I didn't post John Berry's most recent article, Fed Actions Defuse Subprime ARM Rate Reset Bomb, because I wasn't sure if interest rate resets are the major source of the foreclosure problem. There's evidence that falling prices are the main source of the foreclosure problem, not interest rate resets, and I didn't want to push the "don't worry so much" point, or focus attention on resets, if that is not the right thing to look at. First, here's Brad DeLong's summary of John Berry's article:

John Berry Notes that the ARM Reset Bomb Has Been Somewhat Diffused..., by Brad DeLong: He writes, for Bloomberg: Bloomberg: Many analysts and public officials have said that foreclosures of subprime adjustable-rate mortgages would soar this year as owners' monthly payments jumped when interest rates reset to a higher level. Not only is that unlikely to happen, this year's resets of earlier vintages of subprime mortgages may even reduce some payments that increased in 2007. The reason? The index to which many ARMs are tied is the six-month London inter-bank offered rate, or Libor, and that rate has fallen from more than 5.3 percent last fall to about half that level. The Federal Reserve's cuts in its target for the overnight lending rate -- the last to 2.25 percent on March 18 -- from 5.25 percent in mid-September, plus actions to increase liquidity in the inter-bank lending market, have caused the Libor to fall. Unfortunately, most of the defaults and foreclosures that have wreaked havoc in financial markets haven't been due to resets so far. Many borrowers simply bought a house or condo they couldn't afford unless bailed out by rising prices, and lower rates alone won't help them much. Still, the big drop in Libor means there likely will be many fewer foreclosures than there would have been. Much of the discussion about the danger of resets has focused on the initial interest rate, or ``teaser rate,'' that ARMs carried. That left the impression it was a very low rate that would adjust up a lot. Most of the initial rates were 8.5 percent or above, and now many are set to adjust hardly at all...

Here's why I wonder if this is missing the main factor behind foreclosures. This is Richard Green (original post with graph):

Is Everything we Know About Subprime Wrong?, by Richard Green: Yesterday I saw a great talk by Paul Willen of the Boston Fed. An earlier version of the paper he gave is here. I don't think I am caricaturing what he said to say when I describe the following takeaways from his talk: (1) Falling house prices lead to defaults more than defaults lead to falling house prices. ... (2) Interest rate resets have little of anything to do with the large number of defaults we are observing. For the vast majority of subprime loans, defaults or refinances happen before resets take place. It is moreover the case that the size of the resets is smaller than most of us think, because the initial teaser rates are pretty high. (3) While ARMs have higher default rates than FRMs, putting ARM borrowers into FRMs will not necessarily reduce defaults. ... Beyond this last point, a working paper I have with Cutts and Ramogopal shows that ARM borrower are fundamentally more likely to be risk-takers than FRM borrowers, so the difference in loan performance between the two products may say more about the distributions of the different borrowers, rather than the products themselves. In any case, all of this means that many of the policies being pushed at the moment (such as interest rate freezes) may not be particularly helpful in resolving the crisis.

I decided to post on this after all because a debate has broken out about whether Berry's conclusion about resets is correct. But if resets aren't the big problem we should worry about, whether he's right or wrong isn't as important and we should shift our focus away from resets and toward policies that prevent or attenuate falling prices.

With respect to the debate over resets, here's Andrew Leonard with a summary of Yves Smith's criticism of Berry's conclusions:

Whatever happened to the great ARM reset crisis?, by Andrew Leonard: Remember all the concerns expressed about the great ARM reset bulge of 2008, when the introductory, low-rate periods of millions of adjustable-rate mortgages were supposed to expire and send countless more American homeowners into foreclosure? On Thursday, Bloomberg News columnist John Berry suggested that the reset crisis wouldn't be as bad as once predicted. He gave two reasons: First, the interest rate cuts orchestrated by the Fed are having the desired trickle down effect of putting downward pressure on the interest rates that various ARMs will reset at, and second, contrary to popular belief, most borrowers don't actually have mortgages with absurdly low initial interest rates, so they won't suffer too much damage. ... Berry based his conclusions on data presented in a recent report from two New York Federal Reserve Bank economists... I read Berry's column on Thursday and considered noting it here. How the World Works savors contrarian takes. But in my judgment, over the past two years that I've been following his coverage of the Federal Reserve and the economy, Berry has consistently understated the potential harm that might be wreaked by the housing bust and credit crunch. ... So I decided not to call attention to yesterday's Berry column, figuring it just wasn't that interesting that someone who has a track record of optimism about the economy was ladling out some more good cheer. With this background, readers might therefore understand why I was intrigued to read Naked Capitalism's Yves Smith analyze Berry's column this morning and call it "extraordinarily misleading." Emphasizing that the data Berry based his conclusions on came from just one month of mortgage-backed securities issued by just one mortgage lender, Smith took the time to look at a database containing information on 38 million mortgages issued between 2004 and 2006. That database shows that out of 8.4 million ARMS originating during that time period, only 9.1 percent had initial interest rates of 8.5 percent or higher. A whopping 1.1 million were 2 percent or lower. (Contrast that to Berry's assertion that "most of the initial rates were 8.5 percent or more.") ...

