

potential for “ruthless” default among home buyers given trends in the housing market. Using data 

reported by lenders under the Home Mortgage Disclosure Act (HMDA), Avery et al. (2008) 

document the significant growth in home purchase loans made to investors from the late 1990s 

through the mid-2000s. From 1993 to 2001 the share of purchase loans made to investors grew 

steadily from 5.1 percent to 8.6 percent. But between 2001 and 2005 this share doubled to 17.3 

percent. So by 2005 more than 1 in 6 of all home purchase mortgages were made to investors. The 

investor share declined after 2005, but these buyers still accounted for 14.9 percent of home purchase 

loans in 2007. In states experiencing very rapid house price growth, including California, Arizona, 

Nevada, and Florida, investors accounted for roughly a quarter or more of all purchase loans in 2005 

and 2006 (Bernanke, 2008). 

These figures also appear likely to understate the true share of home purchases by investors as a 

common form of mortgage fraud during this period was for lenders and/or borrowers to falsely claim 

that the investor buyers intended to occupy purchased homes as their principal residence. In 

reviewing a small sample of early payment defaults from 2006, Fitch Rating Agency (2007b) found 

that two-thirds of these properties were never occupied by the purchaser. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

18 
To the extent that investors were motivated to purchase properties to realize gains from house price 

appreciation, a mere slowdown in house price growth would be sufficient to induce a ruthless default. 

Given that real estate agent commissions are on the order of 5 to 10 percent of the sales price (not to 

mention costs incurred during the period when a home is on the market), if house prices are growing 

by less than this rate investors will begin to incur losses. Thus, the high share of purchase loans made 

to investors is likely to have made a significant contribution to the high level of early payment 

defaults among loans originated in 2006. However, while the analysis by Demyanyk and Van Hemert 

(2008) did find that investor loans were more likely to experience early payment defaults, they also 

found that the much worse performance of loans made in 2006 and 2007 was not related to there 

being a higher share of investor loans in these years. It may be that the increase in investor loans was 

masked by fraudulent applications indicating the properties would be owner occupied. As will be 

discussed further later, a rise in mortgage fraud was evident in recent years, with misrepresentations 

about owner-occupancy a common form of fraud. 

Unaffordability of Subprime Loans Generally 

Beyond the growth of investor loans, there is strong evidence that the slowdown and subsequent 

decline in house prices played such a prominent role in producing the mortgage crisis fundamentally 

because the rapid growth in the volume of risky mortgages meant that many loans were made to 

borrowers who were struggling to make monthly payments even at the time loans were originated. In 

part, the unaffordability of these loans reflects situations where borrowers did not adequately 

understand the terms of their loans (see, for example, Bucks and Pence, 2006). However, in other 

cases borrowers likely understood the risks they were taking but chose to obtain these loans either to 

tap accumulated home equity or to purchase larger homes than they could otherwise afford. In either 

case, the originators of these loans ultimately determined that overall these loans were expected to be 

profitable even if the risk of default were high. 

In fact, the early termination rate of subprime loans was extraordinarily high throughout the first half 

of the decade, but rapid increases in housing prices meant that a large majority of borrowers were 

able to avoid or resolve a delinquency by prepaying their mortgage—either by selling their homes or 

by refinancing into a new mortgage. Thus, when house price growth slowed, subprime borrowers’ 

inability to afford their mortgage payments could no longer be masked through refinancing or selling 

the home. 

The strongest indications of the importance of prepayment as a means of avoiding delinquencies and 

foreclosures are the findings by Ambrose, LaCour-Little, and Huszar (2005) and Pennington-Cross 

and Ho (2006) that subprime hybrid loans experience a sharp rise in prepayment rates when interest 

rates on ARMs first adjust. As noted earlier, Ambrose, LaCour-Little and Huszar also find that 

foreclosures spike at the time of interest rate resets, while Pennington-Cross and Ho find only a slight 

rise in foreclosure rates at reset. But this may well reflect the fact that the first study examined loan 

performance through mid-2000, while the second study examined a period that extended into 2005 

when house price growth was exceptionally strong in most areas of the country. Finally, Danis and 

Pennington-Cross (2005) further find that the likelihood that a subprime loan will prepay rises 

substantially after a delinquency occurs, leading them to conclude that there is strong evidence that 

delinquent subprime loans are more likely to prepay than default. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

19 
Whether distressed or not, the prepayment rates on subprime mortgages have consistently been very 

high. Foote et al. (2008) plot prepayment rates through mid-2007 for subprime hybrid loans 

originated in Massachusetts, Connecticut, and Rhode Island between 2001 and 2006. They find that 

these subprime loans begin to prepay at a high rate almost immediately after origination. For loans 

originated from 2001 to 2004, roughly 60 percent had prepaid by the time they reached the first 

interest rate reset. By 36 months after origination, more than 70 percent of these loans had prepaid. 

In part, the high prepayment rates might be expected in an environment where interest rates are 

declining so that refinancing would provide lower payments. However, several factors argue against 

this being an appropriate explanation for subprime loans. First, the vast majority of subprime loans 

had prepayment penalties requiring borrowers to pay roughly six months of interest on the 

outstanding balance if the loan is paid off within three years of origination (Quercia, Stegman, and 

Davis, 2005). Demyanyk and Van Hemert (2008) present data indicating these penalties were 

included in 70 to 75 percent of subprime loans originated from 2001 through 2007. Given the stiff 

penalty from prepayment, it seems unlikely that borrowers would be motivated to prepay with the 

goal of reducing mortgage costs. In addition, since the LIBOR index used to set interest rates on 

most subprime loans began rising steadily after mid-2004, for loans originated in 2004 there would 

have been little incentive to refinance in the first two years of the loan in order to obtain a lower 

interest rate. Yet, these loans are shown to have prepaid at nearly the same rate as loans originated in 

2001—which experienced declining market interest rates in the two years after origination. Finally, 

Pennington-Cross and Ho (2006) also find that the prepayment rates on fixed-rate subprime 

mortgages originated from 1998 to 2005 were also fairly high with 60 percent having prepaid or 

foreclosed within 36 months of origination. In short, the high prepayment rates among subprime 

loans are consistent with the argument that borrowers used prepayment as a means of managing 

unaffordable payments. 

Rapid House Price Growth—Cause and Consequence of the Crisis 

The data presented by Foote et al. (2008) provide evidence for the importance of rapid house price 

growth in fueling prepayments. They find that the prepayment rate for subprime loans originated in 

2005 and 2006 began to slow substantially compared to earlier cohorts. For loans originated in 2005, 

only 50 percent had prepaid 24 months after origination compared to 60 percent of earlier cohorts. 

For loans originated in 2006, prepayment rates were roughly another 10 percentage points below the 

rates experienced by the 2005 cohort. The authors speculate that the lower prepayment rates of these 

later cohorts are due to declining housing prices, leaving borrowers without any equity in their homes 

and thus an inability to refinance their existing mortgages. 

There is also some empirical evidence that high house price growth spurred lenders into originating 

riskier loans. An analysis of denial rates reported in HMDA by Dell’ARiccia, Igan, and Laeven 

(2008) find evidence that metropolitan areas with more rapid house price growth had larger declines 

in mortgage denial rates even after controlling for variations in income and employment. The impact 

of house price appreciation rates on denial rates was also much larger for subprime lenders than for 

prime lenders. 

Rapid house price growth may also have been a result of the surge in use of nontraditional mortgages 

and looser underwriting. Greater inflation in house prices might be expected to the extent that new 

loan products gave borrowers the ability to make higher bids for homes than would have been 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

20 
possible using more traditional mortgage products and more conservative underwriting standards. 

Several recent studies described below provide empirical support for this view. Appraisal fraud may 

also have contributed to rapid house price growth. As discussed more below, misrepresentation of 

property characteristics, or the use of disallowed parameters in arriving at property valuations, has 

been identified as a common type of mortgage fraud. Bitner (2008) describes how subprime lenders 

worked with appraisers to manipulate valuations to support higher loan amounts. He further 

describes how these transactions then become comparable sales that are used to justify other 

excessive appraisals in the same neighborhood, creating a self-reinforcing cycle of house price 

inflation. 

Mian and Sufi (2008) find that ZIP codes where denial rates declined by more than would be 

expected given changes in underlying factors related to borrower quality (and so, areas where lenders’ 

underwriting is thought to have loosened) experienced more rapid increases in house prices than 

expected given changes in borrower incomes. In essence, they find that looser underwriting was 

associated with faster house price growth than predicted by basic demand factors. 

Wheaton and Nechayev (2008) develop time series models of house price trends in 59 metropolitan 

areas for the period from 1998 through 2005. They find that fundamental measures of housing 

demand predict much lower levels of house price appreciation than actually occurred. They further 

find that prediction errors are larger in markets with higher shares of subprime mortgages and where 

second home and investor buying was more prevalent. 

Pavlov and Wachter (2008) develop a theoretical model to support the view that aggressive lending 

instruments will fuel more volatile house price cycles by allowing greater borrowing than would 

occur in the absence of these loan products. Using several data sets they also find empirical evidence 

of a link between greater use of riskier loan products and more volatile house price cycles. 

Specifically, they find evidence of an association between greater use of ARMs and more volatile 

housing price cycles loans in Los Angeles County during the period 1990 to 1995 as well as 

nationally from 1996 through 2002. They also find an association between greater house price 

volatility and higher levels of subprime lending based on HMDA data at the metropolitan area level 

from 2001 through 2007. 

Finally, Shiller (2008) examines long-run changes in housing prices at the national level through mid2007 and finds that the increase in house price growth experienced since the start of the current 

decade cannot be explained by economic fundamentals. Instead, he argues that the house boom was a 

classic bubble, fueled by self-fulfilling expectations by consumers of continued robust price growth. 

However, at some point consumer expectations should be chocked off by their inability to bid 

housing prices up beyond levels they can afford. With the advent of non-traditional mortgages and a 

decline in underwriting standards, this constraint may have effectively been removed. 

Rapid Growth of Risky Loan Volumes 

One way in which overall mortgage market risk increased in recent years was by the rapid growth in 

the market share of loans that by their very nature were riskier. Exhibit 9 shows trends from 2001 

through 2006 in the market shares of all mortgage originations by dollar volume that were accounted 

for by subprime, Alt-A, and Home Equity Loans (HELs). 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

21 
Exhibit 9: Market Share of Subprime, Alt-A and Home Equity Loans (HEL) 2001-2006 

25% 

20% 

15% 

10% 

5% 

0% 

9% 

3% 

5% 

8% 

2% 

4% 

9% 

2% 

5% 

7% 

11% 

13% 

19% 

20% 

12% 12% 

20% 

14% 2001 

2002 

2003 

2004 

2005 

2006 

Subprime Alt A HEL 

Source: Inside Mortgage Finance Publications, Inc . 

In 2003 subprime loans accounted for 9 percent of the total dollar volume of originations; by 2006 

this share had risen to 20 percent. The growth in Alt-A loans was even more spectacular, increasing 

from 2 percent in 2003 to 13 percent by 2006. There was also substantial growth over this period in 

HELs, primarily so-called piggyback loans, which allowed borrowers to take out a first mortgage for 

80 percent of the purchase price to avoid mortgage insurance premiums, and then finance the 

remaining 20 percent of the price with an HEL. These loans increased from just 5 percent of the 

market in 2003 to 14 percent by 2006. In all, these three segments went from a combined market 

share of just 16 percent in 2003 to 48 percent in 2006—essentially half of all mortgages originated. 

The rapid growth in these broad market segments does not reveal the full extent to which lenders 

were increasing the volume of risky loans. In the State of the Nation’s Housing Report from 2006, 

researchers from the Joint Center for Housing Studies noted that the combination of rapidly rising 

home prices and interest rates had eroded the affordability of homeownership. With borrowers eager 

to buy into rapidly appreciating home markets and lenders motivated to maintain high origination 

volumes, lenders began to offer a variety of non-traditional mortgage products designed to lower 

monthly payments and allow borrowers to buy ever more expensive homes. The most common of 

these loans were interest-only mortgages, where monthly payments did not include any payment 

toward reducing the principal, but also included payment-option loans, where borrowers could choose 

to make payments that were less than the monthly interest owed, and 40-year amortization mortgages 

due and payable after 30 years. As shown in Exhibit 10, prior to 2003 Inside Mortgage Finance did 

not even track the volumes of these types of loans. In 2004, they were found to account for 7 percent 

of the entire mortgage market. But by 2006 they totaled 29 percent of all mortgages. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

22 
When used in appropriate circumstances, these non-traditional loan terms can be useful for both 

lenders and borrowers to provide loans that address borrower needs or market circumstances. But, as 

recent experience has shown, when used inappropriately, these loan terms can raise the risk of 

borrower default to unacceptable levels. 

