Rather than subprime or lair loans being the culprits, Mr. Liebowitz illustrates that zero equity lead to the mortgage meltdown.

The evidence from a huge national database containing millions of individual loans strongly suggests that the single most important factor is whether the homeowner has negative equity in a house — that is, the balance of the mortgage is greater than the value of the house. This means that most government policies being discussed to remedy woes in the housing market are misdirected.

Many policy makers and ordinary people blame the rise of foreclosures squarely on subprime mortgage lenders who presumably misled borrowers into taking out complex loans at low initial interest rates. Those hapless individuals were then supposedly unable to make the higher monthly payments when their mortgage rates reset upwards.

But the focus on subprimes ignores the widely available industry facts (reported by the Mortgage Bankers Association) that 51% of all foreclosed homes had prime loans, not subprime, and that the foreclosure rate for prime loans grew by 488% compared to a growth rate of 200% for subprime foreclosures. (These percentages are based on the period since the steep ascent in foreclosures began — the third quarter of 2006 — during which more than 4.3 million homes went into foreclosure.)

And the policy implications from his research are huge.  As Obama and our favorite asshat, Barney Frank, feebly attempt to stop the bleeding, Mr. Liebowitz says the current policy approach is vastly misguided.  And why the Federal Housing Financing Agency’s new plan to allow Fannie and Freddie to accept refinancing with 125 loan-to-value ratios simply won’t cut the mustard.

Although the government is throwing money — almost $2 trillion and counting — at the mortgage markets with the intent of stabilizing house prices, its methods are poorly targeted. While Federal Reserve actions have succeeded in reducing mortgage interest rates, low interest rates induce refinancings more than they do home purchases…

…Other government policies are likely to be even less effective in reducing foreclosures. The Obama administration’s “Making Homes Affordable” plan focuses on having the government help lower obligation ratios (the share of income devoted to house payments) down to 31% from levels somewhat above 38%. But my analysis finds that mortgages having such obligation ratios at closing did not later experience high foreclosure rates. This suggests that reducing these ratios is not likely to significantly improve the foreclosure problem.

So what’s the solution, you ask, other than abdicated Barney from his thrown?  It’s not stricter regulation on subprime lenders but rather stronger underwriting standards and higher down payments.

If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell.

Hopefully, our elected officials will heed Mr. Liebowitz’s warnings.  But we aren’t counting on it.

But that’s not the case at all.

You see, the bubble and subsequent crash were inevitable under the current system of housing finance. Fundamental changes must be made.

Standard and Poor’s recently projected the likely future loss rate on the $650 billion of subprime-mortgage-backed securities that are still out in the marketplace. From that we can estimate the losses S&P is projecting on the actual mortgages themselves.

According to S&P, senior AAA-rated bonds will pay out about 60% of principal, junior AAA-rated bonds about 35%, AA-rated bonds about 5% and lower-rated bonds nothing at all. Since about 75% of subprime mortgage-backed securities were AAA rated, we can calculate that S&P thinks subprime mortgages will eventually return about 40% on the original principal amount.

That’s a startling number.

Losses Still to Come

If you had a portfolio consisting entirely of 100% loan-to-value mortgages, on which the appraisals were accurate but a large percentage of the borrowers had poor credit, and house prices were destined to drop between 20% and 25% over the next few years, you’d expect to lose 25% – or perhaps 30% – of principal, but still manage to keep 70% to 75% of your money.

When you had a foreclosure, there would be costs involved that increased your loss. On the other hand, some of the borrowers would be able to make their mortgage payments, leaving you with no loss at all. Thus, if subprime mortgages are expected to return only 40%, almost half of them must have had some fraud involved, either by the borrower, the mortgage broker or the appraiser.

Let’s now turn to actual housing prices. The S&P/Case-Shiller Home Price Indices of home prices in the Top 20 urban markets dropped a bigger-than-anticipated 12.7% in the 12 months that ended in February – the worst showing since the index debuted in 1991. What’s even more alarming, however, is that the decline is accelerating. In February alone, prices dropped 2.7%  – the equivalent of a 28% decline if this rate persisted for the entire year.

That should have alarmed both homeowners with large mortgages and mortgage market participants – if prices were to drop 30% to 40%, instead of the generally expected 15% to 20%, even prime home mortgages would get in trouble and the losses would be appalling – in the range of multiple trillions of dollars.

Since the first-quarter vacancy rate in U.S. housing – owner-occupied and rental – increased to 2.9%, the highest level in 50 years, we may indeed be approaching such a bearish scenario.

However, when you look at factors like the ratio of house prices to incomes, it becomes obvious that the problem is not the current drop, but the previous rise. Since World War II, the average house price was 3.2 times the average income. By 2006, however, the average house price had jumped to 4.5 times the average income. With house prices outrunning incomes in that way, mortgage financing was bound to become more and more risky, and a substantial drop was eventually inevitable – to take prices from 4.5 times income to 3.2 times would require housing prices to plunge 29%. And that doesn’t even consider the possibility that prices might overshoot on the downside. 

The principal reason for the excessive rise in house prices and the high level of fraud was the housing finance system. In the modern system, the originator of a home mortgage loan is paid a fee on the origination, and never has to worry again about the credit risk on that loan, which is passed off to investors through a process known as “securitization.”

Because securitization separates the mortgage originator and the actual investor, the investors – often foreigners – have no idea of the actual underlying quality of the loans that they’re purchasing.

The mortgage broker’s incentive is to maximize loan volume – pretty much regardless of whether or not the borrower can afford the loan. Falsification of documents, suborning of appraisers, and other similarly reprehensible machinations becomes a normal course of action in such a situation, as does turbo-charging the housing market to valuation and sales levels it cannot sustain. A system in which prices are forced up to unsustainable levels and fraud is rampant is broken, and needs to be replaced with something better.

It (Once) Was a Wonderful Life

Years ago, the United States had a superior home-financing system; it was extolled in the 1946 Jimmy Stewart movie, “It’s a Wonderful Life.” Home-mortgage loans were made by local institutions to borrowers whom they knew personally. The system had some inefficiencies. For example, if the housing needs in a particular area expanded rapidly, there might be a shortage of funds, so that mortgages would be unavailable. However, banking is mostly national today, so local funds shortages would be less important, although there would probably be a corresponding decline in personal knowledge of the borrowers.

It’s not true that the Jimmy Stewart system of financing home mortgages was less efficient than today’s: That’s a myth put out by Wall Street, which has been one of the chief beneficiaries of the recent shenanigans. (Riddle me this: Do you think that “George Bailey” – Jimmy Stewart – ever got a million-dollar bonus?).

If you look at the U.S. Federal Reserve statistics on U.S. interest rates (which started recording home mortgage rates in 1972), you will discover that in 1972-78 – when the Jimmy Stewart home financing system was still mostly in place – 20-year Treasury bonds yielded an average of 7.41%, while 30-year fixed rate home mortgages yielded 8.49%, a differential of 1.08%. In 2000-06, an equivalent period that predates the recent worries about credit risk, 20-year Treasuries yielded an average of 5.28%, while home mortgages yielded 6.50%  – a differential of 1.22%. 

Thus, the “spread” of home mortgage interest costs over Treasury bond yields, the most appropriate measure of home mortgage costs, has widened by 0.14%. That may not sound like much until you realize that it’s an effective cost increase of 13%. Where did that increase go?

While some lawyers made money, too – what did you expect – it’s largely Wall Street that would rather you didn’t think about that question.