This article digests the circumstances accompanying foreclosure and the steps which a government should take to curb the rate of foreclosure.
As federal, state, and local governments continue to try to tame high foreclosure rates, the ability of economists, real estate brokers, and investors to predict and explain foreclosures remains limited. Until the government can accurately identify the factors that most impact foreclosure rates, it will be unable to effectively anticipate and prevent their occurrence.
Unfortunately, popular opinion about the cause of foreclosures is rife with conjecture and untested theories. A common belief is that the number of foreclosures can be anticipated from the number of borrowers with a negative equity, for instance, and can be resolved by loan modifications limited to payment schedules. Government policy, congressional and administrative, has largely been based on these beliefs.
However, a recent study from the Federal Reserve Bank of Boston (FRBB) determined that foreclosures are rarely caused by negative equity alone. The study recommended that lenders focus their foreclosure-prevention efforts on forbearance agreements instead of loan modifications. Forbearance agreements, it seems, appeal only to homeowners who are legitimately at risk of foreclosure. In a follow-up article from the FRBB, Christopher Foote takes a look at what causes borrowers to default on their mortgages, and examines commonly held opinions about lender behavior and loan modifications.
One common belief is that homeowners decide to default when a loan is no longer affordable, for example, in a loan with high mortgage payments relative to the homeowner’s income when the loan was originated. Homeowners with high debt-to-income (DTI) ratios (over 40%) are commonly thought to default more frequently than those with low DTI ratios. However, this does not hold true. A review of foreclosures reveals that not all homeowners living in similar houses with similar mortgages default at the same time.
Households that suffer income disruptions, such as job loss, default far more often than others. Job loss, it seems, is a factor with huge consequences. Also, younger households and households with fewer financial resources are more likely to default. Thus, the loan-to-value ratio (LTV) and DTI are poor predictors of foreclosure risk, especially in times of economic upheaval. The most relevant factor leading to foreclosure is the homeowner’s present income, not his income when the loan was originated.
It is likewise a commonly held belief that lenders act against their own best interest when they refuse to modify loans for property owners, since the lenders’ costs of foreclosure are known to be dramatically high. In spite of these high costs, lenders are most often extremely reluctant to modify unaffordable loans. Pundits attribute this to the current widespread securitization of loans, claiming that conflicts and potential conflicts between the many classes of priorities pooled among investors (tranches) holding a loan prevent lenders from taking action to prevent financial loss. However, the belief that securitization is the culprit also turns out to be highly suspect as a factor leading to foreclosures.
Foreclosures have always been common in times of economic hardship, and the contracts within securitized loans do tend to grant loan servicers the fiduciary right to modify loans when necessary. The truth is that lenders may incur higher costs up-front when they foreclose, but the costs of offering loan modifications to solvent homeowners (able to pay) who do not actually need them, or are insolvent (unable to pay) and will only proceed to default anyway (currently 65% re-default within six months), are very likely to negate the money saved by delaying an immediate foreclosure. Thus, the report concludes that it is most often against lenders’ interest to offer loan modifications.
What, then, is the ideal solution for governments seeking to prevent foreclosures? Instead of the government attempting to coax lenders to modify loans (or forestall the inevitable foreclosure) against their own best interests, the report suggests that government efforts should ignore loans entirely, and move their policy focus from the needs of lenders to the needs of owners. Government policies should focus on reducing the impact of job-loss and other revenue shocks on homeowners. They must learn to target the root cause of foreclosures much more directly than merely enacting policies to change unaffordable loans which should never have been made (or should have been made for lesser amounts, with more predictable low fixed rates).
As it turns out, homeowners with stable incomes are far better able to hang on to their homes, even when they are burdened with cumbersome loans. Roughly 3% of California homeowners have lost their jobs since November, 2007 (approximately 240,000 owners) a number likely to rise to just over 4% when considering future employment loss, which is on schedule to end mid-2010. Jobs, not unaffordable loans, are and will remain the real problem in real estate sales. As for mortgages needed to finance these future sales, government regulations must set parameters on rates and payments and place limits on loan-to-value (LTV) amounts.
I totally agree with the last comment. The “big” will always be on top and “folks” will remain and get satisfy of what they have. Too bad.
The comment above is most apropos; however, most of the various re-insuring agencies are out of money, and have been for some time; the only thing holding them together is the US Government. I don’t think there’s a real “conspiracy,” but many folks have figured out how to make money from the distressed notes and the assets that result from foreclosure. It’s not in the lender’s best interest to modify a loan for a borrower, EVEN IF that loan will never be foreclosed again. Most of the modifications I’ve seen (and I’m in real estate, not the loan mod business) have really not helped the borrower. There’s an offer of a temporary payment reduction, and that’s pretty much it.
My contention is, like the above commenter, that the banks either already got their “payoff” for many of these loans (the bailout), or that they will make more money in foreclosure, or that somebody who’s an exec will, or that some other person who is “connected” will…
It’s unfortunate. The “bigs” continue to prevail, and make their income at the expense of the rest of the “folks,” and because these transactions take a bit of investigation and thought to unravel, the large players are pretty much insulated by the very complexity and opacity of all the machinery involved.
In other words, I don’t think it is an “innocent decision.”
Yes, it is most often against Lenders interest to offer Loan Modification, for a much bigger reason than you state: It is because the Lenders make a lot more money when a property goes into default and gets foreclosed upon. With the use of Credit Enhancements, detailed in the Pooling and Servicing Agreements of the Securitizated loans, there are Credit Default Swaps which allow for the lenders to make gobs of money. Servicers make more money once a loan goes into default; servicers and lenders make even more money when the house gets foreclosed upon. Why modifiy when you can make more money foreclosing? How does this happen? First, the credit default swaps are an “agreement” (that works like insurance but isn’t) that says if the (non-underwritten loan) goes into default, Lender will get paid by the credit default swap . Second, the credit enhancement with parties such as AIG, for example, will pay anywheres from 3 to 30 times the value of the loan to the lender. The Math: $100,000 loan at 30 times value could net up to $3,000,0000 to the lender. Which would you pick? Modify a loan worth $100,000 or get paid $3,000,000 – Not exactly a difficult choice. Therefore, lenders happily foreclose and who knows what deal they make with the servicer; foreclosing company etc. I know a lot of folks who are frustrated because they can’t modify their loan; once a homeowner understands this, it elminates a lot of frustration and they can then make whatever business decision they need to make.