Exhibit 10: Non-Traditional Mortgage Volumes and Market Share 

Interest Option 40-Year Total Non- Total Mortgage 

Only ARM Balloon Traditional Market 

Dollar Volume (Billions) 

2004 60 145 0 205 2,920 

2005 481 280 10 771 3,120 

2006 520 255 90 865 2,980 

Market Share 

2004 2.1% 5.0% 0.0% 7.0% 100% 

2005 15.4% 9.0% 0.3% 24.7% 100% 

2006 17.4% 8.6% 3.0% 29.0% 100% 

Source: Inside Mortgage Finance Publications, Inc. 

Weakening of Underwriting and Lender Quality Controls 

In addition to the fact that there was substantial growth in risky loans made to risky borrowers, there 

is also significant evidence that underwriting and lender quality control mechanisms deteriorated in 

the years leading up to the mortgage crisis. Certainly, underwriting standards were loosened in terms 

of such factors as income qualification standards, allowable debt to income ratios, loan to value 

ratios, and borrower credit quality. For example, Reeder and Comeau (2008) use HMDA data to 

observe a substantial weakening of income qualification standards particularly in the private-label 

lending sector, but also at Fannie Mae and Freddie Mac. This weakening permitted a significant shift 

to higher leverage mortgage lending in terms of mortgage loan-to-income ratios between 2004 and 

2006 that could only be achieved by qualifying borrowers at higher payment-to-income ratios or very 

low introductory interest rates with an implied future payment shock. Although the increase in high 

leverage lending was more pronounced among high cost loans, borrowers were disproportionately 

much more likely to use high-leverage loans in both the high- and low-cost sectors to refinance rather 

than purchase their homes. 

In addition, quality control standards to ensure the validity of borrower and property characteristics 

also appear to have deteriorated. Perhaps the strongest evidence for the deteriorating credit quality of 

originated loans is provided by Demyanyk and Van Hemert (2008), who estimate the likelihood that 

subprime loans originated from 2001 through 2007 experienced a serious delinquency 12 months 

after origination. They find that even after controlling for loan, borrower, and market characteristics, 

the risk of early default rose every year from 2001 through 2007. 

Further evidence on loosening underwriting is provided by two studies examining trends in HMDA 

loan denial rates. Dell’Ariccia, Igan, and Laeven (2008) find evidence that metropolitan-area level 

denial rates declined over time from 2000 through 2006 for reasons not related to their measures of 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

23 
borrower risk (primarily income and employment measures). Mian and Sufi (2008) undertake a very 

similar analysis of HMDA denial rates, but at the ZIP code rather than metropolitan-area level. They 

identify ZIP codes that had high denial rates in 1996 and test to see how much of declines in denial 

rates could be related to improvements in borrower risk measures—captured by trends in income, 

employment, and establishments—and how much is related to simply lenders extending more credit 

in areas previously deemed too risky. They find evidence the denial rates declined more sharply in 

areas with previously high denial rates—despite the fact that these areas actually had relatively worse 

trends in their measures of underlying borrower risk. 

Payment Shock from ARM Resets 

Another factor that is often identified as making a significant contribution to rising delinquencies and 

foreclosures is the payment shock associated with adjustable-rate loans, either due to initial “teaser” 

rates that were substantially below the fully-indexed rate or simply because of increases in underlying 

interest rate indexes that produced large increases in payments upon reset. An important part of the 

evidence for the contribution of ARMs to the current crisis is the high delinquency and foreclosure 

rates among these loans in MBA’s National Delinquency Survey. However, there are several studies 

that suggest that the importance in the crisis of resetting interest rates on ARMs may be overstated for 

a number of reasons. 

First, Demyanyk and Van Hemert (2008) find that all types of subprime loans—fixed and adjustable 

rate—experienced consistent increases in early delinquencies over time. But they note that because 

fixed rate loans accounted for lower shares of loans in more recent years, the rise in delinquency rates 

of fixed-rate subprime loans was masked by the fact that the overall portfolio of subprime fixed-rate 

loans tended to include a higher share of older loans than ARMs. The overall fixed-rate portfolio 

therefore was more seasoned than the overall ARM portfolio and for this reason appeared not to 

suffer as much from increased delinquency rates as more seasoned loans will in general perform 

better. 

Second, Foote, et al. plot trends in default probabilities for subprime ARMs originated in 2002, 2005, 

and 2006 and find that there is no evidence of an uptick in default rates at the time that loans reset. 

They cite average measures of initial interest rates compared to fully-indexed rates to suggest that the 

number of loans with initial steep discounts on teaser rates that would experience very large increases 

in interest rates was fairly small. 

Finally, a number of market observers have noted that the underlying index used by many subprime 

ARMs (the LIBOR) declined sharply from September 2007 into the first part of 2008, which would 

reduce the likelihood of a payment shock (see, for example, Berry, 2008). Payment shocks simply 

have not been as evident as they would have been in a less favorable interest rate environment. Based 

on an example of a subprime loan pool from 2006 drawn from the study by Ashcraft and Schuermann 

(2008), Berry notes that had LIBOR rates remained near the level from when these loans were 

originated, the average borrower in this loan pool would have experienced a payment increase of 

about 28 percent by 31 months after origination. Assuming borrowers were paying roughly 40 

percent of their income on mortgage payments, the increase would have meant they would be paying 

more than 50 percent of their income for mortgage payments after the adjustment. However, with 

LIBOR rates down sharply, loans in this pool were not expected to experience much change in 

monthly payments when their rates adjusted. 

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24 
However, the fact that a substantial number of loans face a potentially large payment shock is beyond 

dispute. One of the most comprehensive reviews of this issue is Cagan (2007), who examined more 

than 8 million ARMs originated between 2004 and 2006 and found that given interest rate levels 

prevailing as of the time of his analysis in 2007 39 percent would face a payment increase of between 

25 and 50 percent upon initial reset, 10 percent would face a payment increase of 51 to 99 percent, 

and 15 percent would face a payment increase of 100 percent or more. When it is considered that a 

typical subprime borrower had a housing payment to gross income ratio of 40 percent, increases in 

payments of 25 percent are fairly substantial. Cagan’s analysis was based on interest rates prevailing 

in 2007 and so did not take into account the decline in the LIBOR rate that subsequently occurred. 

But his analysis does put into perspective the number of loans that are at risk of payment shock 

should rates rise again. 

It may also be that the issue of payment shock triggering delinquencies and foreclosures has not been 

evident mainly because many subprime loans are unaffordable even before payments adjust, as 

described above. In support of the argument that payment resets do make loans unaffordable, more 

rigorous studies of subprime loan performance have found a very significant impact of interest rate 

adjustments on the probability of prepayment (Ambrose et al. 2005; Pennington-Cross and Ho, 2005). 

Ambrose et al. also found a significant impact of payment resets on the probability of default in their 

sample that spanned the period from 1995 to 2000, although Pennington-Cross and Ho did not find 

such an effect during the period of more robust housing price growth from 1998 through 2005. 

Finally, tabulations of serious delinquency rates among subprime ARMs originated in 2005 by Fitch 

Ratings agency (2007) do show an upward inflection in these rates in the few months leading up to 

the initial rate reset, suggesting that for recent loan cohorts payment shock is at least a contributing 

factor. 

2.2.4 Overall Conclusions on Precipitating Causes of Crisis 

While softening housing prices were clearly an important precipitating factor in the present crisis, it 

seems clear from the literature that the sharp rise in mortgage delinquencies and foreclosures are 

fundamentally the result of rapid growth in loans with a high risk of default—due both to the terms of 

these loans and to loosening underwriting controls and standards. The current crisis is actually 

unusual in that general economic weakness did not play a significant role in producing delinquencies 

and foreclosures in most market areas—at least not initially. Instead, it was a slowdown in house 

price growth that removed the primary safety valve for the high volume of unaffordable mortgages 

that had been made, which was for borrowers to take advantage of robust house price growth to avoid 

foreclosure by refinancing into a new loan or selling the property for a profit. As Demyanyk and Van 

Hemert (2008) concluded: “...the seeds for the crisis were sown long before 2007, but detecting them 

was complicated by high house price appreciation between 2003 and 2005—appreciation that masked 

the true riskiness of subprime mortgages.” Or, as Mark Zandi of Moody’s Economy.com more 

prosaically put it: “Skyrocketing house prices fed many dreams and papered over many ills” (Zandi, 

2008). 

In fact, several studies have found an association between increases in high-cost lending that enabled 

borrowers to obtain larger mortgages than they could otherwise afford and more rapid house price 

growth than would be predicted by other fundamental measures of housing demand. Thus, the 

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25 
slowdown and then decline in house price growth that precipitated the foreclosure crisis is itself a 

product of the inevitable end to the ability of lenders to keep extending more credit to borrowers. 

Once the downturn began, an oversupply of new homes and a rising tide of foreclosures both added to 

downward pressure on prices, exacerbating the crisis. But given that a significant increase in risky 

lending lies at the heart of the current crisis, the key question becomes what were the factors that 

made it possible for the mortgage market to make so many ill-advised loans? The next section 

addresses this question. 

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26 
2.3 Factors Enabling Expanded Risky Lending 

In this section we examine the factors that contributed to the growth in risky lending since 2000. The 

first part of the section outlines key market developments in the 1980s and 1990s that were important 

antecedents of the trends that emerged since 2000. The second part examines issues related to 

regulation of the mortgage market and how the regulatory structure may not have changed quickly 

enough to keep up with developments in the market. The third section reviews key developments 

since 2000 that fostered the growth in risky mortgage lending. Finally, the last part of this section 

examines evidence for several specific factors that have commonly been cited as important 

contributing factors to the crisis, including an increase in fraud among market participants and the 

role of the Community Reinvestment Act and the GSEs in spurring risky lending. 

2.3.1 Key Market Developments in the 1980s and 1990s 

As described by McCoy and Renaurt (2008), the seeds for the growth of the subprime market were 

planted in the early 1980s by two Congressional acts that were intended to mitigate the challenges 

posed by doubled-digit mortgage interest rates. The first of these was the Depository Institutions 

Deregulation and Monetary Control Act of 1980 (DIDMCA), which abolished interest rate ceilings 

on first mortgages for residences (with “interest” defined to include all costs included in estimating 

annual percentage rates on mortgages). Two years later, Congress passed the Alternative Mortgage 

Transactions Parity Act (AMTPA), which preempted state laws to enable the national use of variable 

rate terms, balloon payments, and negative amortization of both first and subordinate lien loans. 

While McCoy and Renaurt acknowledge that these laws were aimed at alleviating a crisis in mortgage 

lending brought about by high interest rates, they conclude: “Ultimately, however, both statutes had 

far reaching structural effects. By liberalizing the permissible features of loan products and 

facilitating differential pricing according to risk, the DIDMCA and AMTPA set the legal stage for the 

emergence of the subprime market a decade later.” 

While these legislative changes enabled the use of risk-based pricing, the actual development of 

lending practices that offered different interest rates to different classes of borrowers based on risk 

was aided by technological advancements allowing lenders to statistically analyze credit risk and to 

incorporate this analysis into automated underwriting systems. A key innovation in the development 

of automated underwriting was the application of credit scores to assess the credit risk of mortgage 

applicants. Fair, Isaac & Company pioneered the summary of credit history information in credit 

scores beginning in the 1950s and introduced the FICO score for general use in 1989. In 1992 

Freddie Mac researchers evaluated the ability to predict mortgage default using these general credit 

scores and found them to be a strong, statistically significant predictor (Straka, 2000). This led both 

to greater use of credit scores in manual underwriting as well as the incorporation of scores into the 

development of automated underwriting systems used by the GSEs in the 1990s. The subprime 

market was slower to develop automated underwriting systems, but by the late 1990s large subprime 

lenders began to adopt this technology as well (Browning, 2007). A number of studies have pointed 

to the growth of automated underwriting systems as facilitating the rapid growth of subprime lending 

over the past decade (see, for example, Apgar, Calder, and Fauth, 2004; Gramlich, 2007; and Belsky 

and Essene, 2008). 

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Another key factor fueling the growth of the subprime market was the development of the assetbacked securities (ABS) market, where the revenue stream from financial assets—including 

mortgages—is used to back the issuance of a security sold to investors. As described by Belsky and 

Essene (2008), in 1985 the total value of all ABS was $1.2 billion. By 1991 the market had increased 

to $50.6 billion—a large increase, but still small compared to the size of the residential mortgage 

market, which was nearly $600 billion that year. But the ABS market continued to grow extremely 

rapidly through the 1990s, reaching $1.9 trillion in 2005. 

The development of the asset-backed securities market as a source of capital for mortgage lending 

opened the door to rapid growth of mortgage lending by non-depository institutions. Apgar, Calder, 

and Fauth (2004) describe the significant evolution of the mortgage market over the 1980s and 1990s 

from one where depository institutions originated most mortgages and either held them in portfolio or 

sold them into the secondary market with guarantees by the federal government or by the GSEs to one 

where non-depository institutions originated large shares of mortgages using financing provided 

through the sale of mortgage-backed securities. 

