1. Causes of the Foreclosure Problem

There are two major reasons for the recent growth in foreclosures: a decline in housing prices and the growth in subprime and non-traditional loans.

• Declining home prices: Studies show home equity is the biggest predictor of the likelihood of foreclosure. Owners with little or no equity have less incentive to try to hold onto their property, especially when economic shocks, such as a job loss or divorce, make it difficult or impossible to stay current on their payments. The long term trend in the mortgage industry over the past 20 years to lower downpayment requirements to 0-5% has meant that more owners started out with little equity or refinance into loans with low equity, making them vulnerable to declines in home prices.




• Rise in use of subprime and non-traditional loans: Homeowners with subprime loans are the most vulnerable to foreclosure and make up the majority of borrowers in which foreclosure proceedings have begun. According to Mortgage Banker Association data for the third quarter of 2007, subprime loans made up 13% of all loans but 55% of foreclosure proceedings started, while prime loans made up 78% of outstanding loans and 36% of foreclosure starts.

Subprime borrowers are vulnerable because of the way their loans were structured and underwritten. Many times, these loans started out with higher interest rates and fees than prime loans, were often underwritten without full income or other documentation, and served borrowers who tended to have weaker credit scores. In addition, two-thirds are adjustable rate mortgages (ARMS) with interest-rate re-sets that will increase monthly payments by 25-30% or more, depending on changes in key interest indices. However, as a recent report by a multi-state Foreclosure Working Group noted, resetting rates have "not been the largest cause of foreclosures... a large percentage…have become delinquent prior to any rate increase…these loans were simply unaffordable from the outset."

2. Foreclosure Process

Foreclosure laws vary by state, but the basic sequence of events is fairly consistent nationwide. Under most mortgages, borrowers are required to make regular (usually monthly) payments to a loan servicer (either the lender or another institution). If the payment is 15 days late or more, the owner may be charged a late fee.

• Default: If the payment is 30 days or more late, the mortgage is considered to be in default. The servicer then files a Notice of Default and sends a letter to the borrower stating that the loan is in default and what the borrower must do to make the loan current.




• Foreclosure Petition: If no arrangements are made with lender, when mortgage payments are 90 days late, the lender generally begins the legal process to force the sale of the property. Foreclosures are costly, both in terms of losses on the loan taken by the lender and processing costs. Loan servicers also lose fees when mortgages are foreclosed. Studies estimate losses average $26,000 or more when all parties involved, including the owner and the local government, are considered.

3. Evolution of Subprime Lending

Subprime lending began growing in the mid-1990s and grew more rapidly through 2005, as purchasers of securitized prime and government guaranteed mortgage securities began to seek higher returns. This enabled subprime originators to grow since they didn't have to hold the loans. As studies have noted, "fair and responsible" subprime lending has helped low and moderate income households become homeowners and build assets and helped to strengthen previously underserved neighborhoods, but in the past five years, subprime lending increasing involved risky and sometimes predatory nontraditional loan products (e.g. interest-only, "stated income" and hybrid adjustable rate products). Subprime lending peaked in 2004-2006 when it accounted for 10-15% of all purchase mortgages. However, as of 2002, most subprime loans (about 80%) were cash-out refinances rather than initial purchase.

• Massachusetts accounts for 2-3% of all subprime mortgages nationwide, putting it in the top 15 states nationwide in terms of state's share of total subprime mortgages nationwide (California's share is 25%).




• The Government Sponsored Enterprises (GSEs) held $168 billion or less than 10% of the estimated $2 trillion in subprime mortgages outstanding as of mid-2007 through Fannie Mae ($47.2 billion) and Freddie Mac ($120.8).

Definition of Subprime loans There is no consistent definition of subprime loans. Many studies define them in terms of the loan originator, using a list of subprime lenders maintained by the U.S. Department of Housing and Urban Development (HUD).

A recent study by the Federal Reserve Bank of Boston also noted that definitions focus on borrower and loan characteristics and that subprime borrowers "typically refers to borrowers who have a credit score (FICO) below 620 or has been delinquent on some form of debt in past 12-24 months (pre-mortgage) or filed for bankruptcy in last few years. Many loans were written without income documentation or verification (more than half of 2006 subprime loans were "stated income" loans). Many involved no downpayment or didn't meet GSE underwriting standards.

The Massachusetts Division of Banks (DOB) has a definition (issued on January 20, 2008 for the purpose of implementing the State's foreclosure prevention bill) based on loan terms. It defines subprime as an adjustable or variable rate loan that:

• Is a first lien mortgage that is within GSE (Fannie Mae and Freddie Mac) loan limits but doesn't conform to GSE underwriting requirements or is over GSE loan limits and has an APR more that 2.5 points above the yield on a US Treasury security of comparable maturity; or




• Is secured by a second lien on the property and has an APR more than 5 percentage points above the yield on a US Treasury security of comparable maturity.

4. Evolution of Delinquency/Foreclosure Problems

• Delinquencies and foreclosures began to rise as housing prices stagnated and fell, with much of the rise involving subprime mortgages, especially those underwritten in 2005-2007.




• About two thirds of subprime mortgages were adjustable rate mortgages (ARMs) and subprime ARM delinquency rates have been much higher than other subprime products (12.4% vs. 5.8% per FRB as of December 2007). The problem is expected to grow as 2/28 and 3/27 ARMs (i.e. adjustments after 2 or 3 years) reset with interest rate increases of 6% or more (above average initial rate of 8.5%), although some increases have been smaller due to falling interest rates.




• Delinquencies and foreclosures also have hurt renters since multi-family properties have been defaulting at twice the rate of single family properties.




• Delinquency and foreclosure rates for conventional, prime mortgages have also been rising.

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