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110th CONGRESS

lst.csdwon

REPORT

SENATE

10-251

THE 2007 JOINT ECONOMIC REPORT

REPORT
OF THE

JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
ON THE

2007 ECONOMIC REPORT
OF THE PRESIDENT
TOGETER WITH

MINORITY VIEWS

December 18, 2007 - ordered to be printed
U S. GOVERNMENT PRINTING OFFICE
WASHINGTON: 2007

69-010

JOINT ECONOMIC COMMITTEE
[Created pursuant to Sec. 5 (a) of Public Law 304,

79th

Congress]

HOUSE OF REPRESENTATIVES
Carolyn B. Maloney, New York, Vice Chair
Maurice D. Hinchey, New York
Baron P. Hill, Indiana
Loretta Sanchez, California
Elijah E. Cummings, Maryland
Lloyd Doggett, Texas
Jim Saxton, New Jersey
Kevin Brady, Texas
Phil English, Pennsylvania
Ron Paul, Texas

SENATE
Charles E. Schurner, New York, Chairman
Edward M. Kennedy, Massachusetts
Jeff Bingaman, New Mexico
Amy Klobuchar, Minnesota
Robert P. Casey, Jr., Pennsylvania
Jim Webb, Virginia
Sam Brownback, Kansas
John E. Sununu, New Hampshire
Jim DeMint, South Carolina
Robert F. Bennett, Utah

MICHAEL S. LASKAWY, Executive Director
CHRISTOPHER J. FRENZE, Republican StaffDirector
JEFFREY L. SCHLAGENHAUF, Senate Republican StaffDirector

LETTER OF TRANSMITTAL

December 18, 2007
HON. HARRY REID
Majority Leader, U.S. Senate
Washington, DC
DEAR MR. LEADER:
Pursuant to the requirements of the Employment Act of 1946, as amended, I
hereby transmit the 2007 Joint Economic Report.
The analyses and
conclusions of this Report are to assist the several Committees of the
Congress and its Members as they deal with economic issues and legislation
pertaining thereto.
Sincerely,

CHARLES E. SCHUMER
Chairman

iii

Table of Contents
Overview of Current Economic Conditions .................
Majority Staff Reports .........................................
Sheltering Neighborhoods from the Subprime
Foreclosure Storm ......................................
The Subprime Lending Crisis: The Economic Impact
on Wealth, Property Values, and Tax Revenues
and How We Got Here .................................
War at Any Price?: The Total Economic Costs of the
War Beyond the Federal Budget ......................
Energy Efficiency is a Bright Idea: Shedding Light
on the Benefits of Increasing Energy and Fuel
Efficiency to American Families and Our
Environment .............................................
Billions in Offshore Royalty Relief for Oil and Gas
Companies Buys Little For Taxpayers ...................
The Proposed Modification of Internal Revenue
Code Section 199 Will Not Increase Consumer
Energy Prices .........................................
Meeting the Challenge of Household Earnings
Instability.................................................
Links to Majority Reports ..................................
Minority Views of Representative Jim Saxton
and Senator Sam Brownback ..................
............

1
20
21

58
97

132
144

151
155
168
172

110th CONGRESS

lstSe&ion

5SENATE

REPORT

110-251

THE 2007 JOINT ECONOMIC COMMITTEE REPORT

DECEMBER

18,2007- ordered to be printed

MR. SCHUMER, from the Joint Economic Committee,
submitted the following

REPORT
together with
MINORITY VIEWS

Report of the Joint Economic Committee on the 2007 Economic Report of the
President

OVERVIEW OF U.S. MACROECONOMIC PREFORMANCE

INTRODUCTION

The President says his policies are working to make the economy
strong and that all Americans are benefiting, but the facts show
an economic record that has left the vast majority of American
families behind. During the last six years, the economy has
performed in a lackluster fashion, without strong growth in
output, investment, or employment. America's working families
have seen little or no improvement in their standard of living
during this time. The recovery from the recession in 2001 has
been very weak, and household income is still substantially
below its pre-recession peak of the 1990s. Further, the number
of households with employer-provided health insurance has

declined. In short, the economic indicators that matter most to
the typical family are moving in the wrong direction.
By almost every measure, the Bush Administration's economic
policies have produced a recovery that has been remarkably
weak. The President's ill-designed tax policy has added to the
deficit and exacerbated income inequality. At the same time,
programs that benefit middle- and lower-income families have
been cut back. Dramatic increases in defense spending for the
war in Iraq have increased the budget deficit, which will have an
impact on future generations. Instead of focusing spending
increases on areas that would help economic growth in the long
term, such as repairing and modernizing America's
transportation and urban infrastructure, the administration
financed a war that has already produced total economic costs
exceeding a trillion dollars.
The subprime mortgage crisis, which may lead to millions of
Americans losing their homes, and the subsequent credit crunch
The
have weakened an already soft housing market.
deteriorating housing market threatens to have pronounced
negative impacts on growth. The vast majority of American
families have not benefited from the economic gains we have
seen so far and now there are strong indications that a downturn
may be just around the corner.
So far, the Administration has been slow to change course and
are satisfied with the status quo. The country needs a change in
direction to get our economy back on the right track and to
ensure that all American families share in our nation's growing
prosperity.
Macroeconomic Performance: Lackluster Growth, Weak
Business Investment
Over the past seven years, despite Administration claims to the
contrary, the U.S. economy has performed in a lackluster
fashion. The Bush Administration's macroeconomic policies
have failed to deliver strong growth in output, investment, or
employment. In historical terms, by almost every economic

measure, this economic recovery has been remarkably weak. The
majority of Americans have lost ground. And now there are
strong indications that a downturn may be just around the corner.
Figure 1: Real Gross Domestic Product (4-Quarter Percent Change)
I

U.16

0.12

.1
-

0.08

0
f'

0.04

0.00
-0.04

-1
11 NI
I 17
If

I I

11 I I1

IV
I

11. I
11 I

1948 1952 1956 1960 1965 1969 1973 1977 1982 1986 1990 1994 1999 2003 2007
Sources: U.S. Department of Commerce and National Bureau of Economic Research. -

The clearest way to understand the Bush administration's
economic record, and to see most clearly the failure of its
economic policies, is by placing the past seven years in the
context of the performance of prior business cycles. The U.S.
economy reached a business cycle peak in the first quarter of
2001, when President Bush took office, experienced a brief
recession, and then begin to expand. We can get a clear sense of
the Bush economic record by comparing this economic
expansion (or "recovery") to other expansions of similar length. To benchmark this economic recovery's performance, we
examine economic trends from the business cycle peak in 2001
through the 26 quarters of the current recovery and compare
them to the prior three expansions that lasted at least six and a
half years (26 quarters). 1 '2 When we benchmark the current

pervasiveness of cycles is illustrated in Figure 1, which shows quarterly
GDP growth at an annual rate. The dark vertical bars indicate periods of
recession.
2We compare the behavior of the current cycle, which begins at the business
cycle peak in the first quarter of 2001, to the three other U. S. business cycles
which continued 26 or more quarters past a peak. These three peaks occur in
Q2 1960, Q3 1981, and Q3 1990. The business cycle peaks are those
XThe

economic recovery to the performance of prior recoveries, we see
clearly that the primary indicators of the health of our
economy-growth in Gross Domestic Product (GDP),
investment, and employment-are much weaker than in prior
recoveries.
Figure 2: Average Growth of Real GDP
(First 26 Quarters of the Business Cycle)

Gross Domestic Product

Dates of Business Cycle Peak (NBER)
2001:1
1990:1H1
1960:H1
1981:M
2.55
2.81
3.40
4.97

3.7
Average of three cycles
(1960/1981/1990)
-1.81
Difference 2001:
1 and 3-cycle average
Source: U.S. Department of Commerce.

The main indicator of the overall health of the U.S. economy,
GDP growth, has been anemic during this economic recovery.
Since the last economic peak in the first quarter of 2001, the
economy has expanded at an annual rate of only 2.6 percent,
about a third less than the 3.7 percent average growth rate of the
three prior economic cycles of similar length (Figures 2 and 3).
This means that in the current economic expansion, GDP has
risen only 18.1 percent above its level during the prior economic
peak. By this point in the business cycle for prior economic
recoveries, GDP had risen 27.1 percent above the prior economic
peak (or over one third above the level it has under this
administration). This means that our economy has experienced
much slower growth during this recovery than in prior
recoveries, which has meant that job creation and business
investment in productive capital have been slower than normal,
and that incomes of middle income households have stagnated.

identified by the National Bureau of Economic Research, available at
http://www.nber.org/cycles.html.

Figure 3: Real Gross Domestic Product (GDP)
130
120
)O

Three Earlier Business Cycles

110

100

Current Business Cycle

A,1002
90

80
Peak

Source: U.S. Department of Commerce.

Quarters Since Beginning of Cycle

GDP growth is driven in large measure by two components,
investment and consumption. The federal government can
influence GDP -growth by encouraging public and private
investment, using a combination of tax incentives and prudent
spending initiatives. It can-also stimulate consumption through
policies that increase the disposable income of households who
need to spend higher proportions of their income to take care of
their families. The Bush administration's tax and expenditure
policy has by design failed to do either. When compared to
similar cyclical expansions, investment and consumption have
grown slowly.
Business expenditures on fixed investment have been especially
weak during this economic cycle. Non-residential fixed
investment - gross business spending on productive capital
stock, such as plants and equipment - has performed poorly since
the prior economic peak in early 2001. Typically, non-residential
fixed investment has taken nine quarters to return to its prerecession peak, but in this economic recovery it took 18 quarters,
twice as long (Figure 4). Remarkably, 26 quarters into the current
expansion, this measure of investment is only 12.0 percent above
its pre-recession value, whereas the average increase over the
previous three economic cycles was nearly four times as large
(44.6 percent).

6
Figure 4: Consumption Expenditures
130
Three Earlier Business Cycles

125

120

2115
*

110

Current Business Cycle

105
100
95
Peak

Source: U.S. Department of Commerce.

18
16
12
14
10
8
Quarters Since Beginning of Cycle

The weakness in investment is especially significant because
slow investment growth today will likely lead to lower future
economic growth. An economy's potential output (measured by
GDP) depends on its stock of capital, itself the result of prior
investment. As the President's own Council of Economic
Advisers puts it in the 2007 Economic Report of the President,
"[b]ecause a larger capital stock makes labor more productive,
investment is a primary driver of greater economic growth and
higher standards of living."3 The lack of investment is thus a
major factor in the overall weakness of this economic expansion,
and, perhaps more worrisome, a harbinger of more economic
weakness to come.
Consumption has also grown more slowly during this expansion
than in prior economic cycles. Since consumption comprises
more than two-thirds of aggregate demand, consumption growth
is vital to GDP growth. Typically, at this point in the economic
cycle, consumption is about 28.0 percent above the previous
economic peak. However, in this economic recovery,
consumption has only increased by 21.1 percent. Consumption
growth has actually slowed, compared to prior trends, as the
expansion has progressed (Figure 5).
3 Council of Economic Advisers (2007). Economic Report of the President, p.
63.

7
Figure 5: Real Non-Residential Fixed Investment
150
140
30
80

Earlier Business Cycles

OThree

- 120P
-I>

'r9 110
100

90
CretBusiness Cycle
80
Peak

Quarters Since Beginning of Cycle
Source: U.S. Department of Commerce.

The relatively weak growth of consumption would have been
weaker had it not been supported by rising household debt levels.
Debt to income levels have risen sharply during this cycle as
households have taken out larger mortgages, borrowed against,
home equity, and otherwise accumulated debt in an effort to
support their standard of living.4 This has allowed higher
consumption than current income would otherwise allow. For
example, research by the Federal Reserve shows that house price
appreciation - which-creates collateral for a significant part of
household borrowing - has an important positive impact on
aggregate consumption. 5 However, the end of rapid house price
appreciation has removed an important support from
consumption demand, and this is likely to have a negative effect
on the current expansion.

4 See

Karen Dynan and Donald Kohn (2007), The Rise of U.S. Household
Indebtedness: Causes and Consequences, Finance and Economic Discussion
Series, Federal Reserve Board, 2007-37.
5
See Frederick Mishkin (2007), Housing and the Monetary Transmission
Mechanism, Finance and Economic Discussion Series, Federal Reserve
Board, 2007-40.

8
Figure 6: Total Non-Farm Payroll Employment
116
112
0P.

°2 108
11

, 104

100

V Current Business Cycle
96 1
Peak

16
18
10
12
14
8
Quarters Since Beginning of Cycle
Source: U.S. Department of Commerce.
2

Relatively slow growth in GDP has meant slow growth in
employment. Since the peak in the first quarter of 2001, total
non-farm payroll employment has increased less than 4.3
percent, less than one-third the rate of growth as over prior
economic cycles, when employment grew by 14.6 percent
(Figure 6). The employment rate - the share of working age
population that has a job - reflects this slow rate of job creation.
The employment rate has yet to recover to the prior economic
peak and has been declining over the last three quarters (Figure
7). If the employment rate had fully recovered from the last
economic peak, there would be over four million more people at
work as of November 2007.6

The unemployment rate measures the share of people actively seeking work
and can be biased if frustrated workers simply quit working; since the
employment measure shows the share of people with a job, it gets around this
problem.
6

9
Figure 7: Employment-Population Ratio
104

102

~~~~~~~~Three Earlier Business CyclesIn

_100

Ad
2,

98
96

Current Business Cycle

92
Peak

Quarters Since Beginning of Cycle
Source: U.S. Department of

The Administration has argued, as it does in the 2007 Economic
Report of the President, that its policies are successfully "progrowth."7 The evidence tells us otherwise. If the "pro-growth"
policies had been effective, then this economic recovery would
have experienced trends more in line with prior recoveries.
Instead, trends in GDP, investment, consumption and
employment are considerably and consistently weaker than past
recoveries.
FISCAL POLICY: DEFICIT CREATION, REGRESSIVE
TAX CUTS, A COSTLY WAR
Deficit Creation
At the end of the last economic peak, as a result of the fiscal
policies of the prior Administration, the federal government was
running a consistent surplus for the first time in 42 years. Now,
six and a half years into the current economic recovery, we
confront a significant deficit - currently 98.2 billion dollars,
equal to 1.2 percent of GDP (Figure 8).

7 Council

of Economic Advisers (2007). Op cit., p. 72-75.

10
Figure 8: Federal Budget Deficit/Surplus (-/+) as a Percentage of GDP
Fiscal Year, 1954-2007

3.0
2.0
1.0

-F

______

___

____~~~~~~~~~~~~~~~~~~

I____ ________.

0.0
-1 .0
c

15- -2.0
c)~

-3.0
-4.0
-5.0
-6.0
-Sn
1954 1958

1962 1966

1970 1974

1978 1982

1986 1990

1994 1998 2002 2006

Sources: U.S. Department of the Treasury and U.S. Department of Commerce.

In the early years of this economic recovery, the Administration
chose to implement large tax cuts that went disproportionately to
the wealthiest households, while dramatically increasing defense
spending on the war in Iraq. Research based on data from the
Congressional Budget Office has shown that tax cuts and defense
spending account for 48 percent and 37 percent of the growth in
the deficit respectively. 8 Neither policy was effective in targeting
short- or long-term economic growth. The tax cuts pumped
billions of dollars into the economy, but instead of concentrating
income tax cuts on households in the middle- and lower-income
brackets, who are more in need of help and are more likely to
contribute to aggregate demand through spending on the needs of
their families, the majority of tax cuts went to households in the
upper 10 percent of the income distribution (Figure 9).
Moreover, the increased discretionary defense spending in the
last five years has cost nearly one trillion dollars to our economy,
takingimuch-needed funds away from repairing and modernizing
America's transportation and urban infrastructure or investing in
basic research, such as medical research or advanced energy
8 R. Carlitz and R. Kogan (2005). CBO Data Show Tax Cuts Have Played

Much Larger Role Than Domestic Spending Increases In Fueling The Deficit.
Washington, DC: Center on Budget and Policy Priorities, available at:
http://www.cbpp.org/1 -25-05bud.htm.

technology. Very high levels of defense spending have prevented
the government from investing in the aforementioned areas that
would enhance long-term U.S. growth and productivity.
Figure 9: Share of Total Federal Tax Change, 2007
Middle Quintile,
10.7

Fourth Quintile,
17.1

Second Quintile,
5.2

Lowest Quintile, 0.3

Top Quintile, 66.7
Source: Tax Policy Center.
_ _ _ _.

__ _

. . ................................................
.
. ....
.
....
. .......

. ....

,....._

The economy is now burdened by a large government deficit that
is forecast to remain with us for many years to come. This limits
our ability to invest in the future, while also draining future
resources for interest payments.
Regressive Tax Cuts
The extensive tax cuts implemented during this administration
have overwhelmingly favored upper income groups, sending
nearly two-thirds of the tax cuts to those in the top 20 percent of
households. The fact that tax cuts were skewed to higher-income
households in part explains why those cuts did not spur the kind
of employment growth the Administration had projected. 9' 10
According to a study by the Tax Policy Center at the Urban
Institute and the Brookings Institution, the tax cuts between 2001
9

http://www.jobwatch.org/creating/bkg/ceaonbushtaxcuts_20030204_mac
ro-effects.pdf
tO For a summary of the tax changes implemented by the administration see
Tax Policy Center (2006). Maior Tax Legislation Enacted 1940-2006,
available at http://www.taxpolicycenter.org/legislationlindex.cfin.

and 2006, as measured by the percentage change in after tax
income, were regressive as upper-income households received
higher percentage increases in after-tax income compared to
lower income households." The estimated effects of the
administration tax changes for 2007 are detailed in Figure 10.
After-tax income for the upper quintile was increased 4.1 percent
as a result, while after tax income of the bottom quintile
increased only 0.3 percent. Two thirds of all tax reductions went
to households in the top 20 percent of the income distribution i.e. to households with average 2007 incomes around $203,000.
The allocation of reductions is depicted graphically in Figure 9.
Figure 10: Combined Effect of the 2001-2006 Tax Cuts Distribution of the
Federal Tax Cha e b Cash Income Percentile, 2007
Average Federal Average
Share of
Percent
Cash Income
Income
Tax Change
Total
Change in
Percentile
After-Tax Federal Tax Dollars Percent (Dollars)
(ls
Dollars Prn
Change
Income
8,074
0.3
0.3
-22
-7.5
Lowest Quintile
20,521
-360
-19.4
5.2
1.9
Second Quintile
-12.3
37,071
-746
2.4
10.7
Middle Quintile
64,859
-1,192
-8.9
2.3
17.1
Fourth Quintile
-4,656
-8.1
203,046
Top Quintile
3.2
66.7
-8.8
66,439
100.0
-1,396
All
2.8
Addendum
3.4
51.9
-7,247
-8
302,839
Top 10 Percent
-11,863
-8.3
458,039
Top 5 Percent
3.8
42.5
-44,622
-10.3
1,284,199
Top 1 Percent
5.3
32.0
2,037,114
27.2
-75,881
-10.7
Top 0.5 Percent
5.7
6,011,426
Top 0.1 Percent
6.2
16.8
-234,972 -10.7
Source: Tax Policy Center.

Instead of spurring economic growth, the administration's tax
cuts have helped to create a significant budget deficit and have
done little for most American families who have seen their real
incomes remain flat or decline over the past seven years.

1l G. Lierson and J. Rohaly (2006). The Distribution of the 2001-2006 Tax
Cuts: Updated Projections, November 2006, available at
http://www.taxpolicycenter.org/publications/url.cft?IDD411378.

The Iraq War: Rising Economic Costs
As shown in the attached JEC report, the economic costs of the
Iraq war have been substantial. The President's $195 billion
supplemental request for fiscal year 2008 ftnding includes an
estimated $158 billion for the war.12 If Congress approves this
additional request, through 2008, we will have spent over $600
billion on the Iraq war alone. This is over ten times the
administration's original pre-war estimate of $50 to $60 billion.
However, as the JEC report demonstrates, the total economic
costs of the war have been approximately double the direct
budgetary costs so far. Budget numbers do not include the
opportunity costs of financing the war with borrowed funds, the
war's impact on world oil markets, and the costs of medical care
and lost wages for wounded veterans. Should the President's
2008 supplemental be approved in full, the total economic costs
incurred for the war through 2008 will be approximately $1.3
trillion.
Even if there is a considerable drawdown of troops in Iraq, but
the occupation continues until 2017, the JEC estimates that the
total economic costs of the war will reach at least $2.8 trillion for
the entire 2003-2017 period.
THE SUBPRIME MORTGAGE CRISIS: THE HIGH
COSTS OF IGNORING FINANCIAL EXCESS
The impact of the subprime mortgage crisis on the American
economy has been swift and pervasive. As the attached JEC
report explains, during the housing boom of the early 2000s,
brokers and mortgage investors introduced a variety of new
subprime mortgage products to cater to borrowers with weak
credit or who wanted loans with little or no down payment.
Many of these mortgages, made to high risk borrowers and often
on the basis of incomplete information, were so-called "2/28"
and "3/27" hybrid adjustable rate mortgages (ARMs). A typical
12 See Congressional Research Service, The Cost of Iraq, Afghanistan and
Other Global War on Terror Operations Since 9/11, Updated November 9,
2007, available at http://www.fas.org/sgp/crs/natsec/RL33110.pdf

"2/28" hybrid ARM has a fixed interest rate during the initial two
year period. After two years, the rate is reset every six months
based on an interest rate benchmark.
As the housing boom continued, mortgage brokers and lenders
aggressively sought to make more and more of these highinterest subprime loans, which they could then rapidly sell to
investment banks seeking mortgages to pool into mortgage
backed securities.
Between 2001 and 2005, the share of
borrowers with subprime mortgages more than doubled. In 2001,
less than 9 percent of all mortgage originations were subprime.
By 2005, subprime mortgages accounted for 20 percent of all
mortgage originations.
The lengthy run-up in housing prices that began in 1997 was able
to mask the risks inherent in the proliferation of these mortgage
products. As long as home prices escalated, borrowers were able
to avoid the dangers of their interest rate resets by re-financing
their loans, or by selling their homes. However, beginning in
2006, home prices began a nationwide decline. Nationally,
nominal home prices are currently down approximately 5.0
percent from their peak in the second quarter of 2006.
Inventories of unsold new homes have increased, and the
monthly supply of new homes has risen. With housing prices no
longer rising, subprime borrowers cannot refinance their homes
to pay off loans before they reset to higher and often
unaffordable rates. As a result, the delinquency and foreclosure
rates for subprime adjustable rate mortgages have been sharply
rising. Record numbers of borrowers are now defaulting on their
loans, which has led to a crisis in the financial markets that buy
and sell these securitized mortgages and is likely to accelerate the
downward spiral of house prices.
Using state-level data, the JEC report estimates that by 2009, two
million foreclosures will occur as the riskiest subprime
mortgages (the two- and three-year adjustable rate mortgages)
reset over the course of this year and next. This will lead to the
destruction of approximately $100 billion in housing wealth.
Each foreclosure reduces the value of the home, leading to an

estimated $71 billion in losses; and those foreclosures reduce the
value of neighboring properties by an additional $32 billion.
The realized and anticipated losses from these mortgage loans,
and in the securities and financial derivatives based on them,
have caused havoc in credit markets in the U.S. and other parts of
the world. Inter-bank lending, markets for asset backed
commercial paper, and lending in the prime mortgage market
have all been disrupted.
These credit market disruptions, together with the effects of
declining household wealth and deteriorating consumer and
business sentiment, threaten to have pronounced negative effects
on GDP growth and employment. While many experts
recognized that housing prices were approaching bubble levels in
some regions and that there was a rapid increase in subprime
lending, the administration failed to act on those warnings. The
consequences of administration inaction on this issue will likely
be severe. The economic losses connected with subprime
foreclosures will be very high for homeowners and financial
markets alike, and will be a major factor contributing to the
weakened economic growth we expect to see in the coming
quarters.
ECONOMIC WELL-BEING OF HOUSEHOLDS:
STAGNATION AND DECLINE
Slow economic growth and lackluster employment gains have
been hard on America's working families. By the most important
measures of economic well-being, the majority of households
have seen little or no improvement in their standard of living
during this economic recovery. Most families get the bulk of
their income from wages and salaries, so slow employment
growth is directly related to a squeeze on the middle class.
According to the latest Census data (2006), mean household
income remains 0.5 percent below where it had been in 2000 at
the last economic peak. This recovery has generated less income
growth than prior ones: at this point in the recovery of the 1990s,
mean household income was 7.8 percent above its pre-recession

peak and at the comparable point in 1980s, mean household
income was 13.5 percent above its pre-recession peak.'3 The
growth we have seen in household income during this economic
recovery has accrued mostly to those at the very top of the
income distribution. Since 2000, families in the top fifth of the
economic ladder have seen their income rise by 1.0 percent,
while those in the middle fifth have seen their income fall by 2.5
percent and those in the bottom fifth have seen it fall by 4.5
percent (Figure 11). Slow income gains for households at the
bottom of the income distribution are directly related to rising
poverty. The percent of the population in poverty now stands at
12.3 percent, a full percentage point above the 2000 rate of 11.3
percent.
Figure 11: Percent Change in Real Mean Household Income
2000-2006
Lowest quintile

Second quintile

Middle quintile

Fourth quintile

Highest quintile
1.0

1.5
0.5
-0.5

-2.5

-3.1

-3.5
4.5
-5.5

-4.5

Note: Each quintile contains 20 percent of households ranked by household income.
Source: U.S. Department of Commerce.

The income gains that families have seen have been due to
working more, not getting paid a higher salary or hourly wage.
From 2005 to 2006, median full-time earnings fell for both male
and female workers by over a percent (1.1 percent for men and
1.2 percent for women). This is the third year in a row that
median earnings have fallen. Employment rates are higher for
both men and women, indicating that families are coping with
lower earnings by simply working more. By these measures, the
13 Because Census data is annual, we use data covering the periods 1981-1987,
1990-1996 and 2000-2006 to make these calculations.

current recovery has been inadequate for millions of families and
may not improve once we see the 2007 data. In 2006, hourly
wages increased sharply in the last half of the year and, as a
result, 2006 was the first year in three years to show growth in
inflation-adjusted weekly earnings. While inflation-adjusted
hourly wages fell in early 2007, they are now growing but at a
much slower pace than in late 2006.
During this economic recovery, millions have lost access to
health insurance. Between 2000 and 2006, the share of people
with employment-based health insurance fell from 64.2 to 59.7
percent and the share without health insurance is now at 15.8
percent, an all-time high (Figure 12). There would be more
uninsured among us except that in the late 1990s, Congress
extended Medicaid to the children of workers under the State
Child Health Insurance Program (SCHIP). Between 2000 and
2006, the share of children with employment-based health
insurance fell by 6.2 percent while, mostly because of the SCHIP
expansion, the share of children with government health
insurance rose by 5.4 percent between 2000 and 2006. Yet, even
with the SCHIP expansion, there are more children without
health insurance: from 2005 to 2006, the number of uninsured
children increased from 8 million (10.9 percent) to 8.7 million
(11.7 percent). Employment-based coverage fell for adults by
just as much as for children. However, since most adults are
ineligible for Medicaid, they are now swelling the ranks of the
uninsured.

Figure 12: Americans Without Health Insurance.
49
47
.s

45
43
41

39
37
35
2000

2001

2002

2003

2004

2005

2006

Source: U.S. Department of Commerce.

CONCLUSION
The Bush Administration has not delivered on its promises. They
estimated that their economic policies would generate strong
growth, through increasing investment and that this would lead to
strong job gains. This has not been the case. By most measures,
this economic recovery has been weak. While families have
struggled to make ends meet with incomes that are not growing,
the Administration has only offered tax cuts for the wealthy.
When we look behind the administration's claim to "six years of
uninterrupted job growth," we see the results of six years of
economic mismanagement and indifference to the aspirations of
America's middle class. Rather than setting new standards for
economic performance or even just maintaining economic and
job growth, President Bush is competing with his father for the
worst job creation record of any president since Herbert Hoover.
The economy has created only 5.9 million new jobs since taking
office, an average of 72,000 new jobs per month. At this point in
the Clinton administration, 20.2 million new jobs had been
created, an average of 246,600 new jobs per month.
The economy has expanded at an annual rate of only 2.5 percent
over the past seven years, about a third less than the 3.6 percent
average growth rate of the three economic cycles of similar

length. No economist would call that robust, strong, or fast
growth. And as former Chairman of the Federal Reserve Board
of Governors, Alan Greenspan recently noted "... somebody who
has an immune system which is not working very well is subject
to all sorts of diseases, and the economy at this level of growth is
subject to all sorts ofpotential shocks."
Unfortunately, the shocks have mounted. The subprime
mortgage crisis threatens a wave of foreclosures. The reality of
foreclosures has led to a credit crisis and serious problems for the
banking system. At every step, the administration has remained
detached and failed to take vigorous steps to put the economy
back on track.
Instead of performing the important functions of government,
the administration has focused on goals that are irrelevant to the
needs of the economy and middle-class households. While
vigorously seeking to increase defense spending, it chooses to
ignore real problems in employment, business investment,
infrastructure investment, and the economic well-being of
citizens. These are the actions of a government indifferent to and
at odds with the needs of the people it should be championing.

Sheltering Neighborhoods from the Subprime Foreclosure
Storm
Recent increases in delinquencies and foreclosures in the
subprime mortgage market have raised widespread concerns
about the possibility of accelerating foreclosures throughout this
year and next. While lenders, banks, and securities traders
scramble to figure out how to insure themselves from the market
consequences of rising subprime mortgage defaults, local
communities are struggling to stem the tide of foreclosures that
impose significant costs on families, neighborhoods and
cities. This report analyzes the subprime
foreclosure
phenomenon at the local level, describes the high spillover costs
of foreclosures, and argues that foreclosure prevention is costeffective.

Key Points
Subprime foreclosures are expected to increase in 2007 and
2008 as 1.8 million hybrid ARMS-many of which were sold
to borrowers who can not afford them-reset in a weakening
housing market environment.

Varying local economies, housing markets and state
regulatory regimes mean that some local areas are getting hit
by the subprime foreclosure crisis much harder than others
and deserve immediate attention.

It pays to prevent foreclosures, in these high-risk cities every new home foreclosure can cost stakeholders up to
$80,000, when you add up the costs to homeowners, loan
servicers, lenders, neighbors, and local governments.

Policy responses to the subprime crisis should be designed to
address the local foreclosure phenomenon and include both
foreclosure prevention strategies and improved mortgage
lending regulations.

SUBPRIME FORECLOSURES TO DATE: THE "TIP OF THE
ICEBERG"?

Over the past several months, it has become increasingly clear
that irresponsible subprime lending practices have been
contributing to a wave of foreclosures that are hitting
homeowners and rattling the housing markets. (For more
information on subprime loans, see Box A on page 3.) The loan
product that has both fueled the recent growth in the subprime
market over the past two years and that is largely responsible for
the foreclosure spikes is the so-called "exploding ARM." These
are hybrid adjustable rate mortgages that offer a 30-year loan
with an initial fixed rate that is set below market rates (often
called a "teaser" rate). When the rate resets after an initial fixed
rate period (commonly two to three years, hence the nicknames
"2/28s" and "3/27s"), it often resets to a more onerous rate that
leads to a significantly higher mortgage payment. 14 Exploding
ARMS are almost exclusively underwritten to the subprime
market, and the majority of subprime originations over the past
several years were "2/28s" and "3/27s."'5
In recent years, a significant portion of exploding ARMs have
been underwritten without consideration of whether the borrower
can afford the loans past the initial low teaser rate. Because
mortgages are often immediately bundled together and sold as
securities once a loan is placed, the primary financial incentive
for mortgage brokers is to close the deal and collect the attendant
fees and commission, rather than consider the long-term
performance of the loan. When the loan resets after the initial
teaser rate period, the overall increase in monthly payment can
be quite disruptive - particularly for subprime borrowers. A 2006
A typical 2/27 subprime borrower in 2005 may have been issued a loan at a
teaser rate of 7 percent. Two years later, as that teaser rate resets, the
borrower may see his rate reset to 10 percent. But the next time the loan resets
- typically in six months or a year - the rate will go up yet again, based on a
certain margin or spread over short-term interest rates (typically LIBOR).
'5 Testimony of Sandra Thompson, Director of the Division of Supervision
and Consumer Protection at the FDIC, Before the Committee on Banking,
Housing, and Urban Affairs of the United States Senate, March 22, 2007.
14

analysis by Fitch Ratings reported that 2/28 subprime ARMs
carried an average "payment shock" of 29 percent over the
teaser-rate payment, even if short-term interest rates remained
unchanged. 6 Since the short-term interest rate (LIBOR) that
determines the rate at which the loan resets increased at the end
of last year, the payment shock is even higher now - at
approximately 50 percent by some estimates. 17
This payment shock can be even more disastrous for borrowers
who qualify for loans with an initial low rate based on stated
income (qualifying the borrower based on the income they state
on their loan applications, also called "liar loans" or "no-doc"
loans) or reduced documentation ("low-doc" loans). Roughly
half of all subprime borrowers in the past two years have been
required to provide only limited documentation regarding their
incomes.'8 And an estimated ninety percent of borrowers in
stated income loans exaggerated their income.19
Today's housing market - with increasing rates and a softening
of home prices-has placed increased stress on risky subprime
loans. When ARMs reset to higher rates and borrowers can't
make the higher mortgage payments, delinquencies result.
Borrowers who attempt to refinance unsuitable loans before they
reset find that falling home prices make it difficult for them to do
so, especially if their loan is "upside down" because they owe
more than their house is worth. Recent statistics issued by the
Mortgage Bankers Association's nationwide survey show that
14.44 percent of subprime borrowers with ARM loans were at
least 60 days delinquent in their payments in the fourth quarter of
2006.20 This is up from third quarter delinquency rate of 13.22
percent for such mortgages, representing a four-year high.
16 Al Heavens, "On the House; Subprime Loans Start Inflicting Pain," The
Philadelphia
Inquirer, March 25, 2007.
17
ibid.
18 Credit Suisse, "Mortgage Liquidity du Jour: Underestimated No More,"
March 12, 2007.
19 Mortgage Asset Research Institute, Inc., Eighth Periodic Mortgage Fraud
Case Report to Mortgage Bankers Association, April 2006.
20
National Delinquency Survey, Mortgage Bankers Association, March 2007.

Although there is much debate among industry analysts,
economists, policymakers and the media about the risk of
accelerating defaults in the subprime market going forward, a
federal regulator recently agreed at a Senate Banking Committee
hearing that we are only at the-"tip of the iceberg" in terms of
subprime foreclosures. 2 ' The FDIC estimates that this year
alone, one million of these loans will reset to higher rates. Next
year, approximately 800,000 are anticipated to reset to more
onerous payments. 2 If housing prices continue to fall in 2007
and into next year, then last year's foreclosure spike is probably
only the beginning and we could be, as the Center for
Responsible Lending (CRL) has predicted, entering "the worst
foreclosure experience in the modem mortgage market." 23 In
fact, CRL estimates that approximately one in five of the
subprime loans issued in 2005 and 2006 will go into default,
costing 2.2 million homeowners their homes over the next several
years. 4 According to foreclosure tracker, RealtyTrac, 1.2 million
foreclosures were reported nationwide in 2006 alone, an increase
of 42 percent since 2005. That translates into one foreclosure
event for every 92 households. 25 And, according to RealtyTrac,
the pace of foreclosures has continued into 2007, with
foreclosures on track to match or surpass 2006 levels. 26
Gene Sperling, "Subprime Market-Isolated or a Tipping Point,"
Bloomberg News, March 14, 2007; Testimony of Emory W. Rushton, Senior
Deputy Comptroller and Chief National Bank Examiner, Office of the
Comptroller of the Currency, Before the Committee on Banking, Housing, and
Urban Affairs of the United States Senate, March 22, 2007.
22 Testimony of Emory W. Rushton, Senior Deputy Comptroller and Chief
National Bank Examiner, Office of the Comptroller of the Currency, Before
the Committee on Banking, Housing, and Urban Affairs of the United States
Senate, March 22, 2007 (In the Questions and Answers portion of the
hearing).
23 Ellen Schloemer, Wei Li, Keith Ernst, and Kathleen Keest, Losing Ground:
Foreclosures in the Subprime Market and Their Cost to Homeowners, Center
for Responsible Lending, December 2006.
24
Ibid
21.

RealtyTrac 2006 US Foreclosure Market Report, January 25, 2007.
RealtyTrac Foreclosure Database, January and February 2007 foreclosure
numbers.
25

25
BOX A: Subprime Loans: The Good, the Bad, and the Ugly
Subprime mortgages are a relatively new and rapidly growing segment of the
mortgage market. While subprime loans have expanded home ownership
opportunities for borrowers with low or limited credit histories, this expanded
opportunity has come at a cost as subprime mortgages carry higher interest
rates than prime mortgages to compensate for the increased credit risk."
Since their inception, subprime loans have been controversial. On the one
hand, the subprime market has opened up credit opportunities to people who
might not otherwise be able to finance home purchases and has thus
contributed to expanding homeownership. On the other hand, the subprime
market has created opportunities for "predatory" lending to the extent that
unscrupulous lenders have hidden the true cost of subprime loans from
unsophisticated borrowers. According to the chief national bank examiner for
the Office of Comptroller of the Currency, only 11 percent of subprime loans
went to first-time buyers last year. The vast majority were refinancings that
caused borrowers to owe more on their homes under the guise that they were
saving money.
During the recent housing boom, the subprime mortgage market changed
dramatically. From 2001 until last year, historically low mortgage rates,
rising home prices, and increased liquidity in the secondary mortgage market
enticed more non-bank lenders (who are not subject to federal regulation) to
relax their loan underwriting standards and attracted new mortgage brokers
with little business experience into the market. Commercial banks and Wall
Street firms provided these lenders with capital by buying up subprime
mortgages, repackaging them into mortgage-backed securities, and selling
them to hedge funds and private equity investors looking for higher returns
than less risky Treasury and corporate bonds. As a result, loans to subprime
borrowers jumped from just 8 percent of total mortgage originations in 2003,
to 20 percent in both 2005 and 2006.29 There are now $1.3 trillion in

Generally, the increased interest rate charged to subprime borrowers ranges
from one to three percent higher than prime rates. For a more in depth
discussion of the evolution of the subprime mortgage market, see Souphala
Chomsisengphet and Anthon Pennnington-Cross, "The Evolution of the
Subprime Mortgage Market," Federal Reserve Bank of St. Louis Review,
January/February 2006, 88(1), pp. 31-56.
2' Les Christie, "Subprime Losses Lead to Drop in Home Ownership,"
CNNMoney.com, March 27, 2007.
29 Testimony of Emory W. Rushton, Senior Deputy Comptroller and Chief
National Bank Examiner, Office of the Comptroller of the Currency, Before
the Committee on Banking, Housing, and Urban Affairs of the United States
Senate, March 22, 2007.
27

26
subprime loans outstanding, up from $65 billion in 1995 and $332 billion in
2003.3°
The subprime loan market often operates below the federal regulatory radar
screen. Although bank lenders are subject to bank regulatory standards,
mortgage brokers and loan officers in non-bank companies are not subject to
federal enforcement of lending laws. Rather, states have the primary
enforcement responsibility for regulating these mortgage brokers. Statechartered mortgage brokers and nonbank affiliates underwrote approximately
77 percent of subprime loans in 2005.31 While some states have taken
measures to improve the licensing, education and experience requirements for
non-bank brokers and lenders, many states lack the resources and/or mandates
to police predatory lending practices.
Subprime mortgage loans are most prevalent in lower-income neighborhoods
with high concentrations of minorities.3 2 In 2005, 53 percent of African
American and 37.8 percent of Hispanic borrowers took out subprime loans
due in large part to limited access to sound financial counseling, availability of
alternative loan products, and limited assets and income. 33 A study by the
Department of Housing and Urban Development and the United States
Treasury found that subprime loans were issued five times more frequently to
households in predominantly black neighborhoods as they were to households
in predominantly white neighborhoods, even after controlling for income.
Moreover, many of these minority borrowers were steered into subprime loans
when they may have qualified for less expensive, prime loans. 34 Because
minorities and low-income households have less financial resources to draw
upon to help restructure or refinance mortgage loans with steeply escalating

Statement of Scott M. Polakoff, Deputy Director Office of Thrift
Supervision, "Nontraditional Mortgages and Supbrime Hybrid Adjustable
Rate Mortgages," before the Committee on Banking, Housing and Urban
Affairs, U.S. Senate, March 22, 2007; Souphala Chomsisengphet and Anthon
Pennnington-Cross, "The Evolution of the Subprime Mortgage Market,"
FederalReserve Bank of St. Louis Review, January/February 2006.
Scrutinized in Mortgage
31 Greg Ip and Damian Paletta, "Regulators
Meltdown," The Wall Street Journal. March 22, 2007.
32 Paul Calem, Kevin Gillen and Susan Wachter, "The Neighborhood
Distribution of Subprime Mortgage Lending," Journalof Real Estate Finance
and Economics, 2004, vol. 29 (4).
33 Allen J. Fishbein and Patrick Woodall, "Subprime Locations: Patterns of
Geographic Disparity in Subprime Lending," Consumer Federation of
America, September 5, 2006, pg. 4.
34 Ibid; US Department of Housing and Urban Development and US
Department of the Treasury, "Curbing Predatory Home Mortgage Lending,"
2000.
30

27
payments, adverse housing market conditions can put these homeowners at
greater risk of defaults.

THE FORECLOSURE STORY AT THE LOCAL LEVEL

While national foreclosure and delinquency rates are telling, an
examination of local-level foreclosure data reveals that the
subprime lending woes are affecting some states and cities much
more than others. A number of states and cities have much
higher delinquency and foreclosure rates than the national
average, and these localities deserve particular attention from
state and federal policymakers as they craft their responses to the
subprime market crisis. Local economies, housing market
conditions, and regulatory environments can help explain why
particular regions are getting hit the hardest by subprime
troubles. Using state- and city-level foreclosure and delinquency
data provided to the Joint Economic Committee by RealtyTrac
and First American LoanPerformance, the following analysis
highlights areas where subprime delinquencies are getting worse,
and where foreclosures are on the rise.
According to RealtyTrac's data for 2006, states in the Midwest
(Ohio, Michigan, Illinois, and Indiana), the South and West "Sun
Belt" (Florida, Georgia, Texas, California, Arizona and Nevada),
and Colorado experienced the highest rates of foreclosures in
2006.35 RealtyTrac estimates that nearly 60 percent of these
foreclosures are subprime loans, even though subprime loans
comprise only 14 percent of the total mortgage debt
outstanding. 3 6 (See table below.)
The RealtyTrac U.S. Foreclosure Market Report provides the total number
of homes entering some stage of foreclosure nationwide each quarter of 2006.
The total for each quarter and for the year includes foreclosure filings for all
three phases of foreclosure: defaults, auctions, and real estate owned
(properties that have been foreclosed on and repurchased by a bank.) One of
the difficulties in measuring subprime data more accurately on a local level is
that loan documents are not labeled as "prime" or "subprime," so RealtyTrac
uses a prevailing rate methodology instead. That is, they compare the loan
rate to the Freddie Mac index of prime rates on the date of issuance, and
assign any loan with a rate more than 2 percentage points above the prime rate
as subprime.
36 Interviews with RealtyTrac; Mortgage Bankers Association 2006 Survey.
35

28
Figure 1: State Foreclosure Rankings (2006)
:e
ActaIon
Fiscdoaue
Rank'
-

Stat,
Unitd Stats

lmMOreto Forcota
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24
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35
13,4
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Delinquent mortgage payments by borrowers are an indicator of
future foreclosures. Once a mortgage is 90 days delinquent, the
lender will generally begin the foreclosure process, which varies
by states. According to February 2007 data from First American
LoanPerformance, the areas with the highest increase in
delinquencies over 60 days from February 2005 to February
2007 largely mirror the areas that experienced the most
foreclosures in 2006-indicating that these areas are at higher

risk of experiencing even more foreclosures in 2007.37 Notably,
there is also a significant spike in subprime delinquencies in the
Northeastern corridor states of New York, Massachusetts, New
Hampshire, New Jersey, and Rhode Island, suggesting possible
increases in foreclosures for those states in months to come. The
following discussion looks at each of these high risk regions
individually.
The Midwest
Last year, Detroit, Michigan had the highest percentage of
households in foreclosure in the 150 largest metropolitan areas,
with an average of more than 10,000 foreclosures in each quarter.
Foreclosures in Detroit in 2006 directly affected 4.4 percent of
the city's households-one foreclosure event for every 21
households, nearly five times the national average of one
foreclosure event for every 92 households. Detroit's depressed
automotive industry has no doubt contributed to increased high
foreclosure rates. From 2001 to 2006, the Detroit metropolitan
area lost 132,800 jobs, 65 percent of which were in the
manufacturing sector. 38 In 2006, Detroit had an unemployment
rate of 9.7 percent - nearly double the U.S. average. 3 9 (See table
below. For a detailed listing of the top 50 metropolitan areas by
foreclosures, see Appendix A.)
Over the first quarter of 2007, the foreclosure trend in the Detroit
area has gotten worse rather than better. According to RealtyTrac
data, Detroit is on pace to record 11,000 foreclosures in the first
quarter of 2007, about 1,000 more than the 2006 quarterly
average.
In Ohio and Indiana sagging job markets may also be responsible
for recent foreclosure spikes. But states have been hit hard by
manufacturing job losses in recent- years. Cities such as
First American LoanPerformance subprime delinquency estimates are based
on the value of mortgages outstanding and a coverage of 49 percent of
subprime-mortgage originators.
38 Bureau of Labor Statistics, 2006.
37

39
40

Bureau of Labor Statistics, 2006.
RealtyTrac Foreclosure Database, as of April 10, 2007.

Indianapolis, Cleveland, Dayton and Akron are ranked in the top
20 metropolitan areas nationally with the highest number of
foreclosures in 2006. In Indianapolis (ranked 3rd), there was one
foreclosure event for every 23 households last year. In
Cleveland, the ratio of foreclosures to households was one in 40,
while in Dayton and Akron, one in 43 households entered into
foreclosure last year. (See table below.)
In addition, the states of Michigan, Ohio and Indiana lack strict
requirements for licensing brokers and lenders, and testing
requirements for loan originators.4 1 The state of Michigan does
not regulate or license individual mortgage brokers and lenders
(as opposed to companies), nor provides testing requirements for
loan originators. Like Michigan, the Indiana institution that
regulates lenders-the Department of Financial Institutionsneither regulates nor licenses individual brokers or lenders and
has no testing requirement for loan originators. While Ohio does
have licensing requirements for individual brokers, there are also
no testing requirements for loan originators. (See Appendix D
for more information.)
Fi ure 2: Midwest Metro Areas with Hi hest Foreclosures in 2006
-

. PIRM.

Igt.

Foreclosure Rt, £2008
ationrl
Forclosures to Foreclosures
os
FOrecdosure Numberof
Percet of.
MSA
Rank'
Households
Households
OeftUVord4Xa.b=rn, Ml
1
121
4.9
lIrotnapoa.lIN
3
123
4.3
Clew at.Etyuta.mcnter,
OH
14
140
25
OVAtn' OH
15
1:43
2.3
AleenOH
16
1:43
2.3
Columbus.
OH
19
1 45
22
LakeCoury-Keo Count,IL-WI
21
1:48
21
CItago-Naperetb-Joht,IL
22
1:5D
2.0
Warren.Farn>lngton
H>ts-Tray. ml
28
158
1..
ToledoOH
3D
16D
1.7
Gary,IN
44
t81
12
C1~cinnalkM~dte~j~towt-W1Jmion.
O~l(NY4N
4i
1:87
1.1
lPsbtOgl PA
8
1:.8
1.1
IlnatedSt~iat
18:2
11
SourcoaNeltyTmac
and arBeau
of LaborStaites, U.S. Departmet of Labor
'Foreclore~ws
emarented
SoreIm
Itiest
rate of efor ures)to 150Poeest rateof f1tocleetrs).

Unemployment
Rate(2006)
8.
45
5.
5.
52
4,7
415
4.4
82
6.1
5.4
51
48
4A

The Midwest communities are at high risk of experiencing rising
foreclosures over the coming months. The high level of
4' Survey of the Conference of State Bank Supervisors (CSBS) and American
Association of Residential Mortgage Regulators (AARMR) Agency Licensing
Survey," January 2006.

subprime delinquencies in these communities as of February of
this year suggests a likely increase in the number of foreclosures
going forward. According to data provided by First American
LoanPerformance, 24 percent of all subprime loans in Detroit
were delinquent 60 days or more as of February 2007, an
increase of nearly 10 percentage points since February 2005. In
Flint and Jackson, Michigan, subprime delinquencies climbed to
over 20 and 22 percent, respectively in February 2007, an
increase of 8 and 10 percentage points since February 2005. In
the Ohio cities of Cleveland, Akron, Canton and Dayton, at least
19 percent of subprime loans were in delinquency in February
2007, with Cleveland leading with 24 percent of subprimes loans
delinquent. Across the state, subprime delinquencies are up 4
percentage points on average versus February 2005. And in the
Indiana cities of Indianapolis, South Bend and Muncie at least 18
percent of subprime loans were 60 or more days delinquent in
February 2007, an average increase of 5 percentage points since
February 2005. (See map below. For a detailed table of historical
subprime delinquency rates in cities and states across the U.S.,
see Appendix B.)
Figure 3: Increase in Subprime Mortgages 60+ Days Delinquent (in
Percent Points)
J_'_
A
_
-r

32
Source: First American LoanPerformance data comparing the percentage of
subprime mortgages 60 days or more delinquent, in February 2005 and
February 2007.

The Sun Belt
In the Sun Belt states like California and Florida, where job
markets are generally healthier, unemployment is typically
lower, and incomes are higher than the national average, a
different story unfolds. Steep home price appreciation and
population influxes, followed by flat or falling home prices, have
created a difficult housing market for all recent mortgage
borrowers-but particularly for subprime borrowers. For
example, borrowers who took out adjustable rate loans in 2003
and 2004 when home prices were rising are finding that falling
home prices are making it very difficult for them to refinance
their exploding ARMs before the teaser rate period expires,
especially if they are "upside-down" on their loan.
Figure 4: Western Sunbelt States Heat ]

Seven metropolitan areas in the top 50 foreclosure areas are in
California, where home prices appreciated rapidly from 2001
until last year. Although home prices have continued to rise, the
rate of increase declined by 17 percentage points across the state

in 2006. Six of Florida's metropolitan areas are among the top
50 in foreclosures. Florida experienced rapid growth in housing
prices from 2001 up until last year, when home price
appreciation decelerated by nearly 19 percentage points in 2006.
Similarly, Nevada and Arizona experienced a deep slowdown in
home price appreciation in 2006, by 15 and 26 percentage points
respectively, after rapid acceleration during the housing boom.
(See table below.)
Figure 5: Florida Heat Map

#nreme in Sildme"Moflgage eG DaysDanvouet (Paere, Pokts)

LiBtA 2M0. H. Chm.p
,M

14
T~~~~~~wo

Notably, the California Department of Corporations, which
regulates mortgage brokers and lenders, does not require
regulation or licensing for individual brokers and lenders (as
opposed to companies). The state of Nevada does not have
testing requirements for loan originators. Florida has reasonable
state regulations and requirements for mortgage lenders and
brokers, and Arizona's state legislature is currently working on
adopting measures to better regulate individual brokers and
lenders. (See Appendix D for more information.)
In many areas of the Sun Belt states-where housing prices have
surged-the delinquency rates have increased quickly, indicating
more foreclosure trouble to come. For example, in Sacramento,
California, 60-day delinquencies for subprime loans increased 12

percentage points from 3 percent of all subprime loans in
February 2005 to 15 percent of all subprime loans in February
2007. 42 And in Fort Meyers, Florida, delinquencies spiked 8
percentage points to 13 percent from February 2005 to February
2007. (See maps below, and Appendix B for more cities.)
Figure 6: Sun Belt Metro Areas with Highest Foreclosures in 2006

-.
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Northeast

Although the Northeastern states did not rank as high as the Sun
Belt and Midwest states in foreclosures in 2006, a closer look at
the localities along the Northeast coast also suggest more
foreclosures to come. Five Northeastern metro areas were in the
top 50 metropolitan areas with the most foreclosures in 2006:
Camden, Newark, and Edison, New Jersey; Long Island, New
York; and Philadelphia, Pennsylvania. All five metro areas fared
worse than the national average of foreclosures in 2006. While
these areas have unemployment rates close to the national
average, these five metro areas have in common cooling housing
markets, with an average of a 10 percentage point slowdown in
home price appreciation from 2005 to 2006. (See chart below).

FirstAmerica LoanPerformance data, as of April 6, 2007.

35
Figure 7: Northeast Metro Areas wit

NftWk.Ut*

Famdwmm 3 Fawndsw
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H
imhO4 Houstonl
Rob
t54
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Foreclosures in 2006

M0 I

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Is4
145
14 7
144
158

o5.l
.102l

50
43
43

.7 l
ms.

e (ap
Wued Ice_}.

Figure 8: Northeast Heat Map

1-._-8

-;1-

5-1

-~N~
- I
)

Source: First American LoanPerformance data comparing the percentage of
subprime mortgages 60 days or more delinquent, in February 2005 and
February 2007.

The most recent subprime delinquency data suggest that the
Northeastern cities will likely see more foreclosures in the
coming months. Delinquencies are on the rise in all five metro
areas entering into 2007. Across New York, 13 percent of
subprime loans were 60 or more days delinquent as of February
2007, up 7 percentage points since February 2005, with the
highest increases in Long Island, Dutchess County, and New
York City. New Jersey also had 13 percent of subprime loans
delinquent in February, an increase of 6 percentage points in two
years, with the sharpest increases in Newark and Monmouth-

Ocean. In Pennsylvania, a state where 13 percent of subprime
loans were also delinquent in February 2007, Philadelphia had
the highest increase in delinquencies over the last two years, with
a 5 percentage point increase. (See map below.)
Colorado
Colorado experienced the highest level of foreclosures per
household of any state in 2006, with one foreclosure for every 33
households, a substantial jump over previous years. 43 The city of
Denver has been hardest hit, with one foreclosure for every 24
households.44 Yet unlike the Midwest states, Colorado has a
lower unemployment rate than the national average and a healthy
job market. And unlike the Sun Belt and Northeastern regions,
Colorado has not had a dramatic change in home price
appreciation in recent years. For example, from 2005 to 2006,
home prices appreciation Denver decelerated by 3.2 percentage
points, compared to a 7.3 percentage point deceleration
nationwide.
Rather, insufficient lending protections may have been the main
contributor to the increased foreclosures in Colorado as many
homeowners signing loans they were unable to afford during the
housing boom. Notably, limited state regulation, licensing and
education requirements for brokers and lenders as well as weak
anti-predatory lending laws have contributed make Colorado one
of the highest-ranking states for mortgage fraud in the country. 45
Colorado legislators themselves argue that lax enforcement
combined with the proliferation of non-traditional loans
substantially contributed to the state's rapid increase in
foreclosures. 4 6
The Colorado state legislature is currently

RealtyTrac, "More than 1.2 Million Foreclosures Reported in 2006
According to RealtyTrac U.S. Foreclosure Market Report," January 25, 2007
43

44Ibid.

Associated Press, "Colorado Legislators Introduce Measures Targeting
Foreclosures," February 27, 2007.
45

David Ollinger, "Two Bills Target Home Loans," Denver Post, February
26, 2007.

considering a licensing bill that includes enhanced education and
testing requirements for mortgage lenders and brokers.4 7
FORECLOSURES ARE COSTLY TO LOCAL COMMUNITIES

Foreclosures entail substantial costs for individual borrowers and
lenders. Additionally, foreclosures can also impact cities and
neighborhoods, particularly if concentrated, by putting
downward pressure on neighboring housing prices and raising
costs for local governments.
Costs of Foreclosuresto Families
A home is the primary asset for the majority of America's
families. This is particularly true for low-and moderate-income
families, minority families, and young couples, as most have a
large portion of their assets tied up in their homes. As noted,
these are the same population groups that are most at risk of
foreclosure due to unsuitable subprime loans. For a homeowner,
a foreclosure results not only in the loss of a stable living place
and significant portion of wealth, but also reduces the
homeowner's credit rating, creating barriers to future home
purchases and even rentals. For the homeowner, foreclosures
also create a possible tax liability, since any principal balance
and accrued interest forgiven is treated as taxable income for the
owner.
Foreclosures are also costly from a legal and administrative
standpoint. According to one estimate, the average foreclosure
results in $7,200 in administrative charges to the borrower. 48
Cost of Foreclosuresto Businesses
Lenders also bears substantial foreclosure related costs, which
helps explain why the spike in foreclosures has put significant
financial pressure on the residential mortgage industry. Lenders
do not typically benefit from taking over a delinquent owner's
property, so they have an incentive to prevent foreclosure. A
Svaldi, Aldo, "Bill for Mortgage Broker License Passes Senate Committee,"
Denver Post, March 19, 2007.
48 Anne Moreno, The Cost-Effectiveness of Mortgage ForeclosurePrevention,
Minneapolis: Family Housing Fund, 1995.
47

study from the Federal Reserve Bank of Chicago reported that
lenders alone can lose as much as $50,000 per foreclosure. In
2003, this translated into approximately $25 billion in
foreclosure-related costs for lenders alone-well before the 2006
foreclosure spike.4 9 Indeed, substantial losses have led many of
these lenders to tighten their lending standards, which will make
it even more difficult for families facing foreclosure to refinance
their homes, or purchase another if they have already foreclosed.
Costs of Foreclosuresto City and Local Governments
Foreclosures can also be very costly for local governments,
particularly when they result in property vacancies. A foreclosed
property that remains on the commercial market too long and
becomes vacant can become an economic and administrative
drain for cities. Moreover, cities, counties and local school
districts lose tax revenue from abandoned homes. A Chicago
case study by the Homeownership Preservation Foundation
estimates that a city can lose up to nearly $20,000 per house
abandoned in foreclosure in lost property taxes, unpaid utility
bills, property upkeep, sewage and maintenance. 5 0 Many of
these costs of foreclosure fall on taxpayers who ultimately pay
the bill for foreclosure-related services provided by their local
governments.
For example, several suburbs of Cleveland are already spending
millions of dollars in an effort to maintain vacant houses as they
try to contain the fallout of mortgage foreclosures. 5 1 It was
recently reported that there are more than 200 vacant houses in
Euclid (a suburb of Cleveland). Many of Euclid's 600
foreclosures over the past two years were homes of elderly
people who refinanced with 2/28s (low two-year teaser rates),
Desiree Hatcher, "Foreclosure Alternatives: A Case for Preserving
Homeownership," Profitwise News and Views, Chicago Federal Reserve
Bank, February 2006.
50 William C. Apgar and Mark Duda, "Collateral Damage: The Municipal
Impact of Today's Mortgage Foreclosure Boom," National Multi-Housing
Council, May 11, 2005.
51 Erik Eckholm, "Foreclosures Force Suburbs to Fight Blight, New York
Times March 23, 2007.
49

then saw their payments grow by 50 percent or more after the
rates reset." The suburb is currently losing $750,000 in property
taxes a year from the vacant houses.53
Costs of Foreclosureon NeighboringHomeowners
Finally, foreclosures can have a significant impact in the
community in which the foreclosed homes are located. Studies
have found that there is a contagion effect whereby concentrated
foreclosures cause additional foreclosures in the community. 5 4
For lower-income communities attempting to revitalize, the
consequence could be a substantial setback in neighborhood
security and sustainability.
Areas of concentrated foreclosures can affect the price that other
sellers can get for their houses. As higher foreclosure rates ripple
through local markets, each house tossed back into the market
adds to the supply of for-sale homes and could bring down home
prices. A recent study calculated that a single-family home
foreclosure lowers the value of homes located within one-eighth
of a mile (or one city block) by an average of 0.9 percent, and
more so in a low to moderate-income community (1.4 percent). 5 5
For a foreclosure in Atlanta, for example, where the median
home price is $218,500, this would result in a decline in home
prices of approximately $3,100 per single-family home within an
eighth-mile. (For a table of neighboring home price impact of
subprime foreclosures in the largest 50 foreclosure metropolitan
areas, see Appendix C.)
In a more recent estimate of subprime foreclosures on home
prices, the chief economist for Moody's Economy.com projected
that subprime defaults (which he expects to reach 800,000 this
year alone) could result in mid-single digit declines in housing
52

Ibid.

53 Ibid.

NeighborWorks America, Effective Community-Based Strategies for
PreventingForeclosures, September 2005.
54

Dan Immergluck and Geoff Smith, "The External Costs of Foreclosure: The

Impact of Single-family Mortgage Foreclosures on Property Values," Housing
Policy Debate, Vol. 17, Issue 1, 2006.

prices, and as much as double-digit declines in areas such as
Arizona, Nevada, parts of California and Florida. 56 Assuming
that this projection is correct-a 15 percent decline in home
prices in Nevada would cost the average home owner $42,450 in
lost home equity, based on the median home price in Nevada of
$283,000.57
The impact of increased foreclosures on local housing prices can
be more severe in areas where credit tightening adversely affects
the availability of loans, and consequently the demand for
housing. In response to the subprime crisis, commercial banks
are tightening their underwriting standards for residential
mortgages in general, as evidenced by the most recent Federal
Reserve survey of bank lending terms. According to the survey, a
net 15 percent of banks reported they had tightened their lending
standards for residential mortgages - the largest percentage since
the second quarter 1991.58 According to one estimate, about
890,000 fewer Americans this year will be able to obtain
financing to purchase a home because of tighter lending
standards. 59 Moreover, it typically takes a victim of foreclosure
10 years to recover and buy another house, which means that
more and more potential homeowners will be taken out of the
home buyer base.60
Finally, the predominance of subprime loans in low-income
and/or minority neighborhoods means that the bulk of the
spillover costs of foreclosure are concentrated among the
nation's most vulnerable households. These neighborhoods
already have higher incidences of crime, and increased

Les Christie, "Scary Math: More Homes, Fewer Buyers," CNNMoney.com,
March 13, 2007.
56

Census Bureau, American Community Survey, 2005.
Federal Reserve, The January 2007 Senior Loan Officer Opinion Survey on
Bank Lending Practices, January 2007.
59 Credit Suisse, "Mortgage Liquidity du Jour: Underestimated No More,"
March 12, 2007.
60 Schlomer et al, December 2006.
58

U.S.

foreclosures have been found to contribute to higher levels of
violent crime."
Figure 9: The High Costs of Foreclosures
Stekehotders
Homeowner
Lender
Loatl Government
Neighbor'es Home Value
Estiat~ed TobtalCosts of Foreclosure

Estimated Costs Per Foreclosure

$
$

7,200
50,W00
19,2277 3
1,508

7735

$
5$

Sourc
IAnneMoferano
TheConl.Sthcstheesa
of
Fmchbsurlo nf
Minneapnot
Farnir FHousing
Fund,I995
eo, Hutihe: 1otracsunree
ARometma.
A em forProsering HornoenasAhip.
P Flwing
Abowand oVine Febusjar208,
and MarkDuda, a
of'l rneWnlThe
beforeforeclosure
Isroornsted Wlism C Apger
aHurno; pra isabandoned
MOaW Foroidwo
Boorn HomeornseiprFPsorvation Founation, May 11.21Db.
Manninalorpec of Tuoday's
aEsfirnaete

pco doeptciatn baeodan tio national rnodianharnmrcoe oI$17,500 es of205. CensusBurnau
Aksumesa
.9 percenthoame
2005 AnencanCommnuniy
Suwey. Dan Immergbuk
and GeaffSmtb, 'TheEAto CostsofForeclsuiroThe Impeat
of SinleFahilj Mortgnap
Foroisures onProperty
Vues, ushopI-xS Debns. VIL 17.Issue1,

CONCLUSION: IT PAYS TO PREVENT FORECLOSURES

Foreclosures are costly - not only to homeowners, but also to a
wide variety of stakeholders, including mortgage servicers, local
governments and neighboring homeowners. The high costs of
foreclosures - up to $80,000 for all stakeholders combined present a strong incentive to prevent them. In their efforts to
respond to the subprime foreclosure crisis, policymakers may
want to consider enacting some combination of the following
measures to prevent future foreclosures that may come as a result
of a high concentration of unsuitable loans in areas of economic
downturns, areas of steep housing market slumps and areas of lax
regulatory enforcement.
Increase Federal Support for Local Foreclosure Prevention
Programs. In the short term, local community-based non-profits
may be best positioned to implement foreclosure prevention
programs. State and national organizations exist throughout the
country to both enhance homeownership and prevent
According to a study by Dan Immergluck and Geoff Smith, a standard
deviation increase in the foreclosure rate (about 2.8 foreclosures for every 100
owner-occupied properties in one year) corresponds to an increase in
neighborhood violent crime of approximately 6.7 percent). Dan Immergluck
and Geoff Smith, "The Impact of Single-Family Mortgage Foreclosures on
Neighborhood Crime," Housing Studies, Vol. 21, No. 6, November 2006.
61

foreclosures. Many of these programs have been successful in
coordinating a wide range of services for borrowers in order to
help restructure unsuitable loans, aid borrowers with foreclosures
prevention counseling or initiate legal action against the most
egregious predatory lenders. 62 Some of these programs also
provide financial assistance, such as low-interest bridge loans to
help borrowers recover from delinquency. To assist existing
community-based nonprofits with increasing caseloads, the
federal government should work with nonprofits with proven
track records and consider providing them with enhanced
funding. Estimates suggest that foreclosure prevention costs
approximately $3,300 per household - substantially less than
the nearly $80,000 in costs offoreclosure described above. 6 3
Strengthen and Reform FHA. The Federal Housing Authority
(FHA) currently issues more than $100 billion in mortgage
insurance annually for loans made by private lenders to lowincome, minority and first-time buyers. However, the FHA has
not provided insurance for borrowers in the subprime market and
its market share has steadily dropped in the last several years.
William Apgar, at Harvard's Kennedy School of Government,
has proposed that the FHA should be funded and revamped to
oversee a "rescue fund" to purchase the portfolios of failed
64
While
mortgages and try to restore the credit on these loans.
this policy option would also include upfront costs, companies
holding such portfolios may be likely to sell at reduce costs given
the prospect of mass delinquency and foreclosure.

NeighborWorks, Effective Community-Based Strategies for Preventing
Foreclosures, September 2005; Almas Sayeed, "From Boom to Bust: Helping
Families Prepare for the Rise in Subprime Mortgage Foreclosures," Center for
62

American Progress, March 13, 2007.
63

Ana Moreno, Cost-Effectiveness of Mortgage Foreclosure Prevention,

Family Housing Fund, November 1995.
64 Bill Swindell, "FHA Overhaul Might Be Part of a Subprime Loan
Solution," NationalJournal, March 20, 2007.

To prevent the origination of risky subprime mortgages designed
to fail their borrowers going forward, the following measures
may be helpful:
Strengthen Regulation of Mortgage Origination at Federal
Level. Although bank lenders are subject to bank regulatory
standards, mortgage brokers and loan officers in non-bank
companies are not subject to federal enforcement of lending
laws.
Rather, states have the primary responsibility for
regulating these mortgage brokers. While some states have taken
measures to improve the licensing, education and experience
requirements for non-bank brokers and lenders, many states still
lack sufficient oversight requirements. Thirty-nine states,
including the District of Columbia, do not have testing
requirements for loan originators and/or broker and lending
executives, and 17 states, including the District of Columbia, do
not have licensing requirements for individual brokers and
lenders. (See Appendix D.) Improved federal oversight and
enforcement could enhance industry practices, including loan
underwriting, while further protecting borrowers. Federal
standards could include licensing for individual brokers and
lenders (not just companies) and minimum education and
experience standards. Efforts are currently underway in Congress
to investigate ways to strengthen the existing federal mortgage
regulatory structure to improve compliance among non-bank
mortgage brokers.
Create a Federal Anti-Predatory Lending Law that Bans
Unfair and Deceptive Practices. Currently, no anti-predatory
lending law exists at the federal level, but such a law is being
considered in Congress. In the process, policymakers should
investigate whether they should prohibit certain types of harmful
loan provisions and practices all together, like pre-payment
penalties, stated income or low documentation loans.
In
addition, lawmakers should consider requiring all subprime loan
borrowers to escrow property taxes and hazard insurance.
Establish Borrowers' Ability to Pay Standard. In the financial
services sector, investors are required to meet a "suitability

standard" prior to being allowed to invest in certain products,
based on their ability to afford the risk. Policymakers should
consider how to apply similar tests to mortgage borrowers and
lenders. Many exploding ARMs were approved based on the
borrower's ability to pay the mortgage only in the first two or
three years of the loan at the teaser rate, when the interest rate
was lower, but not over the life of the loan once it resets with
higher interest rates. A stricter standard to determine borrowers'
ability to afford the loan over the life of the loan could prevent
borrowers from being trapped in mortgage products that will lead
them down the path to ultimate foreclosure.
Disclosures Relating to Alternative Mortgage Products Must
Be Enhanced. The full impact of new complicated features such
as teaser rates, interest-only payments and option-payments must
be clearly and effectively communicated to potential borrowers.
Existing disclosures designed for traditional mortgage products
that tell borrowers that their payment "may increase or decrease"
based on interest rate changes are not adequate for explanation of
a teaser-rate mortgage in which payments increase dramatically
after two or three years. Additionally, these disclosures must be
written in plain language and must be prominently displayed in a
manner that is visually clear and effectively communicates the
intended information to the potential borrower. Lenders must be
given a new format and new requirements for alternative
mortgage product disclosure. This new disclosure should include
a table clearly displaying a full payment schedule over the life of
the loan, all fees associated with the loan, an explanation of the
"alternative" features of the loan (i.e. negative amortization), and
a full explanation of the risks associated with taking advantage of
those features, including the timeframe in which borrowers were
likely to feel the negative effects of those risks.

APPENDIX A: METROPOLITAN AREAS WITH HIGHEST
FORECLOSURES
Figure 10: US Metropolitan Areas with Highest Foreclosures in 2006
1111111111INWmilf
=-.

JJEIMEF111;tn

National
Foredowsre
Rank'
I
2
3
4
5
8
7
8
9
10
I1I
12
13
14
15,
16
18
18
19
20
21
22
23
24
25
25
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50

Metro Areas
DefreX-Uvonli")vsrbom, Ml
Allntandy SpingsMar,
GA
IndInspolb. IN
DenwirrAurra, CO
Dallas4I
rft. TX
Fet WodthArlinghM TX
Las VegsuPdisdise, WN
Memphis, TN4SAR
Fed LauderdaloPompano eSdch-Oeeiiold
Basch, FL
MibmlMiml SEadEl. FL
S dtockon
CA
San Antorno,TX
RvWndoSnn Bmnardno.Ontarlo, CA
OCo-rlO
DOayon,
OI
Austin-Round Roa. TX
Akron, OH
Howsto.upy Land-Baslwn, TX
Columbus, OH
J.a
.FL
LakeCounty"noslw County, IL-WI
ChicaobNapevill-Jokt, IL
West Palm Seach.Ba Rataneyrmnn Batch. FL
'Sall LAkaCzLUT
Cumden, NJ
Orlanda4lissimmee, FL
LXIt Rock-North LfX Rck'CowY. AR
Wanen.FamiI.dn Hfs.Try. IA1
Oklahoma Cy, OK
Toeu, ON
Tenpamp ltoerbwa-Ctaowatrbx FL
Sacramento-Ad
ado-RasvoA~,
CA
Tdls, OK
Fen
sc
s, AZ
Clodoa
rCrd. NC-SC
Aburqu. NM
Nasau.Sufotk NY
Oaldand Fromornlwward. CA
Frasno. CA
Tacoma. WA
Nowuark4.nian.
NJ-PA
Baktersfeld CA
San Otgo-Carsbad.San M
,arcos
CA
Gary. IN
E Paso. TX
TucsonrAZ
Plaidelphle, PA
Edison. NJ
Cihc
nama"Aiddlalosn.Wtirgton.
OH4KY.IN
FPbh.,h PA

Source: RealtyTrac Foreclosure Database.

20 Total
Foreclosures
40.219
53.737
27S98
37,412
51.730
25.625
19.578
18,155
21.113
24,046
5,153
14.754
30.255
22.t97
8.493
llS13
8,754
41,763
15,175
9,983
4,728
57.706
10,S14
6,t14
4i791
12,271
4.739
16,876'
8,104
4,778
18.985
10,837
5,87
20,140
8,198
4ISS
14.284
12,280
3,873
3,687
10.557
2S964
13250
3.254
Z782
4,484
18.60
1075
9,533
12204

Ratio of
Foreclosures as Foeosures to
Percent of
Number of
Households
Houseolds
4
*1:21
4A
i
4.3
1
4.2
1:24
3S
12E
3.7'
.1
33
t131
3.2
t131
.2.8
13
2.8
135
2.7
t31
2.7
1:37
2.6
t3
2.5
1:t0
23
1:43
2.3
13
2.3
1:43
23
1:43
2.2
1:5
2.1
1:48
2.1
14
2
1.50
2
151
1tS
152
1.8
154
1.8
1t4
1.'
1.
1.7
1
1.7
1j
1.7
1
1.6
16
16
1:81
18
1:
1.5
1
15S.
i
1i5
1.4
1A
1.3
1.3
1.3
1.3
12
1.2
1.2
12
12
1.1
11

1
1:73
1:74
1:
1:
1:
1:
1.81
1:81
1:
1
1
i8
I

46
APPENDIX B: HISTORICAL SUBPRIME DELINQUENCY
RATES
Figure 11: Change in Subprime Delinquencies at State and MSA Level
ALASKA - CALIFORNIA
.

Persentage of Subprinse Mortgages Where Paneets Were Late BySO Days or More

NATIONAL
Alaska
Alabana

Arka"as

Arizona

California

Percentage
Point Change
Febrwary2007 February 200 Fibruary 2005 (2006to 2007)
5.8
6.7%
7.a%
17.4%
2.9
4.7%
S.0%
7.#%
Total
2.9
50%
4.0%
79%
Anch.rpge. AX
41
8.J%
11 9%
12.0%
Total
32
7,3S%
6.8
10.6%
AL
Annisaon.
-.
O
9.5S
81%
92%
Aburn-Opotlika. AL
3.7
9.8%
11.7%
12.32%
BkningnlamAL
2Le
10,1%
v8%
12.6%
Cotandtu,GA-AL
.0.9
8.4%
8.7%
7.6%
Decatur,AL
3.0
6.4%
7.3%
9.4%
DotIn AL
1.7
9.6%
09.6%
11.3%
AL
Florence.
.0.9
9,2%
8.8%
62%
Gadadan.AL
3.
7.6%
88%
11.1%
Huntsvil,.AL
4.0
9.5%
1586%
13,4%
AL
Mobi9e.
3.1
8.8%
8.7%
9.9%
AL
Mantgoenary.
2.0
10.0%
11.8%
11.9%
AL
Tuscaboosa
2.7
9.0%
9.3%
11.7%
Total
4.5
81%
6,5%
106%
Fayetldla.StpngdxkRogors, AR
1.
865%
10,0%
10.1%
FowtSnithAR-OK(
2.9
9.0
10.3%
11.6%
AR
Jaonesbor,
1.4
10.2%
59%
1.8%
Lio PRaNtMl lOe Rod. AR
.1
11.S
11.2%
12.6%
ManrhisTN-AR-MS
1.0
9.51%
12,7%*
10.9%
Pn BtluliAR
4.
7.8%
v.7S
11.S%
-AtR
Tsarkana
3.0
4.3%
2.8%
7.3%
Total
1.3
2.7%
2.4%
4.0%
Flsstalf, AZ-UT
6.1
2.6%
3.4%
7.7%
LeeVgas. NV-AZ
2.7
4.5%
2.6%
72%
FPho il-osea,AZ
2'A
49%
3.8%
7.3%
Tucson,AZ
320
3.1%
2.1%
6.1%
Yu"r, AZ
0.9
2.%
2.9%
11.8%
Total
9.2
1.7%
2.4%
990%
CA
3akaersliald,
6.1
2.7%
4.2%
v8.%
Ct4radvae, CA
7.2
2.4%
3.1%
9.v%
Farest.CA
9.
2.8%
3.4%
9.4%
Los Anplas-.ong5 Boec, CA
10.3
2.5%
28%
12.7%
Merced,CA
10.9
2.8%
4.0%
13.7%
Modesto,CA
9.8
3.5%
4.3%
12.2%
OaIland. CA
7.1
22%
3.0%
9.3%
Orange County, CA
8.0
2.7%
3.0%
8.7%
CA
R ^dding,
10.1
2.5%
4,1%
12.6%
CA
Rfroidean Bernar.dino.
12.5
2.6%
4.2%
15.3%
CA
S cramento.
9.0
1,8%
3.1%
10.8%
atnas. CA
i0.0
2.2%
4.0%
12.1%
SanDlego.CA
4.9
3.0%
38%
7.8%
CA
San Francvow,
4,2
3.7%
3.7%
8.0%
San Joso. CA
7A
2.4%
4,1%
9.8%
Son LuisOispo-Atscarso- Paso Rolbes,CA
9.9
2.5S
24%
12,4%
n4-Af Mrleslwnb4o.CA
B aag
Sanme
4.3
3.6%
3.8
7.9%
Ganta Cnostesomnlle. CA
9.2
33%
3.1%
11,5%
SantaRow.,CA
18.8
3,4%
3,9%
13.8%
Bloclton-Lvdi. CA

Source: First American LoanPerformance

COLORADO - GEORGIA
Percetafp of Subprine MortpgagesWhere Parnenta Mre Lte By 60 Oaya or M1re
Fercentle
Poin
Chrarrge
NATIONAL
Colorado

Connecticut

D.C.
Deaware
Florida

Georgia

Total
Borudor.Lorrgmwr, CO
CoeloradoSprnp.CO
Onrw,CO
Fort Collin.Lovolad. CO
Grand .lwrtorn, CO
Grelay. co
puebfoCO
Total
Eldgaport,
CT
DOabry, CT
Hatrord. CT
wHaverMoldderCT
NOWorron owwlrlr.cCT.NI
Sterno Norwak, CT
Watorry. CT
WorcetBr MA-CT
Total
Weahirnn, OC-MOVA-WV
Totl
DovaerDE
Wilmrarrol-Nwarkr. DE.MD
Total
lnytnrsaBaachr FL
Fort Lauderdale. FL
Foil Myors-Cape Corot FL
Fort FPo.Por St. lbo. FL
FortWekon Beach, FL
Garroea. FL
Jacksorwilt, FL
LaklarndWurlWntor
H
n,FL
MoilbornnraT
ro.pair Bay, FL
Mrmi. FL
Naples, FL
Ocala. FL
Orlando. FL
fanama Cot. FL
Pewmeo, FL,
Purea Caord, FL
S5rdsotorndenton. FL
Tallrassoe. FL
TampaG PetarsburpClearvrutor. FL
WsIt Paten BeacBoceabton,FL
Total
Albaiy. GA
AthensrGA
AgatraGA
Augua.mAJWin, GA-SC
Chreterlog. TN-GA
ColrmrbCGAAL

Febnary 2007 February 26
Fdbruary 2005 (2p0 to 2007)
124%
7.6%
6.7%
5.6
15.2%
11.1%
9.%
5.9
11.9%
10.4%
8.8%
3.1
118%
9.1%
8.9%
3.0
17.6%
13.1%
110%
6
11.8%
9.6%
9.1S
2.7
4.8%
5.2%
52%
O4A
16,7%,
12.4%
9.%
6.9
16.3%
11.4S
10.6%
S
10.8%
7.0%
5.7%
5,1
10.4%
6,8%
5.7S
4.6
9.6%
6.4%
5.1%
4.6
Own
6.B%
5S%
3.9
114%I
7.4%
6.1%
52
11.7%
5.8%
4.5%
7.2
8.8%
5.5%
5.3%
is
11.0%
8.1%
8.8%
4.2
18.3%
7.7S
7S*
10.
10.9%
4.5%
6.3%
S.6
103%
4,3%
5.4%
4.
9.8%
6.9%
6.8%
3.0
9.2%
8.1%
G.%
2.4
9A%
8.9%
6.9%
2.5
10.2%
5.9%
5.1%
6.1
104A
4,5%
5.0%
.53
9.9
8.4%
42%
5.8
128%
3.6%
4.4S5
82
11.3%
4-4%
44%
8.9
8.G%
4,2%
2.5
8.1
7.2%
4,5%
7,3%
40.2
10.7%
7.5S
94%
2.3
9.0%
4.6%
S,%
2.2
11.1%
3.7%
45%
G.6
9A%
5.5%
4.6%
4.8
9.5%
3.7%
3.1%
5.4
7U
42%
.51%
1.2
85%
3.6S%
5.4%
il
10.8%
4,0%
3.9%
6S
11.4%
5.7%
8.3%
8.1
107%
3.5%
58%
5.1
11A%
3.1%
4,8%
6.0
8.1%
6.4%
72%
0.6
.8%
4.%
5.6%
39
10.4%
5.6%
4.B%
5.6
16.2%
12.7%
10.9%
6.3
10.7%
10.1%
9.1%
1.6
14.1%
10.4%
89%
6.2
18.8%
13.8%
11.9%
4.9
132%
11.21%
10.6%
2.6
13.4%
10.7%
9.4S
4.0
12.0
11.1%
11.3S
0.7

Source: First American LoanPerfornance

HAWAII - KANSAS
orSpn
og

.cn
beP

eee

y00

Percerntage of Subpiline Mortgages, Wihere Paymients, wore Lae By 60 Days or More

NATIONAL

Hawaii
Iowa

Macon, CA
Savannah. IGA
Total
Honoluu, H
Total
Is.lA
Ceda RNape
OxvanpwO4 AlinaeRok

island.IAt

te Mro nX LA
lOwe Cr, U
.
IVAQCb1.U~
nveha, NE*4A
Siox C", IA-NE.
mtfrloo.C adat FaS, IA

Idaho

bllinos

Total
Sois City. I10
Pocatelo, If
Total

-NonrnIL
I1

Chnmpaigr 41irnO,
Chilcag. IL

fotino-Rocl. bsand, IA-IL
Othvnpot-I

Indiana

Decalur, IL
Kenktaka. IIL
No MSA
PafrltPavd h,.IL
Roclford. It
Sptinglleld. IL
Sl. Louis, M0-11.
Total

IlN
OH-4CY-IN
Cinscuali. I
sen, IN
EuanstilloF Sendamon, IN-KY
Fort lWayn IN
Gary, IN
indinpotis .IN
Koko=o, IN
Lfayett 1.
N
Low vuioS,K
tY-1N
Munce., IN
So'ut Bern dIN
Terre Hraa sIN

K~amna

Total
Kansas Cit

,MO-KS

Lrnaco. K5
I
Topek.. K5
WVhita, KE9

Percentange
Point Chang
Fabniay 2007 Felruary 2000 February 2005 12105 to 2007)
5.5
0.7%
7.0%C
12.4%
.0.2
14.0%
13.6%
14,71
3.0
4%
0.6*%
1320%
.15
2.6%
2.0%
0.2%
2.9
2.0%
2.9Y
5I5%
4.)
10.3%
1 1.5%
14.6%
3.9
9.0%
10.9%
13.5%
6.0
9.0Y
10.7%
S.0%
4A
1018Y
11.0%
15,2%
3.3
97%
9.3%
3.0%
0.5
8.1%
10.8%
13.4%
3.7
12.0%
14.0%
15.7%
1J3
13 tS
¶2.5%
14.5%
2.7
t2.0%
11.4%
14.7%
4.2
7.1%
G.2%
7.2%
.1.0
a5%
S.1%
69S%
1.1
8.7%
92%
100%
0.9
t.9%
9.8%
14.0%
6.3
9.1%
9.7%
*4.4S
0.3
77%
0.6*%
130%
50.1
0A
9.4%
13.9%
5.0
10.0%
13.1%
15.0%
30
9.0%
I1.s%
¶3S%
3.r
13.0%
1325%
173%
8.1
05%
¶0.4%
10.7%
2.9
11,7%
12,2%
140%
3.5
11.1%
11.9%
¶145%
3.2
11.4%
144%
14,0%
3.5
1005%
12.2%
1433%
4.4
12,2%
13.6%
16.6%
2.7
9.8%
10.7%
12.%
4.*
10.6%
t0.4%
15.1%
5.1
10.2%
10.6%
15.3%
3.9
12.2%
13.7%
15.I%
3.2
12.4%
12.7%
15.6%
24
¶1.9%
12.8%
14.2%
4.6
13.3%
13.*%
17.9%
7.5
10.tS
12.2%
17.0%
4.
9.7S
10.2%
14.4Y
44
12.8%
14.2%
172%
4.6
13.4%
15.0%
150%
4.9
14.5%
19.3SI¶5,0%
1.3
15.3%
I5.4%
140%
3.3
9.4%
10.6%
12.7%
34
10,1%
10.0%
13.5%
3.6
7.3%
10.3%
IM10%
4.0
5110,%
512,0%
2.9
9.1%
10,71
11.9%

Source: First American LoanPerformance

KENTUCKY - MICIHIGAN
Percete

NATtONAL
Kentuky

Louwsina

Massewhusetts

oSuhphIm
7
Mwleps Wheme P

Totat
CirdnneOl40H YI-N
CbrkwApni
tljo, TN-KY:
Everuvll
bdasn, INWKY
HuntirglonA sjhnd. WVKYOI
LWanon, KY
LouvAlbe.,KYYtN
OwenbKro, KY
Total
Alexandria, LA
alnc Rouge,LA
Houn. LA
L*Wayf,LA
Lik.Chales LA
Momea,LA
NoewOdrl., LA
Shrewport-Bosa rCR;, LATotal
Sorrsletbt-Yarawrrrh, MA
Enostr.
MA-NM
Brodonr. MA
Frlth
t*wLmrte, MA
Lew.e, MA-NH
Loao MA-NH
New Sntfd. MA

Maryland

PftMe, MA
Providenco-FetaRl
r-rickk R-4MA
SptrrIglIt& MA
Worcester,MACT
Total
eiirre, MD
Cxrbteni. MD-'rW

Hegratrwil. MD

Milgean

Febnary 2007 Fe
12A%
145%
14,7%
14.t%
12.8%
1t15%.
12.5%
15.9%
11,3%
165%
13.2Z
12.7%
12.4%
11.1%

1.5%
12,3%
15.8%
i22%
1SS8%
18.1%

Percentiage
PO rM
Cheno

r 20
Febry 200M (200 to 2001)
7.8%
8.7%
58
11.5%
10.9%
3.6
11.2%
10.0%
4.6
9.4%
7.7%
6A
13,0%
10.9%
1i
11.0%
105%
1.0
0.7%
S6%
3.0
13.0%
12.6%
33
9,0%
9,0%
2.3
27.6%
10.0%
6.'
13.0%
9I%
3.9
10.0%
10.9%A
1.
185%
s60
*.t
14.SK
9.2%
2.0

17.3%

9.3%

112%
350,
ti.4%
9.1%5
9.1%

10.7%
9.9%
10.0%
6.2%
5.4%

15.9%

t19.8%
*es*
18,8
81.0%
16,7%
t5.9
15.4%
13.9*
17.3%
8.7%

t0,%
9.4S'
7.9%

8.0%

8.2%
8,1%

WeUhngtln, DC4AD-VA9W
Wirrt
rknNemwt
0E4tD
Maine

mts Wote Lat ByGO Ono OrMt

8.6%
7.4X

2.2
1.8
6,8
22
10.2
12.7
.8s

i74S
5,6%
4,9%
S.2%
5,2%

12ii
11.0
11.9
10.

-8B.

4.9%

11.i

11.4%
9.8%
7.9X
9.1%

609%
4S%
8.5%
8.3%
4.5%

8.O
10.5
TA
11.0
4.2

4A%
4.%

5,0%

3.0

6.8%
3.7%
3.6%
5.0%1

7.2%
3,71
39%
5.7S

1.0
4A

4.7
1.7

Total

13.8%

7.7%

5,B%

8.0

WNW. ME
Lirwita-Aubur. ME

14.9%
9.7%

9.1%
7.0%

5.3
5.11%

Portlaed, ME
Porbimuth-lRorhotuer,

13.7%
13.2%

0.4%

4.2%

8.8
4.T
9S.

NH-ME

4.7

21.3%

5.7*
14.9%

85%

Total

12.2%

9.0

AmArbor, Ml

18.5%

12.0%

100%

8.S

Berton Harbor, Ml
Debat MI
Flnt MI
rend Roelesagon-olland. Ml
JaclaonMI
Kzverrmzoo9ttl Creek. Ml
LarelingEaot Larmibg.Ml
Snhsw-EyC*y-itdt, Ml

139%
23.9%
203%
17.9%
21.7%
18S%
18.5%
18.4%

10.4%
17.2%
14%
12.4%A
14,5%

9.4%
145%
12.4%
10.2%
11.9%

12.8%

105%

12.6%
14.5%

10.9%
11.3%

45
89.5
7.9
7.7
*t
90
7B
7.1

Source: First American LoanPerformance

MINNESOTA - NEW HAMPSHIRE
Percertage ot Subprime Mortgages Where Paymients Were Late By 60 D

or More

Percentage
Point Change
February 2007 Ftbruary2006 February205 (2005to 2007)
57%
7.8
7.8%
124%
NAMONAL
9.0
7.8%
10.6%
16.8%
Total
Minnesota
4.8
668%
95%
13.4%
Duklah-Sup
Potrr.MN-W
2.2
7.0%
6.4%
8.1%
ND-MN
rteacd,
5.9
87%
IIS3
12.6%
Grrid ForO
a,NDMN
12.0
6.6%
5,0%
18.f%
La Crosse,WI-MN
9.3
7.9S
10.4*
17.1%
MN-WI
Minneapol s.ST,Paul.
8.8
8,7%
0.8%
155%
Rodester, MN
0.2
7.6%
10.7%
17.1%
St.Cloud,IMN
4.4
8.7%
1o.1%
13.1%
Total
Missouri
1.7
6.3%
682%
.,0%
Celumba.IMO
2.9
9.0%
7.8%
11.9%
Jopfi.MO
4.0
10.0%
15S%
1329%
Kansas C v. MO4-S
4.1
7.1%
8.9%
11.2%
'MO
4.8
64%
8.3%
11.2%
St.Juph, .MO
4.0
BIB%
90%
12.8%
St. Louis.A
M04L
5.1
13.1%
23.1%
15.2%
Total
Mississppi
2.3
12.1%
302%
14.4%
MS
rt-poascagmia,
Nallesbart
2.0
14,5%
25S
18.5%
MS
U
8.0
13.3%
23.2%
21.3%
Jacrktn, NIs
2.
13.3%
133%
18.2%
Merphis. 1rN.AR-MS
1.8
7J%
6.5%
8.DY.
Total
Montana
5.6
859%
.1%
12.4%
samp, M1T
2A
10S.%
10.6%
132%
Great Fab .MT
.1.0
7.6%
7.6%
86,%
Miaeruo,IAT
14
1,.1%
10.6%
127.%
Total
North Carolina
0.3
85%
7.4%
91%
NC
Aothavtib.1
0.2
12.1%
11.4S
12.3%
Chorleaf-Ctasoniea-RdckHONC-SOC
o.e
11.2%
9.8%
105%
Fayettlavs.NC
-1.
15.3%
137%
13.6%
NC
1.1
11.6%
11.8%
127%
PoK. NC
Gonnasbor o.-Warolee-Sahm-N~ch
*.7
11.0%
13.1%
14.6%
NC
GcJabsr
IA
11.5%
12.1%
125%
NC
irgarpen-Lenotr,
onGrdeentvie
Gncn
1.1
8.6%
7.S%
0.7%
a.NC
5.8
2.6%
2,4%
8.8%
BsadhNvport No, VA-NC
o XFa
1.2
l1.3%
10.3%
12.5%
NC
Hii.
whamiChapul
Rdelcgh-ot
0.0
13,65
12.0%
13.6%
nt, NC
RockyMeL
.0.3
7.5%
5.6%
7.2%
n.NC
4.0
5.4%
6.5%
9.3%
Total
North Dakota
3.8
4.3%
4.8%
7.9%
Bisnutrek,
ND
2.7
6.6%
6.4%
9.3%
Fargat-Mo
rheod.NO-MN
3.2
7.9%
8,4%
It
0%
ND-MN
Felr
cs,
Grand
4.2
9.0%
10.5%
13.1%
Total
Nebraska
4.8
7.1%
8A%
12.0%
Lincoln,NE
2.8
10,4%
113%
13.2%
NI-IEA
Omahta,
.1.3
1.4%
103%
15t1%
SieouxCity, tA-NE
7.5
4.5%
7.1%
12.2%
New Hatrmpshire Total
14.7
6S0%
1086%
22.7%
Beston,MW
8.5
8,4%
6.7%
14.9%
MA"NH
Lawtence.
9.f
101*%
13.4%
19.6%
ktNH
Loell. MU
8.3
4,2%
Manchestg
7.3%
12,5%
et,NH

Source: First American LoanPerformance

51
NEW JERSEY - OHIO
Peucnttitige o Subprite Molttgages, Whets Payneatt Were Late By G0D

NATIONAL
New

rJmey

Nashua,NH
Patdmevh-Rochsteas.
NH4AE
Total
Alhtic-CapeMay,NJ
t
crgo-P'B
e NJ
Jeney ty. NJ
Miex
Somer
et'Hsrteordn, NJ
Mt
on. NJi

N:erer,NJ

New MeeIc,

Nevada
New Yoik

NOh

Ptftd.tl49, PA4J
Trenton. NJ
Vthem-m6iBviteBgotan. NJ
Total
Alftquoenuo. NM
Los Crunes, NM
Santa Fe, NM
Total
LosVes, NV-AZ
Rone,NV
Total
AlbenfSchdnetedy-Troy. NY
Dikvhamtor, NY
(Pa"-NIprtFab, NY
DutchossCoenty. NY
Etbri, NY
Glans Fo, NY,
JamestoweNmY
Nosszu-&elk NY
NerwYohNY,
NooMoqh. NY-PA
Rochester. NY
Syntcoe.NY
UceaRemao, NY
Total

Abon,OH
CenteMaossln.pH
Cedhnat, ON-KY-4N
Cleobnd-Lonrin-ElptaO1
ctoll,OH
Ooylon-Sprtngtlald.ON
XHoiyd~ton-M~dletosq,
OH
HItingtoe htand, W -KY.OH
LkrnaOH
Mantrield, OH,
P8e**nbwog-8sttM,WV-OH4
Steober-wlaNto, OH-WJ
Toledo. ON
Whetotg, WVOH
Yeueptorue-WhnenON

Ferlary 2007 Febnesry
1.41%
12.3%
13G%
12.8%
11.1%
10,9%
9.6%
9.7 %
13.1%

13.3%

t221%
1168%
12.2%
9.2%
9,0%
6.9%
9.%9
10.0%
11.0%
11,7%
10,SS
128%1
11 2%
11,7%
130%
11.7%
12.7%
.13,4%
148%
12.2%
ii9%
I1,5%
12.3%
121%
i2.5%
196%

o Mone

200S FPbra
7.0%
.6%
0.3%
7.2%
5.6%
6,0%
4.5%
52%

7.9%

7.5%
7.6%
7.8%
7.4%
0.%
8.6%

.S%
4.6%
4.6%
3.2%

7,9%
BAIA
9.2%
128'%
715%
8.9%
8.2%I
143%
689%
7,4%
.68%
10.4%
10,3%
101%
1G4%

Pecentagt
PontdChang
2005 (2015 to 2007)
t.7%
5.0
3.6%
084
4,5%
9.1
6.%8.
59
G.1%
480
59%
5.0
52%
4.3
.67%
380
6.7%
G4

7.3%

7.4%
,7%*
9.8%
5.9%
9.9%
8a%
10.1%
2,90
3.1%
2,4%
G0%
7,% 102%
118%
5.0%
iO%
98
12,9%
55%
5.6%
54%
9;9%
90%
103%
152I%

4.7
0.0
2.3
408

10.9%

180%

15,4S

18O6%
1s.%
241%
1.8SS
18,7%
1S.i1%
14.7%
17?%
M.7S
10.7%
12MA
t8.-%
13M4
21,4%

14.7%
14,2%
21.0%
14.%
i7 1%
12.
10.0%
14.5%
13,%
87%
130S
15.4%
115%
18.9%

142%
142%
19A%
134%
1V1%
125%
8,8%
125%
12.9S
&1%
115%
13.%
10.4S
i8.%

Source: First American LoanPerformance

041

-2.0
.0.1
8.9
.8
01
8.
3,3
1A
A
G.6
2.1
2
1.9
0.
6.2
0.2
25
3.2
2,1
44

3.
4.3
2A
4.7
34
1.6
2.6
6.
468
386
2J
14
4A
3.0
4.6

52
OKLAHOMA - TENNESSEE
x

._-

Pemtcap o7 Subprnu Moofa W here Pa)IIUs113 WenrLt lySO Days or Mm
Percetage

NATIONAL
OkLahom

Total
EnidOK
Fort Srith, AR-OK
t"Von, OK

Oregon

.Pennsylvania

Rhode island
South Carolina

South Dakota
Tennessee

OtdatronClyOK
Tdta. OK
Total
Co"9sn,OR
OR
Eag"ptir lpdd.
Word.dAshard, OR
PForad-Varourftr. OR-WA
Salam OR
Total
Ajont .etlahem-E snt PA
Aftoora,PA
Eri. P
Hanriburgnifla~ronCarkale, PA
Johtnsor, PA
.Loanoostr.PA
Newburgh, Ni-PA

PoInt Crange
2008 February 200S (2005 to 2007)
2007 February
Febkuary
5,8
6S7%
7J%
12.4%
21
10.J%
Ili%
120%
4,5
10.6*
90%
10,1%
34
11.2%
11.4%
14.7S
OA
95S
10S%
11.3%1,7
10.4%
10.7
t2.1%
15
125%
12M3*
14.0*
0.8
6.4%
5.1%
7.2%
-2.6
6.3%
I5A8
2.7%.
1.2
6.3%
4.%
7.5%6.0
.3.3
4,1.
92%
.0.3
7.3%
52%
7.0%
4.0
7.4*
6.1%
65%
2.1
10.5%
10.S%
12.6%
10
82%
7.8%
9.2%
1.7
10M
130%
11.8%
3.6
13,0%
14.7%
1P.5%
1.3
98%
10.2%
11.1%
2.5
.10.3%
12.7%
12.%
2.0
8.1%
80%
10.1%
4.0
10.%
9.8%
14.6%

PldelptilkPA-NJ

11.MM

Pftorgh, PA
Roeodig,PA
Smarulcn..W¢ano-Nazleton. PA
Sharmn, PA
Stata CoftqegPA
Mliamaporl, PA
Yort. PA
Total
NowLaodon-Naliclh,CT-RI
Provridnca.FU Ribr-Warvik. RIMA
Total
GA-SC
AugustainAkcr
Chrlaston-NrthCharlston. SC
Charfatto.JSIaDAlI-R04 HimNC-SC
Colrtafia. SC
nrjSC
Ftorir
Greertn-Sparndarg-Anderson,SC
Beach.
SC
Myrtle
Surtar, SC
Total
Rapid Ciy, SO
Sioux Falls, S0
ToWt
Chattanoogs, TN-GA
Clarlrarve4iopkrpnlodta. TN-itY
Jacsorn,TN
Johrown City.Kingsnpt-Sott. TN-VA
tftrrle, TN
Mornd*isTN-AR-tS

1.0%
.4*
13.1%
15.5%
0,2%
12.7%
9.1%
13.6%
10.3%
13.0%
13.2%
11.5*
10.8%
13.6%
14.3%
1t6%
14.5%
7.6%
13.5%
11.0%
11t.3%
14.4%
1.4%
12.4%
699%

15.4
87%
8.7%
18.1%

1i4.7%
SdS
12;6%
13.4%
77%
9.9%
75%
0.6%
59%
5.1%
11.9S
11.4%
.0%
12.2%
13.3%
16.4%
13.5%
7
7.6%
18,9%
9.0%
60%
9.S%
t1.0%
95%
9.0%
1i4.5%
8.7
7.4%
15.0%

Source: First American LoanPerformance

2.0

95%

1349%
89%S
12.4%
2.7%
87%
106%
7.5%
3.5%
4.3t
3.t3
11.0%
113%
909%
118%
14.6%
15.6%
14,8%
t0.%
15.8%
7,1%
5,9%
9,1%
9.9%
9,4%
7.^%
11.4%
6.7%
7.3%
131%

2.2
e.6
0.7
2.
e.5
2.2
1.5
10.0
6.0
9.6
0.2.
0.3
0J9
1.8
.42
4.2
0.2
.0
-2.3
4.7
GA
823
3.6
3.0
1.0
41
2.0
IA
s50

53
TEXAS - WASHINGTON
Percaletg of Subpalm Moqtgeas Wheom Pynauts Wer. Lafte By60 Daw or More

NATIONAL
Texas

Utah

Virginia

Varnwont
Washington

Prceilage
Point Change
February 2007 February 2008 Febnuay 2005 (20g to 2007)
12.4%
7.8%
0.7%
s.8
N1asrrife.TN
t1.0%
9.7%
9.3S
1.7
Total
131%
1i.9%
9.9%
3.2
Abiler, TX
9%
9.7%
12.7%
.2.8
Arnanlie.TX
11.6%
89%
986%
2.0
AustimuSanManmos.TX
98%
102%
11.1S
41.3
Baaumor.PorluArthur.TX
14.1N
19,5%
10.9%
*.2
8anwed.TX
145%
13,6%
10.3%
4.2
bS revnsv1Oo
lgsnoa-n Banito, TX
11,6%
10,5%
10.5%
1.1
8"enlbg SlawonTX
7.1%
7.7%
63%
0D8
Corpus ChdriaTX
10.3%
68%
10.6%
.0.2
Deltas, TX
15.1i
12.8%
11.5%
2.
Si Poso, TX
7.1%
863%
8.9%
.1.9
FortWortf-Aslngton. TX
13.8%
11.1S
10.4%
3A
*Galveort-TesCity, TX
13.1%
140%
10.4%
2.7
Houston.TX
14,5%
13.7%
11.3%
3.2
PaleonrTer
.TX
8.5%
886%
10,8%
2.2
Laredo, TX
11,2%
915%
8.9%
2A
LoniewiMarnshs. TX
8.1%
78%
6.5%
1.8
LubSock TX
11.5%
8.1S%
5S.
C9
Mcalon-Edlnbwg.91ihon,TX
10.4%
8II%
9.1%
1.3
Odess"Midlond. TX
8,3%
7.1%
7.8%
0.7
SonArnpeb.TX
9.5%
9O1
7.6N
1J
Son Anrtonb TX
9.3%
8.8%
9.3S
0.0
Shrormn-OnisonTX
11.6%
ii.i%
10.0%
1.8
ToadronaTX.AR
12.9%
72%
8.0%
4.8
Tyier. TX
11.3I
82%
.7.4%
3.7
V'ic", TX
8.3S
9.1%
8.1$
9.2
Waco. TX
11.3%
8.2%
89%
1.7
W kiFt
N ,TX
11M0%
9.4%
96%
1.A
Total
7.5%
62%
10.0%4
2.2
agstaff, AZ-UT
5.21%
11.7%A
7.7%
.2.8
Provo-Orem UT
8.1S
82%
10t3%
4.2
Sa LaksCY-Ogden, UT
8.2%
88%
11.2%
42.9
Total
9.C%
44%
3.8%
S.S
Caideetnvsr,
VA
9.2%
4.4%
4.0%
2.2
DCnvaile.
VA
10.1%
6.9%
7.3%
2.8
Johnson Catin0spert9rislol TN-VA
8.%
58%
4A%
2.1
Linchburg, VA
9.2%
509%
69%
2.8
Norfolt.sgWiinis
Beadiolrort Nos., VA-NC
881
43S
4.1S
2.7
Rldrond.Ptrsur, VA
7%
62S%
.3%
1.
Roaenoke.VA
98
73
8.i%
22
Washinrgon. XC.MD0VA-WV
9.8%
3.1%
2.9%
7A
Total
11.7%
7.0%
S4%
54
Burlington. VT
12.2%
8.7%
6.5%
S.7
Total
7.2%
5.9%
86.%
1.2
olSnghanm
WA
8.7%
44%
53%
1A

8ronoton, WA

OCyra. WA
PaillanilVwnotuver. OR.WA
Ridtland4t enneo -PascoWA
tn

8,6%
7.6%
7.,1
9.4%

5.4%

5S,%

1.1

4.9%

5.2%
5.1%
72%

2.8
1.SS
2.1

%
7.3%

Source: First American LoanPerformance

54
WISCONSIN - WYOMING
Percefntagiof Suliprnte Montgs WValn Paynmot9 Wr

NATION4AL

Wasconsin

Sr s81-bolUevEvorot WA
Sgokane, WA
Taconr, WA
Yaldne, WA
Total
WI
AppbibhnOioshsh lMveenah.
DoAut.suprir, MN-WI

LEaCbrir.WI
GrrocnCay.W1

Lcing, Vill"
Matnespols.8t.
Peal.MN-M
Wl
Rico,.X

West Virginia

Wyoniing

ShaibolganWI
Weusasu,
VA
Total
WV
Charleston.
Cwnbcdland,
MDlW
HaningAhAlnd, WV.KY-OH
Parkersburg.Maritcb. WVW-CH
StuleaboillA.Waatri. OWWV
Washington. DC-MD-VAAW
_weig, WV-OH
Total
Casper, WY
Cheyenne. WY

Source: First American LoanPerforma

Wte BytlO Days or Moe

PtPolnt Change
2005
l2008
to 2007)
Febnarw2007 Febtuary 2006 FPebuara
8.8
6.7%
7.8%
12.4%
0.0
7.3%
6.2%
7.%
0.2
7.9%
5.7%
8.0%
1.8
6.9%
6.0%
8.7%
1.9
10.2%
82%
8.3%
6A
7.6%
9.3%
14.0%
b.T
6.6%
8.4%
12,6%
9.1
8.2%
8.1%
17.3%
1.2
13.8%
11.7%
15.1%
7.0
7.1%
0.3%
14.1%
.4
11,0%
11,4%
14.5%
5.6
7.5%
7.2%
13.2%
3.8
8O8%
7.7%
12.5%
b.9
5.6%
7.5%
11.5%
8.8
6.9%
7.0%
124%
11.A
5.2%
10.9%
18.2%
7.0
6.8%
OJ1%
13.7%
O9A
6.3%
8.68A
1SS%
0.9
11.8%
11.0%
12.5%'
0.1
12.J%
1t.9%
12A%
.4.5
17.9%
17.8%
13,4%
2.8
2.9%
2.7%
54%
0.
13.8%
15.0%
13.6%
4.T
20.8%
l9S%
186.9%
-2.1
15.4%
15.3%
12.3%
J2
7.5%
5.1%
10.9%
03
120%
18.1%
123%
13
4.0%
4.3%
6.1%
2.
3.7%
4,4%
5.9%
3.1
5.8%
4.3S
8

APPENDIX C: IMPACT OF FORECLOSURES ON LOCAL
HOME PRICES

MSA
DETROIT, Ml
ATLANTA, GA
INDIANAPOLIS, iN
DENVER, CO
DALLAS, TX
FORT WORTH, TX
LAS VEGAS, NV
MEMPHIS, TN
FORT LAUDERDALE, FL
MIAMI, FL
STOCKTON, CA
SAN ANTONIO, TX
RIVERSIDE, CA
CLEVELAND, OH
DAYTON, OH
AKRON. OH
AUSTIN, TX
HOUSTON, TX
COLUMBUS, OH
JACKSONVILLE, FL
KENOSHA COUNTY, WI
CHICAGO, IL
PALM BEACH, FL
SALT LAKE CITY, UT
CAMDEN, NJ-PA
ORLANDO, FL
UTTLE ROCK, AR
WARREN, MI
OKLAHIOMA CITY. OK
TOLEDO, OH
TAMPA. FL
SACRAMENTO, CA
TULSA, OK
PHOENIX, AZ
CHARLOTTE, NC
ALBUQUERQUE, NM
NASSAU COUNTY, NY
OAKLAND, CA
FRESNO CA
SEATTLE -TACOMA, WA
NEWARK, NJ
BAKERSFIELD, CA
SAN DIEGO, CA
GARY, IN
EL PASO, TX
TUCSON, AZ
PHILADELPHIA, PA
EDISON, NJ
CINCINNATI, OH
PITTSBURGH. PA

National
Foreclosure Rank

Median Home
Prce

I
2
3
4

S135.900
$218,500
$136,500

S133,900
$117,800
S289,300
$117.500
$245,200

7
8
9
10
11

12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40

S239.100

52486500

$379.600
S97,200
S348.200
$146,700
$124,400

$141,100
5161.000
S123.400

S155.600
$162,000
$238,100
$233,500
S269.800
$177,900
$205,500
$193,200
$108.700
$197,200
-5102,600
$125,500

5183.300
$398,900
S106.900
S207,300
5150,900
$146,900

S440,600
$594,500
S251,000
$290,200
$383,700

42
43
44
45
46
47
48
49
so

S552.000
$126,900
$78,600
5167,400
S209.000
5350,300
S143.400
5104.600

$210,700

Decline in Value
Caused by One
Foreclosure Within
118 Mile (One City
Block)
(S1,2233
($1,967)
($1,229)
($2,152)
($1,205)
($1,060)
($2,604)
($1,056)
($2,207)
($2.219)
(S3,416)
($875)
($3,134)
($1,320)
($1,120)
($1,270)
($1,449)
($1,111)
($1,400)
($1,458)
($2,143)
($2,102)
($2,428)
(51.601)
($1,850)
($1739)
($978)
(S1.775)
($923)
($1,130)
($1,470)
($3,572)
($982)
($1,866)
($1,358)
($1,322)
(53.965)
(55.351)
($2,259)
($2,612)
($3.453)
($1,896)
($4.968)
(S1,142)
($707)
($1,507)
($1,881)
(53,153
($1,291)
(S941I

56
Sources: Dan Immergluck and Geoff Smith, 'The External Costs of Foreclosure: The Impact of
Single-Family Mortgage Foreclosures on Property Values," Housing Policy Debate, Vol. 17,
Issue 1, 2006; U.S. Census Bureau, 2005.

APPENDIX D: STATE REGULATIONS
Table A: Predatory Lending Regulations at the State Level as of
Aril 2007
Enftmvcuwt
NeehwrbMstooata
LaLing
Pred" W"*

Worcs¶un
ACOWOc
&
&ipetam

to
BaiagsE

_&VwbtUndwa

edatoyLandkn

Prduwr Lacing

ESucgtwPtamsStt.,%zr_
Lain

AL__
rc

10
aSA _RS

DCa

-.~~~~~~~~A A

a
.
_____

___

oDa

_______s

MS-

Ml _
Ta

NCo

_ _

Na _
NJ __
ta
NC__

__
--

___

.a
_

_,__ __
-~~________o--_

a__
T
Df__

a
__
___

o
-

a _

aa
a

-D

a
O

_A
RA _ __

_o
_ D

_ ____

___o____I
,:

'EhV
ZWA

a
~~~~__
_