Trends in the primary sources of mortgage financing illustrate this story. As of the early 1990s a 

majority of mortgages were originated through depository institutions. HUD’s Survey of Mortgage 

Lending Activities found that nearly two-thirds of the total dollar volume of mortgages in 1990 was 

originated by depositories (HUD, 1999). At the same time, the secondary market for residential 

mortgages was dominated by the GSEs and Ginnie Mae. Based on data from Inside Mortgage 

Finance, in 1990, a total of $259 billion in mortgage backed securities were issued, with 66 percent 

guaranteed by the GSEs, 25 percent guaranteed by Ginnie Mae, and only 9 percent issued by other 

sources. 

The heavy reliance on either portfolio lending by depositories or sale of mortgages on the secondary 

market with guarantees by the GSEs or Ginnie Mae helped keep standard mortgage underwriting 

fairly conservative into the mid-1990s. In fact, in developing a strategy to help increase 

homeownership among low-income and minority families, HUD characterized the inability to qualify 

for mortgage financing as a “very serious barrier to homeownership” and in response made it a 

priority to foster more “flexible underwriting” and to promote availability of “alternative financing 

products” (HUD, 1995). 

The growth of the non-agency mortgage backed security market during the 1990s helped to expand 

the sources of mortgage financing beyond the GSEs and government-insured sectors. By 1997, the 

share of mortgage-backed securities issued by non-agency sources had increased to 24 percent. 

Along with increased access to non-agency sources of capital to finance mortgages, the share of loan 

volume accounted for by depositories fell rapidly. By 1997, these lenders only accounted for 42 

percent of mortgage originations, down from 64 percent in 1990. By 2005 the share of mortgagebacked securities from non-agency sources had increased to 55 percent. HUD’s Survey of Mortgage 

Lending Activity was discontinued in 1998, but undoubtedly the share of loans originated by 

depository institutions fell further in the years leading up to 2005. One indication of the growing 

importance of non-depository institutions in originating mortgages is that the number of mortgage 

brokerage firms increased more than six-fold from 7,000 in 1987 to 53,000 in 2007 (Essene and 

Apgar, 2007). 

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As described by Belsky and Essene (2008), the greater access to broader capital markets brought by 

securitization not only expanded the amount of funding available for mortgages, but also brought 

investors with a broader range of risk preferences and tolerances and so helped expand the range of 

mortgage products available. The growth of securitization was also associated with the vertical 

disintegration of the mortgage market. Previously the process of originating, servicing, and investing 

in mortgages involved either a single institution (in the case of loans held in portfolio by depository 

institutions) or a couple of institutions (in cases where loans were sold into the secondary market 

through the GSEs or federally-insured programs). With the growth of securitization there was a 

significant unbundling of the various steps in this process, with brokers processing mortgage 

applications, wholesale lenders originating loans, large mortgage banking organizations purchasing 

loans and aggregating them into pools, Wall Street investment banking firms issuing securities based 

on these pools, and investors from around the world purchasing these securities. Since the actors in 

this process are compensated by transaction fees at each step and have little capital at risk, this system 

is rife with principal-agent problems—where the principals acquiring loans cannot be sure that the 

agents supplying these loans have acted in their best interests in insuring the quality of the loans 

produced. As will be described below, in hindsight it seems clear that the regulatory system did not 

adequately evolve to adjust to this new mortgage market. 

2.3.2 Failure of the Regulatory Environment to Adapt to Market Changes 

In contrast to the fairly dramatic changes occurring in the structure of the mortgage market during the 

1990s, there was little change in the regulatory regime overseeing mortgage lending activity. Various 

authors have identified that one way in which the regulatory structure failed to adequately adapt to 

changes in the market was through its continued reliance on consumer disclosure rules as the 

principal means of ensuring that borrowers made appropriate choices with regard to mortgage 

financing—even in the face of much greater variation in mortgage interest rates and fees as well as 

growing complexity of mortgage terms (see, for example, Gramlich, 2007; Essene and Apgar, 2007; 

McCoy and Renaurt, 2008; Barr, 2008). Two key federal laws governing mortgage transactions are 

the Truth in Lending Act (TILA) and the Real Estate Settlement Procedures Act (RESPA), both of 

which are intended to ensure that consumers are provided timely and accurate information about 

mortgage pricing and terms before closing a loan. These commentators have argued, however, that 

the existing system of disclosures was no longer sufficient to protect consumers from making poor 

choices given the increased complexity of choices. The inadequacy of the disclosure system was 

perhaps most succinctly described by the GAO (2004) in its review of federal efforts to combat 

predatory lending: 

“Although improving loan disclosures would undoubtedly have benefits, once again 

the inherent complexity of loan transactions may limit any impact on the incidence of 

predatory lending practices. Moreover, even a relatively clear and transparent system 

of disclosures may be of limited use to borrowers who lack sophistication about 

financial matters, are not highly educated, or suffer physical or mental infirmities.” 

Essene and Apgar (2007) provide a thorough review of the challenges facing consumers in choosing 

the best mortgage for them even given the information made available as a result of TILA and 

RESPA. Among the factors hampering consumers are the challenges inherent in accurately assessing 

risk and in evaluating the total cost of a stream of payments over time. In addition, consumers often 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

29 
have little awareness of mortgage prices and struggle with shopping for a mortgage due to the effort 

involved in obtaining multiple offers and then in comparing these offers across the many factors that 

affect mortgage pricing (HUD, 2008). 

Another way in which the subprime mortgage market presents challenges for consumers is that these 

loans are often aggressively sold to consumers by profit-seeking lenders, rather than sought out by 

consumers. Essene and Apgar (2007) provide a number of examples of the ways in which common 

marketing approaches by subprime lenders are designed to sell loans to borrowers that are not in their 

best interests. A study by the GAO (2006) similarly documented concerns by both federal regulators 

and mortgage industry groups that advertising by subprime lenders generally emphasized the benefits 

of nontraditional mortgage products without explaining the risks. However, there is little systematic 

information on the extent of these practices. Renuart (2004) argues that a significant volume of court 

decisions and government enforcement actions suggest that overly aggressive lending practices are 

widespread. One significant example of such legal actions is described in Congressional testimony 

by the Iowa Attorney General, Thomas J. Miller (2003). In his testimony, Miller described a consent 

judgment against a large subprime lender for a variety of misleading sales practices that involved a 

settlement providing injunctive relief of nearly $500 billion. One study that does provide some more 

systematic evidence of the extent to which mortgage brokers are involved in selling subprime loans to 

borrowers is Kim-Sung and Hermanson (2003). These researchers found that among a random 

sample of roughly 1,000 elderly homeowners who refinanced their loan between 1999 and 2000 more 

than half of those with broker-originated loans reported that brokers initiated contact with them about 

the loan, while only a quarter of borrowers with lender-originated loans were first contacted by their 

lender. 

Subprime lenders also have strong incentives to get borrowers to agree to higher priced loans than 

they might otherwise qualify for as they earn yield spread premiums for loans with rates above 

prevailing levels (Jackson and Berry, 2002; Woodward, 2003). Subprime lenders have also revealed 

that subprime loans in general were much more profitable to originate than other types of loans. One 

lender reported that subprime loans were three to five times more profitable than any other type of 

loan his firm offered, and he saw “no logical reason to sell something that made less money.” 

Similarly, the CEO of Ownit mortgage was quoted as saying: “The market is paying me more to do a 

no-income verification loan than it is paying me to do the full documentation loans. What would you 

do?” 

While difficult to prove, there is evidence that many subprime borrowers took on mortgages that were 

more costly than warranted given their level of credit risk. Lax et al. (2004) compared interest rates 

on a group of A-minus loans purchased by Freddie Mac with a similar group of loans originated by a 

subprime lender. They found that the subprime loans had average interest rates that were more than 

two percentage points higher. Even after factoring in differences in default risk and servicing costs, 

Lax et al. concluded that roughly one-half of the interest rate differentials could not be accounted for 

by higher risk. Further, they note that the interest rate difference does not even account for the fact 

that the subprime loans were also likely to have paid higher points and fees. 

Gruenstein, Ernst, and Li (2006) examined differences in interest rates on a large number of subprime 

loans taking into account a variety of risk measures (including credit scores) and found that AfricanAmerican and Latino borrowers were more likely to receive higher-priced loans than whites. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

30 
32 

Woodward (2003) examined a small sample of loans from a single lender originated through 

mortgage brokers and found that borrowers with less than a college degree paid $1,500 more in fees, 

all else equal, than other borrowers. In addition, African-American borrowers paid $500 more, and 

Latinos paid $275 more than otherwise similar whites. 

Taken as a whole, these studies support the view that at least some subprime borrowers faced higher 

rates and fees than necessary given their level of credit risk, and provide an indication that the 

reliance on a system of disclosures failed to help consumers successfully navigate the increasing 

complex mortgage market. Of course, other borrowers also knowingly took on loans that were 

unaffordable as a means of tapping more home equity or purchasing larger homes than they might 

otherwise have been able to. 

The one relevant exception to federal reliance on consumer disclosures was the Home Ownership and 

Equity Protection Act (HOEPA), which was enacted in 1994 in response to concerns about the 

emergence of subprime lending (McCoy and Renaurt, 2008).32 HOEPA prohibits certain loan terms 

and practices on “high-cost” refinance loans, with high cost defined as loans with interest rates more 

than eight percentage points above the rate on Treasury securities of a comparable term or where total 

points and fees exceed the greater of eight percent of the loan balance or $400. For loans exceeding 

these thresholds, HOEPA restricts or bans balloon clauses, negative amortization, increased interest 

rates after default, prepayment penalties, and loans made without regard to the borrower’s ability to 

make payments. However, in practice, HOEPA has had little influence on mortgage lending as the 

definition of “high cost” was set at such elevated levels that only a tiny fraction of mortgages have 

been covered by the law—less than 0.1 percent of refinancing and home improvement loans in 2006 

(Avery et al., 2007). While the Federal Reserve Board was given authority to implement HOEPA and 

to adopt regulations to achieve the Act’s purposes, it largely refrained from exercising this authority 

until July 2008. 

Over the course of the last decade, many states became concerned about the growth of lending 

practices that were deemed to be predatory. In the absence of stronger federal protections, starting in 

1999 states passed HOEPA-like legislation to ban or restrict specific loan terms or practices on loans 

defined as high cost. By 2007, only seven states had no mini-HOEPA statutes or other laws or 

regulations in effect restricting prepayment penalties, balloon clauses, or mandatory arbitration 

clauses in residential mortgages (Bostic et al., 2007). In their analysis of the effect of state laws on 

subprime lending activity, Bostic et al. generally find that the passage of these laws is associated with 

an increase in subprime originations and a decrease in loan rejection rates. They speculate that the 

laws may actually increase consumer confidence in the subprime lending market. The study does not 

address whether entities subject to state predatory lending laws have had lower foreclosure rates than 

entities not subject to such laws. 

The federal banking regulators do issue and enforce regulations relating to fair lending and equal credit 

opportunity intended to protect borrowers from many abusive practices, but these protections were not 

oriented toward helping borrowers to avoid inappropriate housing and mortgage product choices in the 

years leading up to the crisis. For example, OTS has rules to prohibit discrimination and false advertising. 

See 12 C.F.R. part 528 and 12 C.F.R. §563.27. Furthermore, stronger consumer protections have been put 

in place by Federal banking regulators in response to the crisis. See 74 Fed. Reg. 5489, 5506 (January 29, 

2009). 

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31 
One significant factor that may have limited the impact of these laws is that federal depository 

institutions and affiliated mortgage banking operations were largely exempt from these state laws. As 

described by McCoy and Renaurt (2008), the U.S. Office of Thrift Supervision (OTS) issued a series 

of opinion letters and regulations over the course of the 1990s asserting federal preemption of state 

laws restricting mortgage lending for federal savings institutions, culminating in a sweeping 

preemption regulation issued in 1996. With the growing wave of state anti-predatory lending laws 

after 1999, national banks pushed for their regulator, the Office of the Comptroller of the Currency 

(OCC) to provide them with the same relief as federal thrifts. In response, in 2004 the OCC issued a 

preemption regulation virtually identical to that of the OTS. McCoy and Renaurt and others (see, for 

example, Wilmarth, 2004, and Renuart, et al., 2005) also argue that since the OTS and OCC pay for 

their operations through fees earned from chartering and examining their member institutions, they 

have a strong incentive to offer member institutions the favorable regulatory regimes to help build 

their membership base. 

Importantly, both agencies extended these preemption privileges to mortgage banking operating 

subsidiaries as well. McCoy and Renaurt assert that the appeal of being able to claim federal 

preemption gave impetus to mortgage banking operations being acquired by depository institutions. 

