In February 2009, one month into his presidency, Barack Obama appeared at a high school gymnasium in Mesa, AZ to unveil his administration’s response to the foreclosure crisis. In presidential speechifying, as in real estate, location is everything. Arizona, and the metro Phoenix area in particular, had been one of the country’s high-flying housing markets during the bubble years, and the sector crashed just as dramatically. Two months after Obama’s visit, the data firm RealtyTrac announced in its first-quarter ’09 report that Arizona had the second-highest foreclosure rate in the country, behind only beleaguered Nevada, with one in every 54 homes receiving a filing. President Obama was addressing a community that’s become a symbol of the economic excesses and ravages of the subprime era.

“The Sun Belt markets like Arizona probably got 50 percent-plus overvalued,” says Joe Gyourko, the Martin Bucksbaum Professor of Real Estate and Director of the Samuel Zell and Robert Lurie Real Estate Center at Wharton. They were also overbuilt. “If you go take a field trip to Phoenix,” Gyourko says, “you can find developments way out in the middle of nowhere where clearly no one is going to be buying now.”

Obama told the crowd that the federal government’s $75 billion plan would “not save every home,” but “by bringing down the foreclosure rate” it would “shore up housing prices for everyone.” Nearly two years later, the rhetoric appears wildly optimistic. In September, the number of U.S. homes foreclosed upon hit 102,134—a single-month record. Many of the foreclosure filings originated in the usual problem areas—Nevada, Florida, California and Arizona continue to top the foreclosure list, as they have since the crisis began. Even after government intervention, increased cooperation from the banks and the end of toxic subprime lending, the foreclosure wave appears to be spreading. Of the 206 metro areas RealtyTrac studied, 133 of them, or 65 percent, posted year-overyear third-quarter increases in foreclosure activity. They include previously relatively stable markets like Chicago (up 35 percent) and Seattle (up a staggering 71 percent).

Equally troubling is the number of homeowners underwater, with mortgage loans that exceed the value of their property, which ticked up to 23.2 percent, meaning nearly 14 million U.S. homes have negative equity—a statistic unlikely to shore up home values. All of this has economists, politicians and the American people wondering how much longer the country will remain mired in the housing mess, and how we can pull ourselves out without sliding into the no-growth economy of 1990s Japan.

For his part, Gyourko envisions a period of stabilization in some markets and modest declines in others, especially in housing prices. “While I think the freefall is over,” he says, “I see no reason for prices to rise, largely because there are very big supply overhangs out there, both in terms of vacant homes and foreclosures.” Speaking more broadly of the foreclosure crisis and the erosion of housing values, Gyourko says, “In terms of owner-occupied housing, in the post-war era, there’s nothing like this.”

When looking at the housing crisis, Gyourko says he goes market by market, rather than seeing one national picture. While the Sun Belt has been hammered, he says, “places like Atlanta, Charlotte and Dallas didn’t get overvalued much at all” and the coastal markets, “while they had booms and busts, some are having reasonable growth now.” Susan Wachter, the Richard B. Worley Professor of Financial Management at Wharton, agreed that conditions vary by market, but stressed that “this is a national event, caused by a national bubble, through the under pricing of credit risk. Credit pricing was a national event.” Wachter says the crisis has played out differently across the country largely because local markets had what she calls varying degrees of “supply elasticity”—that is, in places like Texas where there are few regulations on building, supply was high, so prices never rose much, despite great demand. In Arizona, it’s different story.

Alan Mallach, a nonresident senior fellow with the Brookings Institution who studies community planning and housing, has noticed the strange, uneven ways in which the housing crisis has played out. “Foreclosures don’t seem to be as big a problem in Pittsburgh as they are in Cleveland,” he says, “even though the cities aren’t that different,” both located in the hard-hit Rust Belt. Mallach recently gave a lecture in Las Vegas, an area whose economic troubles (Nevada has the highest unemployment rate in the country) are no mystery, a result of “insane overbuilding.” As Mallach says, “People could crank out another 500 houses in the desert and sell them to home buyers or speculators overnight.” His prognosis for the local economy was grim: continued foreclosures, stagnant home values, high unemployment (especially in the construction sector) and population loss are all likely for the next decade.

