On July 3, 2009, the Wall Street Journal published an article discussing the causes of our current mortgage meltdown. The cause is often reported as subprime loans: irresponsible, low-income homeowners who are locked into mortgages that adjust over time to payments beyond their means, and then they are forced to foreclose on their property and exacerbate an already dire real estate market. At face value, it is not difficult to understand the reasoning behind this theory. Foreclosures occur when homeowners cannot pay up. Homeowners cannot pay up when they don’t have enough money. Homeowners do not have enough money when they reside in the lower-earning range of the payscale. However, the new study suggests otherwise. This real estate crisis owes largely to negative equity – when the balance of the mortgage is greater than the value of the house.

This means that most government policies being discussed to remedy woes in the housing market are misdirected.

The focus on subprimes ignores the widely available industry facts (reported by the Mortgage Bankers Association) that 51% of all foreclosed homes had prime loans, not subprime, and that the foreclosure rate for prime loans grew by 488% compared to a growth rate of 200% for subprime foreclosures. (These percentages are based on the period since the steep ascent in foreclosures began — the third quarter of 2006 — during which more than 4.3 million homes went into foreclosure.)

According to a study done by Stan Liebowitz, director of the Center for the Analysis of Property Rights and Innovation at the University of Texas, Dallas, the most important factor accounting for the millions of foreclosures is the extent to which the homeowner now has or ever had positive equity in a home. Negative equity appears to be the greatest indicator of foreclosure risk. Although only 12% of homes had negative equity, they comprised 47% of all foreclosures. Even more revealing is that Liebowitz’s study didn’t account for second mortgages… meaning that his estimate of negative equity’s impact on foreclosures is actually on the conservative side.

In regards to interest rates resetting to higher monthly payments, Liebowitz found that interest rate resets did not measurably increase foreclosures until the reset was greater than four percentage points. Only 8% of foreclosures had an interest rate increase of that much. Thus the overall impact of upward interest rate resets is much smaller than the impact from equity.

The implications for policy-making are significant. At the moment, the government is attempting to funnel almost $2 trillion towards the real estate crisis through programs like Obama’s “Making Homes Affordable” plan, but they might want to refocus their efforts. We will see a significant reduction in foreclosures only when housing prices stop falling and when unemployment stops rising.

Liebowitz suggests that stronger underwriting standards are needed — especially a requirement for relatively high down payments. If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell. We are at a point where we can undo the damage to the housing market by strengthening underwriting standards in a reasonable way. But to do so political leaders must face up to the actual causes of the mortgage crisis, not fictitious causes that fit political agendas and election strategies.