McCoy and Renaurt further claim that while the mortgage banking affiliates are granted the same 

preemption authority over state laws, they are not subject to nearly the same level of examination and 

review as their affiliated depository institution. As a result, McCoy and Renaurt state that these 

mortgage banking affiliates are subject to little oversight by these federal regulators—even though 

mortgage banking organizations have been playing a larger role in the market. 

There are no studies in the literature that make a rigorous comparison of foreclosure rates between 

entities subject to state predatory lending laws and those not subject to these laws. It is also not clear, 

however, that there were a sufficient number of active market participants subject to the pre-empted 

state laws to accurately measure differences in performance. 

The high volume of mortgages being bundled into securities revealed another hole in the regulatory 

fabric. Under the holder in due course doctrine of the Uniform Commercial Code, purchasers of 

securities are generally not liable for illegal activities of lenders who made these loans (McCoy and 

Renaurt, 2008). So even if borrowers were the victims of illegal, unfair or deceptive practices in the 

origination of their loans, they often do not have recourse against the current owners of the loans. 

Engel and McCoy (2004) identify several ways that borrowers can overcome the holder in due course 

restrictions on bringing claims, as well as ways in which security holders may be at risk of litigation 

under other federal regulations. Nonetheless, Engel and McCoy conclude that borrowers face 

significant obstacles in bringing claims against holders of securities so that the litigation risk to 

investors is not substantial. Thus, the securitization process itself provides another layer of protection 

for predatory lending practices. 

McCoy and Renuart (2008) argue that the failure of the OTS, the OCC, and the Federal Reserve 

Board to impose greater protections for borrowers in part reflects the fact that these agencies are 

principally charged with overseeing the safety and soundness of depository institutions and not with 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

32 
consumer protection.33 In fact, there are a variety of ways in which the regulatory structure failed to 

adequately protect the safety and soundness of the finance industry given changes in the market over 

time. As already noted, more mortgage lending was being conducted through mortgage banking 

organizations, both affiliated and unaffiliated with depository institutions. In the case of those 

affiliated with depositories, federal bank regulators have responsibility for examining these 

institutions. But since regulators are largely concerned with depository failures, the failure of a 

subsidiary is not nearly as important and so subsidiaries are subject to less rigorous review (McCoy 

and Renuart, 2008; Gramlich, 2007). Meanwhile, mortgage banking organizations unaffiliated with a 

depository fall under the purview of various state financial agencies, but the resources states have for 

this function are small compared with those of the federal government (Gramlich, 2007). 

Perhaps a larger hole in the regulatory fabric was the lack of meaningful oversight of nationally 

recognized statistical rating agencies—who themselves were the de facto regulators of the securities 

market through their role in assigning ratings to issued securities.34 By assigning AAA and AA 

ratings to large portions of mortgage pools, the rating agencies not only gave investors confidence in 

the safety and soundness of these investments, but in many cases actually made it legally feasible for 

financial institutions to invest in these securities. A key impetus for the role of the rating agencies in 

the mortgage backed securities market was the Secondary Mortgage Market Enhancement Act 

(SMMEA) of 1984, which not only made it easier for private entities to issue mortgage backed 

securities, but also enabled banks, thrifts, state-chartered financial institutions, pension funds and 

insurance companies to invest in the two top rated tranches of these securities (McCoy and Renaurt, 

2008). 

Yet, the activities of rating agencies have been subject to very limited federal oversight. It was not 

until September 2007 that the rating agencies were made to register with the Securities and Exchange 

Commission (SEC) under the Credit Agency Reform Act of 2006 (SEC, 2008). In the wake of the 

subprime crisis, it has become apparent that the rating agencies were subject to substantial conflict of 

interest in that their fees were paid for by security issuers and not investors in these securities. With 

competition among the rating agencies for business, there was substantial pressure on rating agencies 

to meet the needs of their clients in providing favorable ratings. 

A recent formal review by the SEC (2008) of rating agencies’ role in the subprime securities market 

found that the agencies did not appropriately manage the conflict of interest between their role in 

providing investors with ratings while being compensated by the firms structuring and marketing the 

securities. Accounts in the literature and popular press provide a variety of anecdotes about how the 

process of chasing profits led rating agencies to downplay the increasing risk of subprime mortgage 

pools (see, for example, Calomiris, 2008 and Lewis, 2008). Beyond conflicts of interest in their 

compensation structure, the SEC also found a number of other deficiencies in rating agency 

33 As previously noted, the agencies do issue and enforce regulations that provide consumer protections (for 

example, see OTS rules to prohibit discrimination and false advertising at 12 C.F.R. part 528 and 12 C.F.R. 

§563.27) but bank safety and soundness are their primary concern. Recent additions to their regulations 

have strengthened the depository regulators’ consumer protection role. 

34 The three main rating agencies registered with the Securities and Exchange Commission are Fitch Ratings, 

Moody’s Investor Services, and Standard & Poor’s Rating Services (SEC 2008). These firms are referred 

to collectively as the “rating agencies.” 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

33 
performance, such as not adequately disclosing significant aspects of the rating process (including 

rationales for deviations from their models), not having as robust a surveillance process for lenders as 

was evident prior to 2003, and not having consistent internal audit processes. The SEC has also 

argued that the rating agencies may have struggled to handle the increased volume and complexity of 

deals after 2002. Jaffee (2008) argues that rating agencies greatly underestimated the importance of 

house price trends in subprime loan performance as the only relatively large-scale historical 

experience with these loans during an economic downturn occurred around the recession of 2001, 

which was unusual in having weak employment growth coupled with robust house price increases. 

Calomiris (2008) finds that the failure of the rating agencies’ statistical models to account for the 

potential shock of falling house prices resulted in very high proportions of subprime loan pools being 

rated as AAA. Given rules requiring many institutional investors to only purchase securities with the 

highest ratings, as well capital requirements that greatly favored investments in these same securities 

by banks and other regulated financial firms, achieving a high rating opens up a much larger market 

for these securities. A number of reviewers have argued that rating agencies supposedly sophisticated 

methods for assessing risk helped sell institutional investors on the “alchemy of securitization,” in 

which pools of risky mortgages were transformed into safe investments (President’s Working Group 

on Financial Markets, 2008; Coval, Jurek, and Stafford, 2008). In this view, given the agencies’ 

ratings, investors and regulators alike felt confident that the market could appropriately price this risk. 

In a widely-cited speech from April 2005, Federal Reserve Chairman Alan Greenspan touted the 

benefits of technological advancements in helping to achieve “significant efficiencies in collecting 

and assembling the data necessary to evaluate risk and make corresponding decisions about credit 

pricing.” 

However, Calomiris (2008) argued that the underestimate of default risk due to falling house prices in 

rating agency models was clearly observable by investors. By this view, the overly optimistic 

assessment of risk by the rating agencies was driven by investors who were demanding high volumes 

of AAA-rated MBS in which to invest. In support of this view Calomiris cites an anecdote told to 

him by a ratings agency executive that when a large institutional investor was warned about an 

upcoming security issuance rated by a competitor using overly optimistic assumptions, the investor 

responded by saying ‘we have to put our money to work.’ Calomiris argues that the low default rate 

experienced during the 2001 recession gave asset managers the excuse of “plausible deniability”— 

that when house prices inevitably fell and led to high losses among subprime loans, the asset 

managers could explain that the experience with subprime loans during the 2001 recession had misled 

them. His argument is that asset managers were compensated on the basis of fees earned on 

transactions and thus had incentives to place large risky investments for institutional investors since 

they would not share in the losses. 

In contrast to this view, the President’s Working Group on Financial Markets (2008) argued that a 

lack of transparency in the rating agency process made it difficult for investors to understand what 

was used to determine the ratings. Coval, Jurek, and Stafford (2008) have also argued that investors 

were generally unprepared to play a role of questioning the rating agencies’ methods. In either case, 

with little oversight of rating agencies by federal regulators, it is clear that investors were left on their 

own to question the ratings process. Whether investors were unable or unwilling to play this role, 

clearly very few questioned the rating agencies’ methods for rating subprime securities. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

34 
2.3.3 Factors Fostering Surge in Risky Lending in the 2000s 

For the most part, the antecedents to the foreclosure crisis—changes in federal laws, evolution in the 

mortgage market, and a lack of regulatory reform to keep pace with these changes—were largely in 

place in the 1990s. So another important question is what factors came together since 2000 to foster 

the high volume of risky lending that led to the foreclosure crisis. 

One commonly cited ingredient was the high demand for asset backed securities by investors from 

around the world. As described by Zandi (2008), U.S. trade deficits had left international investors 

with a flood of dollars to invest. With global investors seeking dollar-denominated investments, there 

was a surge in demand for U.S. securities markets. Between 2002 and 2006 there was a three-fold 

increase in U.S. credit market instruments held by foreigners, from $2 trillion to more than $6 trillion. 

By 2006, international investors owned nearly a third of all U.S. mortgages. The growth of hedge 

funds also contributed to rising demand, with the value of assets under management by these funds 

more than tripling from $490 billion in 2000 to $1.7 trillion in 2007 (DiMartino, Duca, and 

Rosenblum, 2007). The sharp rise in investor demand for securities was evident in trends in the 

spread between Treasury securities and junk bond and emerging-market interest rates, with risk 

premiums in these markets all but vanishing by 2006 (DiMartino, Duca, and Rosenblum, 2007). 

In part, the willingness of investors to purchase risky mortgages with relatively little risk premium 

also reflects the belief that innovations in financial market instruments were shielding them from 

default risk (DiMartino, Duca, and Rosenblum, 2007). In addition to the security provided by the 

carving up of loan pools into distinct tranches with different priorities for repayment, the development 

of collateralized debt obligations (CDOs) and credit default swaps (CDS) were designed to provide 

further layers of protection against credit losses. CDOs are essentially pools of securities, which are 

intended to further diversify investor risk. CDS transfers default risk from security holders to CDS 

sellers. CDS sellers are essentially selling insurance against defaults to holders of the actual security. 

If a default occurs, the CDS seller either takes delivery of the defaulted security at par value or pays 

the security holder the difference between par and recovery value. With the availability of CDS, 

security investors felt they had the ability to fully hedge default risk. From 2000 to 2007 the volume 

of CDS rose dramatically from $631 billion to over $45 trillion (DiMartino, Duca, and Rosenblum, 

2007). The rapid growth in both of these financial instruments also played a significant role in 

fostering the broader financial crisis that ensued from the meltdown in the residential mortgage 

market. 

But in addition to demand by investors, the surge in subprime lending was also driven by the high 

profits earned by participants at each stage of the process from origination through the selling of 

securities derived from these loans. Between 2001 and 2003, the volume of mortgages originated 

surged as efforts by the Federal Reserve to stimulate the economy led to very low mortgage interest 

rates and spurred both a refinancing boom and strong demand for new housing. According to Inside 

Mortgage Finance, in 2000 slightly more than $1 trillion in mortgages were originated; by 2003 the 

volume had nearly quadrupled to just under $4 trillion. A combination of interest rate increases and 

rapidly appreciating house prices dampened demand for new mortgages, with originations declining 

to about $3 trillion in 2004. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

35 
In order to keep origination volumes high, lenders began offering new mortgage products intended to 

stretch borrowers’ ability to afford ever more expensive homes (Joint Center for Housing Studies, 

2006). Efforts to keep origination volumes high also appear to have contributed to loosened 

underwriting standards. Fishbein and Woodall (2006) cite a variety of evidence that lenders were 

relaxing underwriting standards in pursuit of higher loan volumes, including information gathered by 

regulators about loosening credit standards by lenders as well as accounts in the popular press about 

lenders pushing the envelope on underwriting to maintain loan volumes. An analysis of HMDA data 

by Reeder and Comeau (2008) also documented a substantial increase in the share of loans with high 

mortgage payment-to-income ratios during the 2004 to 2006 period, particularly among high-cost and 

refinance loans. In addition, as noted earlier, several studies by Federal Reserve economists have 

found evidence that mortgage denial rates declined during this period more than would have been 

expected given trends in underlying borrower risk factors (Demyanyk and Van Hemert, 2008; 

Dell’Ariccia, Igan, and Laeven, 2008; and Mian and Sufi, 2008). 

Further fueling loosening underwriting standards was increased competition among lenders (Apgar, 

Calder, and Fauth, 2004). The growing use of technology at all stages of mortgage origination and 

servicing led to greater economies of scale in operation. As a result, the mortgage industry 

experienced tremendous consolidation, with the top 25 lenders accounting for more than three 

quarters of loan originations. The loosening underwriting standards since 2000 appear to have been 

driven in part by lenders seeking to maintain market share. Belsky and Essene (2008) describe this as 

a “classic collective action problem” where lenders might have been better served by enforcing more 

restrained underwriting, but to do so would result in a loss of market share and so few lenders were 

willing to unilaterally tighten lending standards. Recent Congressional hearings into the federal 

takeover of the GSEs identified a potentially similar phenomenon among these institutions, as efforts 

to maintain their market share led the GSEs to purchase risky Alt-A loans over the objections of their 

own risk managers. A review of company documents found presentations indicating that a failure to 

enter this market segment would mean they would lose relevance with their largest lender partners 

and thus relegate the GSEs to a “niche” role in the industry. In essence, efforts to maintain market 

share and profits led most participants in the mortgage market to engage in a race to the bottom in 

making risky loans. 