As for the financial outlook in other cities and nationwide, it’s a bit of a chicken-and-egg debate as to whether housing is dragging down the economy or the economy is responsible for the continued housing woes. Karl Guntermann, a real estate professor at Arizona State University, believes the economy is the biggest factor affecting the local housing market. “How much is the local economy affecting housing? It’s the biggest underlining problem,” Guntermann says. “We’re going to have a serious foreclosure problem well into next year. How fast do those homes get absorbed? That’s where I look to the economy. In Phoenix, we don’t see much evidence of job creation. Until we have jobs here, we won’t have the migration that will bring more demand into the housing market.”

Mallach believes that while the issue is “so damn circular,” the housing collapse is in fact hampering the economy in a variety of ways. “The huge loss of people’s equity is an enormous thing,” he says. Wachter cites the tight restrictions on credit nationally, which affect businesses and workers even in areas relatively untouched by foreclosures, like New York and Washington, DC. The crash has also brought the dismantling of a whole economy that built up around the housing industry during the boom years and fueled spending and growth—jobs in construction, financial services, real estate. “That’s a huge drag on the economy,” Mallach says.

Gyourko agrees that the loss of construction jobs hasn’t helped matters, adding, “You can’t count on new construction jobs goosing the recovery because, quite frankly, we don’t need to build.” But he doesn’t believe housing is dragging the economy down so much as not providing the “normal oomph” he says the country would get from a housing sector recovery. As for that economic oomph coming in the near future, Gyourko says, “We’re not going to get it for sure in the next year, in my opinion.”


The foreclosure crisis has been a windfall for introducing new terms to the lexicon: subprime, no-doc loan, “tickler” rate, toxic debt, mortgage- backed security. To that list, add another: strategic foreclosure. Increasingly, the thousands of foreclosure filings include homeowners who can afford to make their mortgage payments but have chosen to default because it makes economic sense. Mallach explains the trend this way: “Visualize three identical houses, side by side. House A has an owner paying a $250,000 mortgage. House B has an owner who just bought that same house as an REO for $90,000. House C has a tenant of somebody who bought the house at a sheriff sale for $75,000 and is renting it out for $850 a month. The guy in House A is looking at this and thinking: What am I, stupid?”

The concept of strategic foreclosures illustrates the changing face of the housing crisis, and underscores the economic dangers of having so many mortgage holders underwater. In the early phase of the housing bust, most defaulters were those who had signed up for teaser-rate, or option-arm mortgages. The truck driver whose monthly payments ballooned from a manageable $1,300 a month to an unaffordable $2,300 and had little recourse but to foreclose. John Plocher, president of WSR Sales and Management in Riverside, CA, saw the effects of bad lending practices first-hand. Plocher’s firm does “trash-outs,” cleaning and maintaining foreclosed homes on behalf of lenders, and his location in California’s subprime-ravaged Inland Empire has made him a busy man. At the peak of the housing crisis, two years ago, WSR did about 60 trash-outs a day, or 1,500 a month. I followed Plocher’s workers for a story in 2009, and the financial trauma was distressingly visible: freshly built subdivisions riddled with “For Sale” signs in the yard; empty homes with furniture and half-eaten food left behind, as though the inhabitants had been swept off in a plague.

When I called him recently, Plocher reported that the number of trash-outs his crews perform is down by half, though he was by no means optimistic about a housing turnaround. “I don’t think there are any less distressed properties out there,” he says, citing the increase in short sales, government- imposed moratoriums on foreclosures and banks’ willingness to work with troubled lenders as the reasons for the decrease. Plocher has also noticed the changing profile of defaulters; these days, the subprime candidates have given way to strategic foreclosures or families who held on to their homes during the worst of the crisis but lost a job or depleted their savings and tipped into foreclosure. Plocher says: “A couple of years ago, when the market completely fell apart, I think there were a lot of people who thought, ‘This thing is going to change, it’s just a cycle and in a couple of years my property will be back up in positive territory.’ That hasn’t happened. As a matter of fact, we’ve seen a further decay in prices.”

