The Long-term Pain of Foreclosures

An Economic Letter from the Federal Reserve Bank of San Francisco compares the housing market collapse and recovery since the housing market began to turn south in 2006 and looks at how quickly defaulting mortgage holders return to the housing market.

Looking back through history, generally, over an economic cycle, between 0 and 2 percent of mortgage holders default.  This changed markedly as the housing market began its downturn in 2006 with the total default rate climbing to 10 percent of all mortgages and, on top of that, holders of subprime mortgages were defaulting at rates that exceeded 25 percent.  That's right, one in four subprime borrowers found themselves defaulting on their mortgages!  Even now, over three years into "economic recovery mode", 20 percent of homeowners find themselves with more mortgage than house, giving them an increased incentive to default.

Mortgage holders that default give themselves a bit of a financial break; many times, the period of time between default and foreclosure means that borrowers can remain in their homes without paying rent.  As well, since the cost of carrying a mortgage can range upwards from 30 percent of a household's income, not making monthly mortgage payments can greatly increase a household's ability to set money aside.

On the downside, defaulting borrowers often see a big decline in their credit scores and these declines appear to be long lasting.  On top of that, borrowers who default on mortgages tend to default on other types of credit, impacting their ability to borrow.

Looking at loan data between 1999 and the end of 2011, the authors of the research examine how long it takes for a household to borrow again to buy a home after defaulting on a mortgage.  The decision regarding access to credit is treated as it was a decision made by lenders, that is, when are banks etcetera willing to lend to a borrower with a less than stellar credit history?  One of the restrictions on borrowers is the rule that prevents Fannie Mae and Freddie Mac from securitizing loans made to borrowers that have defaulted or declared bankruptcy until four to seven years have passed unless the lender is willing to take 100 percent of the risk and keep the mortgage on its own books.

Here is a graph summarizing the author's findings:

The blue line shows the rate of returning to the mortgage market for borrowers that have terminated their mortgages without foreclosures.  These borrowers may have terminated their mortgages because of a move or because they downsized and required a smaller mortgage.  By the time 50 quarters or 12 years have gone by, 35 percent of these borrowers have taken out another mortgage.  This compares to just over 10 percent of borrowers that had a history of mortgage delinquency as shown with the red line.

Here is a graph showing the rate at which borrowers who have defaulted on their mortgages in the 2001, 2003 and 2008 downturns returned to the mortgage market after defaulting:

Notice that the rate at which defaulting borrowers returned to the mortgage market after the 2001 and 2003 economic downturns was far faster than after the 2008 downturn.  Nearly three years (14 quarters) after the 2008 downturn, only 5 percent of defaulting borrowers had taken out a new mortgage compared to between 15 and 20 percent in 2001 and 2003.  This could reflect one of two things:

1.) The demand for housing in 2001 and 2003 was much stronger than it is now and the post-2001 and 2003 economic recoveries were much stronger than the "recovery" after the Great Recession.

2.) Credit supply is tight and banks are leery of loaning to borrowers with low credit scores.  Keep in mind that the mortgage industry was only too willing to loan to anyone with a pulse in the first half of the decade thus, the advent of the subprime mortgage.

As shown here, borrowers with less than stellar credit (i.e. a score of less than or equal to 650) are much slower to return to the credit market with less than 10 percent returning in 10 years (40 quarters) compared to nearly 40 percent of their more creditworthy counterparts:

By any standard, ten years is a long time to remain out of the housing market.

How will all of this impact the nation's housing market?  Since 2007, an estimated 4 million foreclosures have taken place, greatly reducing the short-term demand for housing.  On top of that, this research shows that households that have undergone the process of foreclosure, are very, very slow to return to the housing market with only about 10 percent returning in a 10 year period.  This means that, over the long-term, the demand for housing will be constrained by a lack of incentive for many badly burned buyers to re-enter America's housing market.