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.

Foreclosures In America - Is the Situation Improving?

CoreLogic recently released its National Foreclosure Report for January 2012.  This report provides data on delinquency rates, completed foreclosures and the foreclosure inventory each month.

In January of this year, CoreLogic reports that 1.4 million homes or 3.3 percent of the nation's inventory of all homes with a mortgage were in the foreclosure inventory (the stock of homes in the foreclosure process) compared to 1.5 million or 3.6 percent one year earlier.  This number is little changed from the previous month, December 2012, when 1.4 million or 3.4 percent of homes were in foreclosure.  Homes are placed into the foreclosure inventory when the mortgage issuer places the home into the foreclosure process after the mortgagee is seriously delinquent.  The property remains in the mortgage inventory until the foreclosure process is completed.  Of the top 100 real estate markets in the United States, 32 are showing an increase in the foreclosure rate in January 2012 when compared to data from a year earlier.

How many homeowners are delinquent on their mortgages?  Nationally, according to CoreLogic, 7.2 percent of borrowers were more than 90 days delinquent, the same level as was seen in December 2011 and down from the level of 7.8 percent experienced one year earlier.  For the 12 months ended January 2012, 860,128 foreclosures were completed.

The one issue that is not improving is the inventory of REO (real estate owned) properties.  These properties are owned by banks, government agencies or other lenders after the foreclosure process is completed and the lender legally repossesses the property.  In January, the inventory of REO assets grew faster than the rate at which these REO properties sold.  This is measured using the distressed clearing ratio which is calculated by dividing the number of REO sales by the number of completed foreclosures.  The higher the ratio (i.e. the closer the number is to 1.0), the faster the pace of REO sales is to the additions of newly completed foreclosures.  In January 2012, the distressed clearing ratio fell to 0.69 from 0.80 in the prior month.  This is not particularly a good sign; it means that the inventory of REO properties is not dropping as quickly as new properties are being added which could put downward pressure on prices in the future.

Let's look at which states have the largest number of foreclosures completed  in January 2012:

1.) California - 155,000

2.) Florida - 86,000

3.) Arizona - 65,000

4.) Michigan - 65,000

5.) Texas - 57,000

These five states account for 49.7 percent of the nation's completed foreclosures in the month.

Now let's look at the states that have the highest overall foreclosure rates for the month of January 2012:

1.) Florida - 11.8 percent

2.) New Jersey - 6.4 percent

3.) Illinois - 5.3 percent

4.) Nevada - 5.0 percent

5.) New York - 4.7 percent

Here are the five states with the highest overall 90 day plus delinquency rate recalling that the national average rate is 7.2 percent:

1.) Florida - 17.4 percent

2.) Nevada - 13.3 percent

3.) New Jersey - 10.7 percent

4.) Illinois - 9.2 percent

5.) Maryland - 8.1 percent

Lastly, here are the five major markets that have the highest 90 day plus delinquency rates noting the percentage point change from a year earlier:

1.) Orlando - Kissimmee - Sanford, FL - 18.2 percent (down 1.4 percentage points)

2.) Tampa - St. Petersburg - Clearwater, FL - 17.1 percent (down 0.1 percent points)

3.) Chicago - Joliet - Napierville, IL - 10.7 percent (up 0.3 percentage points)

4.) Nassau - Suffolk, NY - 10.4 percent (up 0.3 percentage points)

5.) Riverside - San Bernardino - Ontario, CA (down 3.9 percentage points)

From RealtyTrac, here is a map showing the foreclosure rate across the United States with the biggest problem areas in darkest red noting the sun'n'sand and de-industrialized heartland hotspots:

To put all of this data into perspective, let's go to the FRED website and look at a graph showing the delinquency rate on single-family residential mortgages back to 1990:

The vertical grey bars show recessions.  Notice that delinquency rates during the 2001 - 2002 recession barely increased, peaking at 2.41 percent in October of 2001.  Even after the more severe recession in the early 1990s, the delinquency rate only reached 3.42 percent.  This time really IS different.  According to the St. Louis Fed, here's what the delinquency rate looked like since the beginning of 2008:

Notice that the peak delinquency rate of 11.36 percent was reached in the first quarter of 2010.  While this rate has dropped very slightly, it seems to be entrenched above 10 percent and remains very close to the highest rate since 1990.

RealtyTrac projects that foreclosure activity is expected to increase by 15 percent in 2012 compared to 2011.  February's data shows that 21 states reported annual increases in foreclosure activity, a level not seen since November 2011.  While some measures are showing very modest improvements in some parts of the U.S. housing market, it is quite clear that the foreclosure problem is likely to be with us for some time to come.  Until the backlog of foreclosures and delinquencies are cleared up, the housing market will not and cannot recover.  

Who is to blame for America's foreclosure crisis? Only the Fed knows for sure

Everyone's pals at the St. Louis Fed have done it again.  In the July issue of the The Regional Economist, they published an article entitled "The Foreclosure Crisis in 2008: Predatory Lending or Household Overreaching" by William Emmons (a Fed economist) along with Kathy Fogel, Wayne Lee, Liping Ma, Deena Rorie and Timothy Yeager of the Sam M. Walton College of Business at the University of Arkansas. This article attempts to answer the seemingly age-old question; was the increase in the number of foreclosures and the resulting collapse in housing prices due to stupid consumers or stupid lending practices by banks?  As a rather voracious reader of newspapers from around the world and the comments from readers that follow articles that discuss the collapsing housing markets in the United Kingdom, the United States and Eurozone countries, I see a strong divide between those who believe that consumers are to blame for their own poor decisions and those who believe that the banks in these countries did what they could to dupe unsophisticated consumers into overleveraging themselves.  Fortunately for all of us, the St. Louis Fed is doing the heavy lifting and will answer the question for us and point the fickle finger of blame at the party that created the Great Recession.  Thank goodness for all that!  Please remember, that this data and its accompanying conclusions apply only to foreclosures that occurred in 2008, however, as I’ll note later, I think that the conclusions still apply.

Let's open this posting with a quote from the article:

"The answer (to fixing blame for the foreclosure crisis) is difficult to ascertain because it ultimately depends on the intentions of the borrower and the lender. After the fact, a lender would hardly admit to deceiving a borrower, and the borrower would be more than willing to place at least some of the blame for the foreclosure on the lender."

The authors then go on to state that:

"...certainly, both predatory lending and household overreaching occurred during the subprime housing bubble. But it is important to identify the primary reason for the foreclosure crisis because the policy implications are vastly different..."

If it was over-borrowing by households that created the foreclosure crisis, then it is quite possible that another round of house price appreciation like that experienced in the early- to mid-2000s could result in another housing price bubble that would, once again, result in borrowers mortgaging themselves for more than they can afford.  The solution to this problem would require central bank intervention to recognize and prevent the development of real estate asset bubbles among others.  While the sentiment of this solution seems nice, in fact, the easy money policies of the Fed's zero interest rate policy was at least partly to blame for the formation of more than one asset bubble over the past decade (i.e. tech stocks, housing and now probably commodities); one would think that the central bankers would learn from past mistakes but apparently, things aren't quite as simple as that in the rarified air of the Federal Reserve.

On the other hand, if the foreclosure crisis was created by the predatory lending practices of the banking establishment, consumer protection laws like those found in the Dodd-Frank law would act to prevent Wall Street banks from making millions of risky loans that consumers had no possibility of repaying so that Wall Streeters can pack their bank accounts with millions of dollars in bonuses and salaries.

In order to understand the impact of both over-borrowing and predatory lending, Emmons et al used two sources of data.  The first is the RealtyTrac database that compiles nationwide data on all homes in foreclosure.  The second is the Acxiom database which compiles nationwide data on millions of United States households every quarter and divides these households based on income, demography and consumption.  The Acxiom database divides the population into "Life Stage Segments" as described here.  Each household is segmented into one of 70 segments within 21 life stage groups based on specific consumer behaviour and demographic composition.  For example, there are five main PersonicX Earnings Lifestages including Youth, Career Builder, Earning Years, Late Career and Retirement.  Each of these Lifestages is then subdivided into one of 21 Lifestage Groups.  The authors of the study combined the RealtyTrac and Acxiom databases and the resulting combined database had 40 million records with 200,000 foreclosures for the third quarter of 2008 alone.  The authors also noted that since they really had no idea what motivated households to borrow for their mortgages, they would make one of two assumptions:

1.) Households with low income and educational levels would be most vulnerable to predatory lending practices since they likely had a poorer understanding of the mortgage contract that they were signing.

2.) Households with high educational and income levels were more likely to have high economic aspirations relative to their net worth and income and would be more likely to overreach when borrowing to purchase a home.

Now, on to the conclusions of the study.

1.) Value of foreclosed homes:  The authors found that defaulted homes, on average, were more expensive than those owned by households not in default.  The median market value of homes in foreclosure was $242,400 compared to $199,129 for those homes not in foreclosure.  Homes in foreclosure had a median age of 30 years compared to 34 years for those not in foreclosure.  As well, homes in foreclosure had a median size of 1526 square feet, substantially smaller when compared to 1907 square feet for those not in foreclosure.  The median loan-to-value ratio for foreclosed homes was 96 percent compared to 65 percent for homes not in foreclosure. My suspicion is that the loan-to-value ratio for foreclosed homes today would be far worse than 96 percent with millions of homeowners currently underwater as shown here.

2.) Foreclosed Household Demographics: Households in foreclosure tended to be smaller (median size of 2.0 people compared to 3.0 people for homes not in foreclosure) with an average of 56.2 percent of foreclosure households being married compared to 70.8 percent of those not in foreclosure.  As well, 36.9 percent of households in foreclosure were owned by singles compared to 25.7 percent of households not in foreclosure.  Households in foreclosure also had a median length of residency that was substantially shorter than those not in foreclosure; 4.0 years compared to 9.0 years.  When the data is looked at as a whole, it appears to show that that households in foreclosure purchased their homes later in the bubble, paying far more for far less house and that they were at an earlier stage of their careers.  Interestingly enough, the data also shows that households in foreclosure had markedly less education with only 12 years of schooling compared to 16 years for households not in foreclosure.