The final—and perhaps most important—ingredient that fostered the surge in risky lending was the 

rapid increase in housing prices in large swaths of the country through 2006. As summarized earlier, 

a number of commentators have observed that the rapid pace of house price appreciation papered over 

the increasing risks of mortgages originating in the years leading up to the emergence of the 

foreclosure crisis in 2007. In fact, as also noted earlier, the growth in risky lending seems likely to 

have fueled the dramatic rise in house prices. In short, market developments since 2000 helped create 

a self-perpetuating cycle. In pursuit of high profits, lenders and investors poured capital into ever 

riskier loans particularly after 2003. This flood of capital helped to spur rising home prices that 

masked the riskiness of the loans being made, leading to continued loosening of underwriting 

standards. Unrealistic expectations of continued high price appreciation by both borrowers and 

lenders prevented the use of prudent risk management by both parties and created an upward spiral of 

easy capital availability and demand for housing even with inflated prices. When house price growth 

finally slowed in late 2006, the true nature of these risky loans was revealed, bringing down the 

“house of cards” (Stiglitz, 2007). 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

36 
2.3.4 Contribution of Mortgage Fraud, the Community Reinvestment Act, and the GSEs 

Mortgage Fraud 

There is a general conception that fraud on the part of mortgage brokers and borrowers may have 

made a significant contribution to the foreclosure crisis. Technically, mortgage fraud is defined as 

“the intentional misstatement, misrepresentation, or omission by an applicant or other interested 

parties, relied on by a lender or underwriter to provide funding for, to purchase, or to insure a 

mortgage loan” (Federal Bureau of Investigation, 2008). There are significant challenges with 

quantifying the degree of mortgage fraud. One challenge is that there can be a blurry distinction 

between outright fraud and “creative” methods used by brokers to help borrowers qualify for a 

mortgage. One subprime lender has recounted a variety of ways that brokers could manipulate a 

borrower’s profile—in ways that may not have constituted fraud—to help meet underwriting 

requirements, such as employing quick fixes to increase credit scores, omitting co-borrowers with 

poor credit histories, or reporting only recent temporarily increased income levels (Bitner, 2008). 

Fraud is also hard to detect because it generally does not become evident until a borrower defaults on 

their mortgage, revealing the misinformation that was used to originate the loan. During periods of 

robust housing price growth, such as was experienced through 2006, many cases of fraud would be 

hidden by the ability of borrowers to refinance or sell their property to satisfy their outstanding 

mortgage (Mortgage Assessment Research Institute, 2008). 

The most commonly cited information on trends in mortgage fraud are derived from Suspicious 

Activity Reports (SARs), filed by financial institutions, including federally-insured depository 

institutions, and are utilized by several Federal agencies, including the FBI, the Financial Crimes 

Enforcement Network (FinCEN), HUD, amongst others in their efforts against mortgage fraud. 

Importantly, with significant shares of loans made by non-federally insured institutions, this reporting 

system leaves out a significant portion of the mortgage industry. But even with a large segment of the 

market excluded from this system and with strong housing price growth potentially masking many 

cases of fraud, the number of SARs grew sharply beginning in 2004 (Exhibit 11). In 2003 a total of 

6,939 SARs were filed; by 2007 this number had increased nearly 7-fold to 46,717. 

Nonetheless, the number of SARs was still fairly small relative to the number of loans originated 

annually. However, the low share undoubtedly reflects both the difficulty of identifying fraud as well 

as the limited scope of institutions reporting SARs. BasePoint Analytics, a private firm specializing 

in detecting mortgage fraud, has estimated that 9 percent of loan delinquencies are associated with 

some form of fraud (BasePoint Analytics, 2006). Thus, while mortgage fraud is certainly not a trivial 

issue, it is estimated to only account for about 1 in 10 delinquencies. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

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35 

Exhibit 11: Number of Suspicious Activity Reports Filed 

50,000 

45,000 

40,000 

35,000 

30,000 

25,000 

20,000 

15,000 

10,000 

5,000 

0 

3,245 4,210 5,609 6,936 

17,127 

21,994 

35,617 

46,717 

2000 2001 2002 2003 2004 2005 2006 2007 

Federal Fiscal Year 

Source: Federal Bureau of Investigation 

In terms of the nature of fraud, the Federal Bureau of Investigation (FBI) distinguishes between two 

types of fraud: “for profit,” mostly perpetrated by brokers and others to generate profits; and “for 

housing,” perpetrated by homebuyers with the goal of purchasing or retaining a home. The FBI 

estimates that roughly 80 percent of fraud is “for profit” and conducted by brokers and other 

professional parties to the transaction (FBI, 2007).35 Consistent with this conclusion, BasePoint 

Analytics has concluded that most fraud is driven by mortgage brokers in their efforts to earn profits 

by originating loans (BasePoint Analytics, 2007). In support of the association between brokers’ 

profit seeking motives and fraud, their analysis finds a high correlation between the incidence of 

fraud and above average interest rates and fees on loans. Further, they find that about 10 percent of 

brokers account for all the cases of fraud they uncovered in a database of 3 million loans originated 

between 1996 and 2006. 

Based both on information on fraud gathered by BasePoint Analytics (2006), the Mortgage Asset 

Research Institute (MARI, 2008), and Fitch Ratings agency (Pendley, Costello, and Kelsch, 2007), 

the vast majority of fraud involves the misrepresentation of information on loan applications related 

Of course, in some cases homeowners may be complicit in broker fraud, for example by allowing their 

income to be misrepresented so the borrower is able to either take more cash out of their homes or to 

purchase a more expensive home than they might otherwise have been able to. However, to the extent that 

the broker is helping to perpetrate the misrepresentation, the act of fraud is deemed to have been committed 

by the broker. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

38 
to income, employment, or occupancy of the home by the borrower. The growth in no- and lowdocumentation loans appears to be highly related to the growth in fraud. Based on data from both 

BasePoint Analytics and Fannie Mae, the FBI reports that the fraud rate among Alt-A loans (which 

include a very high share of no- and low-doc loans) was three to four times higher than among 

subprime and prime loans. These same sources also find that another significant share of cases of 

fraud involve appraisal misrepresentations, where property conditions are materially different than 

presented in the appraisal or information is used to derive the property value that is typically outside 

of accepted parameters. 

Ultimately, the growing incidence of fraud can be traced back to the lack of adequate underwriting 

controls by lenders to oversee brokers’ activities. A Fitch Rating Agency review of the poor 

performance of loans originated in 2006 highlighted the importance of poor underwriting 

performance and fraud in producing high rates of early payment defaults (Pendley, Costello, and 

Kelsch, 2007). The Fitch report concludes that “poor underwriting processes did not identify and 

prevent and, therefore, in effect, allowed willful misrepresentation by parties to the transactions.” 

The complicity of lenders practices in the incidence of fraud is also demonstrated by the recent 

agreement between the New York State Attorney General and Fannie Mae and Freddie Mac to adopt 

practices to ensure that property appraisals are independent and reliable.36 

The Community Reinvestment Act 

Stories and opinion articles in the popular press have identified the Community Reinvestment Act 

(CRA) as a culprit in the foreclosure crisis. CRA was passed by Congress in 1977 with the goal of 

encouraging banks to meet the credit needs of the communities in which they have branches, with a 

specific emphasis on low- and moderate-income neighborhoods. Banks are subject to reviews to see 

if they are meeting their CRA goals. Since a bank’s CRA rating is considered when banks seek to 

engage in mergers or acquisitions, CRA’s regulations are taken seriously by banks. There is fairly 

significant evidence that CRA has, in fact, resulted in an increase in credit flows to low- and 

moderate-income areas where CRA-covered institutions have branches (Apgar and Duda, 2003). 

Critics of the CRA claim that the wave of risky lending was generated in no small part by banks 

having been pushed into making these loans to meet their CRA requirements.37 While not supported 

by any in depth empirical analysis, this argument has gained enough prominence that a variety of 

newspapers have written editorials to counter these arguments.38 There is a variety of empirical 

evidence that supports the view that CRA’s requirements played little or no role in producing the 

foreclosure crisis. 

One key argument against CRA having played a significant role in the foreclosure crisis is that only a 

very small share of the high-priced loans that have been a key driver of the crisis were originated by 

CRA-covered institutions in geographic areas where they are subject to CRA assessment. A recent 

speech by Governor Randall S. Kroszner (2008) of the Federal Reserve System uses HMDA data to 

36 For details see press release from the Office of the New York State Attorney General, March 3, 2008. 

37 Gross (2008) identifies a number of sources of this criticism. One notable example is a recent editorial in 

The New York Times by Hussock (2008). 

38 See, for example, The New York Times (October 15, 2008), and The Los Angeles Times (October 25, 2008). 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

39 
document the fact that only 6 percent of higher-priced loans were originated by CRA-institutions in 

their CRA-assessment areas. With CRA-motivated loans accounting for such a tiny fraction of 

higher-priced loans it is hard to argue that CRA played a fundamental role in producing the crisis. 

Another weakness in the argument that was an important factor in the crisis is that while CRA lending 

requirements have been in force for over three decades, the foreclosure crisis is a recent phenomenon. 

In fact, the rise of the foreclosure crisis came after a period of sustained decline in the share of 

mortgage lending activity covered under the CRA. As Park (2008) documents, while between 38 and 

46 percent of home purchase and refinance mortgages originated in 1994 fell under CRA review, by 

2005 these shares had fallen to less than 25 percent. It is hard to argue that CRA produced the 

foreclosure crisis even as its influence was waning. 

Finally, there is also some evidence that loans made to low- and moderate-income homebuyers as part 

of banks efforts to meet their CRA obligations have actually performed better than subprime loans. 

In an analysis of CRA-motivated loans sold to a community development financial institution (SelfHelp), Ding, Quercia and Ratcliffe (2008) found that the default risk of these loans was much lower 

than subprime loans made to borrowers with similar income and credit risk profiles. Similarly, 

Laderman and Reid (2008) compare the foreclosure risk of home purchase loans made in California 

in 2004 and 2006 by CRA-institutions in their assessment area with loans made by independent 

mortgage companies while controlling for a range of borrower and loan characteristics. They also 

find that CRA loans were half as likely to go into foreclosure as loans made by independent mortgage 

companies. They conclude that this provides evidence that the CRA helped to ensure “responsible 

lending even during a period of overall declines in underwriting standards.” 

In short, there is little evidence to support the view that CRA made any contribution worthy of note to 

the current foreclosure crisis both because the volume of high-priced loans made to meet CRA 

requirements was very small and because CRA loans had much lower risk of foreclosure than 

subprime loans generally. 

The Government Sponsored Enterprises 

Many of the same voices in the popular press raising questions about CRA’s role in producing the 

foreclosure crisis have also argued that federal regulations requiring the GSEs (Fannie Mae and 

Freddie Mac) to devote a sizeable share of their lending to low- and moderate-income homeowners 

also played a significant role in fostering the growth of risky lending. The serious financial troubles 

of the GSEs that led to their being placed into conservatorship by the Federal government provides 

strong testament to the fact that the GSEs were, indeed, overexposed to unduly risky mortgage 

investments. However, there is evidence to suggest that the GSEs’ entry into subprime lending was 

motivated much more by efforts to chase market share and profits than by the need to satisfy federal 

regulators. 

