US Home Foreclosures: Caught In a Never-Ending Vicious Cycle?

The housing sector is the root cause of the current credit crunch. For more than a year the economy has been suffering from a severe recession and home foreclosures are rising day after day. As the economy worsens further and unemployment level increases foreclosures are bound to skyrocket as well. In this scenario, preventing closures has become one of the key goals of the Obama administration. However reduction of foreclosures is not easy for many reasons. The main reason being that people who cannot afford to pay mortgages should not bought the homes in the first place. Efforts to keep those folks in their homes will not succeed unless their “underwater” values of their homes are erased and their loans redone with heavy cram-downs (reduction of principal owed) and interest-rate changes. Even then it is possible that loan modifications will not help when folks can’t pay their mortgages due to losing jobs, unexpected expenses, etc.

So in order to understand how the foreclosure crisis is impacting the overall economy, I reviewed a recent position paper from IMF titled “Foreclosure Mitigation Efforts in the United States: Approaches and Challenges”. In this paper the authors argue that the burden of restructuring mortgages must be borne by the taxpayers since foreclosures play a key role in adverse housing market dynamics. With foreclosures rate reaching the highest levels since the Great Depression, the paper adds “With house prices falling, lending standards tightening, unemployment rising, and interest rate resets in the pipeline, foreclosures are projected to go even higher”.

The following diagrams nicely illustrate the vicious cycle of falling home prices and its relationship to the overall economy:

Housing Feedback Loop (click to enlarge)