The easy credit and high debt levels that allowed so many Americans to buy a home beyond their means continue to haunt the country in another form. “The unemployment rate in 1981 got as high as it did today,” Gyourko says, “but imagine that you had to put 20-25 percent equity in your house. Would you walk away because you lost your job? Compare that to now when maybe someone put down nothing or one or two percent. It’s a much clearer decision to walk away. It’s the bank who will lose, not you.”

According to Wachter, if there’s a “double dip” and housing values fall 10 percent further, as many as 50 percent of American mortgage borrowers are likely to be underwater, which, she says, “could lead to severe consequences.” Those would include more strategic foreclosures and the further erosion of capital in the banking sector. “Unlike what some believe, borrowers are generally not ruthless defaulters,” Wachter says. “There are some who are strategic defaulters. But most are not. Homeowners usually do want to stay in their home. But the critical factor is that now, on top of the initial crisis, a credit crisis, we have an unemployment crisis. If the mortgage wasn’t underwater, homeowners who can’t keep up with the payments could sell.”


Nearly everyone who studies the foreclosure crisis cites high mortgage debt levels as the underlying problem—the “deep source,” to use Wachter’s phrase. But many are divided as to how to solve the issue, or even if it is solvable. It’s clear, though, that the Obama administration’s Homeowner Affordability and Stability Plan did little to address that deep source. “Restructuring loans just makes them temporarily a little more affordable,” Gyourko says. “It doesn’t change the fact that homeowners can’t support the debt. That’s why this foreclosure problem keeps rolling.”

During the Great Depression, when as many as half the country’s borrowers were underwater, the government created the Home Owners’ Loan Corporation (HOLC), an agency that purchased delinquent loans from lenders, backing them with government bonds and refinancing and stabilizing payments. According to David C. Wheelock, vice president of the Federal Reserve Bank of St. Louis, who authored a paper analyzing the reserve’s response to the housing crisis of the 1930s, the HO LC employed several strategies to aid underwater borrowers. “They allowed interest-only payments for a while,” Wheelock says. “They also showed flexibility in their appraisals. They didn’t appraise homes at current market value, but rather at some estimate of the long-run value of a home, recognizing that in the middle of a depression, market values are going to be depressed.”

Wheelock is careful to point out significant differences between the Depression era and today; short-term, non-amortizing loans were common then, home ownership wasn’t as widespread and mortgage down payments were as high as 50 percent. But some believe the current government should use a similar solution in the form of a shared appreciation deal between lenders and underwater borrowers. If, say, a home carries a $300,000 mortgage but is now worth only $200,000, the lender would write down the difference and receive half the profit if the home sells above its new value. “That’s the kind of deal the administration should have strong-armed the banks and all the people who hold the paper into doing,” Mallach says. “Ultimately, it’s the only kind of deal—something that reduces the principle—that will resolve the situation.”

But Wachter believes there’s no “magic bullet” solution to end the housing crisis quickly, and as she and Mallach both acknowledge, the government is unlikely to launch a “cram-down” program to force banks to accept a deal to absolve billions in loans, especially considering the shrink-government wave that elected Republicans to Congress pledging to reduce spending. “If Obama didn’t embrace this option when he had political clout, it’s unlikely he will now,” Wachter says.

Whether the current and future supply overhang is eaten up in the next few years depends on the economy. “If the economy rebounds strongly,” Mallach says, “you could see a significant increase in household formation that would start eating up the oversupply and you may be out of this by 2015 or so. That’s best case.” If the economy doesn’t rebound strongly, he adds, “we may be in a low-demand, low-production, low-price housing environment for the next decade.” For his part, Gyourko doesn’t see a quickfix plan, either. But he does suggest that the federal government stop subsidizing the restructuring of loan payments (the redefault rates in many of these programs is at least 50 percent) and instead use the money towards a more realistic purpose. “I’d use it to help people get out of homes they can’t afford, get into good apartments, maybe put the money towards a security deposit, a couple of months’ rent,” he says. “I think we’re extending the inevitable with the current policy.”

Plocher, who knows better than anyone the on-the-ground realities in hard hit areas, agrees. “We’re going to start to see things get better,” he says. “But in the short term, no way—it’s a mess out there. The government has put moratoriums on banks to do no more foreclosures for a while, but there is a backlog of foreclosures out there that one day will have to be dealt with.”