Much of the GSEs’ troubles can be traced to their purchases of Alt-A mortgages to prime borrowers 

who provided little or no documentation of income or assets. Recent Congressional hearings into the 

causes of the GSEs financial troubles revealed a variety of information from internal documents 

suggesting that the agency’s own risk managers expressed concerns about the riskiness of these 

mortgages, but that corporate management overlooked these warnings in pursuit of profits and market 

share. For example, an internal memorandum from Daniel Mudd, Fannie Mae’s CEO, in 2005 stated 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

40 
that “the real revenue opportunity was in buying subprime and other alternative mortgages. To 

pursue this course the company would have to accept higher risk and higher volatility of earnings.”39 

While many of these risky loans would help meet the GSEs housing goals, Freddie Mac’s chief 

enterprise risk officer wrote in an internal memo arguing against purchasing these loans: “what better 

way to highlight our sense of mission than to walk away from profitable business because it hurts the 

borrowers we are trying to serve.”40 

One way in which the housing goals may have pushed the GSEs into the subprime market was by 

allowing them to claim credit toward the housing goals by purchasing mortgage-backed securities 

(MBS). Since subprime loans include a high share of low-income borrowers, purchasing the highest 

rated tranches of subprime MBS offered an easy way for the GSEs to obtain goal credits while 

seeming to minimize their risks. A Washington Post article from June 2008 presents the argument 

that the GSEs’ purchases of subprime MBS, motivated by a desire to meet their federally established 

housing goals, was a significant source of capital for the subprime market.41 The article goes on to 

argue that by spurring the GSEs to purchase subprime MBS, HUD’s housing goals may have been an 

indirect cause of the growth of subprime lending.42 

The GSEs did play a significant role as purchasers of these securities, although their role greatly 

diminished even as the market was expanding. The Washington Post article reports that the GSEs 

purchased 44 percent of all subprime securities in 2004, followed by 33 percent in 2005 and 20 

percent in 2006. The fact that the GSEs’ role as a purchaser of subprime securities was declining 

during the period when the subprime market grew most rapidly is not consistent with the argument 

that they fueled the growth of the market. Calomiris (2008) also acknowledges that non-mortgage 

backed securities also experienced shrinking risk premiums during the period after 2004, which is 

evidence that demand by investors other than the GSEs was an important part of market trends. 

Zandi (2008) argues that demand for MBS by international investors, rather than the GSEs, was an 

important factor in the growth of this market. In short, while the GSEs certainly contributed to the 

growth of the subprime market there was clearly substantial demand for these securities from a wide 

variety of investors. 

In evaluating the role of the GSEs’ housing goals in spurring the foreclosure crisis, Congressional 

hearings did not focus on the GSEs’ affordable loan programs that were designed to serve low- and 

moderate-income homeowners as a significant source of their financial woes. Rather, it is their 

purchase of Alt-A loans that has most directly been linked to their financial difficulties.43 As a result, 

there does not seem to be strong evidence that the GSEs’ housing goals played a significant role in 

spurring the growth of the subprime market in the years after 2004. Along these lines it is also 

important to note that most of the rise in homeownership since the early 1990s among low-income 

39 “Former GSE Chiefs Scolded for Careless Lending,” The Washington Post, December 9, 2008. 

40 “Internal Warnings Sounded on Loans at Fannie, Freddie,” The Washington Post, December 9, 2008. 

41 “How HUD Mortgage Policy Fed the Crisis,” The Washington Post, June 10, 2008. 

42 Calomiris (2008) also argues that the GSE purchase of subprime securities made a significant contribution 

to the growth of the subprime market. 

43 Turmoil in the U.S. Credit Markets: The Genesis of the Current Economic Crisis, Senate Committee on 

Banking, Housing, and Urban Affairs (2008, October 16) (testimony of Eric Stein). 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

41 
and minority households—whom the housing goals were intended to help—occurred prior to 2001 

and so before the substantial growth in subprime lending occurred (Joint Center for Housing Studies, 

2008). Thus, to the extent that efforts by the federal government to encourage the GSEs to extend 

credit to low-income and minority homeowners did have an impact on low-income and minority 

homeownership rates, these benefits were largely realized before the problems of the subprime 

market emerged. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

42 
3. Plan for the Final Report: Potential Policy 

Responses to the Foreclosure Crisis 

This section describes the plan for a more detailed discussion to follow in the final report on existing 

policy responses to the foreclosure crisis as well as proposals for additional measures that could be 

undertaken. The first part of this policy discussion will review efforts to address rising foreclosures. 

The second part will present options proposed by various authors that would reduce the future 

origination of mortgages with unacceptably high risk of foreclosure. The final part will present 

options proposed by various authors for more comprehensive reform of the regulatory structure 

overseeing mortgage market operations. 

3.1 Efforts to Address Rising Foreclosures 

Rising mortgage delinquency and foreclosure rates exact a tremendous toll on individual borrowers 

and their communities. Foreclosures can depress property values, lower local property tax revenue, 

and impose additional costs on cash-strapped public agencies in the form of additional police, fire and 

other municipal services needed to respond to the blighting influence that vacant and foreclosed 

properties can have on local communities. Aggressive loan modifications and expanded refinancing 

options can help mitigate these negative impacts. Similar efforts are underway to limit the eviction of 

tenants from rental properties at risk of foreclosure. 

This part briefly discusses these issues, starting with a review of current efforts to promote loan 

modifications. This is followed by a discussion of several newly proposed, and admittedly highly 

controversial, initiatives to expand the range of workout options, including more aggressive use of 

interest rate and even principal write downs to help households avoid foreclosure. The final report 

will add a discussion of the growing range of efforts to help minimize the adverse impacts that 

foreclosures are having on communities across the country as well as on renters living in foreclosed 

properties, and will make recommendations for future policy. 

3.1.1 Efforts to Enhance the Ability of Households to Remain in their Homes 

Over the past two years, there have been a growing number of efforts to engage in expanded loan 

modifications to help consumers remain in their homes. With the assistance of the U.S. Department 

of Treasury and the active participation of a consortium of banks, mortgage servicing organizations 

and other entities led by the Neighborhood Reinvestment Corporation (a.k.a. NeighborWorks 

America (NWA), the Hope Now Alliance was formed in 2007 to help keep borrowers in their homes 

by increasing their access to counseling and information and creating a unified private industry plan 

to facilitate loan workouts. Building on this initiative, in December, 2007, Congress appropriated 

$180 million to NWA, which it distributed in turn to state agencies and not-for-profit entities to 

expand the availability of foreclosure prevention counseling services in their areas. This was 

followed by an additional Congressional appropriation of $180 million to NWA in July 2008 for 

similar purposes. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

43 
44 

The Federal Government has also availed the use of the Federal Housing Administration’s (FHA) 

mortgage insurance capacity to help provide relief to financially distressed homeowners. Late in 

2007 the FHA Secure program was launched as an initial response using FHA mortgage insurance to 

replace risky subprime and high-cost loans with fixed rate, long term financing, including some 

borrowers who were delinquent on their loans due to a payment reset. However, there was limited 

take-up of this program in part due to eligibility criteria that prevented participation in this program 

for many borrowers. In July 2008 the Congress authorized FHA under HERA to insure up to $300 

billion in loans via a new program: HOPE for Homeowners (H4H). This program required existing 

lenders to accept as payment in full of the original first lien mortgage an amount equal to no more 

than 90 percent of the current appraised value of the property (87 percent after payment of the upfront 

premium to FHA) – a substantial principal write down in many cases. Although some lenders have 

expressed interest in the program, as of late 2008 the program had not insured any loans. 

Amendments have been made to increase program participation, including a reduction in the amount 

of principal lenders are required to write down in order to place a borrower in the program. 

Additional changes have been proposed in legislation that will give the FHA important flexibility in 

operating the program and should encourage more interest. 

With participation from most of the nation’s largest servicers, Hope Now members completed nearly 

3.2 million loan workouts from July 2007 through December 2008 (Hope Now, 2008). Initially, the 

majority of these workouts consisted of repayment plans, accounting more than two-thirds of all 

workouts in the first year of operations. While workouts can help some households meet their 

mortgage payment obligations, for many subprime borrowers repayment plans offer limited relief. In 

particular, these plans, by definition, place additional debt repayment obligations on households 

already struggling to make mortgage payments. The problem is even more severe for those 

borrowers with an “underwater” mortgage, namely a situation where the value of the property 

securing the mortgage is less than the amount of their outstanding mortgage debt and deferred 

payment obligations. Indeed, with home prices falling rapidly in many market areas, one widely cited 

estimate is that as many as one in six households with a mortgage are “underwater and it appears that 

a growing number of delinquent owners are simply ‘sending the keys back to the lender,’” and 

accepting the consequences of entering into foreclosure.44 

Loan modifications that include interest rate and/or principal reductions represent the most powerful 

tool for keeping borrowers in their homes, yet they pose difficult issues for investors in these loans. 

Avoiding foreclosure related costs can save investors in the range of $50,000 per property, yet many 

lenders are reluctant to gain a reputation for reducing interest or principal on loans for fear that all of 

their customers will seek interest or principal reductions independent of whether or not they are 

capable of meeting their mortgage payment obligations. The best available information, however, 

suggests that only a relatively small fraction of households with loans that are currently underwater in 

fact “ruthlessly” choose to default on a loan that they could afford to pay. Support for interest and 

principal write downs is also limited by concerns about the moral hazard of forgiving debt on 

homebuyers who overstretched, which may encourage more excessive borrowing in the future. 

See Moody’s Economy.com as published in The Wall Street Journal, Oct 8, 2008 (“Housing Pain Gauge: 

Nearly 1 in 6 Owners ‘Under Water.’”). 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

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45 

Based on data reported by Hope Now, servicers initially seemed reluctant to pursue loan 

modifications. Among other things, many servicers lack the capacity to handle the workload 

associated with elevated requests for loan modifications and write downs. In any event, servicers 

have contractual obligations to investors to comply with a series of preset decision making protocols 

that can limit their flexibility to engage in aggressive loan modification efforts (Eggert, 2007). In the 

face of these competing interests, there has been rising public pressure on investors and servicers to 

engage in more aggressive loan modifications to keep more borrowers in their homes. Since mid2008, Hope Now has reported an increasing number of loan modifications by its participating 

servicers. From July through December 2008 nearly half of the loan workouts reported were loan 

modifications rather than repayment plans. 

Yet to date it appears that most of the loan modifications that have been offered have not reduced 

monthly payments. For example, based on an examination of a data from a large cross section of 

subprime loan servicers, Allen White (2008) found that voluntary loan modifications of subprime 

borrowers completed through August 2008 typically increased a borrower’s principal debt and 

virtually none involved a reduction in principal owed. While servicers did seem willing to lower 

mortgage interest rate, a recent assessment of the Hope Now Alliance program by the Center for 

Responsible Lending (CRL) estimated that only 1 in 5 of all subprime workout plans actually lowered 

monthly mortgage payments for financially distressed borrowers (CRL, 2008). 

In December 2008 FDIC Chair Sheila Bair called for more aggressive loan modifications that 

combine both interest rate reduction and principal reduction to enable delinquent borrowers to obtain 

a 30 year fixed-rate mortgage while paying no more than an affordable 31 percent of income.45 She 

argues that such aggressive restructuring is required to fundamentally change the unsustainable terms 

of the mortgage and make the loan affordable to the borrowers over the long term. 

At the same time, Mason (2007) cautions that there are risks associated with more aggressive use of 

loan modifications as a foreclosure reduction strategy. Loan modifications can prove effective for 

those households with good incomes and limited amounts of other debts. But inappropriate loan 

modifications can also prove harmful, especially as a remedy for those subprime borrowers with 

heavy mortgage and other debt payments. Mason’s main theme is that inappropriate loan 

modification can simply draw unsuspecting borrowers deeper into debt and lead to an even bigger 

default later. In these cases, many borrowers unable to afford homeownership may be better suited 

by relocating to more affordable rental housing rather than chase what Mason labels as the 

“unobtainable chimera of homeownership.” 

The evidence suggests that in the past many of the modifications that have been offered have not been 

sustainable. Even as the number of modifications increases, a growing share of recently modified 

loans is now re-defaulting. According to the joint OCC and OTS 3rd Quarter Mortgage Metrics 

Report, some 37 percent of recently modified loans were 60 days late just six months after the initial 

modification. As noted above, however, few of the modifications offered to date have actually 

reduced monthly payments. 

Remarks by FDIC Chairman Sheila Bair to The New America Foundation conference: "Did Low-income 

Homeownership Go Too Far?": Washington, DC, December 17, 2008. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

45 
Most recently, the federal government announced a new effort to encourage meaningful loan 

modifications as part of its Homeowner Affordability and Stability Plan (HASP) on February 18, 

2009. This plan is designed to offer assistance to seven to nine million homeowners making goodfaith efforts to stay current on their mortgage payments. It provides access to low-cost refinancing 

that will reduce monthly payments for four to five million homeowners who owe more than 80 

percent of their home value and whose mortgages are owned or guaranteed by Fannie Mae or Freddie 

Mac. The plan also commits $75 billion through the Treasury Department, working with the GSEs, 

FHA, the FDIC and other agencies, to undertake a multifaceted strategy to achieve loan modifications 

for up to three to four million at-risk homeowners to help them stay in their homes. This $75 billion 

plan provides an assortment of financial incentives to encourage servicers, investors, and borrowers to 

enter into sustainable loan modifications. 

This homeowner stability initiative is intended to reduce mortgage payments to 31 percent of income 

as a way to help those borrowers in imminent danger of default. HASP aims to achieve this goal 

primarily through subsidizing interest rate reductions, though the program does provide servicers and 

investors with the option of reducing outstanding principal balance as a means of achieving the 

31 percent payment-to-income target. 