__
.,._

__-__'_______

VA -

WYe

__a
_

__D____

TNA

___

_ D_
I-

o___

___

--_ _3.1______
I

____

___
D_=______
'--n. _________a

_ ____I

___

a
a

D
_ _ __

-a _e

_____o____--

________

a_ _ _ _ _

O
___'- _______-=----

Fparcosua Nang

a
__ _ _ _

________a-X~~

_I- - -- --

_ _ _

LA.
WA
MA__

4"n'

.K.li
a

=
u

___ _
arp-:b

1____
__ _ _

aD ___
ce
_ __a~
1uwv

Table B: State Mortgage Regulatory Agency Licensing
Survey
Testin_
I
Reglisin and
Tdh
Ln
ForLoan
dIMuAW(No j Ost
j
_.

A:"

_id

erfadS~tEbra

LkS~beSisiy2XB

ks33aAmrlmaidR
esF§Sle

SimMoeEg

IsnlsibmrbhU3dA~uninbenli bdesa-dlds

EsO-Eabutbidr
nms~
ispcn
pmenflrnbim

E-E-DmnutdFRk}Stfa
S-%iayd9b
OIf-QfmdOmmnual
9 L-94ck
RS>S BoxJfg~f

bdelsark~

n~rbah

eynu

The Subprime Lending Crisis: The Economic Impact on
Wealth, Property Values, and Tax Revenues, and How We
Got Here
EXECUTIVE SUMMARY
As the losses caused by the subprime lending crisis continue to
work their way through the financial markets, there is a growing
awareness among policymakers and financial market regulators
that we need to prevent the continuing foreclosure wave from
affecting the broader economy. A significant increase in lax (and
often predatory) subprime lending during a period of rapid
housing price appreciation put risky adjustable rate mortgages in
the hands of vulnerable borrowers who are now facing
substantial payment shocks and risk foreclosure when their loans
reset this year and next.
Part I of this report shows that unless action is taken, subprime
foreclosure rates are likely to increase as housing prices flatten or
decline, and the effects of the subprime crisis are likely to extend
beyond the housing market to the broader economy. The decline
in housing wealth will negatively affect consumer spending, and
the forced sale of large numbers of homes is likely to negatively
impact the prices of other homes.
Part II of this report shows that, unless action is taken, the
number and cost of subprime foreclosures will rise significantly.
For the period beginning in the first quarter of 2007 and
extending through the final quarter of 2009, if housing prices
continue to decline, we estimate that subprime foreclosures alone
will total approximately 2 million.
Part II also includes forward looking, state-level estimates of
subprime foreclosures and associated property losses and
property tax losses, covering the second half of 2007 through the
end of 2009. For that shorter period, and assuming only
moderate housing price declines, we estimate that:
Approximately $71 billion in housing wealth will be directly
destroyed through the process of foreclosures.

More than $32 billion in housing wealth will be indirectly
destroyed by the spillover effect of foreclosures, which
reduce the value of neighboring properties.
States and local governments will lose more than $917
million in property tax revenue as a result of the destruction
of housing wealth caused by subprime foreclosures.

Part III of the report highlights the underlying causes of the
subprime crisis and explains how incentive structures in the
subprime market work against the interests of borrowers and
have had much to do with the dimensions of this crisis.
Finally, in Part IV, policy options aimed at reducing foreclosures
and preventing the crisis from reoccurring in the future are
offered.
PART I: THE HOUSING DOWNTURN AND ITS IMPACT
ON SUBPRIME MORTGAGE FORECLOSURES
Over the past few months, as residential investment and housing
prices have declined, delinquency and foreclosure rates for
subprime mortgages have spiked sharply upward. - The
deteriorating performance of subprime loans is not suprising. As
the subprime market expanded rapidly after 2001, so did the
share of adjustable rate, "hybrid" loans issued to financially
vulnerable borrowers. The ability of these borrowers to sustain
hybrid mortgages has depended heavily on house price
appreciation. As housing prices have flattened and declined, the
ability of these households to refinance their mortgages has been
reduced. The resulting rise in subprime foreclosures is likely to
harm an already weak housing market, and the reduction in
housing wealth has the capacity to reduce consumer spending
and economic growth.
Housing Price Declines Will Worsen Subprime Loan
Delinquencies And Home Foreclosures
The root of the subprime mortgage crisis is the prevalence of
troubling loans called "2/28" and "3/27" hybrid adjustable rate
mortgages (ARMs) that were largely sold to financially
vulnerable borrowers without consideration for their ability to

afford them. A typical "2/28" hybrid ARM has a fixed interest
rate during the initial two year period. After two years, the rate
is reset every six months based on an interest rate benchmark
(such as the London Interbank Bid Offered Rate, or "LIBOR").
In the current environment, resets have caused payments to rise
by at least 30 percent, to an amount that many borrowers can no
longer afford. As a result, the delinquency and foreclosure rates
for subprime adjustable rate mortgages have been sharply rising.
For more information about the characteristics of subprime loans
and borrowers, see Box A.
When housing prices were rising, subprime borrowers could sell
or refinance their homes to pay off their loans before they reset to
unaffordable rates. As housing prices flatten or decline, these
options dwindle. This section explains how the weakening
housing market is likely to impact subprime delinquencies and
foreclosures in the months ahead. For a detailed examination of
the subprime market and its expansion, see Box B.
Subprime Lending Has Depended on Rapid House Price
Appreciation
The period of rapid housing price appreciation that began in 1997
has helped fuel increased volumes of subprime lending and
masked the weaknesses in underwriting quality and predatory
tactics that accompanied it.
Beginning in 1997, the U.S. witnessed house price appreciation
that was highly unusual in historical terms. Between 1997 and
2006, real home prices increased by nearly 85 percent.'
Sustained price increases near this magnitude have only been
observed once during the twentieth century, in the period
immediately after World War 112 (See Figure 1). In fact, during
the period 2001 through 2005, the annual rate of house price
appreciation accelerated. The S&P/Case-Shiller® Home Price
Index shows annual price appreciation rising from slightly over
eight and one-half percent in 2001 to more than 15 percent in
2005.
Not every part of the housing market witnessed this rate of home

price appreciation. In some states and cities there was significant
price appreciation, while it was more moderate in others. For
example, Figure 2 shows the difference between home price
appreciation in Michigan, Ohio, California, and Florida. But
price increases were sufficiently widespread to produce
significant nationwide increases in housing prices.
Figure 1: U.S. Housing Market in Historical Perspective
Shiller U.S. Real Housing Price Index and Other Economic Indicators,
1938-2007
250

1000
900

200-

150

800
=DU

150~~~~~~~~~~~~5

103

Builiins Costs30

Interest Rate

0
1938

200

100

Population

0
1949

1%0

1971

1982

1993

2004

Source: IrrahionalExuberance, 2nd Edition, 2005, by Robert J. Shiller, Figure 2.1 as updated by author.

Housing Price Appreciation Reduced Subprime Delinquencies
and Foreclosures
The deterioration in underwriting standards in the subprime
market as the market expanded is well documented. (For a
discussion on declining underwriting standards in subprime
lending, see Box B.) Although underwriting standards in the
subprime lending market began to decline after 2001, the effects
of this decline were, until recently, mitigated by house price
appreciation. If a borrower is struggling to make mortgage
payments, but the value of his house has appreciated, he can
solve his financial problems at least temporarily by refinancing
the mortgage. Cash can be withdrawn from the increased equity
in the house, and the new, higher mortgage can be sustained for a
while. The house can also be sold, and the loan principal repaid.

However, when house price appreciation does not create equity,
borrowers' financial weakness cannot be disguised and default
rates rise.
Figure 2: House Price Appreciation Has Varied Across States
House Price Index for Homes in Michigan, Ohio, California and Florida,
Q1:1995-Q2:2007
700
California

600 -

100

303

2(0
Sourc

1995

Ofiecfhigaanuig~trrieOerih

1997

1999

35Wl

20(0

2(05

2007

Source: Office of Federal Housing Enterprise Oversight

There is systematic evidence that when home prices appreciate,
subprime mortgage defaults decline. Using a very large sample
of subprime mortgages securitized between 1999 and 2002,
researchers at the Center for Responsible Lending found
statistically significant correlations between the odds of
foreclosure and cumulative price appreciation in a Metropolitan
Statistical Area (MSA). 3
The option to sell or refinance also should reduce delinquencies,
which are the precursors to default and foreclosure. Recent work
by economists at the Federal Reserve Bank of San Francisco
shows strong negative correlations between delinquency rates
and cumulative house price appreciation across MSA's during
2006.4 This research also indicates that house price appreciation
significantly improved the performance of subprime loans.

63
Figure 3: Home Production Has Outpaced Demand
600

~~~~~~~~~~~~New
Home for
1

fiC0

940

Month Suply of

~~~~~~~~
Homes0

1980

1984

1989

1993

1998

~
2902

~~~New
207

Source: Bureau of the Census, U.S. Department of Commerce.

Subprime Problems are Likely to Accelerate House Price
Declines
The Housing Market Is Contracting
Unfortunately, conditions in the housing market indicate that
house price appreciation will no longer be able to disguise the
financial precariousness of the millions of borrowers whose
subprime adjustable rate mortgages are about to reset. The
decade of steady house price appreciation appears to be at an
end. Nationally, house prices began to decline in 2006 and are
now down approximately 3.2 percent from their peak in the
second quarter of 2006.5
In fact, the housing market has contracted significantly for more
than a year. Inventories of unsold new homes have increased,
and the monthly supply of new homes has risen (See Figure 3).
The Federal Reserve has estimated that so far, declines in
residential investment have reduced the annual rate of GDP
growth by about three-fourths of a percent over the past year and
a half.6
A HousingAsset Bubble May Be Bursting

As residential investment in construction declines and house
prices fall, there is reason to be concerned about the longer term
prospects for housing values. There is apprehension that the
economy is experiencing the bursting of a housing price
"bubble" - a situation in which housing prices are high only
because market participants believe that prices will be high
tomorrow. In other words, home prices deviate significantly from
the equilibrium level consistent with market fundamentals.
When an asset bubble bursts, large price appreciation can be
followed by sudden and large price declines.
If a housing price bubble does exist, then house price levels can
be affected dramatically by shifts in expectations. 7 There is
some evidence that expectations about housing prices are
changing. The National Association of Home Builders/Wells
Fargo Housing Market Index (HMI), based on monthly surveys
of a panel of homebuilders, reached an historic low in October
2007.8 See Figure 4.
A NOTE ON THE HOUSING BUBBLE DEBATE
There is a substantial body of economic research that attempts to explain
housing prices in terms of supply and demand fundamentals such as
construction costs, interest rates, employment growth, and household income. 9
On the basis of this line of research, some economists argue that the housing
price appreciation we have witnessed is not a bubble. These economists focus
on the characteristics of local markets, and argue that once accurate measures
of local supply and demand factors are carefully examined, there is scant
evidence that housing prices have deviated significantly from fundamental
values.1°
There is, however, substantial evidence pointing in the other, less sanguine
direction. Using state-level data for 1985 through 2002, Case and Shiller
provide econometric evidence that, in eight states, fundamentals do not
explain home price appreciation." Dean Baker from the Center for Economic
and Policy Research argues that at the aggregate level it is difficult to point to
changes in economic fundamentals that convincingly explain why housing
prices began to increase in the mid-1990's, rather than at some other time.'2
He points to data showing that GDP, income, and population growth during
this period were not unusually high, and notes that any constraint on supply
caused by urban density or building regulation surely existed well before
prices began to climb. The data in Figure I are consistent with the points
made by Baker.

Subprime Foreclosures Will Put Additional Downward
Pressureon the House Prices
It is widely expected that, as the large number of subprime 2/28
and 3/27 hybrid ARMs originated during and after 2004 reset to
their higher payment rates, the volume of subprime delinquencies
and defaults will rise substantially. Many financially vulnerable
borrowers will be facing substantially higher payments, and the
lack of house price appreciation will prevent sale or refinance.
The Federal Deposit Insurance Corporation (FDIC), citing First
America LoanPerformance data on securitized subprime and
near-prime (so-called "Alt-A") mortgages, estimated in March
2007 that there were approximately 2.1 million hybrid nonprime
ARMs outstanding. LoanPerformance data cover about 70
percent of subprime originations's This implies that as of March
there were roughly 3 million nonprime mortgages, many of
which will reset in the next three years.
From Mortgage Bankers Association (MBA) data we know that
the average value of all subprime ARM loans in 2005 was about
$200,000. If we use this number as the average value of for all
nonprime loans then there were approximately $600 billion in
outstanding nonprime mortgages as of March. Since then, the
number and amount of hybrids yet to reset will be somewhat
smaller. However, the numbers are significant.
While many outstanding subprimes are hybrids, there are many
other subprime borrowers who are also at high risk of default.
Several studies of subprime mortgages show that cumulative
default rates are very high. Estimates range from almost 18
percent to more than 20 percent.' 5 Should housing prices decline
further, cumulative defaults are likely to increase.
Using data on individual subprime mortgages originated between
1998 and the first three quarters of 2006, researchers at the
Center for Responsible Lending estimated cumulative
foreclosures of 2.2 million, with losses to homeowners of $164
billion. 16 Although this forecast tried to take account of the

effect of slowing house price appreciation, it was published in
December 2006. Since that time housing prices have continued
to decline.
Figure 4: Expectations About Housing Market Reached Historic Lows in
October 2007
NAHB/Wells Fargo Housing Market Index (HMI) and Its Three Components
Seasonally Adjusted, January 1985-August 2007

100
90-

60
50
40
30
20

10
0

1985

Sinle F amiW Sols:P eesn

IIMI

-,-77

Sirle-Famy Salqs:*,a

1991

1997

Ssb

ths

TrmfricofPeo

M)3

setv

sonres

2007

Source National Association of Homebuilders

THE IMPACT OF SUBPRIME FORECLOSURES ON
HOMEOWNERSHIP
In addition to property value reductions, foreclosures in the subprime
market have eroded some of the gains in homeownership rates for
minority households. For example, the Center for Responsible Lending
(CRL) estimates that the 2005 vintage of subprime loans will lead to
98,025 foreclosures by black homeowners relative to only 50,925 new
20
black homeowners, or a net reduction in 47,101 black homeowners.
Similarly, CRL estimates a net decline in homeownership among
Hispanic families of 37,693.21

67
BOX A: CHARACTERISTICS OF SUBPRIME LOANS AND
BORROWERS
Subprime Loans Go to Higher Risk Borrowers, Who Pay Higher Rates
Subprime mortgages are issued to higher risk borrowers. They typically have
inconsistent credit histories, lower levels of income and assets, or other
characteristics that increase the credit risk to lenders.' 4 This is reflected in
lower average FICO credit scores, and greater average loan-to-value ratios.
These borrowers pay substantially higher interest rates and fees than other
borrowers, and are more likely to be subject to prepayment penalties, which
make it costly to refinance loans in the early years of their life (See Figure 15
in Appendix).
Subprime Loans Typically Have Higher Delinquency and Default Rates
Because of the higher risk characteristics of subprime borrowers, subprime
loans typically have higher delinquency and default rates. As can be seen
from Figure 11 in Appendix, the delinquency rates for subprime mortgages
are usually several times that of comparable prime mortgages. The same is
true for foreclosure rates, as can be seen in Figure 13 in Appendix. It is
notable, however, that delinquency and foreclosure rates of subprime
adjustable rate mortgages have diverged sharply from those of prime
adjustable rate mortgages since 2006.

The Effects of Foreclosures and House Price Declines Wml Be
Significant
Foreclosures Will Harm Neighboring Home Owners and Local
Housing Markets
Foreclosures can have a significant impact in a community in
which the foreclosed property is located. This is particularly true
when the factors that led to one foreclosure drive a concentration
of foreclosures in the same neighborhood, for example in a
spatial concentration of subprime lending. A concentration of
home foreclosures in a neighborhood hurts property values in
several ways. A glut of foreclosed homes for sale depresses
home market values for the other owners.
Neighboring
businesses often experience a direct monetary loss from reduced
sales and neighborhood landlords experience a loss or reduction
in rental income.
Moreover, the homes left vacant by
foreclosure lower the desirability of the neighborhood since there
is often an increase in crime associated with a vacant house.1 7

As concentrated foreclosures persist in a community, the value of
surrounding homes may decline. Dan Immergluck and Geoff
Smith survey the literature on this subject and estimate the
impact of foreclosures on nearby property values using data on
foreclosures and neighborhood characteristics in the Chicago
They found that conventional foreclosures have a
area.'8
statistically and economically significant effect on nearby
property values. In particular, they found that each conventional
foreclosure within a one-eighth mile of a single-family home
produces at least a 0.9 percent lower property value, and may be
closer to 1.5 percent in low to moderate income communities.
Similarly, Shlay and Whitman find significant affects of
abandoned property on nearby housing values in Philadelphia.' 9
They find that an abandoned property will lower property values
on homes located within 150 feet by $7,627 (or 10.1 percent) and
will lower property values on homes located within 450 feet by
$3,542 (or 4.7 percent). As did Immergluck and Smith in
Chicago, Shlay and Whitman find that the effects of abandoned
properties on nearby home values are cumulative. They find
that, on average, home values on the block decline by 9.1 percent
in the case of one abandoned home on the block, and decline on
average by 15.0 percent for 5 abandoned properties on the block.
Large House Price Declines Have the Potential to Reduce
Growth and Employment
Should housing prices decline dramatically, the effects could be
significant. To the extent that price declines reflect a decline in
demand for new housing, construction activity will decline. This
contraction is already under way, and has reduced residential
investment sufficiently so that GDP growth has declined
markedly in the past year.
House price declines can also affect economic activity through
Econometric work has
their effect on household wealth.
with income, helps to
along
wealth,
established that household
determine the level of aggregate consumption. Higher levels of
wealth lead to higher consumption, all things being equal. Since

declines in home prices reduce wealth, they reduce consumption
and thus output and employment. 28 These effects occur with
significant time lags.
Federal Reserve Board Governor Frederic Mishkin has reported
on simulations of Federal Reserve macroeconomic models of the
U.S. economy in which housing prices are assumed to experience
an exogenous 20 percent decline. One model shows real GDP
declining one-half percent relative to baseline after three years,
another shows a GDP decline of one and one-half percent, with
the largest decline occurring somewhat earlier. 29
While these outcomes are significant, they may understate the
effects of large price declines. If the price of houses were to fall
20 percent in a short period of time, we might well see a shift in
overall business confidence. This could produce negative effects
on credit markets, as recent events have illustrated. Higher
interest rates or restrictions on business credit can in turn reduce
real economic activity. In addition, business decision-making
and capital investment can be affected by any changes in
confidence.
BOX B: THE SUBPRIME MARKET EXPANDED RAPIDLY AND
UNDERWRITING STANDARDS DETERIORATED
DURING 2001-2006
Subprime Market Expanded Rapidly During 2001-2006
Subprime mortgages are a relatively new financial product. As former
Federal Reserve Governor Edward Gramlich noted, they were made possible
by legal changes dating from the 1980s, which eliminated the interest rate
ceilings imposed by state usury laws, and by the development of a secondary
mortgage market that allowed loan underwriters to fund subprime mortgages
through the capital markets. 22
Subprimes now have a substantial presence in the mortgage market. The
share of subprime mortgages in total mortgage originations has risen over
time, with the most rapid expansion occurring in the period 2001 to 2006. In
2001, $190 billion in subprimes were originated, about 8.6 percent of the total
mortgages originated that year. By 2005, the amount of subprime originations
had risen to $625 billion, about 20 percent of the total. Subprimne originations
declined in 2006 to $600 billion, but still made up 20 percent of all
originations (See Figure 8). As a consequence, the share of subprimes in the

total number mortgages outstanding is now significant, rising from 2.6 percent
in 2001 to 14.0 percent in the second quarter of 2007.23
In the past, borrowers who did not qualify for prime loans turned to the
Federal Housing Authority (FHA) and Veterans' Administration (VA) for
loans. Indeed, FHA and VA lending fell from 28.5 percent of the market in
1998 to 9.3 percent of the market (as of September 2007).24 Lending backed
by those government entities declined as housing prices rose, because FHA
limits fell below median home prices in some regions. Additionally,
borrowers may have been attracted to the lower initial payments available
with many subprime loans.
UnderwritingStandardsDeterioratedAs the Market Expanded
There have been significant changes in the types of subprime loans made in
recent years, reflecting lower underwriting standards. As can be seen in
Figure 10, between 2001 and 2006 adjustable rate mortgages (ARMs) as a
share of total subprime loans originated increased from about 73 percent to
more than 91 percent. The share of loans originated for borrowers unable to
verify information about employment, income or other credit-related
information ("low-documentation" or "no-documentation" loans) jumped
from more than 28 percent to more than 50 percent. The share of ARM
originations on which borrowers paid interest only, with nothing going to
repay principal, increased from zero to more than 22 percent.
Over this period the share of subprime ARMs that were originated as
"hybrids" increased dramatically. The share of 2- and 3-year hybrid ARM's
accounted for more than 72 percent of all subprime ARM's originated in 2005
(See Figure 12 in Appendix).
Hybrid ARMS underwritten to subprime borrowers are posing the greatest
problems today. For a typical 2/28 hybrid loan, the interest rate and mortgage
payment are fixed during the initial two year period. After the initial two
years the rate is reset every six months, with a gross margin added to an
interest rate index such as LIBOR. Payments can rise substantially when they
are reset at the end of the initial fixed rate period. Cagan has estimated that
subprime ARMs resetting in 2008 will experience an average 31 percent
payment increase. 25
There are millions of subprime hybrids that will reset in the remainder of 2007
and in later years. Cagan has estimated that 2.17 million subprime ARMs will
have their first reset between 2007 and 2009.26 The Federal Deposit Insurance
Corporation has estimated that there were about 2.1 million nonprime (i.e.
subprime and Alt-A) hybrid ARMs outstanding in March of 2007.27
Loan PerformanceHas Reflected the UnderwritingDecline
Although underwriting standards declined during 2001-2006, loan
performance did not immediately deteriorate. In fact, subprime performance

between 2001 and 2005 was good by historical standards. As can be seen in
Figures 11 and 13, aggregate delinquency and foreclosure rates declined
during 2001-2005. They have since turned sharply upward. The data in
Figure 14 in the Appendix, which track the delinquency rates of subprime
mortgages from the time at which they were originated, tell a qualitatively
similar story. Loans originated during 2001-2005 perform better than those
originated in 2000. Noticeably higher delinquency rates appear for loans
originated in 2006 and 2007.
It is important to notice, however, that the trends in subprime loan
performance between 2001 and 2005 could hardly be characterized as normal.
During this period aggregate foreclosure and delinquency rates were well
below those observed during the years 1998 through 2002. Loans originated
between 2001 and 2005 were performing well, but those originated in 2000
had performed less well.
Since underwriting deteriorated from 2001 to 2005, and the accelerating
housing price boom was giving subprime borrowers important help (see Part
II), a cautious analyst might have questioned whether the improvements in
subprime performance could be sustained. The financial intermediaries who
expanded the supply of these loans were apparently not troubled by this issue.
The reasons for their lack of curiosity may lie in the strong incentives they had
for expanding the subprime market.

PART II: STATE-LEVEL ESTIMATES OF THE
ECONOMIC EFFECTS OF SUBPRIME FORECLOSURES
To better understand how subprime lending and declining
housing prices may affect households and communities in the
near future, we have made quantitative estimates of the potential
scale of foreclosures and their costs at the state and national
levels. We first discuss entirely forward looking, state level
estimates, covering the second quarter of 2007 through the end of
2009. We estimate the number of foreclosures, the loss in
housing value that directly results from each foreclosure, the
effect that a foreclosure has on the value of neighboring houses,
and the state and local government tax revenues that will be lost
as housing values decline.
As is made clear below, these state level estimates rely on
housing price forecasts which show moderate housing price
declines. It was necessary to use these forecasts to obtain state
level results. However, it is quite possible that housing price

declines will be substantially larger. Therefore we also present
national level foreclosure and property loss estimates, assuming
larger future housing price declines. This allows us to learn
about the scale of economic damage if the housing market
evolves in a less favorable way.
The results of the state level estimates, although based on
forecasts of moderate housing price decline, are quite sobering.
We estimate there will be approximately 1.3 million foreclosures
and a loss of housing wealth of more than $103 billion through
the end of 2009 (including approximately $71 billion in direct
costs to homeowners and $32 billion in indirect costs caused by
the spillover effects of foreclosures). The estimated aggregate
cumulative subprime foreclosure rate for this period is 18 percent
(See Figures 5 and 6). The total loss in property tax revenue is
also high, amounting to more than $917 million. The ten states
with the greatest number of estimated foreclosures, in descending
order, are California, Florida, Ohio, New York, Michigan, Texas,
There are,
Illinois, Arizona, Pennsylvania and Indiana. 30
in the
behind
close
are
that
unfortunately, several others
rankings.
The effects of larger price declines could considerably increase
For example, Moody's
the magnitude of these damages.
forecasts that, in the aggregate, housing prices will decline by
about 6.9 percent between Q3 2007 and Q2 2009 and rise mildly
thereafter. If we instead assume that the aggregate price decline
is 20 percent over that period, the total number of foreclosures
for the period beginning in the first quarter of 2007 and
extending through the final quarter of 2009 would be nearly 2
million and the loss of property values would total about $106
billion.
Several assumptions are necessary to make the state level
estimates, and we have been deliberately conservative when
making them. We have assumed that all foreclosures over the
2007-2009 period will come from the stock of subprime
mortgages outstanding at the end of the second quarter of 2007.
This is a very conservative assumption. The growth in the

outstanding stock of subprime loans through the second quarter
of 2007 indicates that incremental subprime loans are still being
made. However, because we cannot forecast the course of future
lending, we assume that all foreclosures come from the existing
stock. This biases our estimates downward. We also assume
that once a mortgage enters foreclosure it is foreclosed within a
year. Although there are variations across jurisdictions, the
average maximum amount of time to foreclose is less than a
year.
To estimate the numbers of mortgages that will be foreclosed, we
begin by examining what determines the fraction of mortgages in
foreclosure (foreclosure rate) during a year. It is reasonable to
suppose that, holding the risk characteristics of borrowers
constant, the foreclosure rate will depend heavily on house price
appreciation and the economic fortunes of borrowers. 3 2 If house
prices appreciate, refinance or sale is easier. If general economic
conditions are good, it is more likely that households will be able
to meet their financial commitments. As it turns out, both these
factors are significant determinants of the foreclosure rate.
Figure 7 shows the results of state-level cross sectional
regressions of subprime foreclosure rates for 2006 on two
independent variables - cumulative housing price appreciation
between 2004 and 2006, and cumulative employment growth in
the same period. The cumulative housing price appreciation
variable is an index of changes in home equity, and the
cumulative employment growth variable is an index of the ease
of finding employment and the overall performance of the real
economy. Both variables are statistically significant. The
significance of the employment variable highlights the
importance of developments in the real economy for loan
outcomes. However, we do not attempt to estimate changes in
employment when we use these results. If employment growth
were to slow during our forecast period, foreclosure rates likely
would be higher than our estimates.

74
Figure 5: Impact of Subprime Foreclosures on Home Equity, Property
Values and Prouertv Taxes

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Figure 7: State-Level Foreclosure Rate Regressions
Independent

Dependent Variable

Variable

Foreclosure Rate ARM

House Price
Appreciation

-14.80 *

(2004-2006)

(2.058)

Employment Growth
(2004-2006)
Constant

Observations
2

-19.22 **
(5.930)

Foreclosure Rate

FRM

-9.27
(1.655)
-11.19
(5.384)

8.88 **

5.42 *-

(0.570)

(0.523)

0.712

0.490

*Significant
ri

at 95% level.
Significast at 99% level.

Data Sources: Foreclosure rate are Mortgage Bankers Association 'foreclosure inventory"; House Price Appreciation is calculated from Office of Federal Housing Enteaprise Oversight housing price indices; Employment Growth is calculated from Bureau
of Labor Statistics 'employees on non-farm payrolls," seasonally adjusted ALldata accessed via Haver Analytics.

To estimate future foreclosure rates, we use current foreclosure
rates, the coefficients on house price appreciation reported in
Figure 7, and estimates of future housing prices. That is, we
calculate foreclosure rates according to FCt = FCtl + b(DHPAt),
where FCQ is the foreclosure rate in year t, FCtl is the
foreclosure rate in the previous year, DHPAt is the change in
cumulative two-year housing price appreciation between years t
and t-1, and b is the estimated coefficient of HPA (house price
appreciation) as reported in Figure 7. The values for the variable
DHPAt are calculated using forecasts of state-level housing price
indices from the Office of Federal Housing Enterprise Oversight
(OFHEO).
The forecasts were produced by Moody's
Economy.com. We estimate foreclosure rates separately for
fixed rate and adjustable rate mortgages. These foreclosure rates
are used to calculate the absolute number of foreclosures in a
given period. 3
Using our estimates of the number of subprime foreclosures, we
then estimate the associated economic costs. Research has
shown that foreclosure causes a decrease in the value of the
We estimate this direct loss in housing
foreclosed house. 34
wealth by discounting the average loan value of a subprime
mortgage. We apply a 22 percent discount rate to the average
home value associated with subprime loans (net of the loss due to
the decline in home prices) to calculate this loss. 35

Foreclosures also affect the values of neighboring houses. We
estimate the effect of a foreclosure on surrounding house prices
as 0.9 percent of the value of all single family houses within 1/8th
36-lvlpplto
mile of a foreclosed house.
We use MSA-level population
densities to estimate the number of houses within one-eighth
mile of each foreclosed house. 37
The loss in property taxes caused by housing price losses is
calculated by assuming that average state property tax rates
remain unchanged through the end of 2009. Tax losses are
calculated by applying existing property tax rates to the change
in housing values caused by foreclosure (net of the loss due to
the decline in home prices).
We conclude by noting that the forecast values for housing prices
clearly play a pivotal role in this analysis, and that the price
forecasts we have used are likely to be conservative. The
Moody's data are forecasts of future values of OFHEO housing
price indices. However, in recent quarters the OFHEO indices
have not reflected the same downward movement in housing
prices registered in other price measures. For example, the
national OFHEO index had not peaked by the second quarter of
2007, but the S&P/Case-ShillerV U.S. national home price index
peaked in the second quarter of 2006 and had declined by 3.2
percent by the end of the second quarter of 2007. Therefore it is
possible that the price forecasts we have used will not pick up all
of the likely housing price declines over the near term.
To account for this possibility, we have applied the procedure
developed for state level estimates to aggregate foreclosures,
assuming a 20 percent decline in aggregate home prices. A price
decline of that amount is not out of the question. When
simulating the possible macroeconomic effects of housing price
declines, the Federal Reserve recently assumed a 20 percent
decline in aggregate housing prices.38
Moreover, futures
contracts based on the S&P/Case-Shillerg indices are predicting
that housing prices may decline as much as 10 percent over the
coming year.3 9 Since the S&P/Case-Shiller& indices already
show a 3.2 percent decline over the past year, calculating

subprime foreclosures by assuming a 20 percent decline in the
OFHEO price indices over two years seems unfortunately
plausible. Under these assumptions, the number of foreclosures
for the period covering the third quarter of 2007 through the end
of 2009 is approximately 1.66 million, and the associated
property loss is about $106 billion. 40 If we add in an estimate of
foreclosures in the first half of 2007, the foreclosure total rises to
approximately 2 million.
PART III: THE ORIGINS OF THE SUBPRIME LENDING
CRISIS
The discussion above highlights the potential economic damage
that could result if subprime foreclosures are allowed to proceed
unchecked. In this section we investigate the underlying causes
of the subprime mortgage crisis in an effort to identify policy
approaches that could prevent the reoccurrence of such a threat to
homeownership, household wealth, and the broader economy.
Financial Intermediaries Drove The Expansion Of The
Subprime Market
Most Lending Organizations Make Few Subprime Loans
The expansion of subprime mortgages during the years 2001
through 2006 came, for the most part, through a well defined
channel of financial intermediaries. The intermediaries in this
channel - brokers, mortgage companies, and the firms that
securitize these mortgages and sell them on to the capital markets
- had strong incentives to increase the supply of these loans.
One outcome was a significant increase in the rate of
homeownership. From 1994 to 2005, the overall homeownership
rate rose from 64 to 69 percent. 4 ' However, since brokers and
mortgage companies are only weakly regulated, another outcome
was a marked increase in abusive and predatory lending.
Most Subprime Loans Are Originated Through Mortgage
Brokers
The mortgages underwritten by subprime lenders come from
many sources, but the overwhelming majority is originated
through mortgage brokers. For 2006, Inside Mortgage Finance

estimates that 63.3 percent of all subprime originations came
through brokers, with 19.4 percent coming through retail
channels, and the remaining 17.4 percent through correspondent
lenders. 42 Their data show the broker share increasing from 2003
through 2006.4344
For the mortgage market in total, Inside
Mortgage Finance estimates that 29.4 percent of mortgages were
originated by brokers in 2006. This percentage does not change
much between 2003 and 2006.45
Independent Mortgage Companies and Other Mortgage
SpecialistsAccount for Most Subprime Lending
Most subprime loans are made by companies that specialize in
mortgage lending. Using 2005 Home Mortgage Disclosure Act
(HMDA) data, former Federal Reserve Governor Edward
Gramlich concluded that "30 percent of [subprime] loans are
made by subsidiaries of banks and thrifts, less [sic] lightly
supervised than their parent company, and 50 percent are made
by independent mortgage companies, state-chartered but not
subject to much federal supervision at all.,46
Because they are not deposit-taking institutions, the independent
mortgage companies and bank subsidiaries are not subject to the
safety and soundness regulations that govern federal or state
banks. These entities are less closely monitored under the Home
Owners' Equity Protection Act (HOEPA) and the Community
Reinvestment Act. They are state-chartered and subject to state
law. Some states have tried to apply federal predatory lending
advisories to all lenders or regulate brokers or lenders in their
state, but the resources that states have for oversight are far fewer
than those of the federal government. 47
Most Subprime Loans are Securitized via Non-Agency
Conduits to the CapitalMarkets
Lenders hold only a fraction of the subprime loans they make in
their own portfolios. Most are sold to the secondary market,
where they are pooled and become the underlying assets for
residential mortgage backed securities. As can be seen from the
data in Figure 8, the percentage of subprime mortgage securitized
rose rapidly after 2001, reaching a peak value of more than 81

percent in 2005. Deposit-taking institutions such as banks and
thrifts, which deal mostly in lower-priced mortgages, sell their
mortgages primarily to government sponsored enterprises (GSEs)
such as Fannie Mae and Freddie Mac. Independent mortgage
companies, however, make their secondary market sales
primarily to other financial market outlets (See Figure 9).48
Hence whatever influence the GSEs have on lender underwriting
standards is missing -from much of the subprime market since
securitization is done by other market participants.
Figure 8: Mortgage Origination Statistics
Total Mortgage
Subprime
Oa
Originations
(Billions)

(Bilions)

(Billons) (Bilitans

Subprime Share In
TotalOriginations
(percentodol

vaper)n
fdla

ubprme Mortgage

Percent Subprlnes
Securitized

Backed Securities

(percent ofdollar

(Billions)

value)

$2215

2002

$2,885

$231

8.0

$121

52.7

2003

$3,945

$335

8.3

$202

60.5

2004

$2,920

$540

18.5.

$401

74.3

2^.>005

$312

2006

$2,980

i812-

$625
$600

. At

A
20
20.1

$50700
$483

80.5

Source Inside Mortgage Finance, The 2007 Mortgage Market Statistical Annual, Top Subprime Mortgage Market Players &
Key Data (2006).

MARKET INCENTIVES FACILITATED PREDATORY
LENDING
Broker and Lender Incentives Work Against Borrowers
Mortgage brokers are salesmen who want to maximize their net
income. Their interest in providing the least expensive mortgage
is limited. In fact, lenders provide them incentives to do the
opposite. Lenders sometimes pay brokers so-called "yieldspread premiums," when they sell loans with interest rates above
the minimum acceptable rate for the loan.49 Some brokers may
also receive higher fees for selling mortgages with prepayment
penalties. 50
Moreover, since mortgage brokers bear little or no risk when a
borrower defaults, they have no economic incentive to originate
loans that a borrower can afford in the long term. Brokers also
lack strong legal incentives to act in the interest of borrowers.

Under state law brokers are not fiduciaries, who must put the
interest of their clients first. Nor do they have a duty to sell their
clients products which are at least suitable to their circumstances,
as registered securities brokers do.
Figure 9: Subprime Lenders Usually Securitize Loans Through Non-GSE
Conduits (Percent Distribution)
Higher-Priced Specialized Lender
Percent Sold In 2004
Not Sold

G-SE

Prhge

Bank or
Ntt
hM

iortVeAe
MAltat
Comy bwgattlo.

Other
Conduth.

Tom

0.0

04s

Deposit Ttking org-dIzofo
Credit tho

0.4

0.0

Asssment Area Loude

1.4

0.0

0.1

0.0

1.0

Oftede AsenO Are-

0.0

0.7

0.0

0.3

8.3

I1 .

todepmdentaMorafgepF ks

126

0.1

1.7

0.6

124

1.6

544
A

AD Loom.

18.4

O.A

1,7

1.5

125

1.9

0.0

CRA.Regilated tenderr

3.4
*1.00i

Lower-Priced Specialized Lender
Percent Sold In 2004
B.ok or MortWe
ToeA
Cqtmeny

AIMIftt
bton

Other
Coottotte

0.3

0.1

0.9

0.5

"A0

1.0

2.8

5.4

29*

0.5

2.1

6.0

0.2

10.4

i26

0.6

4.0

7.8

5.5

19.1

100.0

Not Sold

5.6

1.3

0.0

0.1

Aooomt Areotenders

18.8

11.6

0.0

OistdeAoonnenutArea

8.6

10.1

0.1

1.5

S.6

345

28.5

Deposit Tugn Orgatldouo
Credit

Jalo3

CRtA Revo~ted Lender-g;

Indeperdat Mortgw BMunk
AD~o
L

7Ms

Soero ApSwtet iL 2007.
Note UHW=.Poe d Speddieed Lasdm we, apptomaty fir*, tot spopreted in .obpnie lendi.tLoeer.Prkedt Spreiolzed
LendnO tad to itk. few espdmn tow. Sk. the dscusdos in Apfe aL (2007)1

Because mortgage companies sell many of the loans they
underwrite to the secondary market, they have an interest in
underwriting loans that are desired by the secondary market
investors. 1 This observation has special weight because of
developments in non-mortgage financial markets. In recent
years, as hedge funds have proliferated and the market for
structured financial products has expanded, there has been
significant demand for high-yield assets that can underlie

collateralized debt obligations (CDOs) and other financial
derivatives. Subprime mortgages have, until recently, been
considered terrific assets to include in CDO structures. Hence
subprime lenders have had a strong incentive to underwrite highyielding subprime mortgages, whether or not these loans were
best interests of the borrowers.
Predatory Lending Practices
Given the financial incentives for brokers and lenders to provide
an increasing volume of high yield mortgages, it is no surprise
that tactics were invented to meet the demand. The rapid
expansion of 2/28 and 3/27 hybrid ARMs, and the imposition of
prepayment penalties, are examples of financial innovations that
were widely adopted by subprime lenders. 52 Both made it
possible for loan originators to expand lending-hybrid ARMs
by allowing credit-constrained borrowers to pay initially low
rates on mortgages, and prepayment penalties by raising returns
on loans. However, both innovations can have abusive or
predatory results.
Figure 10: Underwriting Standards in Subprime Home-Purchase Loans
Debt Paymentsto-Income Ratio

Average Loanto-Value Ratio

28.5%00

39.7

84.04

2.3%

38.6%

40.1

84.42

80.1%

&6Pe

42.8i%

40.5

2004

89.4%

27.2%

45.2%

41.2

84.86

2005

93.3%

37.8%

50.7%

41.8

83.24

42.4

83.35

ARiM Share

10 Shame

2001

73.8%

0.0%

2002

80.0%/0

2X<.0035400

2006

91.3%

22.8%

Low-No-Doc
Share

50. /%

source Freddie Mac, obtained from the International Mondary Fund via httpi/www. inf org/external/pubslftifmnlenrn2007/
charts.pdf
Notes: 'ARMi represents 'acustable rate mortgages"; "OWrepresents interest-only mortgaes, where payments do not rdire the
principal value of the loan; 'Low-No-Doc" represents low or no documentation moilgages.

In the abstract, ARM loans need not work to the disadvantage of
borrowers. Subprime hybrid ARMs, however, have frequently
been made on the basis of the borrower's ability to pay at the low
initial rate rather than the reset rate. This is reflected in public
disclosures of lenders, who make it clear that they qualify

borrowers for loans on the basis of their ability to make
payments at or near the initial rate. 53 It is also reflected in loan
performance. When hybrids reset there is a dramatic rise in
prepayments as borrowers refinance and an increase in the
default rate. Prepayments and defaults are very sensitive to the
size of these shocks. Pennington-Cross and Ho estimate that "a
one-standard-deviation increase in the size of the shock is
associated with an almost 50 percent increase in the probability
of prepaying and more than a 25 percent increase in the
probability of defaulting." 5 4 By underwriting hybrid loans on the
basis of the initial rate, lenders make it more probable that a
subprime borrower must sell, refinance or default at reset. This
means there is increased lender reliance on asset values and
prepayment fees to provide earnings, and less consideration of
borrower ability to pay.
Mortgage lending on the basis of asset value, without regard to
borrower ability to pay, is widely recognized as predatory and
harmful to borrowers. HOEPA recognizes asset-based mortgage
lending as predatory, as do several state statutes.5 5 Several
researchers also regard asset-based mortgages as predatory. 5 6
However, HOEPA coverage is limited. Because HOEPA applies
only to loans that have an annual percentage rate that exceeds a
very high threshold, less than one percent of subprime loans are
covered. 5 7 Currently at least 41 states have laws which restrict
predatory mortgage lending, but the terms and enforcement of
these statutes are uneven. 58
Moreover, unscrupulous originators can evade state law by
falsifying information or making "no documentation" loans that
make loans appear affordable even when they are not. 59 The
remarkable expansion of low document and no document loans,
observable in Figure 10, is likely to reflect something more than
risk-taking by lenders. It may also measure the determination of
originators to evade state controls on predatory lending.
Prepayment penalties, which are frequently imposed on all types
of subprime loans at a very high relative and absolute rate (See
Figure 15), have the potential to strip housing equity from

subprime borrowers.
As Farris and Richardson note: "The
typical penalty is six months' interest on up to 80 percent of the
original mortgage balance. For a subprime loan at 12 percent
interest, this means that a prepayment penalty amounts to nearly
5 percent of the loan balance. For a $150,000 loan, the fee is
$7,500, which was about 40 percent of the total net wealth of the
median black family in 2001 .60 Hence, sale or refinance during
the penalty period, which often lasts three or more years, is very
costly to subprime borrowers. A subprime 2/28 borrower with
the example $150,000 mortgage, who began with $15,000 in
equity, would have no equity after two refinancings (even
ignoring closing costs and other fees), unless the price of his
house had appreciated.
Prepayment penalties also raise the likelihood that a subprime
borrower will default. In a study of subprime refinance loans
originated in 1999, Quercia et al. concluded that prepayment
penalties raise the odds of foreclosure, risk factors held
constant.61
This most likely results from the fact that
prepayment penalties prevent subprime borrowers from
refinancing their loans when interest rates decline or their credit
standing improves.
Prepayment penalties are sometimes explained as a means of
compensating lenders for unanticipated interruption to the stream
of mortgage payments. However, it is also usually understood
that a prepayment penalty should lower the interest rate on the
loan, all things being equal, since the lender has insurance
against early payment. This does not appear to be the case in the
subprime market. Borrowers with prepayment penalties do not
receive lower interest rates compared to similar borrowers
without penalties. 62
There is also evidence that the sales effort of mortgage brokers
and mortgage companies has meant that subprime loans are more
likely to be sold to more vulnerable members of the population,
even when those borrowers might qualify for less expensive
mortgages. In a study of a random sample of borrowers who
took out mortgages during 1999 and 2000, Courchane et al.

examined whether factors other than credit risk indicators (such
as FICO score and the loan to value ratio) explain who receives a
subprime loan. 63 Their results show that those who do not search
for the best price, who are not offered choices about mortgage
terms, who obtain their mortgage through a broker, who are
Hispanic, or are older than 65 are more likely to obtain a
subprime mortgage, credit risk factors held constant.64 A second
study by Lax et al. reaches very similar conclusions. 65
PART IV: POLICY RESPONSES
The following section proposes several policy options that
lawmakers should consider to reduce foreclosures and prevent
future foreclosure epidemics and associated economic losses.
Increase Resources For Nonprofit Housing
Counselors Specializing In Foreclosure Prevention
There is a broad consensus among the Administration, Congress,
private sector participants and consumer protection groups that
the role of housing counselors as intermediaries between
borrowers and lenders/loan servicers is critical in helping prevent
foreclosures. Housing counseling agencies across the country are
working on behalf of struggling borrowers to negotiate safe and
affordable loan modifications and refinancings in an effort to
prevent foreclosures. Because of the often competing incentives
of the market players involved in the securitization of subprime
loans, borrowers are often at a loss when it comes to figuring out
how they can financially mitigate an unaffordable rate reset.
Nonprofits that specialize in foreclosure prevention have been
highly effective in acting on behalf of borrowers to explore their
options with their lenders.
In the FY2008 Senate Transportation, Housing and Urban
Development (HUD) Appropriations bill, a $100 million
appropriation targeted to HUD-certified foreclosure-avoidance
nonprofits was approved. The bill also included $100 million in
loss mitigation funding for both nonprofits and private entities.
This is a significant additional funding stream targeted to
preventing foreclosures, but more resources are urgently needed.

Direct Servicers And Lenders To Make Safe And Sustainable
Modifications, Or Refinancing
The most effective way to help prevent foreclosures for hybrid
ARM borrowers that cannot afford their payments after the rate
reset is to modify the terms of their loan to make them
affordable. The Center for Responsible Lending (CRL)
estimates that 20 percent of existing borrowers that were able to
repay their loans before their rates reset but cannot refinance to
conventional loans could afford their loans over the life of the
mortgage if their current "teaser" interest rate was fixed at that
rate. CRL estimates that another 20 percent of borrowers-those
unable to pay the teaser rate because they may have been placed
into stated income loans they could not afford, for examplecould afford their mortgages only if their principal balance or
interest rate was reduced to make it possible for them to afford
the lower payments on the reduced loan balance. Legislation is
currently pending in Congress to temporarily change the tax law
to let homeowners avoid paying taxes on any forgiven debt in
loans being restructured by financial institutions.
The federal regulators have issued guidance to lenders and
servicers to engage in loss mitigation efforts prior to pursuing
foreclosures, and lawmakers should put pressure on the private
sector players to step up their efforts to help subprime ARM
borrowers before their loan resets. Policymakers should also
emphasize the importance of servicers developing a rules-based
approach to doing loan modifications so that the servicers can
handle the volume of borrowers whose loans are due to reset.
Policymakers may also consider requiring specific loss
mitigation efforts prior to any foreclosure filing by creating an
affirmative duty for lenders and servicers prior to foreclosure.
Increase FHA's Ability To Refinance
Congress is currently working to pass the Federal Housing
Administration's (FHA) Modernization Act of 2007, which
would increase FHA's capacity and flexibility to insure subprime
mortgages that can be refinanced. The proposal is designed to
make FHA-insured loans a more attractive option to lenders and
borrowers by increasing allowable loan limits and lowering

down-payment requirements. The Administration has backed the
proposal.
Expand Capability of Government Sponsored Enterprises to
Refinance Subprime Borrowers
Expanding the near-term capabilities of the government
sponsored enterprises (GSEs) Fannie Mae and Freddie Mac to
help subprime borrowers through refinancings could help curb
the pace and volume of foreclosures. Both Fannie Mae and
Freddie Mac have specialized, affordable loan products that they
make available to subprime borrowers. Both of the GSEs are
currently constrained by portfolio limits imposed upon them by
their safety and soundness regulator, the Office of Federal
Housing Enterprise Oversight. Temporarily raising the GSE
portfolio limits, if the increase is focused on the key problem of
refinancing subprime ARMs, could provide much needed
funding to mortgage lenders who will be able to refinance
struggling borrowers in safe and sustainable loan products.
Amend the Bankruptcy Code to Protect Families from
Foreclosure
Many of today's subprime borrowers have loans that are greater
than the value of their homes, which means foreclosure will not
extinguish their debts. Bankruptcy could be a highly effective
tool for helping families recover from subprime loans, but
today's bankruptcy code prevents courts from providing relief on
mortgage loans. In fact, the law singles out the home mortgage
loan as the one debt the courts are not permitted to modify. To
address the subprime crisis, policymakers could amend the
bankruptcy code to either temporarily or permanently exclude
primary home loans from the remedies that are available on
other, less important debts. This would allow borrowers to pay
the fair market value of their home and to keep that home, rather
than seeing the home sold to a third party for its liquidation
value.
Reform Mortgage Lending and Ban Predatory Lending
Practices
The prevalence of predatory lending that helped fuel the volume

of risky subprime loans was enabled by a patchwork of federal
and state regulations that was all-too-easily evaded by subprime
mortgage brokers and lenders. Federal laws are needed that
would offer predatory lending protections to homeowners,
restore common sense underwriting practices and ensure a
borrower's ability to pay. At a minimum, the federal government
should require lenders to determine that the borrower has the
ability to repay a loan at the fully-indexed rate and assume fully
amortized payments. Federal banking regulators have issued
strong guidance requiring depository banks and their affiliates to
underwrite loans at the fully indexed interest rate, but a clear
federal standard is needed that apply this requirement to the
whole mortgage market. Policymakers should also require
lenders to verify a borrower's income using tax documents or
other reasonable documentation.
Policymakers may also want to require mortgage lenders to
escrow for taxes and insurance on all mortgage loans. Failing to
escrow for taxes and insurance on a subprime loan is an unfair
and deceptive practice that contributes to high rates of
foreclosure. 6 4 Furthermore, eliminating prepayment penalties and
yield-spread premiums on subprime loans would help discourage
steering of borrowers into unnecessarily expensive loans.
Policymakers should also consider regulating mortgage brokers
and originators under the existing Truth in Lending Act (TILA)
by establishing a fiduciary duty between brokers and their
customers, and a duty of good faith and fair dealing standard for
all originators. An important takeaway from the subprime
mortgage crisis is that too often mortgage originators have no
incentive to act in the borrowers' best interest. Instead their
interests are aligned with securitizers that repackaged the
subprime loans into securities designed to maximize
attractiveness to investors.
Make Sure All Borrowers Understand the Terms of Their
Mortgages
The current subprime mortgage crisis has made it clear that the
mortgage finance system does not require that borrowers

understand how their loans work. As explained above, subprime
mortgage origination has been accompanied by a rise in
predatory lending practices that can lead borrowers to believe
that they can afford their loans or refinance before they reset to a
much higher payment. Policymakers should consider requiring
that all mortgage lenders disclose the basic facts about the
mortgage loan that they underwrite for the borrower. This form
should be easy to understand and not exceed one page in length.
The borrower should receive this one-page form from the lender
well before the closing of his or her loan. At a minimum, the
form should require that the borrower know the amount of the
loan, the property's appraised value, the term of the loan, the
payments at each reset date, and today's estimate of how much
the rate will increase (the fully indexed rate), as well as the
maximum possible rate on the loan. Other disclosures would
include, in plain language, any prepayment fees and other
estimated costs and fees due at closing.

APPENDIX:
Figure 11: Comparison of Prime Versus Subprime Delinquency Rates,
Total US 1998-2007
18.0
16.0

Adjustable Rate

14.0
12.0
10.0

Subprime

8.0

Prime Adjustable
Rate
Prime Fixed
_

6.0

Rate

4.0
2.0
0.0

1998

1999

2000

Sources: Mortgage Bankers Association.

2001

2002

2003

2004

2005

2006

2007

90
Figure 12: Subprime Mortgage Backed Security Composition
An Analysis of Private Label Securitization Data
Negative
Negative
Amortization Share

10 Share

2- and 3-year

5- 7- and

Hybrid
Adjustable Rate

10-year Hybrid Adjustable
Rate

.9j5%o "0.8

2001

Om.0

0.0

2002

1.2%/s

O.O%

65.4%

1.4%

63.1%

1.4%
1.5%

2003

4.1%

0.%-

2004

16.2%

O.0f/

73.5%

2005

27.2%

0.0r

72.2%

1.5%5

2006

17.0%

0.0%

50.3%

2.0%

Source: Sandra L. Thompson, Director of Supervision and Consumer Protection, FDIC, statement before the Cornmitteee on Banking, Housing and Urban Affairs, U.S. Senate, March 22, 2007. Data from LoanPerformance

Figure 13: Comparison of Prime Versus Subprime Foreclosure Rates,
Total U.S. 1998-2007
10.0
9.0
9.0

Subprime

Fixed Rate

3.0

Prime Adjustable

PrmFx

Rate

rate

2.0

1.0
0.0
1998

1998

1999

2000

Sources: M ortgagD Bankers Association.

2001

2002

2003

2004

2005

2006

2007

91
Figure 14: Recent Subprime Vintages Have Performed Poorly (Percent of
Loans 60+ Days Delinquent by Year of Origination)
14.0
12.0
10.0
8.0
1

6.0
4.0
2.0
0.0
O~ 1

9) %I

N% 11

1¢

91 0

(

Age of Loan in Months
Source: Moody's Investors Service

Figure 15: FICO Score and Sector: 2005 0riginations
Sector

Average Loan

FICO

Size

Score

Combined Loan-to,Value

Pret
Prpayment

Gross Margin
(in basis pts.)

Penalty
me

ARM

$453,000

732

73.9

15.4

256.2

Near Prime ARM

$321,000

711

80.0

52.6

282.4

ubprime ARM

$200,000

624

85.9

72.4

582.6

$499,000

742

70.6

1.7

N/A

$215,000

717

76.2

15.6

NJA

$128,000

636

81.2

76.6

N/A

Prhne Fixed

ear Prime Fixed

Subprimre Fixed

Source: Mortgage Bankers Association, Characteristics of Outstanding Residential Mortgage Debt: 2006, MBA
DataNotes, January 2007, p. 5.

REFERENCES
'Data from Robert Shiller, Irrational Exuberance website, accessed 9/10/07,
available at http://www.irrationalexuberance.com/index.htm.
2
Robert Shillier (2005). Irrational Exuberance, Second Edition. Princeton:
Princeton University Press, p. 13.

92
E. Schloemer et al. (2006). Losing Ground: Foreclosures in the Subprime
Market and Their Cost to Homeowners, Center For Responsible Lending:
Durham, NC, p. 14.
4Federal Reserve Bank of San Francisco (2007). Economic Letter, House
Prices and Subprime Mortgage Delinquencies, Number 2007-14, June 8.
5S&P/Case-Shiller& U.S. National Home Price Index.
6Ben Bernanke, Housing, Housing Finance and Monetary Policy, August 31,
2007, available at
http://www.federalreserve.gov/newsevents/speech/bemanke20070831 a.htm.
7
R. Shiller (2007a). Historic Turning Points in Real Estate, Cowles
Foundation Discussion Paper No. 1610; R. Shiller (2007b). Understanding
Recent Trends in House Prices and Home Ownership, FRB Kansas City
Jackson Hole Symposium, August 31, 2007.
8 The National Association of Home Builders/Wells Fargo Housing Market
Index (HMI) is based on monthly surveys of a panel of homebuilders. The
builders are asked to rate local market conditions. Their responses on three
aspects of market conditions - current sales of single-family detached new
homes, expected sales of new single-family detached homes over the coming
six months, and traffic of prospective buyers in new homes - are used to
construct the HMI index.
9C. Himmelberg et al. (2005). Assessing High House Prices: Bubbles,
Fundamentals and Misperceptions. Journal of Economic Perspectives,
Volume 19, Number 4, Fall, pp. 67-92; E. Glaeser and B. Ward (2004). The
Causes and Consequences of Land Use Regulation. Harvard Institute of
Economic Research, Discussion Paper Number 2124; E. Glaeser et al. (2004).
Why Have Housing Prices Gone Up?
10
Himmelberg et al (2005); Gyourko et al. (2006). Superstar Cities. National
Bureau of Economic Research Working Paper Number 12355, July.
" K. Case and R. Shiller (2003). Is There a Bubble in the Housing Market?
Brookings Papers on Economic Activity, Number 2, pp. 307-12.
12 D. Baker (2007). Midsummer Meltdown: Prospects for the Stock and
Housing Markets, 2007. Center for Economic and Policy Research:
Washington, D.C.
13 Sandra L. Thompson, Director Division of Supervision and Consumer
Protection Federal Deposit Insurance Corporation, statement on "Mortgage
Market Turmoil: Causes and Consequences," before the Committee on
Banking, Housing and Urban Affairs U.S. Senate, March 22, 2007.
14 Inside Mortgage Finance Publications defines subprime loans as those
"made to those who have impaired credit. Generally have higher interest rates
than prime loans. Such loans are tied to borrowers' credit ratings, expressed
as letter grades, such as A-, B, D. Prime loans' credit is most often A." Inside
Mortgage Finance Publications (2007a). The 2007 Mortgage Market
Statistical Annual, Bethesda, Maryland: Inside Mortgage Finance
Publications, p. vi. Subprime lending is also called "B&C" lending.
15
See A. Pennnington-Cross and G. Ho (2006) The Termination of Subprime
and Fixed Rate Mortgages, Federal Reserve Bank of St. Louis, Working Paper
042-A, pp. 22.; R. Quercia et al. (2005). The Impact of Predatory Loan
3

93
Terms On Subprime Foreclosures, Center for Responsible Lending: Durham,
NC; E. Schloemer et al. (2006). Losing Ground, Center for Responsible
Lending: Durham, NC.
6 Schloemer et al. (2006), pp. 15-16.
17 A recent paper by Apgar et al. discusses the non-pecuniary costs associated
with vacant houses, such as increases in crime. See W. Apgar, M. Duda, and
R. Gorey (2005). The Municipal Cost of Foreclosures: A Chicago Case
Study, Homeownership Preservation Foundation, Housing Finance Policy
Research Paper Number 2005-1. The authors found an increase in gang
activity, drug dealing, prostitution, arson, rape and even murder occurring in
vacant properties.
18

D. Immergluck and G. Smith (2006). The External Costs of
Foreclosure: The Impact of Single-Family Mortgage
Foreclosures on Property Values, Housing Policy Debate,
Volume 17, Issue- 1.
19 A. Shlay and G. Whitman, "Research for Democracy: Linking Community
Organizing and Research to Leverage Blight Policy," City & Community,
Vol.5, No. 2. June. 2006.
20
Center for Responsible Lending, "Subprime Lending: A Net Drain on
Homeownership," CRL Issue Paper No. 14, March 27, 2007, available at
http://www.responsiblelending.org/page.isp?itemID=3203203
1.
21
Ibid.

22 E. Gramlich (2007). Subprime Mortgages. America's Latest Boom and
Bust. Washington: The Urban Institute Press, pp. 13-18.
23
Joint Economic Committee calculations using data from Mortgage Bankers
Association,
"Number of Mortgages Serviced."
24
Ibid.

C. Cagan (2007). Mortgage Payment Reset: The Issue and the Impact.
Santa Ana, CA: First American CoreLogic, pp. 29-31, available at
http://www.facorelogic.com/uploadedFilesINewsroom/Studies and Briefs/St
udies/20070048MortgagePaymentResetStudyFINAL.pdf
26
Cagan (2007), pp. 42-43.
27
Sheila Bair, Chairman, Federal Deposit Insurance Corporation, statement on
"Subprime and Predatory Lending" before the House Subcommittee on
Financial Institutions and Consumer Credit of the Committee on Financial
Services, March 27, 2007, p. 7.
28
See, for example, Frederic Mishkin, (2007). Housing and the Monetary
Transmission Mechanism, Finance and Economic Discussion Series, Federal
Reserve Board, 2007- 40, August; J. Muellbauer (2007) Housing, Credit and
Consumer Expenditure, FRB Kansas City Jackson Hole Symposium, August
31, 2007.
29
F. Mishkin (2007), pp. 34-35.
30
This ranking is closely correlated with the size of the outstanding stock of
subprime mortgages, but the correlation is not perfect. As we explain below,
expected housing price movements affect foreclosure outcomes, and these
expected changes are not identical across states.

94
31 Calculations from data at
http://www.realtytrac.com/foreclosure laws overview.asp and at
www.stopforeclosure.com.
32
See the discussion of the role of price appreciation in subprime loan
performance in Part I above.
33 For example, let FC, be the estimated ARM foreclosure rate covering Q3
2007 through Q2 2008 and let FC 2 be the ARM foreclosure rate for Q3 2008
through Q2 2009. Let T be the number of subprime ARMs outstanding in at
the beginning of Q3 2007. Then for the last two quarters of 2007, the number
of ARM foreclosures is estimated by .5* FC1 *T. The number of ARM
foreclosures in 2008 is estimated as .5* FC1 *T + .5* FC 2 *T*(l-.5* FCQ).
34 See the discussion in Part I above.
35 See A. Pennington-Cross (2006). The Value of Foreclosed Property, The
Journal of Real Estate Research, April-June 2006, Volume 28, Number 2, p.
204.
36 See D. Immergluck and G. Smith (2006), p. 69. Immergluck and Smith
also discuss a higher estimate of neighborhood effects, but we use their more
conservative value in our calculations.
37 We estimate the number of houses affected within 1/8h mile net of the
number of foreclosures.

See Mishkin (2007).

Shiller, Professor of Economics, Yale University, statement on
"Evolution of an Economic Crisis?: The Subprime Lending Disaster and the
Threat to the Broader Economy," before the Joint Economic Committee, U.S.
Congress, September 19, 2007, p. 2. Shiller cites a 13 percent real decline.
Given a three percent inflation rate, this translates to a 16 percent nominal
decline.
40 Note that total property loss is only slightly higher than the loss calculated
in our state level forecast. This is a consequence of assuming greater housing
price declines.
41Bureau of the Census, U.S. Department of Commerce.
42 Mortgage brokers originate and process loans for a number of lenders for a
fee or other compensation, and generally do not use their own funds for
closing. Correspondent lenders deliver loans to a lender, but fund the closing
with their own money. Retail lenders offer mortgages directly to the public.
43 Inside Mortgage Finance Publications (2007b). Top Subprime Market
Players & Key Subprime Data 2006, Bethesda, MD: Inside Mortgage Finance
Publications, p. 19.
44 The Mortgage Bankers Association has a similar estimate for 2005. They
estimate that, in 2005, 71 percent of subprime originations came from brokers.
Their estimate, however, excludes correspondent originations. See Mortgage
Bankers Association (2006). MBA Data Notes, Residential Mortgage
Origination Channels, September.
45 Inside Mortgage Finance Publications (2007a), p. 5.
46
Gramlich (2007), p. 7. Gramlich's analysis of the role of independent
mortgage companies is confirmed Apgar et al., "Mortgage Market Channels
39 Robert

95
and Fair Lending," Joint Center for Housing Studies, Harvard University, p.
14.
47 See Gramlich (2007), p. 21-22.
48
Ibid, pp. 21-23.
49
Elizabeth Renuart (2004), An Overview of the Predatory Lending Process,
Housing Policy Debate 15:3, pp. 467-502.
50
John Farris and Christopher A. Richardson, The Geography of Subprime.
Mortgage Prepayment Penalty Patterns, Housing Policy Debate, 15:3, pp. 687714.
5' Statement of Sheila Bair, Chairman, Federal Deposit Insurance Corporation,
on Subprime and Predatory Lending, before the House Subcommittee on
Financial Institutions and Consumer Credit of the Committee on Financial
Services, March 27, 2007, pp. 9, 20-28.
52 As has been discussed above, hybrid ARMS offer an initial low interest rate
and payment, but build in a significant payment shock at the end of the initial
two or three year period.
53 Michael D. Calhoun, President for the Center for Responsible Lending,
statement on "Calculated Risk: Assessing Non-Traditional Mortgage
Products" before the Senate Committee on Banking, Housing and Urban
Affairs, Subcommittee on Housing and Transportation and Subcommittee on
Economic Policy, September 20, 2006, pp. 7-8.
54
A. Pennnington-Cross and G. Ho (2006).
55 See Federal Reserve System (2001), 12 CFR 226. HOEPA was enacted in
response to evidence of abusive lending practices in the home-equity lending
market. According to the Federal Reserve, reports of predatory lending have
generally included one or more of the following: (1) making unaffordable
loans based on the borrower's home equity without regard to the borrower's
ability to repay the obligation; (2) inducing a borrower to refinance a loan
repeatedly, even though the refinancing may not be in the borrower's interest,
and charging high points and fees each time the loan is refinanced, which
decreases the consumer's equity in the home and (3) engaging in fraud or
deception to conceal the true nature of the loan obligation from an
unsuspecting or unsophisticated borrower.
56
R. Quercia et al. (2003). The Impact of North Carolina's Anti-Predatory
Lending Law: A Descriptive Assessment. Center For Community
Capitalism, University of North Carolina, Chapel Hill; E. Renuart (2004). An
Overview of the Predatory Mortgage Lending Process. Housing Policy
Debate, Volume 15, Issue 3.
57
R. Avery et al. (2006). Higher-Priced Home Lending and the 2005 HMDA
Data. Federal Reserve Bulletin, September 8, A123-A166, Table 4.
58
R. Bostic et al. (2007). State and Local Anti-Predatory Lending Laws: The
Effect of Legal Enforcement Mechanisms, available at
http://ssm.com/abstractzr1005423; W. Li and K. Ernst (2006). Do state
predatory home lending laws work? Center for Responsible Lending working
paper, 2006; R. Bostic et al., State and Local Anti-Predatory Lending Laws:
The Effect of Legal Enforcement Mechanisms; Working Paper, Aug. 7, 2007,
available at httn://ssrn.com/abstract+1 005423.

96
59

See Renuart (2004), pp. 481-482.
J. Farris and C. Richardson (2004). The Geography of Subprime Mortgage
Prepayment Penalty Patterns. Housing Policy Debate, Volume 15, Issue 3, p.
689.
61
R. Quercia et al. (2005). The Impact of Predatory Loan Terms on Subprime
Foreclosures: The Special Case of Prepayment Penalties and Balloon
Payments. Center for Community Capitalism, University of North Carolina,
Chapel Hill.
62
K. Ernst (2005). Borrowers Gain No Interest Rate Benefits from
Prepayment Penalties on Subprime Mortgages. Center for Responsible
Lending: Durham, NC. Available at
http://www.responsiblelending.org/pdfs/rrOO5-PPPInterestRate-0105.pdf
63
M. Courchane et al. (2004). Subprime Borrowers: Mortgage Transitions
and Outcomes, Journal of Real Estate Finance and Economics, Volume 29,
Number 4, 365-392.
6Ibid, p. 373.
65 H. Lax et al. (2004). Subprime Lending: An Examination of Economic
Efficiency. Housing Policy Debate, Volume 15, Issue 3.
66
E. Schloemer et al. (2006).
60

War at Any Price?: The Total Economic Costs of the War
Beyond the Federal Budget
EXECUTIVE SUMMARY
The long wars in Iraq and Afghanistan have cost the United
States in many ways. For the American Armed Forces, the
human toll has been profound: as of November 9, 2007, 4,578
American soldiers have lost their lives, and 30,205 have been
wounded, many of them gravely. The damage to our
international reputation at a time when the United States faces
grave security challenges all over the world has also been
severe. And the full economic costs of the war to the American
taxpayers and the overall U.S. economy go well beyond even the
immense federal budget costs already reported. These "hidden
costs" of the Iraq war include the ongoing drain on U.S.
economic growth created by Iraq-related borrowing, the
disruptive effects of the conflict on world oil markets, the future
care of our injured veterans, repair costs for the military, and
other undisclosed costs.
In this report, the Joint Economic Committee estimates the total
costs of the long war in Iraq to the American economy as a
whole:
.

The total economic costs of the wars in Iraq and
Afghanistan so far have been approximately double the
total amounts directly requested by the Administration to
fight these wars.
The future economic costs of a prolonged military
presence in Iraq would be massive. Even assuming a
considerable drawdown in troop levels, total economic
costs of the wars in Iraq and Afghanistan (with the vast
majority of costs a result of in the war Iraq) would
amount to $3.5 trillion between 2003 and 2017. This is
over $1 trillion higher than the recent Congressional
Budget Office (CBO) Federal cost forecast for the same
scenario, which counted only direct spending and interest
paid on war-related debt resulting from that spending.
The total economic cost of the war in Iraq to a family of

four is a shocking $16,500 from 2002 to 2008. When the
war in Afghanistan is included, the burden to the
American family rises to $20,900. The future impact on a
family of four skyrockets to $36,900 for Iraq and $46,400
for Iraq and Afghanistan when all potential costs from
2002 to 2017 are included.
The American people and Democrats in Congress have urged a
dramatic change of course in Iraq. This war has cost Americans
far too much, in terms of lives, dollars, and our reputation around
the world. This report also demonstrates that a change in course
would bring substantial economic savings to our country.
Through 2008, the True Cost of the War Has Been Double
the Administration's Budgeted Cost
To date, the President has requested a total of $607 billion for the
Iraq war alone since 2003. This is over ten times higher than the
$50 to $60 billion cost estimated by the Administration prior to
the start of the war. Costs have increased every year since the
start of the war in 2003. The Administration has requested $804
billion for the Iraq and Afghanistan wars combined (CRS 2007,
Bumiller 2003).1
To provide some perspective on these figures, just the funds
requested for the Iraq war through 2008 would have been
sufficient to provide health insurance coverage to all of
America's uninsured for the 2003-2008 period. (There were
approximately 45 million uninsured Americans at the start of the
war in 2003 and this number rose to 47 million by 2006, which is
the latest figure available from the U.S. Census Bureau).
But even beyond these direct fiscal impacts, there are a large
number of costs that do not appear directly in Administration
funding requests for the Iraq war. The most important of these
include the following:
e

Borrowed money to finance the Iraq War has
displaced productive investment. Since taxes have been
cut and other spending has increased since the beginning

of the Iraq war, it seems clear that the war has been and
continues to be funded using borrowed money. The
increase in government borrowing displaces substantial
amounts of productive investment by U.S. businesses,
thus reducing productivity in the economy over many
future years. Interest costs paid by taxpayers are only a
subset of these costs.
* Substantial Iraq-related costs have been borrowed
from foreigners. The interest payments on this debt
constitute a flow of funds from Americans to those
foreigners who have bought our debt.
* The war in Iraq has disrupted world oil markets
leading to increased prices. The Iraq war has occurred
in a context of greatly increasing world demand for oil, as
well as declining excess production capacity. Both the
direct effect of the war in reducing Iraqi oil production
and the indirect effect of creating greater instability in the
Middle East can act to increase oil prices. Relatively
small increases in oil prices can have substantial
economic effects.
* Other economic and budgetary costs have grown due
to the Iraq war. These expenditures include the costs of
treating the wounded and disabled, lost productivity from
those injured, potential future expansions in the size of
the military made necessary by the war, the costs of
repair and refit for military equipment, increases in
recruitment and retention costs for the military, and
economic disruptions created by the deployment of the
Reserves.

100

Table 1: Requested Appropriations and Total Costs Accrued So Far,
FY2002 Through FY2008
IRAQ WAR ONLY

IRAQ AND AFGHANISTAN

Direct Appropriations*

$607 Billion

$804 Billion

Total Cos;sL*

$1.3 Taillion

$1 6 Trillion

$16,500

$20,900

CostsperFamilyofFour"**

Budget costs in nominal dollars, flow of economic costs discounted to therelevant budge year. See Appendix 13for
disc .ssion of methodology.
Based on (MS and CBO cost estimates of dircct sppropristions. Includes Adnilistration's FY 2008 roqucst for war
funding, which has not been passed by Congress.
*ased on total suim of'present value costs accrued in cach budgetary year from 2002-2008
5
* Total over 2002-2008 period.

The sum of the costs listed above raises the economic costs of the
war from $607 billion in direct funding for the Iraq war to $1.3
trillion. If spending in Afghanistan is included, costs could reach
$1.6 trillion by the close of FY 2008.
There are numerous other impacts of these wars that are not
listed above and are difficult if not impossible to measure. These
include the horrible human cost of the nearly 4,000 U.S. fatalities
since the start of military operations in Iraq, the impact on our
reputation and credibility throughout the world, and the
budgetary and economic costs to other nations besides the U.S.
(most notably Iraq). Finally, the debate over the broader national
security impacts of the Iraq war, and related costs or benefits, is a
complex issue that goes beyond the scope of this report (DoD
2007).
Chart 1: Average American Family Will Bear Heavy Burden to Pay for
the Wars in Iraq and Afghanistan (Family of Four)
$25,000

Total Economic Cost
ODlrect War Costs

$20,000
$15,000
$10,000
$5,000
$0

2002

2003

2004

2005

2006

2007

2008

Source: CRS (2007) for prior appropriations and spending requests, JEC staff calculations. 2008 appropriation request drawn from Administration requested supplemental.

101

If We Don't Change Course, the Cost of the War Will
Balloon to $3.5 Trillion
The costs described above represent only the impacts of the Iraq
war through the close of FY 2008 (if the President's current
budget requests are approved in full). Yet at least some spending
on the war will continue beyond FY 2008. Assumptions about
the future course of the war are necessary to forecast the full
eventual fiscal and economic impacts. Because the
Administration has not been clear about future plans for U.S.
forces in Iraq, these assumptions must be hypothetical.
This study mainly examines potential future costs over a ten year
window, up to the year 2017, similar to the budget spending
window that the CBO used. The paper focuses on a scenario
corresponding to the recent statement by Secretary of Defense
Robert Gates that a protracted "Korea-like" presence would be
required in Iraq. This scenario involves a drawdown in Iraq troop
levels of 66 percent by the year 2013, and a smaller drawdown of
33 percent in Afghanistan forces. The scenario also assumes that
some active conflict with insurgents continues over the period
(CBO 2007a).
Table 2: Possible Economic Costs of Staying the Course (Through 2017)
_

IRAQ WAR ONLY

IRAQ AND AFGHANISTAN

seenario
Tr
Seno
(Troop Strength)

Gradual drawdown from 2007
level of 180,000 troops to
55,000 troops by 2013. Troop
strength constant from 201317.

Drawdown from 2007 level of
210,000 troops to 75,000 troops by
2013. Troop strength constant from
2013-17.

Direct Appropniations*

$1.3 Trillion

$1.7Tnilion

Total Federal Spending

Tnilion
-$19
$ T
$2.8 Trillion

Incudig lnterest*
Total Economic Cost** *
Costs per Family of Four I

$36,900

$2.4 Trilion
$ Tli
$3.5 Trillion
$46,400

Budset costs innominal dollars. flow of economic costs discounted to the relevant budget year. See Appendix B for
discussion of iethodology.
*Bascd on Administration funding request for FY 2008. CRS and CBO cost estimates of direct appropriations.
*eCho estimate from 10/24/2007 testimony to House Budget Committee (c13 2007b).
B*Bsed on total sum orpresern value coats accrued ineach budgetary year over 2002-2017 period

In recent testimony, the nonpartisan CBO detailed Federal direct
appropriations and interest costs for this scenario (CBO 2007b).

102

These CBO estimates are used as a base for the analysis in this
report. Once the full economic costs of the war are added to the
approximately $2.4 trillion in Federal spending forecast under
the CBO scenario, the total economic cost of the wars in Iraq and
Afghanistan rise by over $1 trillion to $3.5 trillion.
Costs could far exceed these projections if the significant
drawdown assumed in this scenario does not materialize. This
CBO budgetary scenario projects that appropriations for the Iraq
war will begin to drop significantly in 2009. But historically
appropriations for the Iraq war have increased every year since
the invasion, by between 12 and 40 percent annually (CRS
2007).
This report also presents costs for several alternative budgetary
scenarios (Appendix A). These include costs for a rapid
withdrawal from Iraq while maintaining troops in Afghanistan,
and the costs to maintain current (post-surge) troop levels in Iraq
for the next decade. These scenarios generate very different
economic costs over the next decade. For example, maintaining
post-surge troop levels in Iraq over the next ten years would
result in costs of $4.5 trillion.
Each state is assumed to bear a share of the total war costs
proportional to its share of the total national economy. On this
basis, the report presents total state costs accrued through FY
2008, as well as potential future costs through 2017.

103
Figure 2: With No Change in Course, Total Costs Incurred per Family
Reach Almost $50,000 by 2017 (Costs for Wars in Iraq and Afghanistan

.ssnoe
o

430.000

520.060
SI,

tso
2
.:2005
2008
2011
2014
20i7
Soirce: JEC stAffcalculaion based on CRn (2007)A mid cBOpprojtie'in ofbudgttary csto for tonsideible
drawdoW'sc,aifs

~lOe

TAXPAYER COSTS OF THE WAR
This section estimates current and future taxpayer expenditures
for the war, based on budgetary information from the
Congressional Research Service (CRS) and Congressional
Budget Office (CBO). 2 The taxpayer costs can be divided into
direct appropriations for the war and interest costs for Iraqrelated debt. (These interest costs are a subset of the wider
economic costs calculated in this report).
-.
Direct Appropriations for the War
Prior to the start of the Iraq war in 2003, the Bush administration
estimated the total cost of the war at between $50 to $60 billion
(Bumiller 2003).
The President has now requested over ten times this initial
estimate just in direct appropriations for the war between FY
2003 and 2008. If the President's latest request for supplemental
funding is approved, the direct expenditures authorized
specifically for the Iraq war from FY 2003 to FY 2008 will total
some $607 billion (CRS 2007; JEC estimates). This includes
$450 billion already authorized by Congress between FY 2003
and FY 2007, plus an estimated $158 billion for Iraq from the
supplemental request that the administration has made for FY
2008.3

104

Estimates of budgetary costs after 2008 depend on assumptions
about the future course of the war. Appendix A of this report
outlines costs for a variety of alternative scenarios, ranging from
a rapid drawdown of troops to a continuation of post-surge
funding and troop levels through the foreseeable future.
In the main body of this report, we focus on the CBO
"considerable drawdown" scenario, which corresponds to the
"Korea-like presence" recently predicted by Secretary of Defense
Robert Gates. Following the war in Korea, force levels dropped
to a level of between 50,000 and 60,000 troops throughout the
1960s and 1970s (Kane 2004). This scenario assumes that force
levels in Iraq drop from their current level of 180,000 troops
down to 55,000 by 2013, and are maintained at this level through
2017.
This level of drawdown implies that beginning in FY 2009
funding levels for Iraq will begin to drop for the first time in the
history of the war. The scenario predicts direct appropriations for
the war drop -from $135 billion in FY 2007 to less than $60
billion in FY 2013. For these reasons, the scenario should be
seen as a conservative one. This CBO scenario implies an
additional $690 billion in Iraq war spending through 2017 (CBO
2007a).
Chart 3: Projected Interest Costs of Iraq War Alone are Higher than
Costs of Children's Health Program and Health Research & Training
53
45

50 O~HeResalmvh

~not onDIrtq-Relaw

40
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2003

2eo6

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2012

105

Iraq Related Debt and Interest Costs to Taxpayers
Since war costs have been borrowed, taxpayers must also pay
interest costs on the war until Iraq-related debt is retired. If the
president's FY 2008 budget request is fully approved, this debt
will total almost $660 billion by the close of FY 2008. It will
reach almost $1.7 trillion by the close of 2017.
This debt has many economic implications, but the immediate
impact on taxpayers will be the annual interest payments
required. If the President's FY 2008 supplemental request for
Iraq funding is passed, almost 10 percent of total Federal
government interest payments in 2008 will consist of payments
on the Iraq debt accumulated so far.
Interest costs on Iraq-related debt will be over $23 billion in FY
2008, and are projected to far exceed spending on programs that
address key national priorities such as education and health.
Chart 3 shows the current and projected future time path of
interest spending through 2012. The chart shows that the annual
interest costs on accumulated war debt already far exceed
spending for such national priorities as health insurance for
children (under the proposed Democratic SCHIP expansion
recently vetoed by the President) and health research.
Under the "considerable drawdown" scenario, by the year 2017
projected interest costs on Iraq-related debt will rise to $80
billion annually. The sum of interest paid on Iraq-related debt
from 2003-2017 will total over $550 billion.
These interest costs are based on the assumption that interest
rates will remain constant at a rate of 4.5%. Interest payments
could grow significantly compared to this forecast if interest
rates rise in the future.
Interest costs will continue to accrue beyond 2017 so long as the
debt is not paid down. Paying down the debt will require cuts in.
government spending and/or increases in taxes. Alternatively,
interest payments can simply be continued after 2017. Because

106

this report projects costs accrued only through 2017, economic
effects of the choices made about handling the debt after 2017
are not reflected in these estimates. It is assumed that the debt
remains outstanding through the end of the forecast period.
Figure 4: Taxpayer Spending on the Iraq War vs. Federal Spending on
Other Priorities (FY2007)
160
8

120

150.
i
78

raq War

Infrastcmture
Repas

NiW I

College Ttlon
Assistance

CHIP

Source: Budget of the United States GovemrneitFiscal Year 2008, E staffestinates based on CRS budgetary
figures Estimaed interegt costs for Iraq deb

Total Taxpayer Costs
Total taxpayer spending is the sum of direct budget costs and
interest costs. The total increase in taxpayer spending over 20032017 due to the Iraq war is a projected $1.9 trillion under the
"considerable drawdown" scenario. If declines in future spending
projected by CBO do not materialize, war spending could be
substantially higher than forecast here (this issue is discussed
further in Appendix A).
To put annual spending-on the war in perspective, it is useful to
consider the spending on other national priorities that could be
funded by just one year-of Iraq spending. Chart 4 shows how Iraq
funding just in the recently completed 2007 fiscal year compared
to spending on various other public investment priorities. The FY
2007 total of $150 billion is greater than the combined sum of
Federal spending on such priorities as the nation's transportation
infrastructure, health research, customs and border protection,
higher education aid, environmental protection, Head Start, and
the CHIP program.

107

Should the President's recent supplemental request be fully
approved, total taxpayer spending for Iraq would be even higher
in FY 2008, approximately $180 billion or $500 million per day.
BOX A: How is the War in Iraq Being Funded?
War funding has been borrowed from the public. Since 2001, Federal
government revenues as a share of Gross Domestic Product have
decreased by one percent, while outlays have grown significantly and
debt held by the public has increased by approximately $1.5 trillion (CBO
2007a). In this environment of growing public debt, it seems evident that
the marginal dollar spent by the Federal government has been borrowed.
The characterization of the Iraq war as a "war of choice" and the funding
of the war through a series of off-budget emergency supplemental bills
makes this even clearer.
Given the already steep fiscal demands on the Federal government, and
the Administration's unwillingness to offer a proposal to pay for the war,
it is fair to assume that the future costs of the war through 2017 will also
be paid for by borrowing from the public.
The assumption
findings in this
costs incurred,
funding would
investment.

that Iraq war spending is borrowed drives a number of
report. These include the level of government interest
and also the assumption that some of the borrowed
have remained available for additional U.S. capital

ADDITIONAL ECONOMIC COSTS
The budgetary costs alone of the war are high. But there are
many additional economic costs of the war that go beyond the
direct budgetary costs. In terms of magnitude, the most
significant economic costs are:
.
.
*

Displacement of productive investment by U.S.
companies due to increases in government borrowing.
Interest payments to foreign capital owners for Iraqrelated debt.
Impact of the war on oil markets.

In addition, there are a number of other, smaller, costs that we
discuss below. Chart 5 shows the estimated division of all
economic costs from the Iraq war alone.

108
Figure 5: Breaking Down the Costs of the War in Iraq, FY2003-2017 (In
Billions of Dollars)

. lAppropriations

$1,300
Other Costs

$100

X||||

Interest To
Foreign Owners,
$220

Oil Market
Disruption/

Foregone
Investment Return

$870

$270

Source: JEC calculations, Congressional Research Service, Congressional
Budget Office, and Energy Information Administration.

THE EFFECT OF GOVERNMENT BORROWING
As discussed above, the Iraq war has likely resulted in major
increases in government borrowing. There is widespread
consensus among economists that such borrowing has two effects
(Friedman, 2005):
.

First, it reduces the growth in productive private
investment in the economy. Funds are diverted from
private investment to purchase government securities.
This depresses the future stock of productive capital
below what it otherwise would have been without the
borrowing.
Second, part of the debt is funded through borrowing
from foreign capital owners. Interest payments on this
debt flow out of the country and constitute an economic
cost.

109

Both of these effects have costs to the U.S. economy. For
government borrowing that fully displaces productive
investment, all the future returns on this capital investment are
lost. The future growth rate of the economy is reduced.
For government borrowing that is funded from world capital
markets, investment is not displaced, but interest payments on
this debt flow out of the economy to foreigners. (Interest
payments to U.S. bond purchasers are a subset of the economic
costs from displaced private investment in the U.S.).
Although there is little dispute that both of these impacts occur to
some extent, the exact balance between the two effects and the
proper way to evaluate them is a subject of some controversy
among economists. Appendix B describes the assumptions used
in this report to estimate the economic costs of Iraq-related
deficit spending.
Because of these two economic impacts, the JEC estimates that
Iraq-related borrowing between 2003 and 2017 will create an
additional income loss of almost $1.1 trillion in present value to
U.S. citizens.4
This loss of investment returns is the single largest cost of the
Iraq war to the U.S. economy beyond the direct budgetary cost of
the war itself.
IMPACT ON WORLD OIL MARKETS
Iraq is a significant oil producer, and is also located in a
strategically vital region which is the center of world oil
production. Since the start of the Iraq war in 2003, the price of
oil has increased, from $37 per barrel (in the week prior to the
war) to a recent peak of well over $90 per barrel in November
2007 (EIAa). This price increase has likely affected U.S.
economic growth, and has transferred many hundreds of billions
of dollars from U.S. consumers to foreign oil producers.
The war in Iraq is certainly not responsible for all of this
increase. Many other factors are also affecting oil prices,

110

including large growth in oil demand from China and India. But
the consistent disruptions resulting from the war have affected oil
prices.
The Iraq War and Oil Prices
The war in Iraq has two potential effects on world oil markets.
The first is a direct effect, stemming from disruption in Iraqi oil
exports to the world market. The second is an indirect
psychological effect.
The direct effect can be examined by considering Iraqi oil
exports compared to capacity. The Energy Information
Administration has stated that current Iraq production of roughly
2 million barrels per day (BPD) is "down from around 2.6
million BPD of production and a~nameplate capacity of 2.8 to 3
million BPD in pre-invasion January, 2003." (EIA 2007c).
Taking the EIA estimate of 2.6 million BPD of actual pre-war
production, the reduction in direct Iraqi oil production has ranged
from roughly 1.3 million BPD (in the invasion year of 2003) to
about 600,000 BPD today. These shortfalls likely impact world
oil prices. As a CBO report discussing oil market developments
from 2003-2006 stated:
"Today, however, worldwide production is close to its short-term
limits. As a result, oil markets appear much more vulnerable than
before to an interruption in supply or a rapid increase in demand.
Even the threat of a reduction in supply of a few hundred
thousand barrels a day causes sharp fluctuations in prices" (CBO
2006).
As a rule of thumb, the Department of Energy estimates that a 1
percent decline in world oil supply generally leads -to about a 10
percent rise in prices (EIA 2004, GAO 2006). Using this rule
leads to the prediction that shortfalls of the levels discussed
above might be expected to increase oil prices by around 15% in
2003, and 7-9% in 2004-2007. Because of rising prices, this
percentage increase creates a consistent rise in the price of oil of
roughly $5.00 per barrel.

III

The Iraq war could have a second, indirect effect on oil prices if
events in Iraq have led to concerns about wider regional conflict,
or increases in terrorism in the region that could affect oil fields.
These kinds of fears would cause investors to bid up the price of
oil on futures markets, and increase the stockpiles of oil they
hold against an emergency.
It seems likely that indirect psychological factors related to the
Iraq war did contribute to increases in oil prices in 2003, and
been one of several factors contributing to oil price volatility
since then.
It is hard to quantify the size of this effect on prices. But it seems
clear that the Iraq war has been one factor contributing to a
generally unsettled state of oil markets over the past several
years. This is due to the combination of the timing of the war
during a period when world oil markets have been under unusual
stress from increased demand, and the psychological effects of
the increased geopolitical uncertainty due to the war. The
combination of direct and psychological effects helps to support
the price effect discussed above.
The Economic Impact of Higher Oil Prices
What impact does this increase in oil prices have on the U.S.
economy? There are two separable effects. The first impact is a
direct transfer to wealth from U.S. consumers to foreign oil
producers driven by the rise in oil prices. This estimated effect
can be counteracted somewhat by reductions in oil consumption
by consumers or if foreign oil profits are spent in the U.S. JEC
estimates find that from 2003-2008 this effect will transfer
approximately $124 billion from U.S. oil consumers to foreign
producers. 5
Most economists agree that there is likely a further impact of oil
price increases on the economy. Beyond any direct transfer
effect, oil price shocks reduce economic growth, due to
reductions in consumer demand and various adjustment costs by
industries that use oil. However, there is substantial controversy

112

over the exact size of the effect. It is generally agreed that these
economic impacts of oil price increases have declined in today's
economy as compared to the 1970s (Nordhaus 2007). Estimates
using macroeconomic simulation models often find small costs
(CBO 2006). However, estimates based on examining the actual
past responses of the U.S. economy to oil price changes often
find much larger impacts, ranging from five to fifteen times those
found in model-based estimates.
It seems likely that the impact varies substantially depending on
the exact type of oil price shock and how it is sustained, with
sharp, surprising increases in oil prices having the largest
negative effects on growth, and slow and expected increases
having smaller or potentially no effect (Li, Ni, and Ratti 1995;
Huntington 2005). But the Iraq war has produced a consistent
series of surprises as the insurgency has grown, unforeseen
interference with oil fields has continued, and new political
disruptions have occurred (such as tensions with Iran and conflict
between Kurdistan and Turkey). As discussed above, this has
taken place in an environment of limited spare production
capacity, and new peaks in world oil prices almost every year.
For this reason, the analysis assumes that Iraq-related oil price
increases have had a wider economic effect. In particular, the
analysis assumes a consistent effect throughout the 2003-2008
period that is proportional to the roughly $5 per barrel price
increase described above. However, no further economic impacts
from rising oil prices are assumed for 2009 or after. 6 The
magnitude of the GDP impact is assumed to be moderate to low.
It is consistent with a wide range of recent studies.7
Under these assumptions, oil price increases from 2003-2008 due
to the Iraq war reduced total U.S. income GDP by a total of
approximately $274 billion, a direct transfer of about $124
billion and a further GDP effect of $150 billion.

113

BOX B: MARKET PSYCHOLOGY
A recent CRS report on world oil prices singled out the Iraq war as
having an important impact on market psychology:
"The war in Iraq has contributed to high oil prices in different ways as
events have progressed. The predominant effect of the conflict on oil
prices has been an increase in uncertainty. During the early stages of the
conflict, concerns about a possible disruption of oil supply out of the
Persian Gulf and disruption of Iraqi production due to military
operations were prominent... .Later, market uncertainty revolved around
the ability of Iraq to export oil in the midst of political transition in
which pipeline and other oil facilities were attacked by hostile groups
within the country. Uncertainty with respect to terrorist attacks, both in
Iraq, and spilling over to other Gulf nations, including Saudi Arabia,
continue to unsettle the oil market and contribute to a "fear factor"
being built into the price of oil." (CRS, 2005)

OTHER ECONOMIC IMPACTS
There are numerous other costs of the wars in Iraq and
Afghanistan that are not reflected in budget estimates. However,
these impacts are even more difficult to estimate than the costs
discussed above. They are also generally somewhat smaller than
the impacts discussed above. The JEC estimates that a fuller
accounting of these impacts would add at least $ 110 billion to the
total future costs of the two wars.
The Impact of Wounds and Disabilities
One such economic impact is the costs of care for wounded and
disabled veterans. Some 28,000 troops have been wounded in
Iraq through October 2007 and almost half could not be returned
to duty within 72 hours (DoD 2007). Should the war continue
through 2017, it is reasonable to expect additional casualties.
Estimates of the costs of disability compensation and medical
care for these injured veterans vary significantly. CBO has
estimated the direct Federal cost of disability payments and
medical care for Iraq War veterans over the 2003-2017 period
(CBO 2007b). This estimate of approximately $10 billion is
included in the budgetary estimates given above. The cost rises
to $13 billion when Afghanistan veterans are included.

114

Other estimates of the entire eventual economic costs of
disability among all Iraq war veterans are far higher than CBO,
running as high as several hundred billion dollars (Bilmes 2007).
But these estimates may not fully separate out the incremental
impact of the Iraq war. Some veterans would likely have incurred
disabilities during their army service even if they served during
peacetime. Further study is needed to determine the full
increment in injury and disability to veterans serving in wartime
as opposed to peacetime.
But it is still likely that the CBO estimate underestimates the
total economic cost experienced due to injuries or disabilities
created by the war. Since the CBO cost estimate runs only
through 2017, it does not include the full lifetime cost of care for
these injured veterans. In addition, CBO may have
underestimated the number of veterans not wounded in action
who will eventually seek disability benefits or medical care due
to war-related health issues. Finally, there is evidence that
veterans disability benefits do not always fully compensate for
earnings losses due to certain conditions.
The types of injuries and disabilities sustained in the war add to
the uncertainty about future medical costs. As battlefield medical
care has advanced, the number of seriously injured soldiers who
survive their wounds has increased. Iraq therefore has a higher
ratio of wounded to fatalities than previous wars, and the severity
of wounds has correspondingly increased (CBO 2007d). For
example, about 800 wounded soldiers have been injured severely
enough to require amputations.
In addition, the widespread use of improvised explosive devices
by insurgents has led to a high incidence of traumatic brain
injury (TBI) among both wounded troops and those soldiers who
survive explosions without other injuries. A recent estimate is
that 10 to 20 percent of returning soldiers who believed
themselves to be healthy had in fact experienced mild to
moderate TBI (PCCWW 2007). The future potential health

115

impacts and costs of TBI (especially in its mild to moderate
form) are not yet well understood.
Post-traumatic stress disorder (PTSD) is another important health
issue related to the Iraq conflict. This psychological reaction to
traumatic stress appears to affect a substantial number of
returning soldiers. Estimates indicate that between 10 and 20
percent of returning soldiers show at least some symptoms of the
disorder (Hoge et. al 2007; PCCWW 2007). Some 40,000
returning soldiers have already received an official diagnosis
(CBO 2007d). Research on the economic effects of PTSD
indicates that it can lead to substantial reductions in earnings and
employment capacity (Veterans Commission 2007; Savoca and
Rosenheck 2000). Advances in treatment have been made, but
there is still a great deal of uncertainty about the future economic
impacts of this disorder and the number of veterans who will
eventually be affected.
The JEC estimates that these factors are likely to add $25 billion
to the total economic costs of injury in the Iraq war, beyond the
2003-2017 costs projected by CBO:
*

A projection of the present value of the lifetime disability
and medical care costs for injured veterans beyond 2017
gives a result of approximately $11 to $15 billion in
additional expenses for the Iraq war. 8 When the cost of
the Afghanistan war is included, this rises to about $13 to
$17 billion.
* There are additional economic costs of injury that are not
reflected in VA disability benefits or medical expenses.
One of these is earnings losses that are not fully
compensated for by disability benefits. As estimate of
earnings losses related to PTSD alone finds an additional
$10 billion in lost earnings to Iraq veterans that are not
reflected in VA benefits. 9
e
The families of injured veterans expend considerable time
and effort to provide care for their loved ones. This can
have significant economic costs. A survey by the DoleShalala commission found that almost 20% of injured

116

veterans stated a family member had to quit a job to
provide care for them. This implies additional economic
costs potentially as high as $1 billion.
Future disabilities resulting from past wars have typically
been underestimated early in the conflict (Veterans
Commission 2007). However, at this time it is very
difficult to project what level of additional disabilities
beyond CBO forecasts may result from the Iraq war.

These costs do not represent the total cost of injuries and
disabilities to veterans. Instead they represent only the additional
economic costs not already included in estimated Federal
spending on injured veterans and should be understood as highly
conservative.
Additional Military Costs
Between 2003 and 2006 alone, the cost of retention bonuses and
re-enlistment incentives for the Army, Marines, Reserve, and
National Guard have skyrocketed, rising by $800 million
annually (Associated Press 2007). If these increased costs stayed
constant over the 2003-17 period, they would add $13 billion to
military budgets over the period. These costs are not reflected in
the budgetary costs previously mentioned.
The military and other sources have also estimated a variety of
potential repair and reset costs for replacing and repairing
equipment damaged in the Iraq conflict. Iraq-related reset costs
in the FY 2007 military budget alone totaled some $27 billion
(DoD 2007). This figure is included in the budgetary costs
already totaled previously.
However, the Department of Defense estimates that
approximately $40- billion in reset costs will be required after
withdrawal from Iraq (DoD 2007). These future costs are not
included in the budget estimates described previously, and
therefore they are added under "additional costs".10
Finally, the Administration has requested a significant long-term
increase in the number of enlisted personnel in the Army and

117

Marine Corps .(CBO 2007e). This increase will eventually total
65,000 additional troops for the Army and 27,000 additional for
the Marine Corps. The CBO calculated costs of approximately
$17 billion annually for this expansion between 2008 and 2012.
But these costs were not included in CBO tallies of the costs of
the Iraq or Afghanistan wars, since the Administration has not
justified this proposed increase in the size of the military solely
with reference to these wars (CBO 2007e).
However, it seems clear that the wars in Iraq and Afghanistan
have contributed to the need for an expansion in the size of the
military. For this reason, the JEC analysis adds one-quarter of the
estimated cost of this increase in military forces (or $4.25 billion
annually) as an additional cost of the war beginning in 2009. This
is a conservative estimate of the level of increase in military
forces that could be required by these wars.
These additional military costs add approximately $85 to $90
billion to total war costs for Iraq and Afghanistan combined.
Based on the split in force levels between Afghanistan and Iraq
going forward, the report assigns 80 percent of this total, or about
$70 billion, to the Iraq war.
Costs of National Guard and Reserve Deployments
Some half a million of the National Guard and Reserve have so
far been deployed in Iraq. Some of the costs of this mobilization
are reflected in government budgetary costs. But some are not,
including the disruption for employers created by the loss of
staff.
Additional (Unquantified) Impacts of the Iraq War
This report does not attempt to quantify any demand-side
macroeconomic effects of war spending on the economy.
Because the war began in the wake of the 2001 recession, some
of the war spending could have worked to close a small part of
the recessionary gap between potential and realized production.
However, the bulk of the war spending took place well after the
recession and any additional demand-side macroeconomic effects

118

(difficult to estimate in any case) are not likely to be large with
respect to the ongoing effects of war spending on the economy.
The over 3,800 American fatalities that have resulted from the
war so far are a tragedy that is difficult to quantify in economic
terms. These losses can be seen as creating a direct economic
effect of many billions of dollars in lost productivity and
creativity for the nation. To this must be added the psychological
costs of the loss to loved ones, families, and communities. The
national security and foreign policy impacts of the war are
beyond the scope of this study. Finally, the impact of the war on
the nation of Iraq is also beyond the scope of the report.
PART III: STATE-BY-STATE COST ESTIMATES OF
THE WAR
War costs can also be expressed in terms of the costs to each
U.S. state. Table 3 shows the budgetary costs and total economic
costs divided between all fifty states, in proportion to each state's
share of the Federal *tax burden. Each state's share of total
economic costs is also shown, divided in proportion to their share
of national GDP. (States will incur the full economic costs of the
war in proportion to their share of the economy). State shares of
total costs vary from $358 billion in California to $5.5 billion in
Wyoming.

119
Table 3: State-ly-State Breakdown of Total Iraq War Economic Costs
Costs 2003-2008 (Bilions)
Budgetary
Economic
Total

i5ate
United States

$600
$10
_

$5.5

Alabama
_S

Anzona

$8.3

Colod

$26.0
$9.2

_a9__

S1A4.'7
DisAca of Columbia

$2.6

Costs 2003-2017 (Billions)
Budgetary
Economic
Total

$700

S1,300

$1,300

$1,470

$2,770

2.2

3.2

85
49
S124

S14.1
$10.5
S20.7

$22
S120
-$I2.3
S18.0

$18.0
S-110.3
$ O6.0

$56.8
$29.9
$22.5_
W.9

2.0
$12.3
$10.~9
$4.7

$21.4

S31.7

$7.3

$5.7

$38 0

70.9

$71.3

Hawaii

$1.9

S3.1

$50

$4.2

Idaho

$1.6

$2.7

S4.2

$3.4

.:_

$9.!

inttucky_

$4.6

S7.8

$12.4

Mussachlmetis

$17.0

S180

S34.9

13.3

$22.3

Mamnea

$l.6

S2.5

S4.1

Minnesttia

S14.4

$13.0

$U7.4

S241

S4.5

$10.0

$16.3

S26.3

$36.8

$37

S74.5

103

$31.2

273

$58.6

$28.8
$9.4
5_
$5.3
541.9

IS.4
S51.5

$10.7

$27.8

$19.7

$5!

$27 4

$151.1

$6.5

S9.0

Nouih Carlina

New Jeney

$79.8

$136.3

$3.43
$35.1
S4.0

S15.5

S5.6

$22

$24.3

$45.6

__$4.

S65.5

oMississipjx

Nebmaska

$258
$22.8
$9.8

$7.

Indiana

$19.9

$25.

S329

Flo=d__

$1&0

$5-S-3

$14.5
8.

$76.9

I45.6

$!1J

s$3507

$110.0

Nevada

$20.0

$25.

SU5

M11.7

S13.2

S24.9

Ohio

545.6

SSI.6

S16.9

$27.4

i5Ui
S4.8
$48

S8.1

SIj9
1.

$10.5
=

$51

$1.

Rhode Isiand

$2.4
$49.1

£24
$7.

5___4.8
$1o.3

Soth Dakota

$0693

Sl7

$2.6

$2.0

$3.6

15.6

$49.1

$56.7

$105.B

$106.3

$119.2

$82s5.

S41.3

$76,6

Textas

$_6 3___
.2a3 hington

Wlc
=ai
WegViouia

13.6

_19.7 ___
S15.6

$6.0

M5.4

$293

$1.6
$3.0
$4 5
$3.4
$6.2
a.
te;'
m:3
it A
S11.0
V)=
-1
.
.
i=4Ites: Budgary ad Ecoiiric COM derived frimJEC tilmlaions bated mn datafrn lie U &Cemus Bureau. Conr
Mficeanid Mfice olminwagmem and Budge.

S9.6
Biidp

CONCLUSION
The direct appropriations alone devoted to the Iraq war are
staggering. President Bush has already requested Iraq war
appropriations over ten times his original pre-war cost estimate.
The President's appropriations request for FY 2008 for Iraq
alone exceeds total U.S. state, local, and Federal spending on our

120

entire surface transportation system. Yet this report has
demonstrated that the indirect costs to the American economy are
roughly twice these direct appropriations.
If the President's supplemental funding request for FY 2008 is
approved, the accrued costs to the economy accrued through
2008 for the wars in Iraq and Afghanistan through FY 2008 will
exceed $1.6 trillion. This is over $20,000 per family of four.
Yet the costs that we will incur if the war continues are far
greater. Even assuming the optimistic scenario of a significant
drawdown in troop strength and no further impacts on oil
markets, a continuation of the war through 2017 will lead to total
economic costs for Iraq and Afghanistan of some $3.5 trillion
over the 2003-17 period under the considerable drawdown
scenario.
We have already experienced massive economic costs due to our
failed strategy in Iraq. The nation will experience even more
significant costs if we do not change course.
The Economic Burden of The Iraq War
The economic costs calculated in this report are a conservative
estimate of the potential costs to the U.S. economy if we do not
change course in Iraq. This study does not include such
unquantifiable impacts as the cost of thousands of U.S. fatalities
in these wars or the effect of the Iraq war on U.S. international
prestige and security. The report assumes no oil market impacts
of a continued Iraq occupation beyond 2008. The report uses
conservative economic assumptions throughout, especially for
the economic burden of injuries and disabilities resulting from
the war. Finally, the report focuses on costs for a future scenario
that assumes a substantial reduction in troop levels and budgetary
costs of the war.

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122

is maintained. This will be true even if a considerable drawdown
takes place and annual direct appropriations for the Iraq war
decline by more than half over the next five years. By any
measure, the economic costs of continuing our current course in
Iraq would be enormous.
APPENDIX A: COSTS OF ALTERNATIVE SCENARIOS
War costs through 2007 can be directly calculated. In this study,
war costs for FY 2008 were estimated by taking the figures in the
President's supplemental spending request, as allocated by the
Congressional Research Service.
Cost projections for FY 2009-17 require forecasting the future
course of the war. The main body of the report focused on the
CBO's "moderate drawdown" scenario to project future costs.
This "moderate drawdown" scenario assumes a 64% drop in the
number of troops in Iraq by 2013, and constant force levels from
2013-17. The scenario implies a sharp decline in war costs
beginning in 2009.
This appendix supplements this scenario with two others. The
first is a "sharp drawdown" scenario under which forces in Iraq
are rapidly reduced to 10,000 by 2010, and withdrawn altogether
by 2011. This scenario corresponds roughly to withdrawal
scenarios advanced by House Democrats. The underlying
budgetary figures are based on CBO fiscal estimates for a sharp
drawdown scenario, with costs in later years assumed to occur
entirely in Afghanistan and not in Iraq. FY 2008 funding is
assumed to be somewhat lower than the President's request. The
future costs for disabilities, as well as additional military costs
such as recruitment, force expansion, and repair, are also
assumed to be a total of $35 billion lower under this scenario.
The second is a "no drawdown" or "status quo" scenario which
assumes post-surge cost levels for the war continue throughout
the budget window until 2017. This scenario corresponds to an
indefinite continuation of the war. To perform this estimate, JEC
staff adopted a CBO estimate of FY 2009 costs. At $121 billion
per year, this estimated spending would still be over $10 billion

123

lower than Iraq war spending in FY 2007, and over $30 billion
lower than FY 2008 spending will be if the President's
supplemental is approved. (It would thus represent the first
annual decline in Iraq spending since the start of the war). The
"no drawdown" scenario then assumes this spending stays
constant in real terms (adjusted for a 2% inflation level) through
2017. This reflects a continued commitment of 155,000 troops to
the occupation of Iraq. The costs for disabilities, as well as
additional military costs such as recruitment, force expansion,
and repair, are also assumed to be a total of $35 billion higher
under this scenario.
Table A-1: Descriptions and Costs of Alternative Future Scenarios
Troop Levels In Iraq and Afghanistan

Scenario

C
2007

No Drawdown
(Status Quo)

2008w2017Alghanist21

210,000
(180,000 in Iraq)

Iraqand

20~AfghanistanjIaqOl
Reduction to 180,000
troops towa(I 55,000 in
Iaq) by FY 2009. No fir54.5 Trillion
_ter

Considerable
Drawdown
(Korea-like
(oresaelne

Costs ( 2003 2017)

1
Only

$3.5 Trillion

reduction.

Gradual reduction to
210,000
75,000 troops total (55,000
(180,000 in Iraq)linlraq) by 2013. This force
$3.5 Trillion
(1ren0,000
athoo
maintained
through 2017.
Rapid reduction to 30,000 Sharp Drawdown
21,00
troops total (10,000 in Iraq.)
(House~
20,00
by 20 10. Full withdrawal
$2.6 Trilo
DeHourtePan
(180,000 in Iraq)
from Iraq after 2010;
Democratic
Plan)
~~20,000
troops mainctained
in Afghanistan
-___

$21. Trillion

$1.7Trillion

Table A- 1 and Chart A-I show force levels and total costs in Iraq
and Afghanistan for all three scenarios. Because such a large
amount of war costs have already been incurred, all of the
scenarios show large total expenses for the war. (For example, all
three scenarios require continued interest payments on warrelated debt accumulated so far). However, the difference
between the "sharp drawdown" and "no drawdown" scenarios
amounts to a savings of approximately $2 trillion in total
economic costs incurred between 2003 and 2017.

124
Figure A-1: Total Economic Costs Under Future Scenarios

$4.0-f _

S3.5 -

/==

Sharp?Drowdomw'p(Dnombt)
Moderae Dtswdowsn (MB)
Stay-,lte-Cours (Whate Ham~)
Total econotalt casts of sian hin raq and Afghanistan. 200-2017

APPENDIX B: METHODOLOGY
THE ECONOMIC COST CONCEPT
Conceptually, economic costs in this paper are the sum of all costs to
taxpayers, plus additional costs to Americans that are not reflected in
government budgets. To be a valid measure of total costs, this method
requires the assumption that costs to taxpayers exactly reflect the true
resource cost of the goods or services being purchased by government.
Of course, this assumption may not be completely true. Some
government costs may include, for example, profits in excess of normnal
rates of return for government contractors. In many analyses of overall
economic costs these profits would be scored as transfers and not costs
at all (they would act as offsetting benefits to governmnent costs). But in
this case the results of adopting such a technique would be misleading
and counterintuitive. For example, if profits were scored as transfers,
this would imply that cases of contractor fraud in which Americans
earned large profits by cheating the government would reduce the
overall costs of the Iraq war to the taxpayer.
Because of the assumption that government costs reflect true resource
costs, those resource costs that appear in government budgets are not
counted twice. To take one example, when disability payments to
injured veterans make up for part or all of their lost earnings, these lost
earnings are not counted again in economic costs.

125

CALCULATIONS OF BUDGETARY SPENDING
Figures from the Congressional Research Service (CRS) were used to
determine the total amounts expended on the Iraq and Afghanistan
wars through the close of 2007, and also in the President's 2008
supplemental request (CRS 2007).1I
Budgetary figures for 2009 and after were drawn from testimony by
the Congressional Budget Office (CBO). These figures are drawn from
Tables 5 through 7 of Robert Sunshine's testimony to the House
Budget Committee in July, 2007. They are increased by 10% to reflect
higher levels of spending than expected at that time. (This increase is
explained in CBO director Peter Orszag's testimony before the House
Budget Committee in October 2007). The scenario used in the main
body of the report corresponds to Scenario 2 in this CBO testimony,
with the 12-month sustained surge option assumed. Based on
discussions with CBO staff, 80% of these budgetary costs are assumed
to be incurred in the Iraq war.
The two other scenarios described in Appendix A also draw on these
CBO budgetary figures, but are modified as described in Appendix A.

ACCRUED COSTS OF FOREGONE INVESTMENT
The accrued costs of foregone investment related to borrowed funds
are estimated using a shadow cost of capital approach. This approach
converts lost investment into the present value of a stream of future
consumption. There is substantial agreement that this approach is
theoretically correct (Cline 1992). However, there are a variety of
methods to calculate the shadow cost. Some methods can have results
that depend heavily on assumptions (Lyon 1990).
This report uses a comparatively stable and conservative means for
calculating the shadow cost of capital, that is less fragile to
assumptions than other methods. The description and justification for
the technique is outlined in Cline (1992). This method involves
summing the real present value of total returns to capital over a 15 year
time horizon. Capital investment returns are calculated using the
marginal pre-tax return to private investment, and discounted by the
social rate of time preference. All of the capital return is assumed to be
consumed, except for whatever share is necessary to compensate for
depreciation.

126
The key assumptions involved are:
1. The amount of borrowed money that represents displaced
capital investment. This study assumes 60% of Iraq-related
government borrowing represents displaced investment. The
other 40% is assumed to be replaced by foreign investors. This
figure is directly drawn from an estimate of the economic
impact of deficits by the Bush Administration Council of
Economic Advisors in 2003 (CEA 2003).
2. The pre-tax real marginal rate of return to capital. This report
assumes a 7% real rate of return on capital, net of depreciation.
This is the standard assumption that the Office of Management
requests that agencies use as the alternative return to capital
used in government expenditures (OMB 1992)12
3. The social rate of time preference, or discount rate. This report
assumes a 3% discount rate. The inflation-adjusted cost of
Treasury borrowing in recent years has been between 2 and 3%
(OMB). The use of this Treasury borrowing rate is also
recommended by OMB when using the shadow price of capital
approach. The rate is higher than the standard 2% rate used by
CBO. (OMB 1992; Kohyama 2006).
The economic costs of foregone investment are then summed in the
following manner:
1. The increase in Federal borrowing each year is calculated
using assumptions about the fraction of appropriations that are
spent in each year.
2. Sixty percent of increased borrowing is assumed to displace
capital.
3. The discounted real present value of the displaced capital is
summed over a 15 year time horizon.
4. The present value of costs are counted as accrued in the year in
which the Iraq-related borrowing took place.
The stream of foregone investment earnings is discounted to the year in
which the borrowing took place. This is done to match economic costs
with the reported budget figures from CBO reports and testimony
(CBO 2007b, c). The costs in the body of the report can therefore be

127

understood as describing future losses to the economy over the entire
2003-2017 period.

INTEREST PAYMENTS TO FOREIGN CREDITORS
The 40% of borrowing that does not represent displaced capital is
assumed to be borrowed from foreign purchasers of debt. Outflows of
interest to these foreign creditors represent an economic loss.
Therefore, each year 40% of payments on Iraq-related debt are counted
as an economic loss. Based on discussions with CBO staff, interest
payments are calculated at a 4.5% interest rate.

OTHER COSTS: MEDICAL COSTS
As discussed in the main body of the report, CBO has attempted to
forecast Federal medical and disability costs for war-related injuries up
to the year 2017. This report adds on the present value cost of a
continuation of these medical and disability costs for a 30-year period,
discounted at a 3% rate. Medical costs are assumed to decline at a rate
of roughly 10% per year due to the healing of injuries and illnesses.
Disability costs remain constant.
The report also adds on a cost of lost earnings for one sample warrelated disability, post-traumatic stress disorder (PTSD). The majority
of lost earnings costs due to war injuries are assumed to already be
counted in VA disability payments, which compensate for such
earnings losses and are included in budgetary costs. However, a recent
study commissioned by the Veterans Commission on the adequacy of
disability benefits found that such benefits only compensate about 80
percent of the earnings losses due to mental disabilities such as PTSD
(Christensen et. al 2007).
The report assumes that 15 percent of serving veterans over the 200217 period will eventually experience PTSD (Hoge et. al 2007;
PCCWW, 2007). The report also assumes that they will experience
earnings losses of roughly 20 percent (Savoca and Rosenheck 2000).
Finally, the assumption is made that the average present value of
lifetime earnings for a veteran absent PTSD is $2 million. (This
estimate is -based on inflation-adjusted results from civilians from Day
and Newburger 2002). The $10 billion figure in the text was calculated
based on these assumptions combined with the average under
compensation from VA benefits discussed above.

128

DISCOUNTING COSTS OVER THE BUDGET WINDOW
This report discounts war costs to each specific budget year. For
example, the lost future consumption due to debt-related displaced
investment is discounted to the year the money was borrowed.
Likewise, the future costs of disabilities and injuries for veterans are
discounted to approximately the estimated year of the injury. However,
costs are not discounted across budget years. This was done to
maintain comparability with actual budget figures and future CBO
budgetary estimates, which are not discounted.
An alternative method would be to discount all war costs to some
specific budget year, such as FY 2008. Discounting and deflating total
costs to real FY 2008 dollars does reduce the overall cost of the Iraq
war between 2003 and 2017. However, the effect is not large. This is
partly because discounting to 2008 increases costs incurred in FY
2003-2007. It is also because under the "moderate drawdown" scenario
the bulk of total costs are incurred in years close to 2008.
As an example of the effect of discounting, discounting all costs to real
FY 2008 dollars at a 3% discount rate and an assumed 2% inflation
rate reduces the total costs of the Iraq war under the "moderate
drawdown" scenario from $2.77 trillion to $2.58 trillion. The combined
costs of the wars in Iraq and Afghanistan are reduced from $3.48
trillion to $3.25 trillion. Costs of the war between 2002 and 2008 alone
would of course be increased by this exercise.
ENDNOTES
I As of November 2007, the Congress had already appropriated $449 billion of
spending on Iraq, and $609 billion for both Iraq and Afghanistan combined.
2
CRS 2007; CBO 2007a and 2007b. See Appendix B for full explanation of
budgetary estimates.
3These direct budgetary costs include estimates of all of the additional
spending so far for the Iraq war by the Defense Department, State
Department, and the Veterans Administration, as well as reconstruction
payments to Iraq.
4This is the present value of the lost returns to investments that did no take
place due to the diversion of capital into Iraq war spending, as well as the
present value of post-tax returns to investments that were funded with foreign
capital. The assumptions used to generate this estimate are further described in
Appendix B.
5This is based on the assumption of a - .1 elasticity for oil consumption by
U.S. energy consumers and a recycling of 10% of foreign oil revenues into the
U.S. economy.

129
Such additional impacts in 2009 and following years are in quite possible,
but since they cannot be reasonably predicted they have not been included in
the analysis.
7 Specifically, the assumption is that a 10 percent rise in oil prices reduces
GDP by two-tenths of one percentage point. This produces GDP impacts
consistent with the recent Global Insight simulation of a $10 rise in oil prices
(Huntington, 2005). It is smaller than the effect found in a recent literature
survey by Jones, Leiby and Paik (2004) and the most recent study by
Hamilton (2004), who both estimate an impact of between five and sixth
tenths of a percentage point of GDP per ten percent rise in oil prices.
However, this GDP impact is somewhat larger than that estimated by the
Congressional Budget Office (2006).
8 Based on projecting the present value of CBO disability and medical care
costs for the year 2017 over an additional 30 years, with an adjustment for the
proportion estimated to come from Iraq. The exact figure depends on what the
starting year of discounting is; discounting to 2008 dollars produces the $9
billion figure, while discounting to 2017 dollars yields a $12 billion cost.
9 See Appendix B. The cost rises to $12 billion when Afghanistan veterans are
included.
10 CBO has raised some question over how much of the repair, reset, and
reconditioning costs related to Iraq are in fact purchases of new equipment
that was not made necessary by the Iraq war (CBO 2007f). However, in this
report we accept the DOD estimate.
ii These figures differ slightly from CBO figures, as CBO is willing to leave
some costs unallocated to either Iraq or Afghanistan while CRS analysts
allocate the entire amount to a specific war.
12 Other estimates are higher; for example, Gomme, Ravikumar, and Rupert
(2006) estimate 7.7% as the average of the real marginal return over the 19502001 period. This would result in a larger amount of lost investment.
6

BIBLIOGRAPHY
Bilmes, Linda, 2007. "Soldiers Returning from Iraq and Afghanistan: The
Long-term Costs Providing Veterans Medical Care and Disability
Benefits." Working Paper, Harvard University.
Bumiller, Elizabeth, 2003. "The Cost of War." The New York Times, p. 4.2.
Christensen et al, 2007. "Final Report for the Veterans' Disability Benefits
Commission: Compensation, Survey Results, and Selected Topics."
The CNA Corporation, CRM D0016570.A2.
Cline, William R, 1992. The Economics of Global Warming. Peterson Institute
for International Economics.
Congressional Research Service (CRS), 2007. "The Cost of Iraq, Afghanistan,
and Other Global War on Terror Operations Since 9/11."
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Congressional Budget Office (CBO), 2007a. "The Budget and Economic
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http://www.cbo.gov.

130
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-- 2007d. "Statement of Matthew S. Goldberg: Projecting the Costs
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-- 2007e. "Estimated Cost of the Administration's Proposal to
Increase the Army's and the Marine Corps's Personnel Levels."
-- 2007f. "Replacing and Repairing Equipment Used in Iraq and
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-- 2006. "The Economic Effects of Recent Increases in Energy
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Council of Economic Advisors, 2003. "Economic Report of the President."
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Day, Jennifer Cheesman and Eric C. Newburger, 2002. "The Big Payoff:
Educational Attainment and Synthetic Estimates of Work-Life
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-Department of Defense (DOD), 2007. Casualty estimates available at
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-- 2007b. "World Crude Oil Production, 1960-2006." Available at
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Friedman, Benjamin M, 2005. "Deficits and Debt in the Short and Long Run."
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Gomme, Paul, B. Ravikumar, and Peter Rupert, 2006. "The Return of Capital
and the Business Cycle." Working Paper, Federal Reserve Bank of
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Government Accountability Office, 2006. "Strategic Petroleum Reserve:
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Should Influence Future Decisions about Fill, Use, and Expansion."
Hamilton, James, 2004. "Oil Shocks and Aggregate Macroeconomic
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Kohyama, Hiroyuki, 2006. "Select Discount Rates for Budgetary Purposes."
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Lyon, Randolph M, 1990. "Federal discount rate policy, the shadow price of
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132

Energy Efficiency is a Bright Idea: Shedding Light on the
Benefits of Increasing Energv and Fuel Efficiency to
American Families and Our Environment
INTRODUCTION
Each time a family decides to change a light bulb, upgrade a
heating or cooling system, or buy a new appliance or a new car,
that family is making a decision that impacts both its pocketbook
and the environment. High energy prices and rising awareness of
the consequences of global warming have led more consumers to
factor energy and environmental costs into their decisions to
invest in new homes, appliances and vehicles. Even so, many
Americans remain unaware of the private and social benefits of
energy-efficient technologies and practices. Energy efficiency
translates into lower household energy costs, less pollution and
fewer greenhouse gas emissions for all of us. Additionally,
increasing household energy efficiency can work to reduce U.S.
reliance on foreign fuel sources.
ENERGY EFFICIENCY MEANS A LIFETIME OF
LOWER ENERGY BILLS
Residential spending on energy is one of the largest sectors of
energy spending in the United States. According to the U.S.
Department of Energy, residential spending on energy in 2005
(the last year for which data are available) was approximately
$215 billion, or about 21 percent of total U.S. energy
expenditure. (See Chart A, Page 5.)2 The average household
now spends an estimated $1,900 in electric and gas utility bills
each year.3
The American Council for an Energy-Efficient Economy
(ACEEE), a leading provider of energy efficiency data and
analysis, estimates that the average energy-efficient household
spends approximately 40 percent less on the energy it uses than
the average household that is not energy efficient. 4 In some
states, governments and utilities add to the savings by offering
rebates on energy efficient appliances and products.5 Moreover,
there is some evidence that energy-efficient appliances and
practices can add to the market value of a home. 6

133

Although important gains have been made in energy-efficient
technologies and practices, too many American families remain
unaware of the potential energy savings that they can gain
through energy-efficient living. In 2006, only 31 percent of the
2,251 households surveyed by the Consortium for Energy
Efficiency (CEE) knowingly purchased an ENERGY STARlabeled product. 7
The following discussion uses data provided by ACEEE to
illustrate the potential for cost savings that can result from
energy-efficient purchases and practices in the home.
ECONOMIC COMMENTARY: Investing in Energy Efficiency

When consumers decide whether to purchase an energy-efficient
appliance or product, they weigh the potential benefits of the product
(the savings in energy costs over the life of the product) against its
purchase price. The purchase price of the product is the first (and most
tangible) cost they will incur, and since the prices of energy-efficient
products are often higher than the prices of less efficient, comparable
alternatives, the purchase price alone could dissuade some consumers
from investing in the more energy-efficient product. But other cost
differentials, such as operating and maintenance costs over the service
life of the appliance, should be factored in. The timing of the costs
and benefits also matters; because appliances provide services over
many years, the future costs and benefits relevant to consumer's
decision are the "discounted" dollar costs and benefits.'
Much of the discussion in this report highlights the potential savings to
consumers stemming from the lower energy costs of operating
efficient appliances, and it is important to recognize that consumers
can enjoy a high rate of return on their investment in many types of
energy-efficient products. In other words, even though consumers
may have to pay more up front to buy an energy-efficient appliance,
they are likely in many cases to recoup the extra upfront costs fairly
early in the product's service life because the future energy savings
tend to be substantial. (See Box A, Page 3.)

Heating and Cooling
According to the ACEEE, reducing heating energy use is the
single most effective way for families to save money on their
energy expenditures. 8 Home heating currently accounts for

134

approximately 30 percent, or about $610, of the average
household's energy costs. In the Northeast and Midwest, where
the winter months tend to be colder than elsewhere, heating
accounted for about 40 percent of the average household's
energy costs, or about $830.9 Cooling a home can also be very
costly, particularly for families in warmer parts of the country.
On average, households across the nation spend an estimated
$270 a year on cooling, while households in warmer states in the
West spend approximately $320 a year on average.
Households that heat and cool their homes efficiently pay about
30 percent less a year in utility bills than less-efficient
households." Efficient heating and cooling alternatives include
energy-efficient boilers, furnaces, or air conditioners, as well as
ENERGY STAR-qualified windows.
The alternatives also
include efficient R-38 ceiling insulation and better-sealed
windows and heating/cooling air ducts.12
Appliances
Households with energy-efficient appliances will also enjoy
energy savings. Appliances account for about 30 percent of total
household energy use, which amounts to approximately $550 per
year. 13 The energy cost of appliances can vary substantially
based upon the age and model of the appliance. For example,
according to the Natural Resources Defense Council (NRDC),
refrigerators purchased today consume 75 percent less energy
than those used in the 1970s.14 Today, households with
ENERGY STAR refrigerators and washing machines are
spending approximately $100 less annually, on average, than
households with less-efficient refrigerators and washing
machines. 15
Water Heating
The average household spends an estimated $220 on water
heating each year. According to NRDC, a water heater that is
more than 10 years old is likely to be half as efficient as when it
was new.16 The ACEEE estimates that a household with an
energy-efficient water heater is spending nearly $100 a year less
to heat water than its less-efficient counterpart.17

135

Lighting
Lighting currently accounts for about 5 to 10 percent of total
energy use in the average American household. The typical
household using 20-watt ENERGY STAR compact fluorescent
light bulbs (CFLs), which use less energy and last up to seven
times longer, is spending nearly $13 a year less per bulb
(assuming 8 hours of use) than a similar household using 75-watt
incandescent light bulbs.' 8 Replacing five 60-watt incandescent
light bulbs with 13-watt ENERGY STAR CFLs can save
households about $30 a year in lighting expenses, assuming the
lights are in use for four hours a day. The total savings only
increase as usage increases. (See Appendix A.)
Illustrative Household Energy Scenarios
The following table is prepared from data provided by ACEEE
and illustrates the potential for in-use savings from energy
efficiency.
Household A (the "Martin" family) spends
approximately $1,820 on utilities annually and represents typical
household energy use. Household B (the "Bailey" family) has
already made several upgrades to its house that have improved its
overall energy-efficiency. The Baileys spend 40 percent, .or
approximately $730, less per year on in-home energy use than
the Martins. These updates include improvements in heating and
cooling, and updating to ENERGY STAR-qualified refrigerators,
washing machines, light bulbs and windows. (See Table A.) (The
Bailey's energy efficiency upgrades are itemized in Appendix
B.)

136
BOX A: Return on Investment in Selected Energy-Efficient Appliances
Over the Life Cycle of the Product
ENERGY STAR Unites Versus Comparable Conventional Units (Dollars)
ENERGYSrAR
Qaletd Uii

COnsAbl
COnvenUonal &K
OIL BOILER

Anmml Opeating Coos
Etry Cost
wftsCyde Cool I

13,027

EOW Opating Cost

Coo ofPurdwe
Ttal

Saslop itlh
ENERGY STAR

S287

4,114
S55,917
S700
$5Y.617
Cost
aS

SS,016
$4,000
$56,16
Sbope NPsybakoritlaAd1l0n=

13,901
-$1,30
$ I51
4

PROGRAMMABLE THERMOSTAT
AnnalOpetivng Cows'

$1130
lie Cyde Costa
1eW Opat Co_
Cost ohPuwsde

$~~~1,378

$248

$12,562
$15,319
$100
_
$1,662
15359
SWePa*yba ofAWt Additoal oat (YVrs'

12,757

S2,697
eOt

AIR CONDITIONER
A

ul Operat Cio
$139:

$153

$14

UfeCyleCostx'
El~ff

Coeins

Costof
Prse
Sim

$1,123
S30
StA23:S
blAk o

S1,230
$270
$1
Si
AddtIm:lCot (e2
. :

~RFRGEATAAAOR

$115
-$30
$8

AWA^:
W...

Anna OperatcgCst

S46
WlieCce CostsA
E-O Opag

Cos

,Total

an cot

*$455

$1,100$
$1,555o i - s
SImple !~4ol0nMlIA0ditioa

cootorpsuho

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the

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~46
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FUEL
EFFICIENT
MEAN
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orta tigool acncsloun~sltscn
fore68 percent
o
Transportation is the single largest sector of consumer spending
on energy, representing $475 billion, or 46 percent of total
spending in 2005 (the latest year for which data are available).' 9
(See Chart A, Page 5.) Transportation accounts for 68 percent of
our nation's oil usage. 20 In 2005, U.S. cars and trucks consumed
174 billion gallons of gasoline, accounting for more than two-

137

thirds of U.S. consumption of petroleum-related products and
contributing significantly to our dependence on foreign-produced
oil. 21 If gasoline prices remain at current levels, the typical
American household with two vehicles will spend nearly $3,700
on gasoline this year, according to the American Automobile
Association (AAA).2 2
To illustrate the potential for gasoline savings from fuel
efficiency, the following table compares the energy costs of two
households that already own two cars of comparable size and
age. Each household drives their cars about 14,600 miles apiece
each year. However, household A (the "Martin" family) gets
poorer gas mileage on each of its cars than household B (the
"Bailey" family). The Martin family gets an average of 25.4
miles per gallon (mpg) out of its cars (the average efficiency for
the U.S. fleet in 2006), while the Baileys get 35.0 mpg.23 As a
result, the Martins will spend about $3,200 on gasoline to fuel
their cars this year, while the Baileys will spend only about
$2,320 on gasoline. That is, the Martins spend approximately
$880 more than the fuel-efficient Baileys.2 4 In short, a household
that operates vehicles with an average fuel efficiency of 35.0
miles per gallon (mpg) can expect to spend 27 percent less on
fuel than a household that operates vehicles with an average fuel
efficiency of the national fleet average of 25.4 mpg. (See Table
B.)
Table A: An Illustration of Potential Energy Savings From Use of
Efficient Appliances and Practices
The Martins vs. The Baileys
Average Annual Household Spending
Martins
Baftys
Household Energy Expense
Heating
Cooling
Waterheating
Lighting
Appliances
Total

$613
S271
$218
S165
S553
$1,820

Total Savings
Sae:

BInd wld*F p

idedbytbeAmkwic

r Den
=EatuaEaficial Ecocemy.

Annual Energy Savings
Difference

$279
S93
$122
$138
$453
$1,086

S334
3178
$96
S27
S100
$734

40%

S734

138

Figure 6: U.S. Energy Expenditures by Sector, Billions of Dollars

Source: Energy Information Administration, U.S. Department
of Energy, Annual Energy Outlook 2007

Table B: An Illustration of Potential Gasoline Savings From Use of Fuel
Efficient Vehicles (The Martins vs. The Baileys)
nisi
M,,arti,,

.Bil eys

MverageFiuel
Efllciency (mpg),

.25.4

35.0

AnnualFue Costs

$3 I19

$2,319

iDifferencein G asoline
.Spendiig PlerYear

$877

Source: JE.C calcuilations bas'ed on dat'a from te Department Sof Tnsportation-an'd
he Dep'artmenit ofEng
t4ote:; Calcuiations. assutme aniannual,^a4vyerag'e gasoline priceofh$2.78 per gallon, the
Energy
Information, Adminisotration's2007project'ion forthe retail price, of a gallon
of regular grade gasoline.

Consumers often underestimate the economic benefits of
purchasing more fuel-efficient vehicles available on the market
today, such as hybrids. In addition to the savings from gasoline
consumption, consumers that purchase certain types of hybrid

139

vehicles may be eligible for significant tax credits from the
federal government. For example, a consumer who purchases a
hybrid sports utility vehicle instead of a standard-engine sports
utility vehicle (from the same model year) can receive a tax
credit of as much as $3,000 to help offset the difference in the
initial purchase price of the hybrid.25 The tax credit, coupled
with fuel savings, may allow the consumer to recoup the
increased price paid for the hybrid in just over two years. 26
IV. ENERGY EFFICIENCY ALSO HAS IMPORTANT
SOCIAL BENEFITS
The benefits of energy efficiency also extend far beyond the
direct savings for individual households. The operation of
energy-efficient homes, appliances and vehicles might also
reduce the nation's need for new power facilities, reduce the
level of pollutants in -the air we breathe, and provide a healthier
indoor environment for families.
According to the EPA, the average single-family home adds
more than twice as much greenhouse gas emissions to the
atmosphere as the average passenger vehicle. 2 7 The process of
heating and cooling homes in the U.S. emits 150 million tons of
carbon dioxide into the atmosphere each year. Such emissions
also generate about 12 percent of the nation's sulfur dioxide
emissions and 4 percent of the nation's emissions of nitrogen
oxides -the main components of acid rain. 2 8 Energy-efficient
households can emit approximately 8,900 fewer pounds of CO2
into the air each year, according to ACEEE. 29 The use of an
ENERGY STAR refrigerator and washing machine alone could
lessen household carbon emissions by 1,200 pounds of CO 2 each
year. 30 And if every American home replaced just one light bulb
with a more efficient (ENERGY STAR-qualified) bulb, we
would save enough energy to light more than 3 million homes for
a year and prevent greenhouse gases equivalent to the emissions
of more than 800,000 cars according to the EPA and the U.S.
Energy Department. 31
According to the U.S. Department of Energy, energy-efficient
homes can also provide a healthier indoor environment. The

140

health risks associated with contaminants such as combustion byproducts and radon, mold, pollen and dust mites can be reduced
by upgrading to energy-efficient products and technologies. 3 2
Further benefits include reduced noise, greater fire safety, and
improved building stability. 33
Greater fuel efficiency in vehicles would also. help curb
greenhouse gases. The EPA reports that the transportation
sector-which is dominated by automobile usage-has
significantly increased its contribution of carbon emissions over
the past forty years, ballooning from one-quarter of all emissions
to one-third (33 percent). 3 4
V. CONCLUSION
There can be substantial private and social benefits for
households to invest in greater energy efficiency-from both a
private savings and a social benefits perspective. To increase
awareness of these advantages, policymakers can promote
measures to make it easier for consumers to factor in both the
energy savings and the reduced carbon emissions over the life of
the appliances and vehicles they may buy to assist them in their
purchase decisions. Energy efficient technologies are available
today, and thus the decision to be more energy efficient can have
an immediate positive impact on our environment and energy
security. Helping more American families to realize the potential
benefits of energy-efficient technologies and practices can go a
long way toward achieving our national goals for energy policy.

141

APPENDIX A: Potential Savings from Replacing a 60-Watt
Incandescent with a 13-Watt Compact Fluorescent Light
Bulb
Ist year

2nd year

3rd year

5th year

10th year

Lighton2hrslday

51.76

$5.52

$9.28

$16.31

S32.59

Lighten 4 nrdiday

$5.52

$12.53

S20.06

$32.59

$66.69

Lighton 8 hrslday

$12.53

$27.08

$39.61

$66.69

$135.38

Llghtonl2hru/day

$20.06

$39.61

$59,67

$100.78

S201.57

Source: Data provided by American Council for an
chase price of the Iilthbulbs.

tgy Efficient Economry, Calculations take into account initial pur-

Not& Savins clcuitions based on conMaring an incandescest light bulb costing 50 providing 850 lumens of wi, for
1000 hours at an electricity cost of S095 par kilowatt hour. vasus a fluorescest bulb costing S2.00, providing 850 htuen of
IWOfor 6,000 httraat the sane cost of electricity.

APPENDIX B: Annual Household Spending on Energy
.,

360

388t0665060a57

5633

12503.22
A484~~~c%33A672

Iss;119

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s~~~~~~~~~~~~~~~~t
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. ,A
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t~~~illuiS;~~~~~~
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$21
020 693
333
32
96015
859~I
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19

t.6634
4si0.cor.

WTTIAiV5NG3.

$057

3543

117t1
306
tS27
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1334

710
37

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5130

s
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534
033~
334
:$m
3361

53
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373

71
55

U6.
ld

0610

6.73

1314

3l.6
3,579
310
1,336

S9S

$321
3.233

334
3*7

9,15

j64 $ .274 9 .

730.go450

pis3

4.539
ishn
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373
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4iYl

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521

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143

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11471
3,57

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5114
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277
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$43
us
362
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593

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30
387

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1,13

1994

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476

04
S
0so
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R2
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67
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344
1

3633

t9.4

ENDNOTES
I Discounting future costs and benefits is required because a dollar to be
received in the future is worth less today than a dollar actually received today.
2 U.S. Department of Energy, Annual Energy Outlook 2007, at p. 141,
available at http://www.eia.doe.gov/oiaf/aeo/index.html.

142
3Environmental Protection Agency, Energy Efficiency: Reduce Bills, Protect
at
available
2007,
April
updated
last
the
Environment,
http://www.epa.£ov/solar/pdf/napee consumer.pdf.
4 Unpublished data from the American Council for an Energy-Efficient
Economy, "Home Energy and Carbon Calculations 2007."
5 ENERGY STAR, U.S. Environmental Protection Agency/U.S. Department
of Energy, "Special Offers and Rebates from Energy Star Partners," available
at hLtp://www.ener-ystar.gov/index.cfm?fuseaction=rebate.rebate locator.
6 U.S. Department of Energy, Energy Information Administration, Annual
Energy Outlook 2007, at p. 42; Building Design+Construction, "Green
Buildings and the Bottom Line," November 2006. According to the trade
journal, Building Design+Construction, builders can add to the value of
homes by upgrading insulation, HVAC systems, windows, and doors in their
projects (and also specify energy-efficient, Energy Star appliances). The
study cites McStain Neighborhoods of Denver, a property group that follows
guidelines established by the Built Green Colorado program, which includes
among many things the stipulation that "House(s) meets the EPA Energy Star
Program criteria." The company CEO says these homes have a resale value
about 4-10% higher than traditional homes.
7 EPA Office of Air and Radiation, Climate Protection Partnerships Division,
National Awareness of ENERGY STAR for 2006: Analysis of 2006 CEE
Household Survey, U.S. Environmental Protection Agency, 2007.
8 American Council for an Energy-Efficient Economy, Consumer Guide to
at
available
2003
8th
Edition,
Savings,
Energy
Home
http://wwxv.aceee.or,/consuwnernuide/topfurn.htm.
9 Unpublished data from the American Council for an Energy-Efficient
Economy, "Home Energy and Carbon Calculations 2007." ACEEE estimates
based on data from the Department of Energy's Energy Information
Administration's 2001 Residential Energy Consumption Survey and 2004
regional price data.
' 0lbid.
11Ibid.
12 R-38 is a commonly recommended ceiling insulation in many parts of the
United States.
13 See Endnote 9.
14
Natural Resources Defense Council, Efficient Appliances Save Energy - and
Money, available at http:H/wwxv.nrdc.org/air/energv/fappl.asp.
15 See Endnote 9.
16 National Resource Defense Council, "Efficient Appliances Save Energyand Money," available at http://www.nrdc.ornlair/energv/fappl.asp.
17 See Endnote 9.
'8 Unpublished data from the American Council for an Energy-Efficient
Economy (See Appendix B.)
' 9U.S. Department of Energy, Annual Energy Outlook 2007, at p. 141,
available at http://www.eia.doe.gov/oiaf/aeo/index.html.

143
Government Accountability Office, "Passenger Vehicle Fuel Economy:
Preliminary Observations on Corporate Average Fuel Economy Standards,"
March
6, 2007, at p. 1.
21
20

Ibid.

Geoff Sunderstrom, "Testimony Before the Senate Committee on Energy
and Natural Resources," May 15, 2007. Estimates based on a gas price of
$3.073 per gallon and assumes household uses 1,200 gallons of gasoline per
year.
23 The average fuel efficiency for the entire fleet of U.S. passenger vehicles
was 25.4 miles per gallon in 2006. (U.S. Department of Transportation,
Summary of Fuel Economy Performance, NHTSA, NVS-220, October 2006,
at p. 4, available at http://dmses.dot.gov/docimages/pdf99/426721 web.pdf.
24 Calculations assume an annual average gasoline price of $2.78 per gallon,
the Energy Information Administration's 2007 projection for the retail price of
regular grade gasoline.
25 Internal Revenue Service, "Hybrid Cars and Alternative Motor Vehicles,"
March
19,
2007,
available
at
http://www.irs.gov/newsroom/article/0,,id=157632,00.html.
26
Joint Economic Committee calculation of simple payback period assuming
purchase of a 2008 hybrid SUV (four-door, front-wheel drive) versus
comparable, conventional model, $3,000 federal tax credit, and gas prices
based on EIA's 2007 Annual Energy Outlook. Present value calculation
assumes annual discount rate of 12 percent over 13 years, the estimated life of
the vehicle, and no difference in maintenance costs.
27
Unit Conversions, Emissions Factors, and Other Reference Data, United
States Environmental Protection Agency, November 2004, available at
22

http://wvww.epa.gov/cppd/pdf/brochtire.pdf.
28

U.S. Department of Energy, Energy Efficiency and Renewable Energy,
"Energy Savers: Tips on Saving Energy & Money at Home," available at
http://wwwl.eere.energy.uov/consumner/tips/heating cooling.htrl.
29 See Endnote 9.
30
ibid.
31 ENERGY STAR, U.S. Environmental Protection Agency/U.S. Department
of Energy,
Compact Fluorescent
Light Bulbs,
available
at:
http://www.energystar.gov/index.cfm?c=cfls.pr cfls.
32 Office of Building Technology, U.S. Department of Energy, "Technology
Fact Sheet: Energy Efficiency Pays," March 1999.
33 Ibid.

Environmental Protection Agency, "Inventory of U.S. Greenhouse Gas
Emissions and Sinks:
1990-2005," April 2007. Se also Government
Accountability Office, "Automobile Fuel Economy: Potential Effects of
Increasing the Corporate Average Fuel Economy Standards," August 2000.
34

144

Billions in Offshore Royalty Relief for Oil and Gas
Companies Buys Little For Taxpayers
The federal government's ill-conceived royalty relief pro-gram
for offshore oil and gas drilling could cost taxpayers up to $80
billion-with precious little to show for it. There is scant
evidence that royalty relief materially affects the domestic supply
of oil and natural gas or our dependence on foreign energy
sources. Moreover, money spent on tax incentives for oil and gas
companies to encourage deepwater drilling is very likely to have
a greater impact on energy security if used to encourage
conservation or the development of renewable energy
alternatives. As an economic policy, royalty relief appears to
have no net effect on jobs at the national level or any effect on
energy prices paid by consumers.
Royalty Relief Could Cost up to $80 Billion in Lost Revenue
The federal government manages the energy resources on federal
lands, including underwater sites on the Outer Continental Shelf
(OCS), and leases production rights to private companies. For
OCS oil and gas, companies bid to acquire the rights to produce
from federal leases and the government collects royalties (a
percentage of the revenue) once production begins. Royalty relief
was enacted in 1995 with the promise to taxpayers that it would
provide incentives to producers that would lead them to increase
domestic production. However, oil and gas companies have
successfully exploited inconsistencies in the law and stand to
receive tens of billions of dollars of unintended royalty
giveaways.
The royalty relief program
thresholds that would limit
detailed in the Appendix, the
be much higher than expected
*

was supposed to include price
the cost of the program, but as
cost of lost leasing royalties could
for the following three reasons:

A successful legal challenge to the way the
Department of the Interior defined the volume of
oil subject to royalty relief adds an estimated $10
billion in costs.

145

An apparent administrative oversight that failed to
include price thresholds on royalty relief for
leases issued in 1998 and 1999 adds an estimated
$10 billion more.
* A lawsuit challenging the authority to apply price
thresholds to any leases issued between 1996 and
2000, if successful, would add an estimated $60
billion more.
* The economic case for any royalty relief is weak.
With these additional costs, the program would
have to deliver huge benefits to satisfy any
reasonable cost-benefit test.
Economic Benefits From Royalty Relief Are Hard to Find
It is difficult to find evidence of economic benefits from the
royalty relief program. The justification for this and other special
subsidies for oil and gas companies usually rests on the
arguments that increasing domestic oil and gas production will
lessen our dependence on foreign sources of sup-ply, promote
employment and economic growth, and hold down energy prices
for consumers. Yet, as discussed be-low, it does not appear that
royalty relief is a cost effective way of achieving any of these
ends.
Royalty relief is one part of a package of government sub-sides
for oil and gas companies. In addition to royalty relief, these
subsidies include special tax provisions for exploration and
production of oil and gas, and direct spending on research and
development for oil and gas production technology. Oil and gas
companies also benefit from general tax subsidies such as the
manufacturing tax deduction and favorable inventory accounting
rules that apply to other industries as well. It is questionable
whether these targeted subsidies are an important incentive to
new production, especially at a time when oil and gas companies
are recording record profits.
Royalty Relief Does Little to Increase Domestic Supply
According to the General Accounting Office, the Minerals
Management Service of the Department of the Interior (MMS)

146

has not conducted a cost/benefit analysis of the impact of
deepwater royalty relief. An MMS-commissioned study did look
at the effects of the royalty relief incentives on leasing, bidding,
and competition, but did not look at actual exploration and
production. The study, however, did simulate the effects of
royalty relief on production and revenues going forward from
2003 under various assumptions about the continuation of the
royalty relief program. The study found that compared with the
base case of no royalty relief, royalty relief similar to that
enacted in the Deepwater Royalty Relief Act of 1995 (DWRRA)
would be expected to increase new production by only 2.8
percent over the next forty years while reducing the present value
of royalty revenue by about 32 percent.
The study also noted that changes in the assumptions about the
expected price of oil and natural gas had a much greater
influence on future exploration and production than royalty
relief. It is not surprising that royalty relief would have a much
smaller impact. Oil prices are subject to consider-able volatility
and at their peak in 2006 were almost four times their 1999 level
(Chart 1). Price changes dwarf the dollar value of the subsidy
from royalty relief.
Royalty Relief Is the Wrong Policy for Achieving Energy
Security
U.S. dependence on foreign oil stems from the 10 million barrel
per day gap between domestic demand for oil and the supply
forthcoming from domestic sources of production (Chart 2).
Production from the Gulf of Mexico ac-counts for a little less
than 10 percent of total U.S. oil sup-ply (domestic production
plus imports). The United States imports about 65 percent of its
total supply, with about half of that coming from OPEC
countries.
Dependence on foreign sources of oil is particularly problematic
when those sources are dominated by countries in unstable parts
of the world such as the Middle East and governments unfriendly
to the United States such as Venezuela. Thus, the key to energy
security is to reduce the gap between U.S. oil consumption and

147

U.S. oil production in order to reduce our dependence on foreign
sources of supply.
From the standpoint of energy security, it is immaterial whether
we reduce our dependence on insecure sources of oil by reducing
our overall demand or by increasing our domestic supply. The
key to judging the effectiveness of a particular energy security
policy is whether we are getting the best "bang-for-the-buck" in
terms of reducing our dependence on insecure sources of supply.
If some or all of the money being spent on one policy could
achieve a larger reduction if it were diverted to a different policy,
we could achieve better energy security for the same amount of
money.
Chart 1: Spot Price of West Texas Intermediate Crude Oil
80
70
60
50

=40

30
20
10
0
1996

1998

2000

2002

2004

2006

Source: Wall Street Journal.

A broader criterion for an optimal energy security policy is
whether the benefits of devoting additional resources to energy
security would justify the additional costs, both economic and
environmental. Based on the available evidence, royalty relief for
oil and gas production fails both the cost- effectiveness ("bangfor-the-buck") criterion and this broader "optimality" criterion.
The subsidy currently going to royalty relief would almost surely
be better spent on more cost-effective, demand-side strategies to

148

conserve on energy use or the development of alternative fuels to
substitute for oil. Scaling back or eliminating government
subsidies would appear to sacrifice little in terms of energy
security relative to the cost of the subsidies.
A preliminary study by the RAND Corporation finds, for
example, that the current pace of renewable energy development
could reduce projected oil consumption by 10 percent by 2025.
The study says that raising the use of renewables to 25 percent of
all U.S. energy consumed would reduce U.S. reliance on oil by
double that or roughly the equivalent of imports from Saudi
Arabia and Venezuela. Such prospects illustrate the potential for
2
public policies that encourage such demand-side solutions.
Chart 2: Disposition of US Oil Supply, Millions of Barrels, 2000-2005
7,000
Gulf of
Mexico

6,000
-

5,000
4,000
Non-OPEC

o 3,000

2 2,000

1,000
0

0
2000

Ad
X

2001

PEC
a ::;>Countnies
2002

2003

2004

2005

Source: Energy Information Administration.

Royalty Relief Has No Effect on Jobs and Prices
Oil and gas royalty relief, like other subsidies to encourage
domestic energy production, are sometimes alleged to have
benefits in terms of job creation or keeping energy prices more
affordable for consumers. In general, however, production
subsidies aimed at a particular industry or sector are unlikely to
increase jobs at the national level, and small increases in
domestic oil production will not affect prices.

149

Increases in domestic production can increase the demand for
workers in the oil and gas industry. However, the industry is
relatively capital-intensive, and the small increases in production
likely to stem from royalty relief are not likely to have a large
employment effect. The number of workers employed in oil and
natural gas extraction was just over 143,000 at the end of last
year, compared with a total of over 114 million jobs in the nonfarm private sector. More important, over time and at the national
level, jobs created in the oil and gas industry are more likely to
represent jobs diverted from other industries than they are net
new job creation.
With respect to prices, oil prices are set in a world oil market.
Relatively small increases in domestic supply are un-likely to
move world oil prices at all. That is not to say, however, that a
meaningful reduction in U.S. dependence on foreign oil achieved
through a well-conceived energy security policy that includes
significant conservation and alternative fuel development cannot
have a large enough impact to affect prices.
Conclusion
The federal government has not performed a systematic analysis
of the costs and benefits of the oil and gas royalty relief program.
It seems clear, however, that the program would fail such an
analysis. The economics of the program were questionable when
it was instituted and oil prices were low. In today's economy,
there is no reasonable economic justification for continuing the
program.
Royalty relief has not led to meaningful increases in the domestic
supply of energy, nor has it led to the creation of new jobs or the
lowering of energy prices. What royalty relief has done is cost
taxpayers tens of billions of dollars without reducing our
dependence on insecure sources of foreign oil. Our failed
experiment with royalty relief invites further examination of the
effectiveness of the dozens of other tax incentives designed to
increase oil and gas production in the current tax code. To the
extent that demand-side policies such as conservation and the

150

development of alternative fuels are likely to be more effective at
increasing our energy security, shifting energy tax incentives into
those policies would give taxpayers more energy security "bang"
for their tax "bucks."
Endnotes
Ashton, P.K., L.O Upton II, and Michael H. Rothkopf, 2005. Effects of

Royalty Incentives for Gulf of Mexico Oil and Gas Leases. Volume I:
Summary, U.S. Department of the Interior, Minerals Management Service,
Economics Division, Herndon, VA. OCS Study MMS 2004-077, Table 5-10,
page 56. Results are for the $46/bbl price scenario.
2Rand has temporarily pulled the report from its website to make technical
corrections to the models used. The estimates reported in the text are based on
news reports at the time the study was first released. See 25x'25, "25 Percent
Renewables by 2025 Is Achievable and Affordable,"
http://www.25x25.org/storage/25x25/documents/RANDandUT/
RANDFactSheet.pdf,
and Fialka, John J., "Renewable Fuels May Provide 25% of U.S. Energy by
2025," Wall Street Journal, November 13, 2006; page A10,
http://online.wsi.com/public/article/SB116337967603521181XoaCh ov6vOJvhW2wd4vO3 inahO 20061213.html?mod=tff main tff top.

151

The Proposed Modification of Internal Revenue Code Section
199 Will Not Increase Consumer Energv Prices
The following analysis by the majority staff of the Joint
Economic Committee (JEC) at the request of Senators Jeff
Bingaman, Chairman of the Senate Energy and Natural
Resources Committee, and Max Baucus, Chairman of the Senate
Finance Committee examines the impact of denying the Internal
Revenue Code (IRC) Section 199 manufacturing deduction to
major integrated oil and gas producers on consumer prices of oil
and natural gas. The report finds that the removal of this
deduction would have a negligible effect, if any, on consumer
energy prices. This tax provision will likely be included in a
larger Senate energy bill as a way to finance renewable and
energy conservation efforts.1
Key Points
Because the removal of the tax deduction does not affect
production decisions in the near term, removing or modifying
the tax deduction will have no effect on consumer prices for
gasoline and natural gas in the immediate future.
In the long run, the removal of the tax deduction is unlikely
to have any effect on consumer prices for oil and gas. Oil
prices are more than three times higher than they were when
the tax deduction was implemented in 2004 - and those high
prices are an incentive for investors to continue to invest in
oil and gas companies. Although natural gas prices are not
significantly different from their 2005 levels, natural gas
prices rose significantly over the last decade and those higher
prices also provide good incentives for investors.

152

What is the current tax deduction and what is the proposed
removal?
IRC Section 199 was modified in 2004, as part of the American
Jobs Creation Act, to allow manufacturers to deduct, as a
business expense, up to a specified percentage of qualified
domestic production activity income in a given year. Initially,
manufacturers were allowed to deduct up to 3 percent of
qualified income. The specified percentage rose to 6 percent in
2007 and will increase to 9 percent in 2010. For the domestic oil
and gas industry, the deduction applies to oil or gas that was
"manufactured, produced, or extracted in whole or in significant
part in the United States." 2 Currently, the marginal corporate
income tax rate is 35 percent and this credit will reduce the
marginal tax to 31.85 percent when the deduction is fully
implemented. 3
The proposal excludes gross receipts of major integrated oil
companies derived from the sale, exchange or other disposition
of oil, natural gas, or any primary product thereof from the
domestic production deduction for purposes of Section 199. The
Joint Committee on Taxation estimates that removal of the credit
for major integrated oil and gas producers would bring in $9.433
billion in federal revenue over the next eleven years.4
Why the removal of this income tax deduction won't cause a
consumer price hike:
1. In the short run, an effective increase in the marginal
corporate income tax rate for oil and gas producers would not
affect output or price of either domestic crude oil or natural
gas. In the short run, these producers will continue to
produce where the marginal cost of extracting (or refining or
transporting) the next unit of crude oil (or natural gas) is
equal to the price of crude oil (or natural gas). While an
increase in the marginal income tax will raise average costs
of engaging in the activity, it will not affect the short-run
marginal cost. In the short run, firms make production
decisions based only on marginal costs.

153

2. In the long run, it is likely that the high prices of crude oil
will send adequate signals to investors in the domestic oil and
natural gas industries. Indeed, an oil executive testified
recently that removing the recent tax breaks (including
Section 199) given to his company would not affect his
company. 5 The effect of eliminating this deduction for the
domestic oil and gas industry will raise long-run average
costs and generally decrease rates of return to investments in
the oil and natural gas industry, all other things being equal.
However, the price of crude oil has more than doubled since
2005, when this deduction took effect. See Figure 1 below
for the West Texas Intermediate spot price of crude oil from
January, 2001 to the present. In January, 2005, when this
deduction took effect, the spot price in West Texas was
$46.84/barrel. Currently, the posted price of West Texas
Intermediate oil is $94.62.6
Figure 1: Spot Crude Oil Price: West Texas Intermediate
Dollars per Barrel
100
90
80
70
60
50
40
30
20
10
0
2001

.....................
2002

2003

2004

2005

2006

2007

Source: Wall Street Journal
Note: Prices are in nominal (not inflation adjusted) dollars

3. While the price of natural gas has not risen as dramatically as
crude oil in the last 3 years, the price of natural gas has
increased substantially in the last decade from its low of
$1.85 per million BTU in August, 1999 to its present level of
$7.14 per million BTU in November, 2007. See Figure 2
below.

154
Figure 2: Spot Natural Gas Prices: Henry Hub, Louisiana (Dollars per
Million BTU)
14
Hurricanes

Katrina and Rita,

4
2

1995

1996

1997

1998

1999 2000

2001

2002

2003

2004

2005

2006

2007

Source: Wall Street Journal
Note: Prices are in nominal (not price adjusted) dollars
1 See the Senate Finance Committee's summary of the tax provisions in the
Clean Renewable Energy and Conservation Tax Act of 2007.
2 See American Jobs Creation Act of 2004, Public Law 108-357 § 199
(c)(4)(A)(i)(I), available online at http://frwebgate.access.gpo.gov/cgibin/getdoc.cgi?dbname= 108 congpublic_laws&docid=f:publ357.108.pdf.
This deduction allows manufacturers, including oil and gas producers, to
deduct, as a business expense, the specified percentage of domestic income
subject to a limit of 50 percent of wages that are allocable to the domestic
production during the taxable year.
3Congressional Budget Office, "Corporate Income Tax Rates: International
at
online
available
2005,
November
Comparisons,"
http://www.cbo.gov/ftpdocs/69xx/doc6902/11-28-CorporateTax.pdf.
Currently, the 6 percent credit reduces the corporate marginal tax rates to 32.9
percent.
4 This tax provision is identical to the S199 tax provision in an earlier Senate
Finance bill, The Energy Advancement and Investment Act of 2007. See
Joint Committee on Taxation, "Estimated Revenue Effects of the Energy
Advancement and Investment Act of 2007," June 18, 2007, available online at
2
http://fmance.senate.gov/sitepages/leg/LEG%202007/Leg% 0110%20061907
%20chart.pdf.
5 See transcript of the Joint Hearing before the Committee on Commerce,
Science, and Transportation and the Committee on Energy and Natural
Resources, 109th Congress, November 9, 2005, available online at
http://frwebgate.access.gpo.gov/cgiIn that
bin/getdoc.cgi?dbname=l 09_senate hearings&docid=f:26108.pdf.
hearing, the chairman and CEO of Exxon-Mobil testified that if Congress took
back the billions of dollars in brand-new tax breaks, it would not affect
Exxon-Mobil.
6 In real terms, this reflects more than an 85 percent increase in less than 3
years.

155

Meeting the Challenge of Household Earnings Instability
The U.S. labor market is a constantly churning sea of job
creation and destruction. On average, 18 million new jobs appear
each year, while 15 million jobs are lost.' The vitality of the
labor market creates great opportunities for those who can
navigate it successfully, but it also creates great risk and
uncertainty for working families.
One result of a constantly changing labor market is that many
American families experience substantial year-to-year instability
in their earnings. While there is an ongoing debate whether that
volatility has increased significantly in recent years, there is no
question that it exists. About one in five workers experiences a
decline in earnings of at least 25 percent from one year to the
next, while one in nine workers sees a decline of 50 percent of
more.2
Some of the volatility in earnings reflects family decisions to
change jobs or to take time off from work to devote more time to
family responsibilities. It also reflects involuntary loss of
earnings as a consequence of illness or injury. Some of the
volatility, however, is the outcome of the shifting job market as
workers are displaced by slack demand, technological change, or
competition from foreign producers.
Elements of the social safety net can help cushion the impact of a
temporary decline in earnings because of a job loss, but there are
few government programs to help those who suffer a permanent
reduction in earnings. Unemployment Insurance (UI) is the main
bulwark against temporary job loss, but the UI program has
many gaps and is not designed to help with long-term job
displacement or reduced earnings once a worker is reemployed.
Programs explicitly designed to help displaced workers such as
Trade Adjustment Assistance (TAA) are limited in scope and
reach very few workers.
The federal income tax provides some assistance to families who
experience a decline in earnings through the Earned Income Tax

156

Credit (EITC), but that help is limited to those families whose
earnings are low enough to qualify for the credit. Moreover, the
EITC itself and other features of the tax system can exacerbate
the consequences of earnings fluctuations by imposing higher
taxes on families whose income fluctuates from year-to-year than
on families with the same average earnings but whose earnings
remain steady. This paper explores the extent of earnings and
employment instability faced by American families and possible
ways to improve the social safety net and the federal tax code to
help cushion the blow of job displacement and the complete or
partial loss of earnings that too-often occur in today's economy.
DIMENSIONS OF THE PROBLEM
According to recent testimony by Congressional Budget Office
(CBO) Director Peter Orszag, there is significant earnings
volatility among American workers. CBO found that among
those who were not in school, one in five workers ages 25 to 55
saw a one-year decrease in inflation-adjusted earnings of at least
25 percent, while one in nine saw a decrease of at least fifty
percent. Other workers saw substantial increases in earnings. One
in four workers saw a oneyear increase in inflation-adjusted
earnings of 25 percent while about one in seven saw an increase
of at least 50 percent. While these results were for changes from
2001 to 2002, years in which job growth was slow, CBO found
similar changes between 1997 and 1998 when employment was
growing more rapidly. 3
Workers without a high school degree tend to experience more
earnings instability than workers with more schooling but there is
little difference in earnings instability for workers in different
age groups. There is some evidence that income instability is
greater for lower-income families. 4
Job Displacement
A key reason for family income instability is job turnover. Over
the course of 2006, 4.9 million workers were hired each month
on average, while another 4.5 million lost or quit their jobs. 5
Total job separations (quits, layoffs, and other separations) were
about 3.4 percent of the total number of workers each month.

157

Some workers who quit or are displaced find new jobs right
away, but others may take weeks or months to find new
employment. The median duration of unemployment was about 8
weeks for those unemployed in January 2007 (half had been
unemployed for less than 8 weeks, half for more). The average
duration of unemployment, however, was over 16 weeks,
meaning that workers unemployed for more than 8 weeks tended
to have lengthy spells of unemployment. About 2.1 million
unemployed workers (30 percent of the unemployed) were
without a job for more than 14 weeks, while 1.1 million workers
(16 percent of unemployed workers) were unemployed for more
than 26 weeks. 6
Some displaced workers are unable to find work and drop out of
the labor force entirely. While the official number of unemployed
workers was 7 million in January 2007, another 4.6 million
workers wanted a job but had stopped looking for work and were
therefore no longer counted as part of the labor force.7
Earnings Loss
A sizeable fraction of displaced workers who lose a fulltime job
return to work at less than full-time. About 10 percent of
displaced full-time workers end up working part time, with the
percentage higher during slack labor market periods such as the
early 1980s and 1990s, 8 Even among those workers who are able
to find new full-time employment, many who lose- full-time jobs
often earn considerably less at their next job. Among reemployed
full-time workers, average earnings were 17 percent less than
what they could have expected to earn had they remained on
their previous job in 2001-2003, more than twice the average
earnings loss for displaced workers in the late 1990s. 9
HELPING FAMILIES MANAGE EARNINGS
INSTABILITY
Whether because of technological change, plant closings, or
foreign competition, job separation and earnings instability is a
fact of life for many American workers. The troubling news is
that more and more workers could be subject to this job churning

158

as global competition increases. While it may prove impossible
to turn back this tide of international competition, it is possible to
improve support for displaced workers both as they search for
new employment and after they become reemployed.
Some amount of job turnover is an inevitable part of a dynamic
and flexible labor market that adjusts quickly to new economic
opportunities and in turn contributes to strong economic growth
and a rising standard of living. However, excessive job turnover
and income instability can create worker anxieties and
insecurities that impede those adjustments and ultimately slow
economic growth. Reducing the harshest impacts of job
dislocation and income instability is one critical step to reducing
growth-inhibiting worker insecurity. In addition, policies that
mitigate income losses and make it attractive for workers to
pursue new training and job opportunities can facilitate
adjustments to change and reduce the economic losses associated
with job dislocations.
Unemployment Insurance
Unemployment Insurance (UI) is currently the main program to
provide support to displaced workers. UI is designed to provide
temporary assistance to workers who lose their jobs while they
look for new employment. UI is a joint federal-state program.
While the federal government administers the program and sets
general guidelines, the states determine key features such as
which workers are eligible for UI payments, and the amount and
duration of benefits.
About 7.3 million workers received UI benefits at some time
during 2006.10 While many workers benefit from the program,
there are issues regarding coverage, benefit amounts, and the
duration of payments that undermine the effectiveness of the UI
program as a cushion against family income shocks.
Coverage
UI is intended to cover workers who involuntarily lose their jobs.
Workers entering or reentering the labor force or those who
voluntarily leave their jobs without good cause are not eligible.

159

The definition of good cause for voluntary separation varies from
state to state, but may include reasons such as sexual harassment
(in all states but six), anticipation of a plant closing, and, in a few
states, certain personal reasons such as increased family caregiving responsibilities. '"
Though nearly one in five workers is employed part time (35 or
fewer hours of work per week), part-time workers are not
covered in most states. Workers with low-wages or intermittent
work histories also may not qualify. States require that workers
meet minimum eligibility requirements with respect to earnings
and hours of work in a base period. Most states continue to use a
base period that includes the first four of the most recent five
completed calendar quarters. This can deny benefits to workers
who would meet the work history requirement if the base period
included the most recently completed quarter. Finally, workers
must be able to work and actively looking for full-time work
while they are unemployed.
Many workers do not qualify for benefits as a consequence of
those restrictions. In recent years only about 40 'percent of
unemployed workers receive UI payments, although about 80
percent of the unemployed who lost their last job did qualify for
benefits.' 2

There are various proposals to improve UI coverage. These
include standardizing the base period for determining eligibility
to the past four quarters prior to a job loss, which would
particularly help those with intermittent work histories; using
hours of work rather than earnings to determine eligibility;
allowing those who had been working part time before
unemployment to remain eligible for benefits when looking for
part-time work; broadening the definition of voluntary separation
for good cause; and enabling reentrants who were eligible for UI
at the time of job separation to receive benefits when they return
to the labor force.13

160

Benefit Levels
Benefits in most states are set at half of a Ul recipient's average
weekly earnings up to a maximum amount. In January 2007, the
maximum weekly amount ranged from a low of $210 in
Mississippi to a high of $575 in Massachusetts.14 Because of the
cap, few state programs replace, on average, half of lost wages.
While the percentage varies among states, on average UI benefits
replace only about 36 percent of previous weekly earnings."
Duration of Benefits
Most states limit the duration of benefits to 26 weeks, although
extended benefits are automatically triggered when the state
insured unemployment rate exceeds certain levels. Congress
enacted the Temporary Extended Unemployment Compensation
Act in 2002, which provided up to 13 weeks of benefits to
workers who exhausted their regular Ul benefits; but that
program was not renewed when it expired in December 2003.
Because benefits are only available for a fixed duration, many UT
recipients exhaust their benefits- on average about one-third.
The percent of recipients who exhausted benefits reached 44
percent in 2003. 16
Trade Adjustment Assistance
Trade Adjustment Assistance (TAA) provides extended
unemployment insurance benefits and job training to workers
dislocated by trade. Under TAA, displaced workers can receive a
trade readjustment allowance benefit once they exhaust regular
or extended UI benefits, extending the total duration of benefits
to 52 weeks. Workers in an approved training program can
receive benefits for an additional 52 weeks after the basic TAA
benefit expires.
Eligibility requirements to participate in TAA are strict. TAA is
limited to workers who lose their jobs because of import
competition. It is further limited to only manufacturing workers,
excluding the large number of workers in technology and other
services who are displaced by offshoring of jobs. In addition,
workers who are laid off because their employers shifted
production overseas may not qualify for TAA if the destination

161

country has not entered into a free trade agreement with the
United States.' 7
Because of restrictions on eligibility and lack of adequate
funding TAA has helped only a limited number of workers.
There were fewer than 55,000 new recipients of TAA trade
readjustment benefits in 2006.18
Wage Insurance
Wage insurance would supplement the earnings of displaced
workers who are forced to take new jobs at lower wages. Wage
insurance would pay a worker who has been displaced and then
hired at a new lower-paying job some portion of the difference
between wages on the old and new job. Typically, payments
would continue for a limited period of time and would be subject
to an annual cap. Some proposals also include an earnings ceiling
for eligibility based either on earnings at the old or new job. For
example, a wage insurance proposal suggested by a number of
analysts would pay 50 percent of lost earnings, cap total
payments at $10,000 per year, and limit payments to two years.' 9
Wage insurance offers a number of potential benefits. First it can
soften the blow of lost earnings for displaced workers. Wage
insurance would take over where unemployment insurance ends
once a displaced worker begins a new job. Second, the wage
insurance supplement would enable some workers to take jobs
that they might have otherwise forgone. Getting reemployed
sooner can reduce the earnings loss a family faces after job
displacement. Finally and perhaps most importantly, wage
insurance would subsidize the hiring and training of workers who
transition into new jobs or sectors. On-the-job training is often
the most effective way workers can learn new skills, which in
turn can lead to long-term wage gains.
Concerns about Wage Insurance
While wage insurance has advantages in encouraging workers to
move more quickly to a new job, some have expressed concerns
that such a program could hurt workers. First, critics of wage
insurance argue that knowing that workers could get wage

162

insurance could lead some employers to offer lower wages than
they otherwise would have. Second, they argue that workers
might take a poor quality job at a lower wage during the
eligibility period even if waiting a little longer would lead to a
better job at a higher wage. They are also concerned that workers
may fail to take advantage of available job training opportunities
in order to claim the subsidy as soon as possible. Third,
opponents believe that, in an environment where there are limited
resources available to benefit unemployed workers, some
traditional protections could be undermined if wage insurance
were seen as a replacement for unemployment insurance or job
training programs. With appropriate administrative rules,
however, potential adverse effects of a wage insurance program
can be minimized. In conjunction with well-funded UI and job
training programs, wage insurance offers potential additional
protections for workers against the income instability caused by
job loss.
Lessons from existing wage insurance programs or
demonstrations
There are a few demonstration projects of wage insurance (and
similar) programs from which to draw some lessons. During the
late 1990s, Canada instituted a wage insurance demonstration
project to test the effectiveness of a wage supplement for
reemployed displaced workers. Workers were randomly assigned
to either the supplement group, in which they received an
earnings supplement in addition to standard UI benefits and
services, or to the control group in which they only received
standard UI benefits and services. The supplement was payable
to those who were reemployed full time within a 26-week period,
covered 75 percent of the earning difference for up to 2 years,
and was capped at $250 a week. 20
The demonstration project showed a moderate increase in
employment among those in the supplement group but no impact
on unemployment benefits taken. Reemployment rates were
higher in the two months just before eligibility was to end. The
authors who evaluated the project concluded that the wage

163

insurance offered had little impact on worker's search behavior
but did broaden the scope of the jobs they considered.
In 2002, when Trade Adjustment Assistance was reauthorized, a
small, temporary wage insurance program was added for older
workers. Alternative Trade Adjustment Assistance (ATAA) is
available to displaced workers 50 years or older, whose job
losses are certified as having been caused by trade, and who are
reemployed full-time within 26 weeks at a job with a lower
wage. The benefit is 50 percent of the difference in earnings up
to a total of $10,000 for two years, provided the new job pays
less than $50,000 per year. In general, relatively few displaced
workers have been declared eligible for TAA, and take-up rates
for the older worker supplement have been even lower due to a
variety of factors including poor dissemination of information
about the program to eligible workers and the possibility that
because the workers were over 50, very few employers were
willing to hire them.2 2
In the mid to late 1980s three states experimented with programs
in which unemployed workers were given one-time cash bonuses
if they became reemployed within a certain period. While
researchers found modest increases in employment rates among
those eligible for the bonus, these experiments took place in tight
labor markets.
CHANGING THE TAX SYSTEM
Families whose income fluctuates from year to year can pay
more federal income tax than families with the same average
income but whose income is steady. This is a result of the
progressive structure of the federal income tax in which higher
income is taxed at a higher marginal tax rate. For example,
suppose a couple had taxable income of $60,000 in both 2006
and 2007, putting them near the top of the 15 percent tax bracket.
(Taxable income excludes exemptions and deductions so the
couple's total income would be much higher). The couple would
pay combined total federal income taxes of $16,463 for the two
years. By comparison, another couple with income of $40,000 in
2006 and $80,000 in 2007 would pay combined taxes of $18,093

164

- over $1,600 more. This would occur because most of the
second couple's income in excess of $60,000 in 2007 would be
taxed in the 25 percent bracket.
The effect of fluctuating income on federal taxes is modest for
most families. The average tax change for an increase or
decrease in income of 25 percent is only about 0.4 percent of
after-tax income. 23 However, the effects are more pronounced for
families with modest income who qualify for the earned income
tax credit (EITC). Because of the high implicit tax rates in the
way the credit phases in and phases out as income rises, families
who qualify for the EITC are more likely to move between tax
brackets if their income fluctuates from year to year.
Lower-income families can suffer another tax penalty from
fluctuating incomes. All families can claim personal exemptions
and a standard deduction (or itemized deductions if higher) when
calculating the amount of tax they owe. As result, in 2007 a
married couple with two children would not pay any tax on the
first $24,300 of income. If a family's income drops below that
exempt amount, any unused exemption is lost. Thus a lowerincome family whose income fluctuates from year-to-year could
pay more income tax than a family with the same average
income who is able to use the entire exemption each year. There
is no provision in the tax code for families to carry back or carry
forward unused exemptions to years when its income is higher.
Businesses, on the other hand, can carry back unused net
operating expenses for up to two years or carry them forward for
up to 20 years.
Income Averaging and Carry Back of Unused Deductions
and Credits
A possible solution to the effect of fluctuating incomes on the
taxes paid is to allow some type of income averaging. Income
averaging was part of the federal tax system from 1964 through
1986 when it was eliminated. There were a number of reasons for
eliminating income averaging including the overwhelming
complexity of the way in which income averaging was
implemented, and the thought that it was no longer needed

165

because the 1986 tax reform eliminated many tax brackets and
thus reduced the chances that fluctuating income would move
families into different tax brackets.
For example, one proposal recommends targeted income
averaging limited to the EITC. Families would be able to average
income over two years when calculating the EITC, and would
also be able to carry back unused exemptions for one year.24
In addition, income averaging also could benefit independent
contractors, free-lancers, and others, including writers and artists,
who are paid on a per-project basis, and whose earnings therefore
often fluctuate from year to year.
CONCLUSION
Economic instability is a fact of life for many American families.
With increasing globalization, rapidly changing technology, and
shifting demand for goods and services, more workers may
experience job displacement that can be temporary or more longlasting. While the economy benefits from a dynamic and flexible
labor market, excessive job turnover can increase family
economic insecurity and ultimately impede economic growth.
Strengthening the social safety net to reduce the economic
pressures from job churning and earnings instability is critical,
but should be done in a way that not only provides the needed
support but also allows workers to embrace new training and job
opportunities. Wage insurance can be a welcome new thread in
the safety net, but it is just as important that we strengthen
existing programs such as unemployment insurance and trade
adjustment assistance.
Ultimately, the American economy will thrive in the changing
global environment as long as businesses provide jobs that offer
workers real opportunities, and workers obtain the skills and
training needed to fill those jobs.

166
ENDNOTES
"Trade and Jobs," Remarks by Governor Ben S. Bemanke at the
Distinguished speaker Series, Fuqua School of Business, Duke University.
Federal Reserve Board, (March 30, 2004).
2"Economic Volatility," Statement by Congressional Budget Office Director
Peter R. Orszag before the Committee on Ways and Means, U.S. House of
Representatives. Congressional Budget Office, (January 31, 2007).
3 Ibid.
4 Lily L. Batchelder, "Taxing the Poor: Income Averaging Reconsidered,"

HarvardJournalon Legislation, 40(3 95), (2003).
U.S. Department of Labor, Bureau of Labor Statistics, "Job Openings and
Labor Turnover: December 2006," USDAL 07-0197, (February 6, 2007).
http://www.bls.gov/jlt/.
6 U.S. Department of Labor, Bureau of Labor Statistics, "The Employment
Situation: January 2007," USDL 07-0159, (February 2, 2007).
http://www.bls.gov/ces/.
5

Ibid.

8Henry

S. Farber, "What do We Know About Job Loss in the United States?
Evidence from the Displace Workers Survey, 1984- 2004," Economic
Perspectives, Federal Reserve Bank of Chicago, vol. 29, no. 2 (2005).
9

Ibid.

'0 U.S. Department of Labor, Employment and Training Administration,
available at http://atlas.doleta.gov/unemploy/ claimssum.asp.
'1 U.S. Department of Labor, Significant Provisionsof State Unemployment
InsuranceLaws, Employment and Training Administration, Office of
Workforce Security, (July 2006).
12 Congressional Budget Office, "Family Income of Unemployment Insurance
Recipients," (March 2004).
13 Lori G. Kletzer and Howard F. Rosen, "Reforming Unemployment
Insurance for the Twenty-First Century Workforce," Discussion paper 200606, The Hamilton Project, The Brookings Institution, (September 2006).
14 U.S. Department of Labor, Significant Provisionsof State Unemployment
InsuranceLaws, Employment and Training Administration, Office of
Workforce Security, (January 2007): and Julie M. Whittaker, "Unemployment
Insurance: Available Unemployment Benefits and Legislative Activity," CRS
Report for Congress, RL33362, the Congressional Research Service, (Updated
January 25, 2007).
15 Kletzer and Rosen, op. cit.
16 Congressional Budget Office, op. cit.
17 Workers whose employers have shifted production outside the United States
are only eligible if the new production facilities are located in a country that is
party to a free trade agreement with the United States, or a country that is
named as a beneficiary under the Andean Trade Preference Act, the African
Growth and Opportunity Act or the Caribbean Basin Economic Recovery Act.
18 U.S. Department of labor, Employment and Training Administration,
available at http://www.doleta.gov/Performance/results/
Quarterly report/PerfonnanceHighlightsO6.pdf.

167
19 Lael Brainard, Robert E. Litan, and Nicholas Warren, "Insuring America's
Workers in a New Era of Offshoring," Policy Brief # 143, The Brookings
Institution, (July 2005), and Lori G. Kletzer and Robert E. Litan, "A
Prescription to Relieve Worker Anxiety," Institute for International
Economics, Policy Brief PB01-2 (2001).
20 Lori G. Kletzer, "Trade-Related Job Loss and Wage Insurance: a Synthetic
Review," Review of InternationalEconomics, 12(5), 724- 748, (2004).
2t Howard Bloom, Saul Schwartz, Susanna Lui-Gurr, and Suk-Won Lee,
"Testing a Re-employment Incentive for Displaced Workers," (SRDC, 1999).
p. 48.
22 U.S. Government Accountability Office, "Trade Adjustment Assistance:
Most workers in Five Layoffs Received Services, but Better Outreach Needed
on New Benefits," GAO-06-43. (January 2006).
23 Peter R. Orszag, "Taxes and Income Volatility," Tax Notes, (November 24,
2003). p. 1039.
24 Batchelder, op. cit.

168

LINKS TO MAJORITY STAFF REPORTS
January 2007: Billions in Offshore Royalty Relief for Oil and Gas
Companies Buys little for Tax Payers
The federal government's ill-conceived royalty relief pro-gram for offshore oil
and gas drilling could cost taxpayers up to $80 billion - with precious little to
show for it. As an economic policy, royalty relief appears to have no net effect
on jobs at the national level or any effect on energy prices paid by consumers.
February 2007: JEC Fact Sheets on Middle Class Opportunity Tax Credits
"Investing in a College Education"
"Investing in Families Taking Care of Elderlv Parents"
"Investing in Raising Children"
The systematic squeeze on the Middle Class is making it difficult for working
families to raise their children, provide them with a college education, and
take care of their aging parents. The rising costs of childcare, healthcare, and
education and erosion of retirement savings from traditional pensions coupled with stagnating wages - have made raising a child and caring for an
aging parent a financial high wire act for many American families. Targeted
tax relief to middle-class families will help them to mange the crunch of
balancing work and family, achieve their aspirations, and contribute to
America's economic growth.
March 2007: Meeting the Challenge of Household Earnings Instability
Many middle class families are experiencing ups and downs in their year toyear earnings and income, and their economic instability may be greater than
in the past due to the consequences of globalization and technology. Elements
of the social safety net can help cushion the impact of a temporary decline in
earnings because of a job loss, but there are few government programs to help
those who suffer a permanent reduction in earnings.
April 11. 2007: Sheltering Neighborhoods from the Subprime Foreclosure
Storm
Increases in payment delinquencies and foreclosures in the subprime mortgage
market have raised widespread concerns about the possibility of increasing,
concentrated foreclosures throughout the country. While lenders and banks try
to insure themselves from the consequences of increased mortgage defaults,
communities are also struggling to stem the tide of foreclosures. This
comprehensive report argues that foreclosure prevention is cost-effective and
presents policy suggestions for curbing future subprime foreclosures.
April 16. 2007: Tax Day Reports
Families Missing Out on Billions of Unclaimed Tax Credits
Free E-Filing Makes Sense for Both Taxpayers and the IRS
Benefits such as the dependent care tax credit, the earned income tax credit
(EITC), education tax credits, and the saver's credit are among the federal
government's most effective tools to help American families afford to raise

169
their children, pay for higher education, and save for retirement. Yet each year
millions of these taxpayers do not claim the credits for which they are eligible,
leaving billions of tax credit dollars on the table.
May 13, 2007: Mother's Day Report: Helping Military Moms Balance Work
and Longer Deployments
Like all mothers, military moms face challenges in meeting monthly expenses,
getting good child care and health care for their families and themselves. But
military moms face the added burden of longer deployments and frequent
separation from their children and spouses. While the military has taken steps
to address the needs of mothers, the report finds that more still needs to be
done.
May 24, 2007: Memorial Day Report: Money in the Bank. Not the Tank:
Report on the Economics of CAFE standards
Compiled as Memorial Day weekend approached and the average gas prices
hit record highs of $3.22 a gallon, this report revealed that the average
American family will spend approximately $3,180 on gas this year alone. The
report entitled "Money in the Bank, Not in the Tank," shows that the average
American family could save about 22 percent of their current expenditures on
fuel by increasing their average fuel efficiency to 35 miles per gallon.
May 17, 2007: Most Baby Boomers are Saving Enough. But Many are at Risk
of Significant Shortfalls
As the first wave of baby boomers reaches the traditional retirement age next
year, the question of whether workers are preparing adequately for retirement
has become more important than ever. Despite numerous media reports on
boomers' dire retirement prospects, by various measures the average baby
boomer household is on track to retire comfortably. Nevertheless, a significant
minority of boomers-particularly those at the bottom of the income and
wealth distributions-is at risk of a substantial decline in living standards
during retirement.
May 22, 2007: Assistance Available Through the Tax Code for Families with
Children
As the costs of raising a child continue to increase, working families need
assistance to make ends meet and manage the difficulties of balancing work
and family. Several provisions in the federal tax code are available to help
families with children: the Child Tax Credit, the Child and Dependent Care
Tax Credit, the Earned Income Tax Credit, and Dependent Care Assistance
Programs.
May 22, 2007: Economic Benefits of Investing in High-Oualitv Preschool
Education
Future fiscal challenges, global economic competition, and shifting
demographic trends all highlight the need for policies to improve the skills
and productivity of American workers and thereby increase future living

170
standards. A promising strategy for achieving these aims is expanding
government investment in high-quality preschool education.
June 14, 2007: Energv Efficiency is a Bright Idea
Families that take advantage of energy efficient practices, appliances and
vehicles could save an estimated $1,600 each year in energy costs, while
reducing greenhouse gas emissions, pollution, and our nation's dependence on
foreign sources of energy. As the energy bill is debated on the Senate floor,
Schumer, who chairs the JEC, initiated the report to shed light on the benefits
of increasing energy and fuel efficiency to American families and the
environment.
June 22, 2007: Report Update: Sheltering Neighborhoods from the Subprime
Foreclosure Storm
In an update to the Joint Economic Committee's March report, "Sheltering
Neighborhoods from the Subprime Foreclosure Storm," the report finds that
foreclosures continue to rise across the nation as more and more subprime
borrowers' loans reset to higher rates in a weak housing environment.
July 18, 2007: CHIP Makes Economic Sense
As the Senate prepares to reauthorize the Children's Health Insurance
Program (CHIP), a fact sheet highlights the benefits of reauthorizing and
expanding CHIP. According to the fact sheet, CHIP has dramatically reduced
the number of uninsured children since its creation in 1997. Over one million
children currently covered by the program stand to lose coverage under the
President's reauthorization proposal, as states would face a total federal
funding shortfall of as much as $7.6 billion
August 29, 2007: Annual Income, Poverty and Health Insurance Reports
The Number of Americans without Health Insurance Rose Again in 2006
Household Income up Slightly in 2006 but Down Since 2000
Nearly One in Eight Americans Living in Poverty
The U.S. Census Bureau released its 2006 report on income, poverty and
health insurance coverage in the United States. Although median household
income rose slightly in 2006, after adjusting for inflation, the report showed
that all but the richest of American households have seen their incomes
decline since 2000. The reports compile highlights of the Census Bureau's
report and analysis of economic conditions under the Bush administration in
three fact sheets focusing on poverty, income, and health insurance.
September 12, 2007: Fiscal Responsibility: Which Party has a Better Record?
The great majority of our national debt has been incurred by the past three
Republican administrations. Over the past thirty years, those administrations
have borrowed an average of $233 billion each year from the public. In
contrast, under Democratic administrations the Federal government has
borrowed an average of $26 billion each year, just one-ninth as much. The
JEC analysis highlights a proven track record of fiscal responsibility under

171
Democratic administrations, and conversely a sharp increase in debt under
Republican administrations.
October 25. 2007: The Subprime Lending Crisis: The Economic Impact on
Wealth, Property Values, and How We Got Here
The report is the first of its kind to project economic costs on a state-by-state
basis from the third quarter of 2007 through 2009. The report reveals that
families, neighborhood property values, and state and local governments will
lose billions of dollars as two million subprime mortgage homes are
foreclosed. The subprime fallout report argues in favor of foreclosure
prevention, which can save the economy billions in housing wealth and ease
falling housing prices.
November 13. 2007: War at Any Cost?: The Total Economic Costs of the
War. Beyond the Federal Budget
The long wars in Iraq and Afghanistan have cost the U.S. in many ways: in
lost lives, in international standing, and in economic growth. The full
economic costs of the war to the American taxpayers and the overall U.S.
economy go well beyond even the immense federal budget costs already
reported. These "hidden costs" of the Iraq war include the ongoing drain on
U.S. economic growth created by Iraq-related borrowing, the disruptive
effects of the conflict on world oil markets, the future care of our injured
veterans, repair costs for the military, and other undisclosed costs. The report
finds the total economic costs of the wars in Iraq and Afghanistan so far have
been approximately double the total amounts directly requested by the
Administration to fight these wars.
December 3. 2007: Analvsis of the Energy Bill Tax Provision 199
At the request of Senators Jeff Bingaman, Chairman of the Senate Energy and
Natural Resources Committee, and Max Baucus, Chairman of the Senate
Finance Committee, the report examines the impact of denying the Internal
Revenue Code (IRC) Section 199 manufacturing deduction to major
integrated oil and gas producers (while simultaneously freezing the deduction
for other oil and gas producers) on consumer prices of oil and natural gas. The
report finds that the proposed modification of this deduction would have a
negligible effect, if any, on consumer energy prices. This tax provision will
likely be included in a larger Senate energy bill as a way to finance renewable
and energy conservation efforts.

173
MINORITY VIEWS OF REPRESENTATIVE JIM SAXTON
AND SENATOR SAM BROWNBACK
OVERVIEW OF CURRENT AND RECENT MACROECONOMIC
CONDITIONS

The economic expansion continues, despite the ongoing correction in
housing markets and the financial market turbulence experienced in the
latter part of this year. Unemployment, inflation, and long-term
interest rates remain low by historical standards. Employment growth
and healthy growth in the inflation-adjusted (real) gross domestic
product (GDP) continued throughout the past year. The economy
began 2007 with a low annualized growth rate of 0.6%. Growth has
been remarkably robust over the past two quarters ending in the third
quarter of 2007, averaging a rapid, above-trend, 4.4% annualized pace.
Most analysts expect slower, below-trend, growth through the end of
next year, partly a reflection of significant adjustments in the housing
sector and financial markets. But growth is expected to remain
positive and to revert back toward more trend-like rates by the end of
next year.
Even after accounting for effects of the correction in the housing
market and financial turbulence stemming from losses associated with
subprime mortgage lending, many economic indicators show that
economic conditions of the past few years display striking contrasts to
conditions prevailing prior to enactment of pro-growth tax relief under
the Jobs and Growth Tax Relief Reconciliation Act enacted in May of
2003. Highlights of the contrasts include:
* GDP growth averaging a very healthy 3.2% following the
enactment of tax relief, in contrast to the tepid average of 1.3%
from the first quarter of 2001 through the second quarter of
2003.
* Growth in real business (non-residential) fixed investment
averaging 6.3% following the enactment of tax relief, in
contrast to an average 5.6% rate of decline from the first quarter
of 2001 through the second quarter of 2003.
* A decline in the unemployment rate from a recent peak of 6.3%
in June of 2003 to 4.7% in November of 2007.
* Healthy average monthly gains in payroll employment of
155,000 jobs per month from June of 2003 through November
of 2007, in contrast to an average monthly loss of 92,000 from
January of 2001 through May of 2003.

174
* Strong gains in equity markets following the enactment of tax
relief, in contrast to losses prior to relief: the Dow Jones
Industrial Average has risen by 54% between the end of May of
2003 and December 7 of 2007, in contrast to a 17% decline
between the beginning of 2001 and the end of May of 2003; the
NASDAQ has risen by over 70% between the end of May of
2003 and December 7 of 2007, in contrast to a 31% decline
between the beginning of 2001 and the end of May of 2003.
* The Institute for Supply Management (ISM) indexes of
manufacturing and non-manufacturing (service sector)
activities, which signal expansion when above 50 and
contraction when below 50, displayed robust expansions
following tax relief, in contrast to displays of contraction or
tepid growth prior to tax relief; the ISM manufacturing index
has averaged a healthy 56 since June of 2003, in contrast to a
contraction-signaling average of 48 from the beginning of 2001
through May of 2003; the ISM index of non-manufacturing
activity has averaged a robust 60 since June of 2003, in contrast
to a much more moderate expansion-signaling average of 52
from the beginning of 2001 through May of 2003.
While correlations do not imply causality, there has been a clear and
striking turnaround in a wide array of economic indicators from signals
of contraction or tepid growth prior to enactment of the pro-growth tax
relief in 2003. to signals of strong expansion and robust growth
following tax relief.
Despite the recent correction in the nation's housing and mortgage
markets and turbulence in financial markets, we are encouraged by the
direction the economy is heading in terns of growth and opportunity.
This does not mean that the economy will be without significant
challenges in the months and years ahead, but it does mean that
economic policy decisions that have lowered taxes on American
households and allowed American families to keep more of their hardearned incomes have paid dividends for the nation's citizens.
Economic Growth Accelerated Recently
Following the low 0.6% annualized growth in real GDP in the first
quarter of 2007, growth accelerated to an above-trend rate of 3.8% in
the second quarter and an even more rapid rate of over 4.9% in the
third quarter. Slowing of the housing market has led to seven
consecutive quarters, through the third quarter of 2007, in which
declines in residential investment have shaved an average of 0.8
percentage point from overall GDP growth. Despite that drag from

175
housing, GDP has continued to grow. Adding substantially to overall
GDP growth in recent years, exports have grown at a rapid annualized
rate of close to 9.0% over the past four years, through the third quarter
of 2007. On average, over the past seven quarters in which residential
investment has shaved an average of 0.8 percentage point from GDP
growth, exports have added a full 1.0 percent to GDP growth, more
than offsetting the drag from housing.
Prior to the recent housing market correction, as new and existing
home sales repeatedly set record levels and double digit rates of home
price appreciation were recorded, rapid increases in housing valuations
likely helped support consumer spending. As households perceived
large wealth gains in housing, they were, perhaps more easily than in
the past due to financial innovations, able to tap into home equity to
help support consumption spending. A risk of significant slowing of
consumer spending exists if the wealth effect works in the other
direction because of substantial home value declines.
Thus far, however, consumer spending, which accounts for roughly
70% of GDP, has remained healthy throughout the expansion.
Annualized growth in consumer expenditures has averaged 3.0%
during the current expansion and 2.9% over the past year ending with
the third quarter of 2007.
Consumer Spending has Remained Resilient
Annualized growth in consumer spending has remained resilient,
averaging 2.9% since the beginning of 2001, despite a sequence of
adverse shocks to the economy including the tragedy of September 11,
2001, the aftermath of corporate accounting scandals, two wars,
devastating hurricanes, a prolonged period of significant increases in
energy costs, fallout from losses and risks associated with subprime
mortgage lending, and the correction in the housing market. Support
for consumer spending has come from, among other factors, expanding
employment and growth in disposable (after-tax) income.
*

Payroll employment has increased by over 8.3 million new
jobs since June of 2003, following enactment of tax relief, in
contrast to job losses of 2.7 million between the beginning of
2001 and May of 2003 when the job market was recovering
from the recession of 2001 and the downturn in GDP that
began in the third quarter of 2000.

Real (i.e., inflation-adjusted) disposable income has risen by
over 15.2% since the third quarter of 2003, following
enactment of tax relief, in contrast to the more modest increase

176
of 5.5% between the beginning of 2001 through the second
quarter of 2003.
Growth in consumer spending averaged a 2.5% annualized rate
between the beginning of 2001 and the enactment of pro-growth tax
relief in 2003; it has averaged a healthy 3.2% following the enactment.
of tax relief which helped Americans keep more of their hard-earned
incomes for use in private consumption, investment, and saving.
Inflation Remains Moderate Despite Run-Ups in Energy Costs
Energy prices remain elevated and oil prices have flirted with the
psychological nominal (i.e., dollar-value unadjusted through time for
effects of overall inflation on the general purchasing power of a dollar)
threshold of $100 a barrel. The acceleration of crude oil prices from
below $20 a barrel at the beginning of 2002 to nearly $100 a barrel in
recent months reflects tight supply and continued growth and strength
in global demand. Rises in crude oil prices eventually are reflected in
gasoline and heating oil prices and, of course, in the overall rate of
inflation of consumer prices.
Consumer price inflation, measured by the year-over-year percent
change in the overall consumer price index (CPI), has remained low by
historical standards throughout most of the ongoing economic
expansion. Accelerating energy prices caused acceleration of overall
CPI inflation, pushing inflation above 4.0% during some months of
2005 and 2006 and in November of this year. Easing of energy prices
in the second half of 2006 and early in 2007 helped pull overall CPI
inflation from a recent peak of 4.3% in June of 2006 to 1.3% in
October of 2006. Re-escalation of energy prices since that time,
especially in recent months, has contributed to an acceleration of the
rate of overall CPI inflation.
Over the past year through November 2007, inflation in the overall CPI
averaged around 2.7% on a year-over-year basis-moderate by
historical standards. Inflation in the "core" CPI, which excludes
volatile energy and food prices and is used partly to gauge the extent to
which energy price increases are feeding into more general inflation in
prices of other goods and services, has also been moderate. Core CPI
inflation has averaged 2.3% on a year-over-year basis over the past
year through November of 2007. Inflation in the core personal
consumption expenditures (PCE) price index, one of the Federal
Reserve's preferred measures of consumer prices, has fallen from rates
that neared 2.5% at the beginning of 2007 to rates around 1.9% during
the past two months through October, below what many regard to be

177

the ceiling on the Federal Reserve's comfort zone for core PCE
inflation of around 2.0%.
Many analysts view November's core CPI inflation of around 2.3% to
be just above the upper region of the Federal Reserve (Fed) monetary
policymakers' comfort zone for consumer price growth. Core CPI
inflation and core PCE inflation began in 2007 at year-over-year rates
of 2.7% and 2.4%, respectively. Those rates have since moderated:
core CPI inflation was 2.3% on a year-over-year basis in November of
this year and core PCE inflation was 1.9% in October.
The Fed acknowledges moderation in core inflation rates but remains
alert to upside risks for future acceleration of inflation, especially in
light of recent run-ups of energy prices.

Consumer Price Inflation
(Year-over-year percent change in consumer price index [CPI])
5%
4%
3%
2%
1%
l

zone

2001
2002
2003
Source: Haver Analytics

2004
I

2005

2006

2007

178
Crude Oil Price
(West Texas intermediate spot price, dollars per barrel)

$100
$80
$60
$40

$20

2003
2001
2002
Source: Hawer Analytics

2004

2005

2006

2007

Long-Term Interest Rates Remain Low
While the Fed has raised, on balance, its target for overnight interest
rates from 1.00% at the end of June 2004 to the current 4.25%, most
long-term interest rates have edged down, on balance. The nominal
yield on a 10-year constant maturity Treasury note, for example,
averaged 4.73% in June of 2004 and averaged 4.15% in November of
2007. The persistence of relatively low long-term interest rates is an
ongoing area of economic research to establish the important
contributing factors.

Long-Term Rates Remain Low
(Percent interest rates)
10%
Fed's Target Overnight Interest Rate

8%
6%
4%
2%

~19
l~
1995
1990
Source: HaverAnalytics

200

2005

2000

2005

179
To some extent, the low long-term rates could reflect reductions in
term and inflation-risk premiums demanded by investors, perhaps a
partial reflection of gains in Federal Reserve credibility for keeping
inflation low and less volatile than in the past. To some extent, the low
long-term rates could reflect what Federal Reserve Chairman Ben
Bernanke has called a global "savings glut," with investors in some
economies, such as in Asia and oil-exporting countries, having an
excess of savings relative to investment. Those investors then,
perhaps, decide that the best opportunities for the excess savings lie in
the strong, liquid, and relatively low-risk financial markets of the
United States. The relatively strong demand for U.S. assets exerts
upward pressure on the prices of those assets and, correspondingly,
downward pressure on their rates of return.
Whatever the reason for the relatively low long-term interest rates, they
have been carefully analyzed by economic analysts because longerterm interest rates have been below short-term interest rates in some
recent times, a phenomenon known as an "inverted yield curve."
Analysts are alert in the presence of an inverted yield curve because, in
the past, such a condition has presaged recession. To the extent that
Fed Chairman Bernanke's "global savings glut" hypothesis holds true,
recent conditions do not carry the signal of a possible recession ahead
as like conditions have in the past. Some support for Bernanke's
position comes from observing that recent inversions of the yield curve
have not been unique to financial markets in the United States. Similar
conditions have held in a number of industrialized economies.
Inflation in consumer prices remains moderate, despite the relatively
high level of energy prices. It is important to keep in mind that if
energy prices remain elevated but do not grow further, there would not
be persistent effects on overall consumer price inflation. Rather,
further and persistent effects on consumer price inflation from energy
would require further and persistent growth in energy prices.
Many analysts have noted that oil shocks, in the form of rapid
increases in the price of energy-primarily oil-in 1973, 1979, and
1990, were each followed by a recession. But we have seen the price
of oil rise from around $20 a barrel in 2002 to nearly $100 a barrel
recently, and there has not been a significant downturn in economic
activity. The question of why the U.S. economy may be less
vulnerable to oil price shocks today than in the past has been the focus
of numerous recent studies. One factor that most studies agree on is
that oil represents a smaller share in the U.S. economy's production of
goods and services.

180
Energy Prices Have Been Volatile and Elevated
A notable feature of recent economic developments is the increase, on
balance, in energy prices since the beginning of 2007 following
reductions seen in the second half or 2006. Energy prices rose
significantly from the beginning of 2002 through the summer of 2006;
the spot price of a barrel of West Texas Intermediate crude oil, for
example, rose by 278% from the beginning of 2002, when the price
was around $20 a barrel, to over $74 a barrel by July of 2006.
Between August of 2006 and the beginning of 2007, the spot price of
West Texas intermediate crude had retreated to below $55 a barrel.
Since the beginning of this year, however, energy prices have reescalated as continued robust global demands for energy have met tight
supplies; the spot price of a barrel of West Texas Intermediate crude
oil, for example, has accelerated from just below $55 a barrel on
average in January of this year to an average of close to $95 a barrel in
November of this year-a 73% rise. Rising energy costs add to the
Federal Reserve's concerns about acceleration in inflation in general
consumer prices.
The Fed Eased Recently in Light of Financial Market Turbulence
Beginning in October of 2006, the Federal Reserve ended its tightening
policy that consisted of increases in its target for overnight interest
rates (i.e., its target "Federal Funds rate," a rate that commercial banks
charge on overnight lending). The Fed had raised its overnight interest
rate target from a 45-year low of 1.00% in 17 quarter-point increments
beginning in late June of 2004 and ending in early June of 2006. The
Fed kept its target for overnight interest rates at 5.25% through the
summer of this year. However, as discussed in greater length below,
following events in financial markets associated with. risks and
uncertainties stemming from subprime mortgage markets and
mortgage-backed securities, the Fed has since been easing policy by
cutting rates and injecting funds into the banking system.
In the last three scheduled meetings of the Federal Open Market
Committee, the Federal Reserve's monetary policymaking committee,
the Fed decided to cut its overnight interest rate target by 100 basis
points in total (one basis point equals one hundredth of a percent) to its
current 4.25%. Despite rising short-term interest rates, long-term
nominal interest rates have not increased significantly and remain low
by historical standards.

181
Economic Growth Since 2001
Growth in real GDP has averaged a healthy 2.5% annualized rate since
the beginning of 2001 and has averaged a robust 3.2% since the
enactment of pro-growth tax relief in 2003. There have been 24
consecutive quarters of growth in real GDP through the third quarter of
2007.
The economy began 2007 with a low annualized growth rate of 0.6%,
but economic activity picked up considerably in the second and third
quarters of the year. GDP growth was remarkably rapid over the past
two quarters ending in the third quarter of 2007, averaging a rapid,
above-trend, 4.4% annualized pace. Most analysts expect slower,
below-trend, growth through the end of next year, partly a reflection of
significant adjustments in the housing sector and financial markets.
But private forecasters expect growth to remain positive and to revert
back toward more trend-like rates, reaching annualized growth of
around 2.7% by the end of next year.
Slowing in the housing sector of the economy has served as a drag on
overall GDP growth. Residential investment declined by an average
annualized rate of 14% over the past seven consecutive quarters with
declines in residential investment. Over that period, those declines
have shaved an average of 0.8 percentage point from overall GDP
growth. Fortuitously, export growth over that same period has
averaged 9.3%, adding an average of a full percentage point to overall
GDP growth.

Economic Growth Since 2000
(Inflation-adjusted annualized GDP growth)
8%
6%

!U1 IL 40%
~4%

Blue Chip Forecast 2 %
2000 2001

2002 2003 2004 2005 2006 2007 2008

Source: Bureau of Economic Analysis

182

Contributions to Percent Change in Real GDP
(Percentage point)
U Residential I nvestrnent

Exports
2.5
2.0

I--. .

. ..

. .

IFI

. .

I IAIE 4

/
/
/
;Pll //
ZZ //
I

C
Z/
Z.- I
--

;?
Z-

-11. I Z
71
71
71
ZV
71

Z
I/

//
1,111

VV
Z

Z 1.5

1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
-2.5

2001

2002

2005

2004

2003

2006

2007

Source: Bureau of Economic Analysis

Consumer spending, which accounts for around 70% of economic
activity, has remained resilient since the.beginning of 2001, despite
numerous negative shocks to the economy. Growth in inflationadjusted consumer spending has averaged 2.9% since the beginning of
2001, and an even more impressive average of 3.2% since the
enactment of pro-growth tax relief in 2003.

Consumer Spending Growth Since 2000
(Inflation-adjusted annualized growth)
8%
6%

iIS

2002
2003 2004
2000 2001
Source: Bureau of Economic Analysis

2005

2006

2007

183
Growth in business investment has also contributed substantially to
overall GDP growth since the enactment of pro-growth tax relief in
2003. Annualized growth in inflation-adjusted private fixed nonresidential investment spending has averaged a healthy 6.3% from the
third quarter of 2003 through the third quarter of 2007. This stands in
marked contrast to an average annualized rate of decline of 5.6% from
the beginning of 2001 through the second quarter of 2003.

Non-Residential Investment Growth Since 2000
(Inflation-adjusted annualized growth)
16%

Tax Relief Enacted

12%
8%

0%
-4%
-8%
-12%

-16%
2000

2001

2002 2003

2004 2005

2006

2007

Source: Bureau of Economic Analysis

Job Creation and Low Unemployment Continue
A record of 51 consecutive months of payroll job gains have added
over 8.3 million new jobs to business payrolls. In the year ending in
November of 2007, over 1.4 million new payroll jobs were created in
the nation's labor markets. Payroll job gains have averaged 155,000
per month since the enactment of tax relief in 2003, above the
threshold that many believe must be crossed for job creation to exceed
growth in the population. In marked contrast, from the beginning of
2001 through May of 2003, prior to the pro-growth tax relief enacted in
2003, there was an average loss of 92,000 payroll jobs per month.

184

Over 8.3 Million Jobs in Past 51 Months
(Change in employment, in thousands)
500
400

Tax Relief Enacted

*-- -

. 1. -

300
200

.. - - - i, ... V,

illih
I I I II i
0 - - - 0 8III I F10, 01 I II la I

100
-100
-200
-300

_-_2000

2002

2001

2004

2003

2006

2005

-- -

-400

2007

to payroll employment data.
Source: Bureau of Labor Statistics; data include preliminary estimate of next benchmark nevision

The unemployment rate in November of 2007 was 4.7%, below the
recent peak of 6.3% in June of 2003. The 4.7% unemployment rate is
also below the averages of each of the 1960s (4.8%), 1970s (6.2%),
1980s (7.3%), and 1990s (5.8%).

Unemployment Rate Below Previous Peaks
(Civilian unemployment rate)
12%

10.8%

10%

7.8%

Recent Peak: 6.3% 8%
Current: 4.7%

6%
4%
Tax Relief Enacted

1990
1985
1980
Source: Bureau of Labor Statistics

1995

2000

2%
0%

2005

American Workers see Real Gains in Wages, Salaries, and Benefits
Escalating energy costs witnessed over the past few years have served
to erode the purchasing power of wages and salaries. Consider, for
example, average hourly earnings. There were, for several quarters
beginning in 2004 through the first half of 2006, declines in the
inflation-adjusted (real) value of those earnings caused largely by
escalations in energy costs. Reductions in energy costs that followed
helped restore positive growth in real earnings and, despite recent re-

185
acceleration in energy prices, real average hourly earnings have been
growing at healthy pace.
On average, over the past year through the third quarter of 2007, real
average hourly earnings have been growing at a year-over-year rate of
1.8%. Whenever real hourly earnings grow, workers are able to buy
more goods and services from their earnings.
It is useful to keep in mind that average hourly earnings is a very
incomplete measure of worker compensation that ignores around 20%
of the workforce by measuring only earnings of non-supervisory
workers and ignores around 30% of overall worker compensation by
measuring only wages and salaries and not including benefits.
More comprehensive measures of compensation accruing to American
workers, that include benefits as well as wages and salaries, show that
workers have made healthy real gains since the beginning of 2001. For
example, in inflation-adjusted terms, compensation measured in the
National Income and Product Accounts has grown on a year-over-year
basis at an average 1.9% pace since the beginning of 2001. Growth in
the real wage and salary component of overall compensation has
averaged 1.4%, while growth in the benefits component (supplements
to wages and salaries) has grown at a very robust average 4.0% pace
since the beginning of 2001. In spite of a period in which we observed
significant escalation of energy and select other prices, workers'
overall compensation in real, purchasing power, terms has grown at an
average year-over-year pace of close to 2.0% since the beginning of
2001.
Growth in Real Hourly Earnings
(Year-over-year % change, 1982 dollars per hour)

4%
2%
M

-o0%

-2%
-4%
-6%
1980

1985

1990

Source: Bureau of Labor Statistics

1995

2000

2005

186
A key to increases in living standards is growth in productivity, as the
next chart clearly illustrates. Pro-growth tax relief, such as that
enacted in 2003, lays a solid foundation to facilitate continued strong
growth in the productivity of American workers. That growth
ultimately boosts workers' wages, salaries, benefits, and living
standards.

NIPA Real Employee Compensation and Components
(Year-over-year % change)
Total Compensation
Wages & Salaries
Supplements to Wages & Salaries

12%
9%

3%
0%
-3%
-6%
1980

1985

1990

1995

2000

2005

Source: Bureau of Economic Analysis

Healthy Productivity Growth Continues
From the beginning of 2001 through the third quarter of 2007,
annualized growth in labor productivity-output per hour in the nonfarm business sector-has averaged 2.6%. This is well above the 2.1%
average of the 1990s and above the long-term average of 2.3% from
the beginning of 1948 through the third quarter of 2007.
Business Activity Continues to Expand
Economic activity in both the manufacturing and the service sectors of
the economy remains healthy, according to surveys by the Institute for
Supply Management (ISM). The ISM index of manufacturing activity
has been above a value of 50, indicating expansion in the
manufacturing sector, for 54 months beginning in June of 2003,
immediately after tax relief was enacted, with only two exceptions: in
January of this year the index edged down to 49.3 and in November of
2006 it was 49.9 indicating two months of slight contraction in
manufacturing.

187

Capacity utilization in the industrial sector (manufacturing, mining,
and utilities), after hitting a near-term low of just below 74% in
December of 2001, has trended upward to average close to 82% over
the past year through October of 2007, moving into line with long-run
historical norms.
The ISM index of non-manufacturing (service sector) activity has
remained above 50 for 56 consecutive months beginning in April of
2003. The service sector, which accounts for the majority of output in
the U.S. economy, continues to expand at a healthy pace.
The Housing Market Correction Continues
New home sales and existing home sales have fallen or remained
unchanged on a year-over-year basis for 23 consecutive months
through October of 2007, with some months showing significant
double-digit rates of decline. Housing starts and building permits have
each declined for 20 consecutive months through November of 2007 as
builders cut back on construction activity to work. off recent growth in
inventories of unsold homes. The inventory of unsold new homes at
current sales rates rose from an average of just over four months
between the beginning of 2001 and the end of 2005 to over nine
months as recently as August of this year.
Existing and New Home Sales; Growth since 2000
(Year-over-year percent change)

Existing Home Sales

New Home Sales
40%
20%
A_ E)dsting Horne Sales

1
-20%

New Home Sales
2000

2001

2002

Source: Hawr Analytics

- - .- -- - . - 2003 2004

2005

-40%
2006 2007

188

Housing Starts and Permits
(Year-over-year percent change)

Housing Starts

Housing Permits

30%
20%
10%
0%
-10%
-20%
-30%
-40%
2000

2001

2002

2003

2004

2005

2006

2007

Source: Haer Analytics

New Home Inventory
(Months of supply at exsting sales rate)
12
9
6

3
0
2000

2001

2002

2003

2004

2005

2006

2007

Source: Haver Analytics

According to the house price index compiled by the Office of Federal
Housing Enterprise Oversight, year-over-year home price appreciation
declined from the double digit rates observed between the third quarter
of 2004 and the first quarter of 2006 to 1.8% in the third quarter of
2007. Other measures of house prices show declines in recent quarters.
By all measures, the rapid rates of home price appreciation shown
between 2004 and the beginning of 2006 have ended.

189
Home Prices
(Year-over-year percent change)
-S&P/Case-Shiller

Conventional Mortgage Home Price
. - - -Existing Home Median Price

- OFHEO
New 1-Family Home Price

20%
15%
10%
5%
0%
-5%
-10%
2000

2001

2002

2003

2004

2005

2006

2007

Source: HaAer Analytics

Mortgage Delinquencies and Foreclosures Have Risen
Moderation in home price appreciation has contributed to increases in
mortgage delinquencies, especially for subprime mortgages with
adjustable interest rates (which recently have accounted for as much as
70% of subprime first-lien mortgages and about 9% of all first-lien
mortgages). 6 5

Mortgage Delinquencies
(Installments past due 90 days)
-

All Mortgages - - - Subprime Fixed Rate

Subprime Adjustable Rate

6%
5%
4%
I..-

- ,
* 10 - - - -

-11 -' r -11 _ I.
- - - - - __- - - - -

- .- I - . .

- -- - - -- - -

1%
0%
2001

2003

2005

2007

Source: Haver Analytics

65 A first-lien mortgage represents a claim on a property that secures the

mortgage loan and is a claim that takes priority over all other encumbrances
over the same property.

190

Rate of Serious Mortgage Delinquencies
(Installments past due 90 days+mortgages in foreclosure as percent of loans serviced)
All Mortgages

Subprime Adjustable Rate

- - Subprime Fixed Rate -

. - - . - - __- - - - ,

25%

20%
-

~ ~~ ~.
~~~ ~~~~
.

15%
.

10%
5%
0%
2001

2003

2005

2007

Source: Haver Analytics

The rise in delinquencies has begun to show through to foreclosures.
Foreclosures Started
(Loans sent to the foreclosure process as a percent of the total number of mortgages)
All Mortgages - - - -Subprime

Fixed Rate -

Subprime Adjustable Rate

5%
4%

3%
2%
1%
0%
2001
Source: Haver Analytics

2003

2005

2007

191

Loans in Foreclosure
(Number of loans in the foreclosure process as a percent of the total number of mortgages)
-

All Mortgages - - - - Subprime Fixed Rate -

Subprime Adjustable Rate

12%

10%
8%
6%
4%
2%
I
2001

2003

2005

III

2007

Source: Haver Analytics

In addition, roughly 2 million adjustable rate mortgages originated in
recent years will reset in the remainder of this year or in 2008. At a
time when builder inventories of homes for sale are relatively high,
housing markets may continue to be sluggish through next year as
foreclosed properties are put on the already sluggish new-sale and resale housing markets.
Recent Problems in Mortgage Markets
With rising mortgage delinquencies and defaults, especially associated
with subprime mortgages and significantly so for subprime mortgages
with adjustable interest rates, many mortgage originators have gone out
of business and many have suffered financial losses. Holders of
securities that are backed by mortgages ("mortgage-backed" securities)
have also suffered losses.
There has been vast development over the past decade or so of
secondary markets for mortgages. In those markets, loan originators
sell mortgages to investors who then package them according to risk
into other derivative securities (backed by the mortgages and, hence,
by the properties on which those mortgages are claims). Those
securities are then sold to other investors with various appetites for risk
in the form of mortgage-backed securities.
Mortgage-backed securities bundle a large number of mortgages
together into a pool, and shares of that pooled bundle are then sold.
The buyers of these mortgage-backed securities receive a share of the
payments made by the homeowners who borrowed the funds. The
pooling creates a form of insurance for investors. Pooling of

192
mortgages gives investors a greater degree of precision in predicting
the quantity of defaults and the repayment rates (i.e., in assessing
risk-in much the same way that auto insurers bundle together drivers
to get a greater degree of precision in predicting what fraction of the
insured will have collisions, but not exactly which individuals).
Depending on the terms of the sale, when an originator sells a loan and
its servicing rights, the risks (including risks associated with poor
underwriting) are largely passed on to the investor rather than being
borne by the originator. Perhaps because of increases in perceived risk
among investors, upon seeing the significant increases in defaults on
subprime mortgages, supply of credit to subprime lenders, to
mortgage-backed security issuers, and to funds with possible exposure
to subprime mortgages, has fallen. Some subprime originators have
gone out of business as their lenders have cancelled credit lines and
some have received infusions of funds from large financial institutions
and remain in operation.
Recently, problems in the subprime mortgage market, which is a
relatively small part of the financial system, became systemic and
adversely affected the entire financial system. This occurred on or
about Thursday, August 9.
It is difficult to identify a particular fundamental reason for the
systemic difficulties that began in financial markets in early August,
such as release of data indicating significant deterioration in economic
conditions. Many believe that continued declines in the value of
certain mortgage-backed securities and observations of fund losses
rather suddenly led to a sharp increase in investors' risk intolerance.
Two events occurred closely prior to August 9, though it cannot be said
that those events were the proximate cause of difficulties in global
financial markets that would follow. On August 2 and August 8, two
banks in Europe reported difficulties associated with investments in
U.S. subprime loans.
Whatever the reason, investors and banks seemed to have suddenly
become concerned about the quality of assets on balance sheets of
financial institutions and other borrowers and, sensing an inability to
accurately assess the risks inherent in those assets, became unwilling to
risk lending to those institutions.
When investors and banks feel that they have underestimated risks in
one place, like the subprime sector and exposure of possible trade
counterparties to that sector, they may begin to question the accuracy
of their risk assessments elsewhere. This could lead to heightened risk
aversion generally among lenders and investors.

193
This heightened risk aversion, in turn, can lead to an aversion of
lenders to lend to anyone with less than the highest possible level of
creditworthiness. Such circumstances can lead to a "flight to quality"
or "flight to safety" in which lenders cut off lending to most
counterparties and seek safe havens for their funds in the form of very
safe assets such as U.S. Treasury securities.
In response to a perception of significant stress in global financial
markets and what seems to have been a flight to quality, the Federal
Reserve injected large amounts of funds into the U.S. banking system
on August 9 and 10, on the heels of even larger injections by the
European Central Bank (ECB) into the European banking system.
Following August 9 and the Fed's subsequent open market operations,
financial markets did not immediately seem to have weathered the
liquidity event. In response, sensing that banks and other investors
were still having difficulties obtaining financing, the Fed acted, on
August 17, by cutting the discount rate it charges on loans that it
makes to banks through its discount facility by 50 basis points (onehalf percent). According to the Fed, the action was taken in the interest
of providing banks with "...greater assurance about the cost and
availability of funding.". The Fed also changed its usual practices of
lending on only a very short term basis to allow for renewable term
financing to banks for as long as 30 days. According to the Fed, the
announced changes "...will remain in place until the Federal Reserve
determines that market liquidity has improved materially."
* The discount rate is the rate that the Fed charges commercial
banks and other depository institutions on fully secured loans
they receive from their regional Federal Reserve Bank's
lending facility-the discount window.
* The Federal Reserve Banks offer three discount window
programs to depository institutions: primary credit, secondary
credit, and seasonal credit, each with its own interest rate. The
discount rate is correlated with, but is different from, the more
well-known federal funds rate (the interest rates at which
banks borrow and lend with each other on an overnight basis),
another instrument of monetary policy.
The Fed's actions on August 17 were taken because, according to the
Fed at that time: "Financial market conditions have deteriorated and
tighter credit conditions and increased uncertainty have the potential to
restrain economic growth going forward."
Sensing that significant uncertainties remained in financial markets
following its August 17 actions, the Fed cut its target for the federal

194
funds rate by 50 basis points at its monetary policy meeting on
September 18 and also cut the discount rate by another 50 basis points.
The Fed then cut both its target federal funds rate and discount rate by
a further 25 basis points at each of its next two monetary- policy
meetings, on October 31 and on December 11 to the current respective
rates of 4.25% and 4.75%.
In its most recent monetary policy statement, the Fed noted that there
has been recent intensification of the housing correction and strains in
financial markets. The Fed also noted that: "Recent developments,
including the deterioration in financial market conditions, have
increased uncertainty surrounding the outlook for economic growth
and inflation."
The quarter-point reductions in the Fed's target lending rates in
December and October, in conjunction with the Fed's more aggressive
half-point cuts in September should, according to the Fed, "...help
promote moderate growth over time."
On Wednesday, December 12, 2007, the Federal Reserve announced
measures designed to address recent "elevated pressures" in short-term
funding markets. In particular, the Fed has joined with four other
major central banks in measures designed to inject added cash into
global money markets in hopes of alleviating credit pressures that
could threaten economic growth. The Fed has created a new "Term
Auction Facility" (TAF), under which it would lend at least $40 billion
and potentially far more, in four separate auctions starting on Monday,
December 17. The TAF is intended to open up a source of liquidity to
the financial system to complement open market operations, which
deal with a more limited set of counterparties and collateral, and
discount window lending.
The TAF loans will be at auction rates that should be below the rate
charged on direct discount-window loans from the Fed, with a
minimum auction rate established at the overnight indexed swap rate
corresponding to the maturity of the credit being auctioned. (The
overnight indexed swap rate is a measure of market participants'
expected average federal funds rate over the term of the operation).
The new loans can still be secured by the same, broad variety of
collateral that banks pledge for discount window loans. Consequently,
the TAF effectively eliminates or at least greatly reduces penalties
associated with discount window borrowing. One non-pecuniary
penalty that will be eliminated is banks' fears that borrowing from the
discount widow might be mistaken for accessing emergency loans for
troubled institutions-a signal that banks would rather not send to
markets. Such fear inhibits that ability of the discount window in the

195
provision of liquidity to sound financial institutions. TAF borrowing
will be significantly more anonymous, thereby avoiding the "stigma"
problem associated with discount window borrowing.
The Fed also said it had created reciprocal "swap" lines with the
European Central Bank (ECB), for $20 billion, and the Swiss National
Bank (SNB), for $4 billion. These will assist the ECB and SNB in
making dollar loans to banks in their jurisdiction, in hopes of putting
downward pressure on interbank dollar rates such as the London
Interbank Offered Rate, or Libor, market. The inability of foreign
central banks to inject funds in anything other than their own currency
has been a factor creating the squeeze on bank funding in those
markets.
The Fed indicated that the new TAF lending facility could become a
permanent addition to its monetary policy toolkit.
It is too early to tell whether financial markets have stabilized, whether
the liquidity event and flight to quality is over, or whether recent
events will continue and lead to the restrained economic growth that
the Fed fears.
Federal Reserve's Regulatory Response to Mortgage Difficulties
In cooperation with other federal supervisory agencies, the Federal
Reserve has been active in reviewing and issuing rules and supervisory
guidance regarding mortgage lending standards. Those are standards
that banks should follow to ensure that borrowers obtain loans that they
can afford to repay and that give them the opportunity to refinance
without prepayment penalty for a reasonable period before the interest
rate resets.
The Fed is also reviewing Truth in Lending Act (TILA) rules for
mortgage loans and will be conducting consumer testing of mortgage
disclosures for this purpose. In addition, the Fed is developing
proposed changes to TILA rules-one to address concerns about
incomplete or misleading mortgage loan advertisements and
solicitations and a second to require lenders to provide mortgage
disclosures more quickly so that consumers can get the information
they need when it is most useful to them.
The Fed intends to use its rulemaking authority under the Home
Ownership and Equity Protection Act (HOEPA) to propose additional
consumer protections this year. The Fed is looking closely at some
mortgage lending practices, including prepayment penalties, escrow
accounts for taxes and insurance, stated-income and lowdocumentation lending, and the evaluation of a borrower's ability to
repay.

196
On Tuesday, December 18 of this year, the Fed proposed and asked for
public comment on changes to Regulation Z (Truth in Lending) to
protect consumers from unfair or deceptive mortgage lending and
advertising practices. The rule, which would be adopted under
HOEPA, would restrict certain practices and require certain disclosures
to be provided earlier in the mortgage transaction. According to the
Fed, the announced proposal includes four key protections for "higherpriced mortgage loans" (which would capture subprime mortgages and
generally exclude prime loans) secured by a consumer's principal
dwelling:
1. Creditors would be prohibited from engaging in a pattern or
practice of extending credit without considering borrowers'
ability to repay the loan.
2. Creditors would be required to verify. the income- and assets
they rely upon in making a loan.
3. Prepayment penalties would only be permitted if certain
conditions are met,.including the condition that no penalty will
apply for at least 60 days before any possible payment
increase.
4. Creditors would have to establish escrow accounts for taxes
and insurance.
The recent problems in subprime lending have underscored the need
not only for better disclosure and new rules but also for more-uniform
enforcement in the fragmented market structure of brokers and
lenders. In that regard, the Conference of State Bank Supervisors
(CSBS) has partnered with the American Association of Residential
Mortgage Regulators (AARMR) to develop a nationwide licensing
system and database for mortgage professionals. The system is
expected to start up in early 2008 with seven states, and another 30
states have committed and will be added gradually. A nationwide
system would-help limit the ability of originators who run afoul of their
state regulators to continue operating simply by moving to another
state.
Congressional Legislation Regarding.Mortgage Market Difficulties
In efforts. to address difficulties faced by American homeowners,. many
legislative remedies have been debated in Congress. Remedies that
have been considered to help homeowners broadly contain the
following features:
Tax relief on borrower debt that is forgiven to mortgage
borrowers through workout agreements with mortgage lenders.
Under current law, the Internal Revenue Service treats some

197

loan forgiveness as taxable income to those who arrange
workout agreements.
Reform of the Federal Housing Administration (FHA) and
government sponsored enterprises. Reform has typically been
considered through proposals such as increasing the cap on
Federal Housing Authority (FHA) loan limits, allowing for
variation in FHA premiums, replacing the Office of Federal
Housing Enterprise Oversight (OFHEO) with a Federal
Housing Finance Agency (FHFA), and amending or adding to
the defined objectives of government sponsored enterprises
Fannie Mae and Freddie Mac.
Alteration of the bankruptcy code to change the manner in
which residential housing is treated.
Features of recent legislative proposals intended primarily to prevent
recurrence of mortgage-lending problems include:
* Cracking down on "predatory lending" (a loose term) by
imposing higher degrees of legal responsibility on lenders and
brokers; requiring "ability-to-pay" underwriting standards,
imposing civil and criminal penalties on brokers who engage
in fraud; imposing additional disclosure and communications
requirements on brokers; and cracking down on abuses in
prepayment penalties.
The "ability-to-pay" underwriting
principle requires that a loan be made based on an individual's
current and expected income and assets, as opposed to a
"collateral dependent loan" that is based on expected changes
in the value of the collateral (e.g., home).
* Establishing national standards and requirements relating to,
for example, mortgage originator registration and licensing,
formulas to evaluate borrows' ability to pay, and establishment
of national databases and registries.
* Providing or mandating counseling and financial education for
borrowers trying to work out mortgages and for prospective
homeowners. Many proposals provide for funding, through
the department of Housing and Urban Development (HUD), to
various types of counseling and financial assistance programs
(including grants to existing state, local, and non-profit
organizations, grants to states to set up homeownership
protection centers, and grants to housing agencies to provide
one-time
emergency financial assistance to satisfy
homeowners' past-due payments).

198
While the list above is by no means all-inclusive, it is clear that
Congress must continue to work to address difficulties facing
American homeowners as the nation's housing correction continues.
Included in that work will be support for efforts already underway by
the Administration, Treasury Secretary Paulson, Federal Reserve, and a
variety of regulatory bodies. At the time of writing this report,
Secretary Paulson, the Administration, the Treasury Department, and
private partners such as the American Securitization Forum had just
unveiled new guidelines for lenders and security holders under the
HOPE NOW alliance. That alliance represents a government and
private-sector plan aimed at streamlining processes of refinance and
modification of home loans to help homeowners who are currently
facing difficulties with their mortgages and those facing the prospect of
difficulties.
The HOPE NOW Plan Announced on Thursday, December 6, 2007
The HOPE NOW plan announced on December 6 is designed to help
subprime borrowers who can at least afford the current, "starter" rate
on a subprime loan, but will not be able to make the higher payments
once the interest rate goes up.
* There are four groups of subprime borrowers facing rate
increases on their adjustable-rate loans:
* Those who cannot afford their payments even at the
current rate;
* Those who could afford payments at the higher rate;
* Those who can refinance into sustainable mortgages while
keeping investors whole;
- Those who can afford their mortgages today but could not
at the higher rate.
Only the last group will get help, and only for those who took out their
mortgage loans between January 1, 2005 and July 31, 2007 and are
scheduled to rise to higher rates between January 1, 2008 and July 31,
2010
HOPE NOW members have agreed on a set of new industry-wide
standards to provide systematic relief to these borrowers in one of three
ways:
1. Refinancing an existing loan into a new private mortgage;
2. Moving them into an FHASecure loan (FHASecure is a
new initiative at the Federal Housing Administration

199

launched by the Administration to offer refinancing to
certain homeowners);
3. Freezing their current interest rates for five years (freezing
at the introductory "starter," or "teaser," rate, preventing
rates from rising).
HOPE NOW estimates that under this streamlined approach up to 1.2
million subprime ARM borrowers will be eligible for fast-tracking into
consideration for affordable refinanced or modified mortgages (using
one of the above three ways).
Streamlining will free-up resources so servicers can better focus on
borrowers whose situations require more in-depth review and can
devote resources to identify, contact, and counsel struggling
homeowners.
The program announced December 6 will be available only for owneroccupied homes-to ensure that relief is not provided to real estate
speculators.
The highest-profile part of the plan is the freeze on certain subprime
mortgages to the "starter" rates for five years.
*

The freeze will allow time for housing sales and prices to start
rising again-a rebound would enable homeowners to
refinance their current adjustable rate mortgages into fixed-rate
loans with more affordable payments.
The big sticking point in negotiations leading to the plan was getting
investors who purchased the mortgages after they were bundled into
securities to agree to accept lower interest payments. Officials
representing the mortgage and securitization industries believe the plan
will withstand legal challenges as loan modifications will be
undertaken in line with interests of mortgage-backed security holders.
Why was there government involvement?
The standard loan-by-loan evaluation process that is the current
industry practice would not be able to handle the volume of work that
will be required. Instead, the industry needed a streamlined approach to
address this increased volume. The role of government has been,
according to Secretary Paulson, "to convene market participants with
common interests to determine if, and then how, they could develop a
shared framework to address both the market complexity [existing in
current mortgage and mortgage-related-securities markets] and the
upcoming volume of mortgage resets."

200
Regulating Mortgage Lending
Regulators must work to ensure that fraud and abusive lending
practices do not occur and must safeguard against any recurrence of
risky financial practices in mortgage lending through adequate
oversight. At the same time, they must ensure that regulations are not
so onerous as to choke off segments of the mortgage market that have
provided and can continue to provide avenues to home ownership for
those with subprime credit ratings.
Broadly speaking, financial regulators have four types of tools to
protect consumers and to promote safe and sound underwriting
practices: required disclosures by lenders, rules to prohibit abusive or
deceptive practices, principles-based guidance with supervisory
oversight, and less-formal efforts to work with industry participants to
promote best practices.
The last time Congress tackled "predatory" mortgage lending was in
1994, when it passed the Home Ownership and Equity Protection Act
(HOEPA). While HOEPA applies to all lenders, enforcement is
handled by an alphabet soup of authorities, each with some oversight
of the U.S. mortgage industry: the Federal Trade Commission (FTC),
the Office of Thrift Supervision (OTS), the Federal Deposit Insurance
Corporation (FDIC), and the Federal Reserve, to name four that cover
bank lenders. States also have their own powers.
The vast array of non-bank mortgage lenders that has proliferated in
recent years is also subject to HOEPA rules. However, Federal
authorities have no power to enforce those rules on them, because such
brokers and lenders are regulated in their home states.
The patchwork nature of enforcement authority in subprime lending
poses a special challenge. For example, rules issued by the Federal
Reserve Board apply to all lenders but are enforced-depending on the
lender-by the Federal Trade Commission, state regulators, or one of
the five Federal regulators of depository institutions. To achieve
uniform and effective enforcement, cooperation and coordination are
essential.
The Fed is considering proposing additional rules under HOEPA this
year aimed at prohibiting mortgage lending practices that it finds to be
unfair and deceptive, including those that could deal with pre-payment
penalties, seen by most critics of recent mortgage lending as among the
most egregious practices. (The Fed, in 2001, banned several other
practices for high-cost loans, such as loan flipping-a practice
characterized by frequent and repeated refinancing to generate fees for
lenders).

201
Policy Considerations in Addressing the Mortgage Market
There are three broad considerations in formulating any policy option
aimed at addressing rising current and prospective delinquencies and
defaults in mortgage markets and rising current and prospective
foreclosures on homeowners unable or unwilling to pay their
mortgages.
Consideration #1: Bailouts and Moral Hazard-Policiesthat involve
Federal relief to homeowners on their mortgage debts can introduce
moral hazard into future mortgage transactions. Moral hazard refers to
the chance (hazard) that someone in a transaction will take an
inappropriate ("immoral") action.
In the context of a mortgage transaction, if a borrower were to believe
that he or she may not have to carry the full burden of possible future
losses (such as foreclosure and financial loss because a property loses
value), then the borrower may become more inclined to take on more
risk than he or she otherwise would.
A bailout today of mortgage obligations can increase borrowers'
perceptions about chances that future bailouts will occur, leading to
more risk taking than is socially optimal.
Consideration#2: Separating True Victims from Speculators and those
who Misrepresented Themselves-A political difficulty in the current
environment is that there are truly people who were victimized by
fraudulent and misleading lender practices, but would find it difficult
and expensive to prove fault and take civil action against those lenders.
It is hard to not feel sympathy for the plight of those victims. At the
same time, there are also truly people who were recklessly taking out
mortgage loans, sometimes through misrepresentation of their actual
financial conditions, to either obtain more housing than they could
reasonably afford or to obtain housing in the hope that house prices
would continue to climb at elevated rates (gamblers, speculators,
flippers). Those people should bear the full responsibility of their
obligations.
Absent financial punishment upon the realization of losses that arise
because house price appreciation failed to be as high as expected, there
will be no reason for speculators and those who misrepresented
themselves not to engage in high-financial-risk behavior in the future,
which can adversely affect their lenders, their personal lives, and even
the financial system.
Consideration #3: Walk a Fine Line in Stepping Up RegulationRegulators in the mortgage market must be obliged to prevent fraud
and abusive lending. At the same time, regulators must tread carefully

202
so as not to suppress, through overly-stringent regulations, responsible
lending. Regulations that are too onerous threaten to eliminate
refinancing opportunities for existing subprime borrowers and new
financing opportunities for prospective subprime borrowers.
While there truly were victims of abusive and fraudulent lending
practices of some mortgage lenders, along with fraudulent practices by
some borrowers, to impose regulations so stringent that lenders
effectively and altogether shut off credit to some segments of the
market, such as subprime borrowers, would deny deserving individuals
opportunities for homeownership.
Policy Implication: Leave a Small Footprintif Relief is Provided and if
New Regulations are Issued-To minimize the introduction of moral
hazard into mortgage transactions, any relief should attempt to
minimize perceptions that relief will be forthcoming in the future
should similar circumstances prevail. To minimize onerous regulation
and to keep credit flowing to deserving participants in subprime
markets, new regulations should be carefully crafted.
International Developments
The foreign-exchange value of the dollar has been on a general decline
since early in this decade. From the beginning of 2001 through
November of 2007, the trade-weighted value of the U.S. dollar has
depreciated by around 19.8%. Vis-A-vis the euro, the dollar has
depreciated by 36.1% during the same period; vis-A-vis the yen, the
dollar has depreciated by 4.8% in the period. From its recent peaks in
February of 2002 on a trade-weighted basis and vis-d-vis the yen, the
dollar has depreciated by around 24.1% and 16.9%, respectively. From
a recent peak in October of 2000, the dollar has depreciated by around
41.9% vis-A-vis the euro.
Many believe that further depreciation of the dollar may arise given
that the U.S. trade deficit is large relative to GDP and given the
possibility of lower U.S. interest rates relative to rates on alternative
global assets as the U.S. economy works through the housing and
mortgage market difficulties. A declining dollar makes imports more
costly and less competitive in U.S. markets and makes U.S. exports
more competitive in world markets. As we have seen, robust recent
growth in U.S. exports helps fuel overall GDP growth and has been a
fortuitous benefit associated with free trade, coming at a time when the
housing market has served as a drag on GDP growth. Rising costs of
U.S. imports, however, may pose risks to U.S. consumer price inflation
if those costs are passed through from importers to consumers.

203
Trade deficits have helped fuel historically high U.S. current account
deficits. The current account deficit, after hitting a near-term low as a
percent of GDP of 3.5% in the fourth quarter of 2001, rose to 6.8% of
GDP by the fourth quarter of 2005, and has since retreated to around
5.1% of GDP. The current account deficit means that U.S. savings are
not sufficient to fund U.S. investment; on the other hand, it also
reflects the fact that investors abroad continue to view the U.S. as a
particularly attractive place to invest.
Prospects for U.S. exports of goods and services have improved in
recent years, with improvements, on balance, in growth in the eurozone and in Japan's economy. Perhaps buoyed by declines in the
foreign-exchange value of the dollar and by growth abroad, export
growth in the U.S. has been brisk. Real (inflation-adjusted) export
growth has averaged 9.1% over the past 17 consecutive quarters with
positive export growth; 10.4% over the past year through the third
quarter of 2007; and 18.9% in the third quarter of this year.
The Federal Budget
The federal government recorded a total budget deficit of $163 billion in
fiscal year 2007, $85 billion below the deficit incurred in 2006. The
2007 deficit was 1.2% of GDP, down from 1.9% in 2006. Federal
government receipts in fiscal year 2007 rose by 6.7% relative to fiscal
year 2006, exceeding the growth of nominal GDP. for the third
consecutive year. In fiscal year 2006, receipts rose by 11.8% and in
fiscal year 2005, receipts rose by 14.5%. Receipts as a share of GDP
rose to 18.8% in fiscal year. 2007, above the average of 18.2%
experienced since 1965. Outlays, too, rose in 2007-by 2.8% over their
2006 levels.
Despite the recent favorable swings in the government's fiscal position,
the threat to stability in longer-term government finances comes from
projected runaway growth in mandatory spending, including Social
Security, Medicare, and Medicaid. The relatively certain demographic
outlook involves large-scale retirement of the "baby boom" generation,
meaning fewer workers per beneficiary in Social Security. Currently,
around 3.25 workers contribute to the Social Security system per
beneficiary. The number of beneficiaries by 2030 will have doubled
and the ratio of workers to beneficiaries will have fallen to around
2.00. At the same time, Medicare spending per beneficiary is expected
to rise with increases in the costs of medical care.
In fiscal year 2007, federal outlays for Social Security, Medicare, and
Medicaid amounted to 8.8% of GDP, up from 8.5% last year. The
majority of the rise in those outlays came from rapid growth in

204
Medicare and Medicaid spending, which together grew by an average
of 9% annually over the 2002-2006 period and by 9.7% in 2007.
Social Security outlays rose by 5.9% in 2007. Projections by the
Office of Management and Budget suggest that the share of GDP
accounted for by federal outlays for Social Security, Medicare, and
Medicaid will rise to roughly 13% by 2030.
The nation faces important questions as it examines whether promises
imbedded in the Social Security system, Medicare, and Medicaid are
sustainable, given budget and social priorities. Many fear that these
systems have committed more resources to the baby boom generation
than they can realistically deliver without imposing massive burdens
on younger generations. If those commitments are untenable, then
making changes to the promises should come sooner rather than later,
giving people as much time as possible to plan their work, savings, and
retirement plans and reducing the fiscal burden on future generations.
THE OUTLOOK

Recent economic data show that economic growth has slowed relative
to the blistering pace of the past two quarters, partly reflecting a
cooling of the housing market. Looking forward, most forecasters see
a gradual return to annualized growth of slightly below 3.0% by the
end of next year. Recent escalations in energy prices pose a threat to
higher inflation, but inflation expectations seem to remain contained.
Unemployment and long-term interest rates remain low by historical
standards, and job and real compensation growth continue.
Of course, risks and uncertainties remain. The extent to which the
housing market correction is behind us or has a way to go remains
uncertain. Uncertainties and turbulence in global and U.S financial
markets continue. Continued rapid growth in China, India, and other
countries may continue to put upward pressure on prices of key inputs
such as oil and commodities. Rising import prices associated with
declines in the value of the dollar may put upward pressure on
consumer prices. The global risks of terrorism and unrest in the
Middle East also remain. And there are uncertainties concerning
effects of near-term budget pressures that will increasingly be felt from
the demographic tidal wave of baby-boomer retirees in conjunction
with existing entitlement promises and rising healthcare costs.
Despite our nation's challenges, we maintain our confidence in the
economy's ability to expand and provide improved job opportunities
for all Americans. We must work to insure that fiscal and regulatory
burdens do not hinder economic growth and job creation and we must
continue to fight protectionism against our trading partners that would

205
prevent Americans from benefiting from the gains of free and fair
trade. In light of renewed recent uncertainties and heightened risk
aversion in financial markets, expectations of below trend growth in
the near term, and stresses placed on American families facing
difficulties with their mortgages, one thing seems perfectly evident:
Now is not the time to raise taxes on American families, as many
members of the majority currently favor.

Representative Jim Saxton
Ranking Republican Member
Senator Sam Brownback
Senior Republican Senator

206

SELECTED REPUBLICAN STAFF REPORTS
PREPARED BY THE STAFF OF
REPRESENATIVE JIM SAXTON,
RANKING REPUBLICAN MEMBER

207
INFORMATION TECHNOLOGY INCREASES EARNINGS
DIFFERENTIAL AND DRIVES NEED FOR EDUCATION
Education premiums. In 1975, U.S. workers with high school
diplomas earned a real mean average of $28,471 (all earnings herein
are in real 2005 dollars; see Chart I for increases in real mean earnings
and Chart 2 for education premiums). U.S. workers with bachelor's
degrees earned a real mean of $44,767, a premium of 57 percent more
than high school graduates, while U.S. workers with masters,
professional, or doctoral degrees earned a real mean of $60,714, a
premium of 113 percent more than high school graduates.
Over the next thirty years, these education premiums expanded
significantly. The real mean earnings of U.S. workers with high school
diplomas grew by 3.4 percent to $29,448 in 2005, while the real mean
earnings of U.S. workers with bachelor's degrees swelled by 22.2
percent to $54,689 in 2005. Thus, the education premium for college
graduates with bachelor's degrees increased to 86 percent.
Likewise, the real mean earnings of U.S. workers with masters,
professional, or doctoral degrees grew by 31.7 percent to $79,946 in
2005. Thus, the education premium for college graduates with
masters, professional, and doctoral degrees expanded to 171 percent.

Chart 1 - Change in Real Mean Earnings for U.S. Workers (Age 18 and Over) by
Highest Educational Achievement 1975-2005

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What caused this expansion of education premiums? During the
last three decades, a skill-biased technological change (SBTC) altered
the demand for different types of labor in the United States. As the

208
real cost of acquiring and using information technology (IT) assets
plummeted, U.S. firms substituted computers and computer-driven
machinery for workers performing routine tasks. Simultaneously,
computerization improved the availability, accuracy and timeliness of
information, increasing the marginal productivity of highly skilled,
college-educated workers performing cognitive non-routine tasks.
Because SBTC concurrently dampened the demand for routine labor
and stimulated the demand for cognitive non- routine labor, SBTC
increased the real earnings of college graduates relative to less
Chart 2- Education Premiums for U.S. Workers (Ages 18 and Over) 1975-2005

h.~~~~~~~~~~~~~~Ys

educated workers.
SBTC explained a majority of the observed changes in the demand
for different types of U.S. workers and the real compensation that these
workers received over the last three decades. Moreover, SBTC
explained a majority of the observed expansion of the earnings
differential among U.S. households over the last three decades. Other
causes together explained a minority of the observed changes in labor
earnings differentials.6 Computerization
demand, compensation,
66~
~~~~ ~ ~and~~~~~~~~~6
The progressive liberalization of international trade and investment tends to -increase the
compensation of highly skilled workers relative to less skilled workers in both developed and
developing economies. For example, see Robert C. Feenstra and Gordon H. Hanson, "Foreign
Investment, Outsourcing, and Relative Wages," National Bureau of Economic Research Working
Paper No. 5121 (May 1995); Robert C. Feenstra and Gordon H. Hanson, "Global Production
Sharing and Rising Inequality: A Survey of Trade and Wages," in Kwan Choi and James
Harrigan, eds., Handbook of International Trade, Basil Blackwell (forthcoming); and Pinelopi
Koujianou Goldberg and Nina Pavcnik, "Distributional Effects of Globalization in Developing
Economies," National Bureau of Economic Research Working Paper 12885 (February 2007).
Large scale immigration of low-skill workers may have depressed real wage growth in the
lower half of the income distribution. See: George J. Borjas, "Native Internal Migration and the
Labor Market: Impact of Immigration," (May 2004). Finally, statistical anomalies such as the

209
and labor demand. Computers and computer-driven machinery
rapidly perform routine tasks that can be expressed logically and
codified into a sequence of unambiguous commands to achieve desired
results. Thus, firms may substitute IT assets for workers performing
routine job tasks (e.g., firms may replace filing clerks with personal
computers to maintain their records or welders with welding robots to
attach parts on assembly lines). Computers do not think creatively,
handle ambiguity, or solve problems. Cognitive non-routine job tasks
(e.g., analyzing problems, creating new products, interacting with
suppliers and customers, and managing) require uniquely human input.
Computers dramatically reduce the cost of providing accurate and
timely information. By expanding the availability of information,
computerization improves decision-making and increases the marginal
productivity of highly skilled workers. Thus, IT assets complement
cognitive non-routine labor.
Plummeting cost, increasing investment.
The real cost of
acquiring and using IT assets dropped during the last three decades.
From 1975 to 2005, the real cost of acquiring computers and
peripherals plummeted by 99.4 percent, while the real cost of acquiring
software dropped by 27.5 percent. The decline in the real cost of
acquiring and using IT assets increased computerization. From 1975 to
2005, real private non-residential investment in computers and
peripherals rose from less than $500 million to $166 billion, or 1.50
percent of GDP, while real private non-residential investment in
software grew from $4 billion to $206 billion, or 1.87 percent of GDP
(all investments are in real 2000 dollars; see Chart 3).
Chart 3 -Falling Real Costs Doive U.S. Business Investment in Computers,
Penpherals, and Software 1975-2005
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210
Skill-biased technological change. A fall in the real cost of
acquiring and using IT assets simultaneously reduces the demand for
their substitute, routine labor, and increases the demand for their
complement, cognitive non-routine labor. Economists describe this
computer-driven shift in the relative demand for different types of
labor and the compensation that they receive as a skill-biased
technological change. SBTC does not directly affect the demand for
manual non-routine labor (e.g., firefighters, servers, and truck drivers).
Autor, Levy, and
SBTC increased education premiums.
Murnane (2003) found strong empirical support for SBTC as the
principal cause for shifting labor demand and the resulting increase in
the college education premium.6 7 The authors employed detailed U.S.
Department of Labor data to identify five major categories of job tasks(1) cognitive non-routine analytical;
(2) cognitive non-routine communicative, interactive, and
managerial;
(3) cognitive routine;
(4) manual routine; and
(5) manual non-routine
- for approximately 450 aggregated occupations in 140 industries
spanning the U.S. economy. The authors measured changes in the
demand for job tasks from 1960 to 1998.
Throughout the U.S. economy between 1970 and 1998, the
demand for routine task inputs (3 & 4) declined, and the demand for
cognitive non-routine inputs (1 & 2) increased. The authors found that
task shifts occurred primarily within industries rather than between
industries. Thus, the observed task shifts were caused by changes in
the mix of labor inputs that U.S. firms used in their production
processes rather than changes in U.S. consumer demand for goods and
services with higher inputs of cognitive non-routine labor.
The authors also tested two formulations of a computerization-task
model. One used the annual change in the percentage of an industry's
workers using a computer as an independent variable, while the other
used an industry's annual investment in computers, peripherals, and
Either formulation largely
software as an independent variable.
industries, while other
within
explained the observed task shifts
independent variables (e.g., aggregate investment) that were
statistically insignificant.
67 David H. Autor, Frank Levy, and Richard J. Mumane, "The Skill Content of Recent
Technological Change: An Empirical Exploration," Quarterly Journalof Economics, 118(4),
November 2003.

211

The authors found significant task changes within nominally
unchanged occupations. For example, secretaries typically perform
more analytical, communicative, interactive, and managerial functions
and fewer routine functions today than secretaries did a generation ago.
The computerization-task model explained these task changes within
occupations.
Finally, the authors translated the observed task changes into the
demand for college-educated and non-college-educated labor. Since
1980, the "model can explain a large fraction - 60 to 90 percent - of
the estimated increase in relative demand for college employment.
Notably, almost 40 percent of the computer contribution to rising
educational demand in the last two decades is due to shifts in task
composition within nominally unchanging occupations.' 6 8
SBTC expanded income inequality. Autor, Katz, and Kearney
(2006a, and 2006b) found strong empirical support that SBTC-induced
changes in real compensation accounted for a majority of the observed
changes in inequality in U.S. income distribution during the last three
decades. 6 9
High school graduates that perform routine job tasks are clustered
in the middle of the U.S. income distribution, 7 0 while college graduates
that perform cognitive non-routine job tasks are clustered in the top
two quintiles7'1 By widening education premiums, SBTC has caused a
secular expansion of inequality in the upper half of the U.S. income
distribution over the last three decades.
For example, the 8 0th
percentile to median household income ratio increased from 1.78 in
1980 to 1.98 in 2004, while the 9 5th percentile to median household
income ratio grew from 2.86 in 1980 to 3.54 in 2004.
68

Computerization contributed to a rapid increase in CEO compensation by reducing the
importance of firm-specific knowledge and increasing the importance of general management
skills. Successful managers seeking a CEO position are less limited by firm-specific knowledge
to their current firm. As firm-specific knowledge has become less important, firms can easily hire
a successful CEO away from another firm in a different industry. This expanded competition
among firms for talented CEOs has increased CEO compensation. Kevin J. Murphy and Jan
Zabojnik, "CEO Pay and Appointments: A Market-Based Explanation for Recent Trends,
American Economic Review (May 2004), 192-196.
69 David H. Autor, Lawrence F. Katz, and Melissa S. Keamey, "The Polarization of the U.S.
Labor Market," National Bureau of Economic Research Working Paper 11986, January 2006; and
David H. Autor, Lawrence F. Katz, and Melissa S. Kearney, "The Polarization of the U.S. Labor
Market," American Economic Review, May 2006, 189-194.
70 The median income for households headed by a high school graduate was $38,191 in 2005.
This was in the third quintile.
71 The median income for households headed by a college graduate with a bachelor's degree was
$72,424 in 2005. This was in the fourth quintile. The median income for households headed by a
college graduate with an advanced or professional degree was $100,000 in 2005. This was in the
top quintile.

212
Worldwide phenomenon. Expanding education premiums and
growing income inequality are not limited to the United States. In its
most recent World Economic Outlook, the International Monetary Fund
reported, "The income share of labor in skilled sectors [in developed
economies] ... has been on the rise, especially in Anglo-Saxon
countries."7 2
Moreover, developing economies have experienced explosive
growth in the real compensation paid to highly skilled, collegeeducated workers relative to other workers in their economies. Thus,
education premiums have expanded more rapidly in developing
economies such as China and India than in developed economies such
as the United States.7 3 While SBTC did contribute to these changes,
other factors such as domestic economic reforms and globalization are
likely to have played greater roles in developing economies than in the
United States.
Conclusion. Skill-biased technological change is the major cause
for higher education premiums and the resulting increase in income
inequality among U.S. households since the 1970s. This secular trend
has continued through multiple U.S. business cycles, different
presidential administrations, and a variety of federal policies toward
taxes, spending, and regulation. This trend is occurring simultaneously
in many economies, both developed and developing, around the world.
Since few would forgo the life-improving, productivity-enhancing,
and growth-generating benefits of IT assets merely to reduce income
inequality, policymakers must seek other ways to increase economic
opportunities, especially for Americans in the lower half of the income
distribution. The most promising approach is to improve the quality of
primary and secondary education so that all Americans may pursue
college educations and consequently earn more over their working
lives. In addition, it could be made easier for older workers to obtain a
college education so that they may enhance their marketable skills and
increase their earnings.

International Monetary Fund, "The Globalization of Labor" in World Economic Outlook,
Washington, D.C., April 2007.
73 Goldberg and Pavcnik (February 2007).

213
EXCESS BURDEN OF FEDERAL TAXES IMPOSES HIGH
ECONOMIC COST
Introduction. The overall burden of taxation is much larger than
the tax receipts that government collects each year because taxes
distort the behavior of individuals and firms. These distortions reduce
potential output or economic welfare.
Economists refer to this
reduction as the excess burden or deadweight loss of taxation, which
is usually expressed as a percent of tax collections either on average or
at the margin (the last dollar of tax collected).
Overall cost of taxation. The overall economic cost of the federal
tax system above and beyond tax collections arises from three sources:
1. Administrative costs are the expenses that the U.S. government
incurs in devising, administering, and enforcing its tax laws. In
fiscal year 2006, the Internal Revenue Service spent $10.7 billion,
or 0.5 percent of federal tax receipts.
2. Compliance costs are the value of time and the out-of-pocket
expenses that individuals and firms must shoulder to learn tax
requirements, keep records, and prepare returns, including
accounting and legal fees. In 1999, compliance costs were
estimated to be $100 billion, or about 9.4 percent of federal income
tax receipts.7 4
3. Excess burden or deadweight. loss is the reduction in potential
output or economic welfare that occurs when taxes distort
* behavior. High marginal tax rates:
> discourage individuals from working and firms
undertaking investments that would increase GDP-,

from

cause individuals and firms to arrange their transactions in
ways that minimize tax payments even though these
arrangements may reduce GDP; and

prompt individuals to increase their consumption of less
valuable goods and services that are tax-preferred instead of
more valuable goods and services that are taxed.

74 Joel Slemrod and Jon Bakija, Taxing Ourselves: A Citizen's Guide to the Great Debate over
Tax Reform (Carnbridge, Massachusetts: MIT Press, 2000): 137.

214
A JEC study published in 1999 found a midpoint estimate of the excess
burden of the federal tax system to be 40 percent of federal tax
receipts.
Labor taxation. A higher marginal tax rate on labor income
increases the tax wedge between what firms (as consumers of labor)
spend to employ workers (including taxes) and what workers (as
suppliers of labor) receive. By reducing the after-tax wage rate or
equivalently the opportunity cost of leisure, a higher marginal tax rate
on labor income simultaneously reduces work effort and increases
leisure. 76 The resulting reduction in work effort increases the excess
burden of taxation.
The size of the increase in the excess burden depends in part on
how responsive the supply of labor effort from workers is to a higher
marginal tax rate. Economists use elasticity (which is the ratio of the
percentage change in one variable to the percentage change in another
variable) to measure the responsiveness of labor effort to the after-tax
wage rate.77 Thus, a higher elasticity of labor effort with respect to the
after-tax wage rate implies a larger marginal excess burden from any
given increase in the marginal tax rate on labor income.
Early empirical research measured labor effort through the quantity
of hours-worked. Because only married women had a significant
elasticity of hours-worked with respect to the after-tax wage rate, early
empirical research found a small excess burden or deadweight loss.
Hours-worked is an incomplete gauge of labor effort because
hours-worked measures only the quantity of labor effort. Workers may
also reduce the quality of their labor effort in response to a higher
marginal tax rate. For example:
>

Higher taxes may prompt some workers to choose easier jobs over
more demanding jobs that are more productive and consequently

Richard K. Vedder and Lowell E. Gallaway, Tax Reduction and Economic Welfare, prepared
for the Joint Economic Committee, 106 th Cong., I' sess., April 1999.
76 The inverse relationship between marginal income tax rates and labor effort is a substitution
effect. An income effect (i.e., higher marginal tax rates may cause some workers to increase work
effort to replace lost after-tax income, and vice versa) partially offsets the substitution effect.
However, empirical studies have found the substitution effect consistently dominates the income
effect, producing a net substitution effect.
77 Economists use (E) as the symbol for elasticity. The elasticity of labor effort with respect of the
marginal tax rate on labor income (£) is the ratio of the percentage change in labor effort (L) to the
percentage change in the after-tax wage rate (w * (1 - tL)). Mathematically, ;
6L/8 (w * ( -tL)) * (w *(I -tL))/ L.

215
pay better. Although both jobs may entail the same hours-worked,
this choice reduces the quality of labor-effort and thus output.
> Higher taxes may prompt other workers to forgo additional training
or aver moving or changing occupations because of the smaller
increase in after-tax income from securing more productive jobs in
different industries or locations. Again, these choices may reduce
the quality of labor effort and thus output without changing the
quantity of hours-worked.
All other things being equal, increasing the marginal tax rate on
labor income decreases taxable income by reducing both quantity and
quality of labor effort by workers. Higher taxes produce other
behavioral changes that also lower taxable income:
>

Firms and their workers may alter the mix of labor
compensation by decreasing taxable wages and increasing nontaxable fringe benefits.

Individuals may tend to purchase more tax-preferred goods
and services as higher marginal tax rates make deductions
more valuable. For example, individuals may purchase a
house to take advantage of tax-deductible mortgage interest
and property tax payments rather than renting an apartment.

Because the marginal cost of leisure, fringe benefits, and taxpreferred consumption all equal the after-tax wage rate,
economists may combine all of these behavioral responses, estimate
the elasticity of taxable income with respect to the after-tax wage
rate, and then use this estimate to calculate the marginal excess
burden.
Capital taxation. Under the existing federal tax system, personal
saving and investment are taxed multiple times. Saving, which is the
remainder of after-tax income that is not consumed, is taxed again
when it is invested into financial assets that earn interest and dividends.
Moreover, dividends are taxed twice - first as profits at the corporate
level and again as dividend income at the individual level. Finally,
financial assets may be subject to capital gains taxes when sold or
estate taxes upon the death of the owner.
By raising the price of saving and investment relative to
consumption, this multiple taxation creates a bias against saving and
investing in favor of consuming. This bias undermines an important
source of capital formation. Although certain provisions in the tax
code are designed to offset some of this bias, many of adverse effects
from multiple layers of taxation remain. This multiple taxation raises

216
the cost of capital, rendering some investment projects unfeasible.
Thus, the tax bias against saving and investment reduces economic
growth and creates a number of specific distortions.
The double taxation of dividends as profits at the corporate level
and then again as dividend income at the individual level causes:
>

the retention of earnings within profitable U.S. corporations
instead of the payment of dividends to shareholders that could have
been invested more profitability elsewhere in the U.S. economy;
and

the diversion of funds that would have otherwise been invested in
U.S. corporations into the U.S. real estate sector and to foreign
corporations.

The deductibility of interest payments, but not of dividends
induces U.S. corporations to finance their investments through more
debt relative to equity.
>

Tax-induced higher debt levels make U.S. corporations more
vulnerable to cash flow fluctuations during economic recessions.

In turn, this vulnerability biases U.S. corporations toward shortterm investments because even though long-term investments may
have higher present values, the cash flow is more variable from
long-term investments than from short-term investments.

Capital gains taxes are largely voluntary since an asset owner can
delay paying this tax by not selling assets or can avoid this tax
altogether by using appreciated assets to make charitable contributions
or holding assets until death. Taxes on capital gains slow the
reallocation of investment funds from established corporations to
entrepreneurial ventures that could use these funds more profitably.
Owners of capital may make other behavioral changes in response
to a higher marginal tax rate on capital income. For example,
individuals can substitute tax-exempt municipal bonds for taxable
corporate bonds to lower their taxable income. Owners of eligible
small firms may elect to organize as S corporations rather than C
corporations to avoid paying income taxes- at both the firm level and
again at the individual level.
Historically, economists estimated the excess burden from capital
taxation through the elasticity of saving with respect to the after-tax
investment return. Because the volume of saving has displayed a low

217
elasticity with respect to after-tax investment return, many economists
assumed that taxes on investment income produced a small excess
burden. However, Feldstein (2006) observed that saving is not an end,
but rather a means to an end, namely future consumption. 7 8 Consider
this example:
>

A 45-year-old individual who saves $1 now in expectation of using
his savings for consumption during retirement 30 years later;

An expected pre-tax return on a well diversified portfolio of stocks
and bonds of 10 percent annually during the next 30 years;

Reinvestment of all interest and dividend income over 30 years in
the portfolio; and

A 50 percent marginal tax rate (includes all federal, state, and local
taxes).

In absence of all capital taxes, this individual could consume
$17.45 in 30 years. After taxes, however, this individual would be able
to consume only $4.32.79 In this example, capital taxation creates an
effective marginal tax rate on future consumption of 75 percent.
Therefore, the relevant elasticity that should be estimated to calculate
the marginal excess burden of capital taxation is the elasticity of future
consumption with respect to the after-tax rate of capital income.
Feldstein (2006) concluded:
>

an excess burden from capital taxation occurs even if the volume
of saving is unchanged;

taxes on investment income can reduce the incentive to work and
receive taxable earnings just as taxes on labor income do;

existing taxes on investment income slow capital accumulation and
real GDP growth; and

slower real GDP growth depresses the real growth of federal tax
revenues over time.

Empirical estimates. Examining data before and after the Tax
Reform Act of 1986, Feldstein (1995) found that the elasticity of
taxable income (plus partnership losses) with respect to the after-tax

78 Martin Feldstein, The Effect of Taxes on Growth andEfficiency, NBER Working Paper 12201
(May 2006).
79 If this individual were to place this dollar into a tax-deferred retirement saving plan, he or she
would have $8.72 available for consumption 30 years later.

218
wage rate ranged from 104 percent to 125 percent. 8 0 Using a different
model that also accounts for changes in non-tax factors over time,
Auten and Carroll (1998) found an elasticity of 66 percent.81 While
Auten and Carroll found a lower elasticity than Feldstein, both were
significant above the findings of earlier empirical research.
Feldstein then calculated the economic effects of a 1 percentage
point increase in all federal income tax rates. Assuming an elasticity of
taxable income with respect to the after-tax wage rate of 40 percent
(much less than what either Feldstein or Auten and Carroll actually
found), Feldstein found the marginal increase in the excess burden or
deadweight loss is $3.5 billion over time, or 76 percent of the $4.6
billion actual gain in tax revenue. Thus, the actual cost of a new dollar
of federal spending in this example is $1.76. Moreover, this
hypothetical tax increase would net only $4.6 billion in new revenue,
or 57 percent of the $7.5 billion estimated under static modeling. A tax
that imposes such high economic costs relative to its revenue gain is
inefficient and counterproductive.
Conclusion. While policymakers have frequently debated how
proposed federal tax changes would affect the balance in the U.S.
government's budget, the level of interest rates, and the short-term
growth prospects for the U.S. economy, far less attention has been paid
to how these changes would affect the U.S. economy.
Alternative tax policies that raise the same amount of revenue can
Given the enormous
have vastly different marginal excess burdens.
size of the excess burden from the existing* federal tax system,
policymakers should pay greater attention to the effects of proposed
changes on the efficiency and international competitiveness of the U.S.
economy when shaping federal tax policy.

80 Martin Feldstein, "The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the

1986 Tax Reform Act," Journalof PoliticalEconomy (June 1995): 551-572.
81 Gerald Auten and Robert Carroll, The Effect of Income Taxes on HouseholdIncome, U.S.
Department of the Treasury, OTA Working Paper 75 (1998).

219
TAX INCREASES WOULD DAMAGE THE ECONOMY
Introduction. Federal policymakers have recently floated a
number of proposals to levy new taxes or to increase existing taxes.
These include:
> higher individual income tax rates,
> higher tax rates on capital gains and dividends,
> an income tax surcharge on upper income households,
> removal of the earnings cap on payroll taxes for OASDI benefits
(i.e., Social Security pensions),
> eliminating the tax treatment of carried interests as capital gains,
> higher motor vehicle fuel taxes, and
> a new tax on the carbon content of energy.
However, these tax proposals are not paired with significant
spending reductions. Instead, many are combined with plans for new
spending. It is doubtful whether these proposals should be considered
as deficit reduction measures.
Moreover, the tax relief provisions enacted in 2001 and 2003 are
currently scheduled to expire on December 31, 2010. These include:
> the reduction in individual income tax rates from a range of 15
percent to 39.6 percent to a range of 10 percent to 36 percent,
> the $1,000 per child tax credit,
> the 15 percent tax rate on long-term capital gains and dividends,
> marriage tax penalty relief, and
> the "death" tax phase-out.
Imposing tax increases at this time, whether through legislation or
the failure to renew expiring tax relief provisions, may slow real GDP
growth in an economy that has already been weakened by the bursting
of housing bubble, the meltdown of the subprime residential mortgage
loan market, and high oil prices. Over the next several quarters, real
investment in housing may decrease, and a negative wealth effect due
to declining housing prices may dampen real growth in consumer
spending.
Any significant increase in the marginal tax rates for either
households or businesses at this time may slow the growth of business
investment in new structures, equipment, and software and may
exacerbate any weakness in consumer spending. Hence, tax increases
at this time would counteract the monetary easing by the Federal

220

Reserve and could push the U.S. economy into an otherwise avoidable
recession.
Macroeconomic effects of higher taxes in the aggregate. Recent
research has found that higher federal taxes may significantly reduce
real GDP during the following three years. Christina Romer and David
Romer (2007) examined the macroeconomic effects of all U.S. tax
changes from 1947 to 2006.1 Using official records, the authors
classified all tax changes by their primary purpose into two categories:
endogenous and exogenous. Endogenous changes were intended to
maintain or restore normal economic growth. These include tax
increases to pay for specific programs 2 and short-term countercyclical
tax changes. 3
In contrast, exogenous tax changes were intended to stimulate
long-term economic growth or to reduce inherited federal budget
deficits. 4 By separating tax changes into endogenous and exogenous
categories, Romer and Romer obtained a more accurate estimate of the
macroeconomic effects of any given tax change expressed as a percent
of GDP. The authors found:
> "[Exogenous] tax increases appear to have a very large, sustained,
and highly significant negative impact on output ... [exogenous]
5
tax cuts have very large and persistent positive effects on output."
An exogenous tax increase equal to one percent of GDP caused a
decline in GDP over the next ten quarters to a maximum of 3
percent below the baseline before leveling out.6
> Most of this reduction in GDP occurs because of a decline in
investment. "In response to a tax increase of one percent of GDP,
the maximum fall in personal consumption expenditures is 2.6

1~~~~~~~~~~~~~~~~~~~~~

Christina D. Romer and David H. Romer, "The Macroeconomic Effects of Tax Changes:
Estimates Based on a New Measure of Fiscal Shocks," National Bureau of Economic Research
Working Paper 13264 (July 2007). Found at: http://www.nber.org/paoers/wl3264.
2For example, enactment of the motor vehicle fuel tax to pay for the interstate highway system
and a number of increases in payroll taxes to pay higher OASDI benefits before they were
indexed for inflation.
3For example, the surtax in 1968 and the tax rebate in 1975.
The pro-growth tax reductions include the Kennedy-Johnson Revenue Act of 1964, the Reagan
Economic Recovery Tax Act of 1981, the Bush (43) Economic Growth and Tax Relief
Reconciliation Act of 2001, and Jobs and Growth Tax Relief Reconciliation Act of 2003. The
deficit reduction tax increases include the Bush (41) Omnibus Budget Reconciliation Act of 1990
and the Clinton Omnibus Budget Reconciliation Act of 1993.
Romer and Romer, 20.
6
Ibid., 19.

221
percent, just slightly less than the maximum fall in GDP. The
maximum fall in gross private investment is 12.6 percent." 7
Romer and Romer subdivided exogenous changes into tax
reductions to stimulate long-term growth and tax increases to reduce an
inherited budget deficit. Tax reductions for long-term stimulation have
similar effects to exogenous changes as a whole. In contrast, "output
does not fall at all following deficit-driven tax increases." 8 However,
there were too few examples of tax increases for deficit reduction to
calculate their effects precisely.
"Deficit reduction packages ... often include at least some small
cuts in spending." 9 Accompanying spending reductions may signal
that additional tax receipts will actually be used to reduce budget
deficits rather than to boost spending. Thus, deficit reduction packages
may have beneficial effects on output through expectations concerning
long-term real interest rates that can offset the negative effects that
higher taxes and lower spending would otherwise have on output.
Tax increases for deficit reduction raise gross private investment
over the first three quarters, but this effect declines over the next seven
quarters. Housing investment is more responsive than business
investment. Consumer spending on durable goods increases, while
consumer spending on non-durable goods and services declines. This
pattern suggests that household expectations may improve and real
long-term interest rates (to which housing investment is particularly
sensitive) may fall in response to tax increases for deficit reductions

High economic costs from existing federal taxes.

Existing

federal taxes already impose a large burden on the U.S. economy. In
fiscal year 2006, federal revenues were $2.4 trillion (equal to 18.4
percent of GDP). However, the federal tax system imposes other costs
on the U.S. economy above and beyond the amount of federal tax
receipts collected. These costs arise from three sources:
1. Administrative costs are the expenses that the U.S. government
incurs in devising, administering, and enforcing its tax laws. In
fiscal year 2006, the Internal Revenue Service spent $10.7 billion,
or 0.5 percent of federal tax receipts.

2. Compliance costs are the value of time and the out-of-pocket
expenses that individuals and businesses must shoulder to
learn tax requirements, keep records, and prepare returns,
7Ibid.,

38.
Ibid., 22.
9Ibid., 23.
Ibid., 40-41.
8

222

including accounting and legal fees. In 1999, compliance
costs were estimated to be $100 billion, or about 9.4 percent
of federal income tax receipts."
3. Excess burden of taxation. Excess burden or deadweight
loss is the reduction in potential output or economic welfare
that occurs when taxes distort behavior. High marginal tax
rates:
discourage individuals from working and businesses from
undertaking investments that would increase GDP;
> cause individuals and businesses to arrange their transactions
in ways that minimize tax payments even though these
arrangements may reduce GDP; and
> prompt individuals to increase their consumption of less
valuable goods and services that are tax-preferred instead of
more valuable goods and services that are taxed.
Examining data before and after the Tax Reform Act of 1986,
Feldstein calculated the economic effects of a 1-percentage point
increase in all federal income tax rates. Under static modeling, this
hypothetical tax increase would generate $7.5 billion in federal
revenue. However, Feldstein estimated that it would net only $4.6
billion, or 57 percent of the static amount, after taking into account the
excess burden of this tax increase on the economy. The marginal
increase in the excess burden is $3.5 billion, or 76 percent of the $4.6
billion net gain in tax revenue. Thus, the actual cost of a new dollar of
federal spending in this example is $1.76 ($4.6 billion of additional
spending financed by an equal amount of new taxes really costs the
economy $8.1 billion in taxes and lost potential GDP).12
Effects of different types of tax increases. Whether endogenous
or exogenous, previous research has found that the elasticity of labor,
investment, saving, and consumption with respect to after-tax return
(cost) varies widely. Thus, the marginal excess burden of each type of
tax differs substantially. 13 Alternative tax increases designed to raise
>

Joel Slemrod and Jon Bakija, Taxing Ourselves: A Citizen's Guide to the GreatDebate over
Tax Reform (Cambridge, Massachusetts: MIT Press, 2000): 137.
12Martin Feldstein, The Effect of Taxes on Growth and Efficiency, NBER Working Paper 12201
(May 2006).
Charles Ballard, John B. Shoven, and John Whalley (1985) found that while the average excess
burden across all taxes of raising extra revenue was 33.2 percent, the marginal excess burden from
specific taxes ranged from 11.5 percent to 46.3 percent. Charles Ballard, John B. Shoven and

223
the same amount of receipts can have significantly different effects on
output. For example:
> Private business investment in non-residential fixed assets is very
responsive to expected after-tax returns. The after-tax return is
affected by the marginal individual income tax rates, the marginal
corporate income tax rate, tax depreciation schedules, investment
tax credits, and marginal tax rates on dividends and capital gains.' 4
> Households may choose when to sell their assets. The realization
of capital gains is very responsive to changes in the marginal tax
rate on capital gains.
If the goal of the federal tax system is to raise a given amount of
receipts with the smallest negative effect on output (i.e., minimize the
excess burden of taxation given the desired level of revenue), then
policymakers should concentrate taxes on economic activities that have
a low responsiveness with respect to their after-tax rate of return. Of
course, policymakers may have other objectives in designing taxes.
These include the "ability to pay" principle, the desire to link certain
benefits and taxes, simplicity and ease of collection, and concerns
about the after-tax distribution of income and wealth among
households.
However, many of the proposed tax increases that have been
recently floated are precisely those types of tax changes that previous
research suggests are the most damaging to future economic growth by
increasing the marginal tax rate on economic activities that are the
most responsive to changes in the after-tax rate of return. These
include:
> higher individual income tax rates,
> higher tax rates on capital gains and dividends,
> an income tax surcharge on upper income households, and
> removal of the earnings cap on payroll taxes for OASDI benefits.
Conclusion. The bursting of the housing bubble and the meltdown
in the subprime residential mortgage loan market may weaken real
GDP growth over the next several quarters. Some policymakers have
recent floated proposals to levy new taxes or increase existing taxes.
Recent research suggests that exogenous tax increases are very
damaging to economic growth. Moreover, many of the ideas floated
John Whalley, "General Equilibrium Computations of the Marginal Welfare Costs of Taxes in the
United States," American Economic Review 75 (March 1985).
14 For a discussion, see: Robert P. O'Quinn, FederalIndividual Income Taxes and Investment:
Examining the EmpiricalEvidence, prepared for the Joint Economic Committee, 107"' Cong., 2"d
sess. (June 2002).

224
for raising taxes are precisely the types of tax increases that are likely
to have most damaging effects on GDP for each dollar in new receipts.

OPEC'S PURSUIT OF $70 TO $80 OIL
Increasing world oil demand. The world economy has continued to
grow, and as a result, world oil consumption has kept rising while also
following a seasonal pattern. There is a relative high in the winter and
a relative low in the spring. Figure 1 shows oil consumption by
quarter beginning with 2004. Based on the typical increase, the Energy
Information Administration (EIA) projects oil consumption to reach
87.4 million barrels per day (b/d) in the fourth quarter of this year (see
dotted line).
Figure 1

WORLD OIL CONSUMPTION

88 -

EIA

~~~~~~FORECAST_

84-

2007
2005
2004

tempered by warm winter,
80

78
Q1

OPEC cut its supply. Countries outside OPEC can only increase oil
output slowly. The cartel, on the other hand, can increase oil output
relatively quickly; however, it has cut back its rate of oil production.
Figure 2 shows EIA oil supply data for OPEC (excluding new member
Angola) over the past 10 quarters. The price of crude oil has been
above $70 per barrel this summer and presently exceeds $75. If OPEC
does not reverse course soon and the demand pattern represented in
Figure 1 holds, the price may increase still further. The cartel
members will meet on September 11 and decide whether to increase oil
production in time for the winter heating season.
OPEC's Price objective. In past years, OPEC officials have indicated
implicit price objectives in the $50 and then in the $60 per barrel
range. Since last summer, they actually may have been aiming for $70.
In August 2006, OPEC's president expressed satisfaction with $70 oil
and claimed that it was not damaging the world economy. Heightened
supply risks-war in Lebanon and the possibility of another "Katrina"
among others-had threatened the oil market and moved oil buyers to

226
OPEC OIL SUPPLY*

Figure 2
35.0
o34.5-

34 0 33.5 -

33.0 -

ydtOffician
support pnce.

32.0
' Excluding
Angola

Q1- Q205 05

Q305

Q4- Q1- Q2- Q3- Q4- Q1- Q207 07
06
06 06 06
05

stock up precautionary inventories. OPEC did not accommodate the
added demand, which consequently pushed the price up. When
Precautionary inventories were released again, the cartel withdrew
supply from the market to support the price. The top portion of Figure
3 shows 2006 oil inventory levels in the summer rising far above the
range of the previous five years. By autumn, the most severe supply
risks had passed and oil from inventory was meeting consumption
demand. Some OPEC members promptly reduced their output to
offset the oil flow from inventories. But as the price continued to
decline, the call went out to all cartel members to cut production by a
Figure 3 OECD TOTAL COMMERCIAL OIL STOCKS
Billion
barrels
2.8

OECD stocks

Vlhs):

2001-2005 range

-2006 2007

2.7
2.6
2.5
Spare OPEC capacity
(million barrels daily, rs

2~~~~~~~~~~~~~~~~~~~~~~~~~~~

Jan

Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr
2007
2006

RP Statistical Review of World Energy 2007

Source: 1EA,EIA
BP 2007
Sr

227

total of 1.2 million b/d. The vertical bars in the bottom portion of
Figure 3 represent resultant increases in the cartel's spare pumping
capacity.
OPEC idled more and more pumping capacity as oil from
inventory entered the market (note the decline in the inventory level as
of September 2006 and its return to the five-year average range by
February 2007). OPEC managed to reverse the price decline. Warm
weather during early winter and a slowing U.S. economy tempered the
seasonal rise in 2006 fourth quarter oil consumption (see circled data
point in Figure 1) and price fell, whereupon OPEC cut output by
another 500 thousand b/d in February. Figure 4 depicts the crude oil
price movements since 2005. Starting at $50 this year, the price has
climbed back above $70 per barrel. Throughout, the cartel has held to
its reduced oil output quotas. OPEC officials often proclaim that they
offer as much oil to the market as is "needed" and blame a host of
factors outside their control for high prices. Unofficially, however,
they appear to have been working toward a crude oil price of $70 per
barrel all along 96 The cartel's September meeting may reveal whether
they now are aiming still higher.
OPEC is behind the rising trend in oil prices. It bears emphasis that
increases in oil demand do not necessitate higher prices in this market.
The cost of oil production, less than $10 per barrel for OPEC as a
whole and $5 or less for its Persian Gulf members, is so far below price
that supply could expand very profitably to meet incremental demand
without further price increases. OPEC's concerted effort to constrict
oil production in the face of rising demand is driving the price up.
Having abandoned its previous official price band of $22 to $28 per
barrel, OPEC refuses to announce a new one and counteract
precautionary or speculative demand surges, because it wants the price
to keep rising as world oil consumption increases. To facilitate the
price rise, it cut its oil production unabashedly and is adding new
members to it ranks. Angola, one of the fastest growing oil producers
and China's largest supplier of crude in 2006, joined the cartel as of
January "St. Reportedly, Angola will be assigned a quota soon to cap
its oil output growth.

96 International Energy Agency's (LEA) director general, Claude Mandil, stated: "The market has
become aware [that OPEC] has set an implicit new objective of keeping prices at or around $70
per barrel and that the organization is trying to defend this level." Thomson Financial, 8/28/2007.

228
Figure 4

THE PRICE OF CRUDE OIL
- Dated Brent
- - _- - _

US dollars per barrel
- - -

prce-eobjictive.

s
75PECk

70
65

Average
60 price),A-

55
OPEC reverses
price decline
-with-ovember
output cut.

45
40
35Jan-05

_______

May-05

Sep-05

BP Statistical Review of World Energy 2007

Jan-06

May-06

Sep-06

-PEGoffsets
mild winter with
-- ;--F el5Farycut.
Jan-07

May-07
COBP2007

Conclusion. OPEC's public statements should not always be taken at
face value, but they can provide clues about its intentions, particularly
in retrospect when one can match observable actions to them. OPEC
takes any new oil price peak that the world economy has absorbed,
even for a short time, as the rightful price for its oil. To speed the
return to a price peak, it will reduce its oil supply even as demand is
trending upward. Oil demand has been increasing mainly in Asia, and
the cartel leaders appear to believe that Asia's rapid economic growth
not only will be sustained, but together with Middle East growth, can
97
Therefore, the cartel has become less
offset a slow-down elsewhere.
concerned with the economic stress ever-higher oil prices cause and
more assured in its pursuit of aggressive price objectives. At its
September 11 meeting, it is likely to remain intransigent with respect
to oil supply expansion.

97 See Bhushan Bahree, "Why Fears of a U.S. Slowdown Aren't Weakening Oil Prices," The
Wall Street Journal, 8/27/2007.

FRASER