The Impact of State Mortgage Foreclosure Policies and Income Forecast Error on Foreclosure Rates During the U.S. Subprime Mortgage Crisis

Abstract

This study examines the relationship between foreclosure rate and income forecast error, along with the impact of state requirements for judicial foreclosure on this relationship, using county data from 8 states over a period of study spanning from 2007 to 2009. It is hypothesized that negative income forecast errors (in other words, when realized income is less than expected income) are associated with higher foreclosure rates as a result of consumers adjusting their optimal consumption levels in response to new information. By regressing foreclosure rate on income, two measures of permanent income, and income forecast error in four separate regressions, it was found that income forecast error and income both have significant negative relationships with foreclosure rate, with income forecast error being a stronger predictor of foreclosure rate than income alone. Furthermore, it was found that foreclosure rate responds more strongly to changes in income in states that recognize non-judicial foreclosures as compared with states that require judicial foreclosures, corresponding to the fact that non-judicial foreclosures are less costly than judicial foreclosures. This effect is not present in the relationship between foreclosure rate and income forecast error, suggesting that income forecast error is effective at predicting the most detrimental mortgage defaults, in which there is little chance of loss mitigation and foreclosure is the least costly option. Ultimately, the results of this paper suggest that, while lax underwriting practices were partially to blame for the Subprime Mortgage Crisis, consumer behavior also played a part, with consumers inadequately recognizing the risks associated with taking out subprime mortgages.