Again, though, we shouldn't get too wrapped up in this debate if it is not the source of the problem. If it's prices and not resets, then policy prescriptions need to deal with price effects, e.g. setting a price floor, rather than wasting a lot of time constructing proposals to insulate homeowners from interest resets.

On price floors and mortgage bailouts to prevent foreclosures, it's nice to see people coming around to the idea. Ryan Avent of The Bellows discusses how we determine irresponsible actions, if we even can, and what this means for policy:

More on Mortgage Bailouts, The Bellows: It should be clear that I’m coming around on the idea of providing assistance to struggling homeowners, for a number of different reasons. A big one is that the case for concern about moral hazard grows weaker by the day. In looking at McCain’s mortgage assistance plan (which is, basically, there will be none), you see that he doesn’t want to reward those who got themselves into this position by acting irresponsibly. But is it the case that most of the people harmed by the housing collapse are those who acted irresponsibly? ... The ... fate of an individual homeowner depends on the state of the market. McCain says he doesn’t want to reward folks who bought a house knowing they could only afford it if prices continued to rise. Fine. How does he feel about folks who bought a house knowing they could afford it so long as prices didn’t decline by 20 percent? Or so long as half the surrounding homes didn’t enter foreclosure? Why is this important? Let me quote OFHEO: The causal relationship between home prices and foreclosures is two-directional: high foreclosure activity can both cause and be caused by home price declines. Home price declines can cause foreclosures by decreasing the equity homeowners have in their properties. Mortgagors are much more likely to default on their loans if the current value of their property falls below the outstanding loan balance... Declines in home prices will increase the frequency with which homeowners ... “walk away” from the property and the mortgage. Home foreclosures contribute to weakening prices by introducing additional supply to the inventory of unsold homes. Compounding this influence is the fact that the sellers of foreclosed homes, frequently creditors, may be strongly averse to holding onto the property for an extended period of time. As a result, they may be willing to sell for lower prices than resident homeowners. So, we had some borrowers who were going to default if prices quit skyrocketing. When prices quit skyrocketing, they went belly up, and prices stopped rising entirely. Then the borrowers who needed prices to rise at least a little went belly up, pushing prices downward. Then the borrowers who needed prices to at least stay level went belly up, pushing prices downward. You see where this is going. At the same time, troubles in credit markets due to defaults have pushed up key interest rates and made it difficult for potential buyers to get loans, heaping still more downward pressure on housing markets. The end result is that a lot of people who weren’t speculating, and who weren’t really being too reckless, have found themselves in a great deal of trouble. At some point the best way to handle this issue is not to make sure that wrongdoers are punished, because the damage has simply spread too far and included too many people who weren’t trying to game the system. At that point, you bail out the system to keep it from sinking, and you fix the rules that allowed this situation to arise in the first place. We’re at that point, and the failure to recognize that fact will mean that this cataract just sucks in a steadily widening field of homeowners, who are steadily less responsible for the problems we face.

That's the argument I've been making, "you bail out the system to keep it from sinking, and you fix the rules that allowed this situation to arise in the first place."

Update: I have a question, and it's come up in comments as well. It's easy to explain how interest rate resets could increased foreclosure rates since the monthly housing payment will change as a result of the reset, but why do falling prices cause increased foreclosures? Falling prices don't change monthly payments, so why do more people default?

I can think of one reason. Every month, a certain number of people will become unemployed and the unemployment event itself could cause foreclosures if they cannot meet monthly payments. But the problem is worse when prices are falling below loan values since if the person needs to move to take a new job, the only option they may have is to move and default on the loan, or stay where they are and default on the loan (and there's no longer any equity in the house that can be used to tide them over until they get another job). Thus, as housing prices fall and this happens more and more often, we see foreclosure rates increasing (the fall in housing prices may be associated with rising unemployment rates making it worse). Similarly, many housing sales are driven by divorce. When this happens and neither person can make the payments alone, it's often necessary to sell the house. If prices are falling, default is more likely since they may not be able to make up the difference between the loan value and the value of the house. Neither of these explanations have much to do with people making bad decisions about the housing purchase per se, if they had stayed employed or stayed married they could have made the payments, but that's not what happened. When housing prices are falling below loan values, the problems people experience in life are amplified.

How else could falling prices increase foreclosures?

Update: Richard Green gives an answer: