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Foreclosures:

In a comment to my earlier post, a Commenter notes that foreclosures have risen dramatically over the past several months. This raises an excellent quesiton, and one that I was actually going to address in my initial post. It may be worth mentioning briefly why I don't view foreclosure numbers as a particularly good metric for measuring financial distress. I thought it might be too distracting to discuss in the initial post, but since it was raised in the Comments I'll go ahead and say a few words here.

Home foreclosures are analytically more complicated than consumer debt delinquencies and charge offs. There are two competing theories of foreclosures. One is a "distress" theory the other is an "option" theory. Under the distress theory, a rise in interest rates could cause an involuntary default and subsequent foreclosure, by making it more difficult to make monthly payments. The option theory views foreclosure as a rational economic "option," which is that when you buy a house using a mortgage you also buy an option to default. When housing prices fall, economic theory predicts that more people will exercise this option to default and permit foreclosure. One would especially expect to see the exercise of such an option for "investment" properties, such as condominiums held as a speculative investment rather than for owner-occupancy. And if the loans are non-recourse, then this makes the option even more valuable. I discuss some of this literature in passing in my article on the bankruptcy crisis.

The empirical difficulty is disentangling the option theory from the distress theory, especially if there is a simultaneous rise in interest rates and fall in housing prices (the two being related, of course). A rise in interest rates would lead to increased foreclosures under a distress theory (because it will be more difficult for consumers to make their monthly payments), whereas a fall in housing prices would lead to increased foreclosures on an option theory.

If interest rates have stabilized, but housing prices have continued to fall, this would be more consistent with the option theory of foreclosure.

To the best of my knowledge, we don't know the extent to which the recent rise in foreclosures is the result of investors exercising their default option to surrender their properties. I have seen reports that some cities that have had the largest rises and falls in residential real estate are also those that had the largest number of speculators, but this seems to be anecdotal.

Certainly consumer debt more generally has this option value built into it, but the value of the option is not as likely to vary over time as for real estate and real estate foreclosures.

Cathy (mail) (www):
An increase in the numbers of calls to legal aid organizations for help in avoiding foreclosures would signal that there's been a rise in the "distress" category.

(And from what I've heard, there's data indicating that such an increase has been occuring.)
12.20.2006 12:09pm
Byomtov (mail):
Don't states vary in the degree to which mortgage debt, as a practical matter, is non-recourse or full-recourse? Clearly "option foreclosures" should be more common in states where the debt is closer to non-recourse, so some sort of state-based comparison might let the two types of foeclosures be disentangled.

Another approach might be to look at how long a property's value was less than its loan balance before foreclosure. My guess is the longer this was the case the more likely the foreclosure was due to distress. Getting this data might be difficult, though.
12.20.2006 12:18pm
Alex R:
A fall in housing prices can lead to a rise in "distress" foreclosures as well as "option" foreclosures.

After all, in a period of rising housing prices, homeowners in distress are much more likely to have the option of simply selling their house to pay off their mortgage and other obligations. Only when the housing market is slow and the prices available are low will a distressed homeowner have to resort to defaulting on their mortgage and going through foreclosure.
12.20.2006 12:20pm
cirby (mail):
I know a few people who have had recent foreclosures.

Every single one of them was trying to make money by "flipping" houses for investment and resale. None of them lost their actual homes.
12.20.2006 12:47pm
abean:
And correspondingly investment properties have a higher risk premium built into the interest rate.

What you need is data that classifies foreclosures by whether or not the property was the primary residence.
12.20.2006 1:01pm
Tracy Coyle (mail) (www):
Cirby: I know a few people who have had recent foreclosures, and not a one of them was an investor.

Current example: Client bought a house in 2004, ARM, 6 month adjustments starting in year 2....June to be exact. Mortgage payment first 2 years, about $1100 increased to $1,475 in July and it is expected to increase to $1,590 in January. It will increase to about $1,700 in July to about $1,800 on Jan 1, 2008. Interest rates only need to rise another 1/2% to max out the rate at 14.25% 8.25 to 14.25 in 18 months. Client's fault though...they signed the papers.

We have had no investor led housing boom in WI. The current rise in foreclosures approaches 50% in the region. The vast number of foreclosures here are by families and couples of modest means.

Todd, the only option foreclosure we are seeing is the one exercised by mortgage companies when they wrote the mortgage. A 6% increase in interest rates in 18 months is a foreclosure scam in everything but name. By the way, the mortgage company is Homecomings....not exactly a small operator.

Make all the comments about clients getting in over their head, we agree. BARF failed however to hold the credit granting industry accountable too. Is there anyway you think an honest mortgage company could assume anyone could afford a 60% increase in mortgage payments?
12.20.2006 6:40pm
ohwilleke:
I know of very few states other than California in which a mortgage debt is non-recourse. Generally, the remedy is to make a bid at a foreclosure sale, which, if insufficient to cover the entire debt, results in a deficiency judgment against the debtor-former homeowner.

The deficiency judgment is a powerful motive for investment property owners who make up a very small percentage of foreclosures, since they have other assets from which the deficiency can be collected (although underwriting makes such deficiencies rare). This is consistent with them acting as rational actors.

But, residential foreclosures are common, precisely because most people facing a residential foreclosure are insolvent, rendering the deficiency judgment meaningless. The are grossly overrepresented among subprime loan customers who generally lack even the funds to make a significant down payment. It is often eliminated in a subsequent bankruptcy or by operation of the statute of limitations on enforcement of the deficiency debt or judgment.

I don't see the meaningful analytic difference between a defiiency judgment debt of an insolvent person and a credit card debt of the same person. Since foreclosed upon persons are overwhelmingly insolvent household, mistrust of foreclosure figures as an indicator of financial distress is misplaced.
12.20.2006 7:28pm
Aleks:
Re: Generally, the remedy is to make a bid at a foreclosure sale, which, if insufficient to cover the entire debt, results in a deficiency judgment against the debtor-former homeowner.

Doesn't PMI pay the shortfall in such cases? I thought that was the whole reason why PMI was mandatory in cases where the borrower would have low or minimal equity (generally less than 20% of the assessed value of the house; there's unlikely to be a shortfall if the borrower has more than 20% equity in the property, meaning the mortgage debt is less than 80% if the property's value).
12.20.2006 9:10pm
cathyf:
I know about cases where the borrower finds a buyer willing to pay the market value of the property, which is less than the mortgage, and convinces the lender to take the sales amount and forgive the remaining balance. Such arrangements can be the best deal for the lender, since they would have to pay various agents to prepare the property for sale and sell it if they foreclosed, whereas if the borrower does the sale then borrower has a strong interest in making the property as attractive as possible.

How do such "distressed" sales count? Typically, the deal is that the borrower puts some "sweat equity" in to minimizing the lender's loss, and in return the lender does not report anything adverse on the borrower's credit report.
12.20.2006 11:01pm
Tracy Coyle (mail) (www):
I don't know about other state's foreclosure process, but here is Wisconsins: Foreclosure complaint filed after 90 days delinquent; no objection or no cause not to grant results in default judgment about 35-40 days after service upon homeowner; 12 month redemption period UNLESS at the time the mortgage is written, clause allowing 6 month redemption period with no opportunity for deficiency. Standard mortgages in this state all have that clause. 6 months after judgment, sheriff sale is scheduled and held (usually 2-4 weeks) and then a confirmation hearing 15 days later. We have filed Chapter 13s up until confirmation (including one 4 minutes after the confirmation hearing was scheduled to start but finished filing before the signing of the confirmation order - not recommended and was a pain...client ended up defaulting on post-petition payments and chapter 13 plan payments 5 months later).

Except for the credit report hit, foreclosures are pretty painless here for the client (financially speaking). They can stay in the property up until confirmation paying only utilities and insurance. After time from first late to confirmation is usually a year, often more.
12.20.2006 11:21pm
neurodoc:
TZ: "If interest rates have stabilized, but housing prices have continued to fall, this would be more consistent with the option theory of foreclosure."

I should think the economic analysis to support such an inferrence might be rather tricky. The price that bonds trade at might adjust immediately in response (inversely) to changes in interest rates, but housing prices don't change in such lock-step synchrony with interest rates. And I expect "momentum" is a potentially significant factor, with a rise or fall in interest rates setting off rises or falls (again, usually an inverse relationship) in housing prices, but with some initial delay, then quickening upward with exuberance or downward with panic.

One can manage for awhile with their head under water, but then must come up to breath. A "distressed" homeowner may hold out for awhile with their figurately underwater, but they will come up for air, the question only how long can they hold out for? If they bail quickly, will they appear to be "distressed," as they in fact are, or an "option" owner exercising it.

Professor Bernstein has made clear that an "option" is not for him. (There may be more volatility in real estate values because of fewer opportunities to hedge, but to offset that effect there is the "stickiness" in residential real estate, since non-distressed owners can often elect to stay longer in their current homes, holding out for the higher price they hope to get when real estate rebounds.)
12.21.2006 3:30am