Sunday, October 19, 2008

Negative Equity and Foreclosure: Some Interesting Factoids and Opinions from Recent Research

Cutts, Amy Crews and Richard K. Green, 2004, “Innovative Servicing Technology: Smart Enough to Keep People in Their Houses?” Freddie Mac Working Paper #04-03, July.

Deficiency judgments can mitigate moral hazard caused by falling house prices. In states that allow them, other borrower assets can be claimed by the mortgage lender to cover losses incurred through the foreclosure (and foreclosure alternatives) process, and thus discourage a borrower from reneging on their obligation. Most lenders require an involuntary inability to pay before workouts are approved, meaning the borrower does not have the capacity to fully reinstate and carry the mortgage due to illness, job loss, significant property damage or depreciation, or other significant economic shock.

Only six states currently prohibit the lender from seeking a deficiency judgment recourse against a foreclosed borrower – California, Minnesota, Mississippi, Montana, North Dakota, and West Virginia. In the early 1990s, California, a non-recourse state, and Massachusetts, a recourse state, suffered similar declines in house prices and job losses. In 1995, the peak default year in both places, Fannie Mae saw more than 7 times the REOs and foreclosure sales in California than in Massachusetts but had only 5 times more credit-risk exposure (Inside Mortgage Finance, 1995). Although only anecdotal evidence exists of California borrowers ruthlessly using their option to default through moral hazard rather than involuntary inability to repay, the Fannie Mae experience suggests that allowing deficiency judgments at least reduces the incidence of foreclosure when home values decline.

Cutts, Amy Crews and William A. Merrill, 2008, “Interventions in Mortgage Default: Policies and Practices to Prevent Home Loss and Lower Costs,” Freddie Mac Working Paper #08-01, March.

We find that the foreclosure process varies widely across states, currently lasts an average of 354 days between the due date of the last payment made and the loss of the home at the foreclosure sale, and that the costs associated with foreclosure rise significantly with the length of the foreclosure timeline, by as much as 12 percent for every 50 days added to the timeline. Perhaps more importantly, we find that the likelihood a borrower will reinstate her loan out of foreclosure falls as the length of time in the legal foreclosure process increases – by our estimates, states with excessively long legislated foreclosure timelines could increase the probability of successful reinstatement of delinquent borrowers by 3 to 9 percentage points by shortening their statutory timelines to match the national median timeline. Timelines that give the borrowers too much time in the legal foreclosure process tip the balance from the threat of imminent home loss from perfected foreclosure towards the benefit of “free” rent for the duration of the process, providing an incentive for borrowers to forego reinstatement of the loan even if they have the means to do so. By the same reasoning, some very short timeline states may find that lengthening their legal foreclosure timelines may improve cure rates out of foreclosure by giving delinquent borrowers enough time to cure the delinquency once the formal legal foreclosure process has been initiated.

Foote, Christopher L., Kristopher Gerardi, and Paul S. Willen, 2008, “Negative Equity and Foreclosure: Theory and Evidence,” Federal Reserve Bank of Boston Public Policy Discussion Paper No. 08-3, May.

Millions of Americans have negative housing equity, meaning that the outstanding balance on their mortgage exceeds their home’s current market value. Our data show that the overwhelming majority of these households will not lose their homes. Our finding is consistent with historical evidence: we examine more than 100,000 homeowners in Massachusetts who had negative equity during the early 1990s and find that fewer than 10 percent of these owners eventually lost their home to foreclosure. This result is also, contrary to popular belief, completely consistent with economic theory, which predicts that from the borrower’s perspective, negative equity is a necessary but not a sufficient condition for foreclosure. Our findings imply that lenders and policymakers face a serious information problem in trying to help borrowers with negative equity, since it is difficult to determine which borrowers actually require help in order to prevent the loss of their homes to foreclosure. We review several policy proposals. Proposals to address this information problem either drastically limit the effectiveness of the policy, or lead to serious moral hazard problems. We argue that the most promising policy proposals focus on making mortgage payments temporarily affordable, without permanently reducing the outstanding balance owed.

LaCour-Little, Michael, Eric Rosenblatt, Vincent Yao, 2008, “Do Borrowers Facing Foreclosure Have Negative Equity?” Unpublished Working Paper, July.

We have shown that in Southern California the majority of borrowers facing foreclosure in late 2006 and 2007 had negative equity, whether measured before or after transaction costs. Most of these households had experienced very rapid house price growth during their tenure as homeowners and had already extracted most of the accumulated appreciation through either refinancing or junior lien borrowing. Total equity extracted exceeds $300 million. Even after these foreclosure events, the unleveraged return on investment for these property owners is very high: roughly 40% over their holding period. If borrowers financed these purchases with 100% financing, of course, the returns on investment are infinite. Why such borrowers should enjoy any special government benefits such as waiver of the income taxation of debt forgiveness is at best unclear.

While capital losses resulting from the house prices declines that began, in most cases, in 2006 contributed to incidence of negative equity, excessive borrowing was also an important contributory factor. In addition, while house price declines were important in explaining the incidence of negative equity, its magnitude was more strongly influenced by increased debt usage. Hence, borrower behavior, rather than housing market forces, is the predominant factor affecting outcomes. We also found a surprisingly large number of homeowners who appear to have substantial positive equity at the time of foreclosure. Why they were unable or unwilling to sell their property and mitigate their losses associated with foreclosure is unclear. Careful examination of this subset of foreclosure sales represents an interesting future research extension.

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