3.1.2 Efforts to Enable More Aggressive Loan Modifications 

While the greater use of interest and/or principal write downs may be needed to help stem 

foreclosures, the ability of loan servicers to offer such write downs can be stymied by the complex 

way foreclosure-prone subprime loans were initially securitized, “sliced into pieces” and sold to 

diverse investors around the world. More than three quarters of all subprime loans are now held in 

mortgage backed securities. Loan servicers, acting as fiduciary agents for investors and bond 

insurers, collect payments from borrowers and funnel these payments through to investors. These 

contracts—called pooling and servicing agreements, or PSAs—define the rules concerning how 

servicers address delinquencies and use of loan modification tools. 

Adding to the complexity is the fact that owners of different risk tranches of a single mortgage pool 

may be differentially impacted by a proposed mortgage modification or other change in the terms of 

individual mortgages in the pool. Thus, many servicers have been reluctant to offer interest rate 

reductions or principal write downs. In part this reflects concerns that existing PSAs may limit the 

ability of servicers to engage in loan modification activities that involve mortgage write downs. Yet 

at the same time, many of these agreements contain inconsistent, and arguably not enforceable, 

language as to what actions are permissible under the contracts. HASP offers subsidies for interest 

rate reductions, provides bonus payments for successful modifications to lenders and borrowers, and 

creates clear industry-wide standards on how best to interpret these PSAs: thus, the expectation is that 

HASP will encourage wider use of loan modification tools. 

There remains concern that the HASP approach, on its own, is not sufficient to address all situations. 

For some borrowers, the subsidies provided through HASP will not be sufficient to allow them to stay 

in their homes. Some of these borrowers may be helped through an improved Hope for Homeowners 

Program. But many have argued that bankruptcy reform is needed to allow bankruptcy judges to 

modify mortgages for families who have run out of other options. Some worry too that there may be 

remaining ambiguities in PSA language that will limit the willingness of servicers to participate in the 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

46 
HASP plan. In light of these concerns, some have called for “safe harbor” rules to protect servicers 

from the threat of litigation as the industry works out the extent to which modifications are consistent 

with the contractual language in existing PSAs. Other proposals call for changes to the Real Estate 

Mortgage Investment Conduit (REMIC) rules. Yet each of these proposals also has its critics, 

including those who suggest that it is inappropriate to retroactively intervene to override the language 

of existing contracts. 

Proposed Legislative Changes to REMIC Rules 

Recognizing both the complexity and variability of pooling and servicing agreements now in force, 

the extent to which existing agreements limit servicer discretion concerning the use of loan 

modification tools remains somewhat unclear. Yet there is growing consensus that the rules 

governing securitization can and do limit the flexibility of servicers to pursue modifications, even in 

situations where an aggressive modification would benefit both the borrower and investors. To 

address this issue, Michael Barr and James Feldman (2008) have proposed legislation that would 

provide servicers with both the legal authority and the appropriate incentives to take distressed loans 

out of securitized pools and loan portfolios and sell them to the U.S. Department of Treasury or 

another public purpose organization so that the loan can be restructured or refinanced. 

Moreover, because selling mortgage loans to congressionally authorized programs would advance 

important public interests, Barr (2008) further propose that Financial Accounting Standards Board 

(FASB) should modify its Statement 140, which provides accounting rules governing qualified 

special purpose entities such as certain mortgage-backed securitization trusts. Barr agues that 

modifying FASB Statement 140 could provide servicers with further legal comfort in broadly 

modifying and selling mortgage loans under appropriate mortgage restructuring programs while not 

conflicting with the underlying purposes of this rule. 

Proposed Bankruptcy Reform 

Recognizing that restructuring the terms of a mortgage and mortgage security involves the interests of 

the borrower and potentially scores of distinct investors, not to mention the interests of the public at 

large, some argue that these matters are best left to a judicial process. Yet under current law, 

bankruptcy courts are not authorized to modify the terms of primary mortgages of consumers who file 

for bankruptcy protection, even though such approaches are common in efforts to resolve delinquency 

situations involving commercial real estate. 

Proponents of bankruptcy reform legislation argue that by altering the payment schedule, reducing the 

contract interest rate, or reducing the amount of principal owed, these loan modifications would 

enable borrowers to remain in their home by lowering (and in the case of adjustable rate loans, 

stabilizing) their monthly payment to an affordable amount. This not only avoids the costly 

foreclosure process and benefits delinquent homeowners, but it also benefits mortgage 

servicers/investors if the net present value of the future cash flows from the modified loan exceeds the 

net present value that could be realized via foreclosure. Under current law, similar modifications can 

be applied to loans secured by cars, boats, second homes and vacation home, but not by the debtor’s 

principal residence. As a result, the legislation would not set a new precedent but simply would 

extend to homeowners the same protections in bankruptcy that are now afforded to family farmers, 

corporations, or others who own investment properties. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

47 
Legislation was introduced in the House in 2007 to grant bankruptcy judges the authority to reduce 

outstanding principal balances. This proposal led to the release of a number of studies designed to 

estimate the impacts of bankruptcy reform on homeowners, servicers/investors and the mortgage 

market. Though estimating the market implications of such a complex change in rules governing 

bankruptcy is admittedly difficult, White and Zhu (2008) developed a model and estimated that 

allowing for mortgage write downs in bankruptcy could enable an additional 100,000 families to save 

their homes from foreclosure. In addition, the Center for Responsible Lending predicted that 

allowing bankruptcy judges to mandate principal write downs would encourage loan servicers and 

investors to more aggressively pursue loan modifications and mortgage write downs prior to the 

commencement of bankruptcy proceeding (Twomey, 2008). 

Opponents from the mortgage industry, among others, argued that allowing bankruptcy judges to 

change the terms of the mortgages would interfere with the sanctity of contracts, would encourage 

homeowners to file for bankruptcy to escape mortgage debts, would clog the courts with hundreds of 

thousands of bankruptcy cases, and would cause lenders to tighten lending standards raising the cost 

of mortgage credit for all homebuyers and homeowners (Labaton, 2008). 

This last objection—namely that allowing judicial modification of loans as part of bankruptcy 

proceedings will raise mortgage costs for future borrowers—has emerged as perhaps the most hotly 

contested issue of the debate. While it seems likely that such a change could raise mortgage rates in 

the future, there is considerable disagreement as to the magnitude. The Mortgage Bankers 

Association asserts that judicial modification of primary home loans as specified in HR 3609 would 

raise mortgage rates by 150 basis points (MBA, 2008). In contrast, using mortgage market data from 

the period following previous legislation that first eliminated home mortgages secured by primary 

residences from being eligible for mortgage modifications, Levitan and Goodman (2008) argue that 

the market effects of the proposed reversal of these rules would be modest. Levitan and Goodman 

also note that there is no difference today between the mortgage rates charged for owner-occupied 

two-family homes where judicial modifications are allowed in bankruptcy proceedings and for 

owner-occupied single family homes where judicial modifications are not allowed. 

3.1.3 Efforts to Reduce the Negative Impact on Communities 

Not only is stemming the tide of foreclosures important to the well being of millions of at risk 

households, reducing the flood of foreclosed properties onto today’s housing market is critical to 

efforts to help stabilize home prices and to halt the resulting loss of housing wealth. Though 

aggressive mortgage write downs can help many borrowers remain in their homes, in many instances 

foreclosure is unavoidable, and the best option is to encourage the owner to sell the home, or 

otherwise convert the property to rental occupancy. In weak market areas where the cost of pursuing 

a foreclosure exceeds the likely amount recouped from the sale of the foreclosed property, often both 

the owner and the lender “walk away” from the property in that they do not even bother to complete 

foreclosure actions or to record the outcome of any foreclosure sale. In these instances the outcome 

often is an abandoned property with a title in legal limbo. 

It is obviously difficult to disentangle the effects of foreclosures from the effects of the collapse of the 

housing bubble since 2006. It seems clear, however, that the two reinforce one another—the collapse 

in house prices has increased the number of foreclosures and the increase in foreclosures has further 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

48 
exacerbated the decline in house prices. By the end of 2008, this vicious cycle was being further 

reinforced by the onset of a severe recession and associated widespread job losses. Consistent with 

the forecasts of a deepening recession, forecasts of the likely number of foreclosures grew equally 

more pessimistic. Indeed, one widely cited estimate suggests that home foreclosures could top 8 

million before the current economic downturn has run its course in 2012 (Credit Suisse, 2008). 

In addition to direct costs, the rise in foreclosures can impose a wide range of “collateral damage” on 

communities. In a recent review of the literature on community impact of foreclosure, Alan Mallach 

(2008) identified several types of damage: 

• Diminution of the value of surrounding properties; the more foreclosures in the 

immediate vicinity, the greater the loss of value; 

• Destabilized economic and social conditions in the neighborhood; and 

• Imposition of additional cost burdens on state and local governments, while reducing the 

revenues available to those entities. 

Though local efforts have been underway for several years, the major federal initiative to address 

these adverse impacts of foreclosure on states and localities was the Neighborhood Stabilization Act, 

introduced as H.R.5818 in April 2008 and enacted into law as part of the HERA legislation. Dubbed 

the Neighborhood Stabilization Program (NSP), Congress appropriated $3.92 billion and authorized 

heavily impacted states and localities to work to mitigate the adverse impacts of foreclosures by 

acquiring, rehabbing, or converting to rental or other use foreclosed or vacant residential properties. 

Recognizing that many areas had more foreclosed and vacant properties than could be productively 

reused, the legislation also authorized the demolition and possible land banking or longer term 

redevelopment of sites created through demolition of blighted properties. The recently passed 

American Recovery and Reinvestment Act includes an additional $2 billion to support neighborhood 

stabilization activities. 

3.1.4 Efforts to Protect Renters Affected by Foreclosures 

The damage from today’s mortgage foreclosure crisis reaches deep into the rental market. Numerous 

studies document that many of the properties facing foreclosure -- including single-family homes and 

small multifamily properties -- are occupied by renters. For example, Harvard’s Joint Center for 

Housing Studies estimates that by the end 2007, one out of every five foreclosure actions nationwide 

involved absentee owners of one to four family rental properties (Joint Center for Housing Studies, 

2008). According to another 2008 study by the National Low Income Housing Coalition of twenty 

metropolitan areas, roughly 40 percent of the recent foreclosures nationwide are on properties likely 

to be occupied by renters, namely non-owner-occupied single family and multifamily rental homes 

(Pelletiere and Wardrip, 2008). Pelletiere (2009) also demonstrates that given the geographic 

concentration of multifamily foreclosures in urban communities, these foreclosures are 

disproportionately affecting low-income and minority renters. 

Under current law, foreclosure generally leaves renters at risk of eviction -- regardless of whether or 

not they paid their rent on a timely and regular basis. Given the limited supplies of affordable rental 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

49 
housing, many housing advocates argue that foreclosure related evictions will add greatly to the rental 

cost burden and in extreme instances leave the evicted tenant homeless. On the other hand, the 

effects of a weak economy on rent levels as well as the increase of rental stock from transferring 

single-family from owner-occupied to rental (due to the poor sales of single-family homes) may 

mitigate these effects. Unfortunately, data that traces the post-foreclosure occupancy status of 

families is extremely limited although there is clearly a potential for a large number of low-income 

households to experience stress from displacement or post-eviction rent increases. Advocacy 

organizations have conducted surveys of individuals seeking assistance from homeless shelters or 

other housing assistance program and gathered information from individuals who call into foreclosure 

avoidance hotlines. While many of these studies are anecdotal in nature, they suggest that the 

ongoing foreclosure crisis combined with increasingly weak economy will exacerbate the economic 

stress of low-income families and individuals. 46 

Since the foreclosure crisis emerged several years ago, local and state governments have undertaken a 

variety of initiatives to protect renters from foreclosure related evictions. Though tenant protections 

vary from one state to the next, the foreclosure process generally overrides existing rental lease 

provisions. In general, this results from a state’s "first in time, first in right" laws, which maintain 

that if the mortgage was recorded before the tenant signed the lease, then the lease becomes obsolete 

if the property enters foreclosure. There are several exceptions to this rule, including recipients of 

Section 8 vouchers and tenants living in rent controlled units, who are able to maintain their leases 

after foreclosure by law. In addition, a growing number of states (including the District of Columbia, 

Massachusetts, Minnesota, New York, New Jersey, and New Hampshire) require "just cause" as a 

condition for eviction. These laws protect renters by ensuring that landlords can only evict with 

proper cause, such as not paying rent on time. In general, foreclosure does not count as a "just cause" 

to justify eviction in these locations.47 

Increasing the requirements for providing notice to tenants of a pending foreclosure constitutes 

another approach to protecting tenants from the adverse consequences of eviction. In many instances, 

renters may not have any warning that the property they are living in is going through foreclosure 

until they receive a notice of eviction. The new property owner (typically the mortgage lender) can 

evict the occupants with as little as 3 days notice in some states. A number of states (including 

Minnesota and Rhode Island) have enacted or are considering policies to ensure that tenants receive 

warning of a pending foreclosure and to extend the period that tenants can remain in the home after a 

foreclosure. 