By using the Acxiom PersonicX Life Stage Segments as noted above, the researchers were able to define more accurately the households that were responsible for a share of foreclosures that was out of proportion to what would be expected.  To observe which Life Stage Segments were responsible for a disproportionate share, the authors calculated the share of the total number of foreclosures for each Life Stage and then compared that to the share of the total number of households for each Life Stage.  For example, the Cash and Careers Group accounted for 5.52 percent of all households however, they accounted for 11.3 percent of all foreclosures.  The excess share of foreclosures is therefore 11.32 minus 5.52 which gives us an excess foreclosure rate of 5.78 percentage points.  For your information, on the following graph, the Group codes ending in B represent Baby Boomers, the Groups ending in X and Y represent Generations X and Y, the Group ending in M represents the Mature generation (50 and 60 year olds) and the Group ending S represents seniors.

Here is the graph showing the excess foreclosure percentages for some of the Life Stage Groups:

Let's look at the group that tended to overreach first.  Right away, it is apparent that the young, relatively affluent households of Generation X Cash and Careers Group (born in the mid-1960s to early 1970s) were responsible for an excessive number of foreclosures with 5.52 percentage points more foreclosures than their share of the population.  This group had the highest average household income ($59,500) and the highest number of years of education (14.8 years).  Next in line for an excessive number of foreclosures compared to their share of the population was the Generation Y Taking Hold Group of households with 3.66 percentage points more foreclosures than would be expected.  This group has an average age of 27.8 years, has the second highest average income ($55,500), third highest net worth (I'm assuming that's net worth prior to the foreclosure) and fifth highest education level (14.1 years).

Now let's look at the group that was most likely the victim of predatory lending practices because they had they either had lower educational levels or lower net worth and income.  The Generation Y Group Beginnings and Generation X Group Mixed Singles ranked in ninth or tenth place in income, education and net worth yet ranked seventh and eighth in terms of the number of foreclosures with 2.67 percentage points of excess foreclosures.  Note that these two less “sophisticated” groups accounted for an excess of only 2.67 percentage points compared to their better educated and affluent counterparts in the previous paragraph who were responsible for a combined 9.44 percentage point excess.

The researchers then looked at the geographic distribution of the foreclosures in the early stage of the Great Recession.  In general, the areas with the greatest price appreciation between 2000 and 2007 (think bubble) were in Florida and the Southwest and Northeast states.  Now let's look at a map that shows the concentration of foreclosures by state for the third quarter of 2008:

The concentration of foreclosures in Florida and the Southwest states tells us that these were likely a result of overreaching as households bid endlessly higher prices for their homes.  Note the disproportionately large number of foreclosures in the north-central states (Indiana, Michigan, Ohio and Illinois).  These states did not see massive price appreciation but the disproportionate number of foreclosures is likely due to the shuttering of the America’s manufacturing heartland.  When the foreclosure rates are compared to price appreciation at the state level, it is quite apparent that overreaching seems to be the cause of most of the foreclosures, that is, for those states that are outside of the states in the manufacturing heartland.  While I realize that this data is nearly three years old, it is interesting to see that the RealtyTrac foreclosure map still more or less shows foreclosure hotspots in the same bubblicious areas of the United States as were seen in the second half of 2008:

The researchers conclude that most of the foreclosures in the early part of the downturn were due to overreaching by young, affluent and highly educated households.  The existence of the housing bubble in certain parts of the United States followed by its collapse led to an elevated number of foreclosures.  It was in these areas that consumers tended to ignore the risk involved in purchasing a home because it appeared that prices would always rise.  Of course, the willingness of lenders to loan money to households that would clearly not be able to repay the debt in the future is at least part of the problem that is facing America's real estate market today and in the third quarter of 2008.  While the researchers for this paper seem to give them a pass, when one is dealing with tens of millions of mortgages, I would suspect that more than a few of them had a predatory aspect to them.

In conclusion, I'll close with the last paragraph of the article since it summarize the issue facing policymakers:

"If capitalist economies are subject to periodic asset price bubbles, Hyman Minsky (an economist who wrote that prolonged periods of economic stability lead to speculative lending) suggested that policymakers take steps to eliminate bubbles that threaten to become systemically important. This, of course, requires the ability to 1) recognize an asset bubble, 2) classify the bubble as a systemic risk to the economy and 3) curb the formation of the bubble either through monetary policy actions or through more-targeted interventions, such as higher bank capital requirements or more stringent mortgage underwriting criteria." (my bold)

As I said at the beginning, one would wonder just how long it will take the Federal Reserve to recognize that their policies are, at least in part, responsible for the formation of asset bubbles in the economy?  As well, giving a pass to the actions of their Wall Street banking buddies for their creative lending practices during the formation of the real estate bubble is hardly reasonable but I guess it is simpler to blame consumers for overreaching their credit than it is to blame your future employer. 

That said, it is at least interesting to see where the great minds at the Federal Reserve point their fickle finger of blame at when assessing America’s housing crisis.  Apparently, it’s all Main Street’s fault.  For shame, for shame!