A Root Cause of the Mortgage Crisis: The Smoking Gun

I have blogged several times about the observation that mortgage defaults were not only a consequence of lax lending standards or predatory lending or uninformed consumers, but also a result of urban sprawl.

I noted that for a typical new home, which is now priced at about $178,000 (median price), the cost of driving to and from the home over the course of a 30-year mortgage exceeds $300,000 for homes located in sprawl and the energy costs exceed $75,000 on average.

It seemed evident that a system designed to look only at the ability of the borrower to pay back the $178,000 or so loan but that ignored the affordability of the $375,000 commitment to transportation and utility costs was bound to go wrong.

But now we have solid proof. Today NRDC released Location Efficiency and Mortgage Default, a study that shows a direct, statistically significant link between the high costs of personal transportation imposed by poor location efficiency and a much higher risk of default. The report was authored by Stephanie Y. Rauterkus of the University of Alabama at Birmingham, Grant I. Thrall of the University of Florida, and Eric Hangen of I Squared Community Development Consulting, Inc., with support from NRDC.

The study looked at the conventional wisdom variables, such as credit score, payments-to-income ratio, etc, and found that even after these had been taken into account, adding location efficiency to the equation increased the predictive power of the formulas for estimating the likelihood of default.

What this means on an individual household level is that two homebuyers with exactly the same profile in terms of credit score, debt-to-income ratio, and loan-to-value ratio will have different probabilities of foreclosure: the one in the more location efficient area will be less likely to default.  For example, in a relatively location inefficient, neighborhood (with, say, a median auto ownership rate of one car per $33,000 of income), if a homebuyer has a credit score of 680, a total debt-to-income (“back end”) ratio of 41 percent, and a home loan-to-value ratio of 80 percent, the model predicts a 9.9 percent chance that the home will fall into foreclosure. For a second buyer with all of the same mortgage underwriting characteristics as the first buyer—but who is buying in a more location efficient area with, say,  a median auto ownership rate of one car per $58,000 of household income- the chance that the home will fall into foreclosure drops to 7.2 percent.

So the second homebuyer could have a much higher debt-to-income ratio (up to 62.5 percent holding other factors equal), a lower credit score, or a higher loan-to-value ratio, and still have only the same risk of foreclosure as the first buyer.

This result is astonishing if you think about it. Would you want to make a loan to a family whose monthly mortgage payments were over 62% of their gross income? Would you take on such an obligation yourself and think you could keep up?

I don’t think so.

Yet the risks of such a loan (for a house in a neighborhood of high location efficiency) are no higher than they would be for the first buyer, and no one thought twice (or still thinks twice) about the prudence of such a loan.

What does this mean for America’s ability to recover from the recession? It means that either:

A)    We thought we were tightening standards enough to prevent a new tsunami of defaults, because there are  important risk factors we are still ignoring; or

B)    By tightening credit standards indiscriminately—limiting the ability of families to qualify for homes that entail very low transportation and energy costs as well as those burdened by high transportation and energy costs—we are choking off a recovery in homebuilding

C)    Or maybe we are somewhere between A and B

But wherever we are, it isn’t what we need for economic success as a nation.

NRDC, along with other NGOs, has long advocated that mortgage qualification should be evaluated on the basis of the sum of loan repayment costs PLUS transportation costs PLUS energy costs. This study shows that incorporating transportation costs would be a prudent, conservative step to take right now. For the Chicago example described above, the study’s results showed that every dollar saved in transportation allowed a family to spend over THREE DOLLARS more in mortgage payments with no higher probability of default.

So allowing the dollar-for-dollar tradeoff between mortgage obligations and transportation obligations implied by considering the sum of monthly costs clearly will be supported by the further study that NRDC recommends to allow the lending system to incorporate the effects of location efficiency and energy efficiency in the optimal way. But the perfect should not be the enemy of the good. If we base lending on the sum of loan repayment costs PLUS transportation costs PLUS energy costs NOW, we will improve consumer choice, revitalize homebuilding in places where families can lower their transportation costs, and reduce the overall risks of default.

…And it will be good for the environment too.