Finally, various federal proposals for comprehensive foreclosure mitigation efforts include special 

provisions to protect renters. For example, HR 3915, “The Mortgage Reform and Anti-Predatory 

Lending Act of 2007,” would not only address homeowner protections, but would provide that 

foreclosures would generally not override tenant leases and that month-to-month tenants would be 

entitled to 90 day termination notice. In light of the growing federal concern some investor/servicers, 

46 For an overview on what is known about what happens to displaced tenants, see Wardrip (2008). 

47 For a comprehensive review of state and local tenant protections, See National Low Income Housing 

Coalition, 2008, “State-by-State Tenant Foreclosure and Eviction Practice,” Briefing Document prepared 

July 23, 2008. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

50 
including Fannie Mae, have recently announced that they are suspending tenant evictions pending the 

outcome of new federal regulations governing this matter. 

3.2 Efforts to Reduce the Risk of Unacceptably High Rates of 

Mortgage Foreclosures in the Future 

While many factors have undoubtedly contributed to the recent rise in foreclosures, as discussed 

earlier, no small part of the increase stems from recent increases in abusive forms of subprime 

lending. In particular, the fact that relatively high shares of loans end in foreclosure less than two 

years after origination is a clear indication that many, though not all, such loans were made with little 

regard to borrowers’ actual ability to repay. In the final report, this section will review a series of 

initiatives designed to improve the functioning both of the primary and secondary market, and in 

doing so to reduce the number of foreclosure-prone loans before they are made. 

3.2.1 Expanding the Ability of Consumers to Make Wise Choices 

In the face of aggressive push marketing by subprime lenders over the past decade, there were 

numerous efforts to expand homeowner counseling and promote consumer awareness of truly abusive 

lending practices. Consumer awareness campaigns, including “Don’t Borrow Trouble Campaign” 

initiated by Freddie Mac, were designed to help unsuspecting buyers and borrowers from falling prey 

to abusive lenders. Implicitly, these efforts are built on a presumption that once provided with 

information about alternative loan products, consumers will act “rationally.” Yet frequently the 

underlying assumptions behind the presumption of rationality can lead to a distorted view about how 

consumers behave and a faulty basis for generating effective policy approaches that can help 

consumers avoid falling victim to abuse in the mortgage market. 

Essene and Apgar’s (2007) research on consumer behavior provides evidence that many consumers, 

including many who had access to traditional mortgage counseling and the information distributed 

through consumer education campaigns, took out mortgages that they did not understand or that were 

not suitable for their needs. In particular, they find evidence that efforts to educate consumers are all 

too often overwhelmed by aggressive mortgage sales and marketing efforts that exploit various 

consumer decision making weaknesses. Notably, some mortgage market participants use their 

knowledge of consumer decision making tendencies to aggressively market specific mortgage 

products that may not be in the best interest of the borrower. Instead of supporting informed choices, 

aggressive and misleading marketing can play on consumer fears and lack of knowledge. 

Unfortunately, even the best designed education and outreach efforts can be easily swamped in a 

marketplace characterized by aggressive outreach in which some sophisticated and abusive subprime 

lenders promise to approve a mortgage application in a matter of hours, if not minutes, even for 

borrowers with ‘bad credit.’ In the face of this marketing onslaught many community groups and 

counseling organizations are taking a more aggressive approach and expanding their capacity to work 

with buyers individually to search for the best mortgages. Of course, for such a service to be helpful, 

community groups must keep abreast of mortgage market trends and developments in mortgage 

products, and must be recognized by potential borrowers as a trusted source of information. Indeed, 

some community groups already operate a mortgage brokerage business with the explicit goal of 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

51 
using their good standing in the neighborhood to become a ‘buyer’s broker,’ while at the same time 

earning a small fee for offering this service like any other mortgage broker. 

Borrowing from the automobile blue books, other local counseling agencies make mortgage ‘rate 

sheets’ available to recent graduates of home buying courses, participants at fairs, or any homebuyers 

interested in purchasing a home in their area. Armed with knowledge of their credit score, income, 

and other characteristics, borrowers use these rate sheets to help shop for the best product and to 

better evaluate unsolicited offers. Working to enable borrowers or their trusted advisors to be better 

shoppers and resist such marketing practices would go a long way to not only reducing the incidence 

of predatory lending, but also to stemming the growth of foreclosures that inevitably follow in the 

wake of these same predatory lending practices. 

Barr, Mullainathan, and Shafir (2008) suggest applying the “opt-in/opt-out” principle identified in the 

consumer behavior literature to structure more effective mortgage marketing of “good loans,” that is 

loans that are fairly priced and that consumers can understand and afford to repay over the life of the 

loan. For example, many programs first offer a prospective consumer a “safe” level payment fixed 

rate mortgage priced in an affordable manner. By starting with the default option of offering a simple 

and safe product, this approach builds on the observations that consumers often latch onto the first 

option for which they qualify. Those borrowers who meet a certain set of criteria, e.g. lower income 

to housing expense ratio, could be allowed to “opt out” of this requirement, a feature that would still 

allow for mitigating circumstances of some borrowers, but research shows that such an approach is 

more likely to help consumers make choices that are more likely to be in their (and society’s) long 

term interest. 

3.2.2 Legal and Regulatory Efforts to Ban Deceptive Lending Practices 

While expanding the range of consumer counseling and consumer assistance efforts is likely to be 

helpful, it may also be important to more forcefully counteract aggressive marketing practices and 

consider banning inherently deceptive loan features. Moreover, since the mortgage market will 

continue to create new products, efforts to ban specific loan terms or mortgage products may not keep 

pace with these innovations. Therefore, focusing on efforts to reform the mortgage lending process 

itself is an equally important strategy. 

Disclosure is the major form of regulation for most home mortgages in the United States. The Truth 

in Lending Act (TILA) requires lenders and brokers to disclose the total finance charge and Annual 

Percentage Rate (APR) of loans. The Real Estate Settlement Procedures Act (RESPA) mandates the 

disclosure of closing costs for home mortgages. In addition, all mortgage lenders must comply with 

the Home Ownership and Equity Protection Act (HOEPA) of 1994, which regulates a number of 

practices, including balloon clauses, loans without regard to the borrower’s ability to pay, negative 

amortization, prepayment penalties, and abusive refinancing. In addition, lenders who make HOEPA 

loans must provide special Truth in Lending disclosures to loan applicants in advance of closing. 

Finally, consumers are also covered by a patchwork of state and federal anti-predatory lending laws. 

In July 2008, some minor elements of anti-predatory lending reform were included in the HERA 

legislation, along with the act’s major reforms of the programs and the oversight of the FHA, the 

GSEs and the Federal Home Loan Bank System. HERA also included the Secure and Fair 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

52 
Enforcement (S.A.F.E.) for Mortgage Licensing Act, which provides for a nationwide mortgage 

licensing system and registry for all State-licensed mortgage originators. This Act is intended to 

enhance consumer protections and reduce fraud by establishing more consistent licensing 

requirements and oversight of all mortgage lenders. In the same month, after considerable prodding 

by Congress to more aggressively utilize existing legislative authority, the Federal Reserve Board of 

Governors issued new rules that would more broadly ban unfair and deceptive mortgage practices and 

improve TILA disclosures, while in November HUD issued new RESPA rules designed to increase 

transparency and enable all borrowers to get firm price quotes on loans and settlement services in 

order to comparison shop. 

But even while applauding these initial efforts, many consumer advocates argue that additional 

reform is needed. Among areas of greatest concern are efforts to limit or ban yield spread premiums, 

which provide brokers and loan officers with incentives to sell borrowers on higher priced loans, and 

prepayment penalties, which lock borrowers into high priced loans and expose them to high fees if 

they need to refinance or sell their homes. There are also proposals to develop new standards for 

truth-in-lending so that mortgage brokers and lenders do not have incentives to get around disclosure 

rules. Under this approach, federal regulators would evaluate whether a creditor’s disclosure was 

objectively unreasonable, in that the disclosure would fail to communicate effectively the key terms 

and risks of the mortgage to the typical borrower. 

Details of these legislative and regulatory initiatives to counter deceptive lending practices will be 

presented in the final report. 

3.3 Comprehensive Mortgage Market Reform 

Arguably, failure of federal regulation to adapt to the rapid changes in both the primary and 

secondary market was a key element in the explosion of high risk lending and resulting surge in 

mortgage delinquency and default. Over the past several decades, Federal legislation and regulation 

focused much of its energy on regulations that related to deposit-taking institutions, including major 

commercial banks and thrifts as well as thousands of smaller deposit taking institutions. For these 

federally supervised institutions, teams of examiners review loan level records including HMDA 

reports. Examiners also check for lending discrimination, and the degree to which the lender 

evaluates the borrower’s ability to repay the mortgage. 

This detailed loan level review did not extend to the growing number of nonbanks chartered by states 

and not subject to federal supervision, nor even to the many mortgage banking affiliates and 

subsidiaries of federally regulated banks and thrifts. Similarly, while much attention was given to 

oversight of the GSEs, increasingly capital was flooding into the mortgage markets through lightly 

regulated (or even entirely unregulated) Wall Street conduits. The uneven regulation and supervision 

left what one former Governor of the Federal Reserve Board described as a “gigantic hole in the 

supervisory safety net” (Gramlich, 2007). 

3.3.1 Efforts to Promote Uniform Regulations in the Primary Market 

Since the boom and bust of the subprime market was led by non-bank institutions and less fully 

regulated affiliates and subsidiaries of banks, in large measure the nation’s regulatory mechanisms 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

53 
may have been focused on the wrong parts of the system. To realign regulation with today’s 

organization of financial services, greater uniformity of regulation is needed across the lending 

practices of all segments of the mortgage industry and its regulators. Reforms could reduce the 

incidence of nonbanks or bank affiliates and subsidiaries playing by different rules and could 

encourage hands-on oversight to improve fair lending enforcement and compliance monitoring. 

An example of harmonizing the rules for all loan originators could be reform of the Community 

Reinvestment Act (CRA). Such reform would involve expanding the current onsite reviews and 

detailed file checks now performed on assessment area lending of CRA-regulated entities to all 

mortgage lending activities. Most importantly, CRA could be expanded to cover independent 

mortgage banking operations and other newly emerging non-bank lenders. 

3.3.2 Secondary Market Reform Initiatives 

As with regulation of the primary market, it is important to take note of the lack of uniformity in the 

regulation of secondary market participants. The Federal Housing Enterprise Financial Safety and 

Soundness Act of 1992 established a complex regulatory framework for Fannie Mae and Freddie 

Mac. Under this system, the Office of Federal Housing Enterprise Oversight was created to oversee 

safety and soundness regulation of these two GSEs, while HUD was charged with “mission 

regulation,” or the task of overseeing the extent to which the GSEs helped to expand access to 

affordable housing for the nation’s lower-income individuals and communities. 

At the time the legislation was enacted, the subprime sector barely existed and the secondary market 

for subprime loans was just emerging. Many of the new secondary market institutions and capital 

market instruments that became the mainstay for funding subprime mortgages did not exist. Similar 

to potential regulatory changes for the primary market, the changes in mortgage industry structure and 

the emergence of new mortgage delivery channels imply that federal oversight of the secondary 

markets must adjust as well. 

As a result of the above, Fannie Mae and Freddie Mac are subject to extensive federal oversight; 

however, most of the funding for the subprime market had been flowing through the lightly regulated 

private label mortgage backed securities market. Though the Securities and Exchange Commission 

(SEC) is charged with the responsibility of monitoring the wide range of security transactions linked 

to the subprime sector, the degree of due diligence in this sector falls short of the more extensive 

oversight review of the GSEs. Developing a new and comprehensive regulatory structure for the nonGSE segment of the secondary mortgage market will be important. 

In considering how best to regulate the GSEs and other secondary market participants, it is important 

to place these issues in the boarder context of how the capital markets channel investment dollars into 

the subprime mortgage market. Just as is the case in the primary market, the development of detailed 

secondary market regulations that apply to only one segment of the marketplace can be both 

counterproductive and unfair. Considering how best to reduce the tendency for capital used to fund 

higher-priced mortgages to flow through less regulated capital market channels is a worthy addition 

to the current debate on GSE reform in particular, and on capital markets in general. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

54 
The recent enactment of GSE regulatory reform under the 2008 HERA legislation and subsequent 

placement of Fannie Mae and Freddie Mac into conservatorship make examination of the broader 

issues relating to the regulation of the secondary mortgage market in general a high priority. A more 

detailed discussion of policy options in this area will be presented in the final report. 

Interim Report to Congress on the Root Causes of the Foreclosure Crisis 

55 
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