What role will ex-homeowners who lost their homes to foreclosure or short sale play in the housing recovery?
Singling out foreclosed homeowners
Once a homeowner loses their home to foreclosure or short sale, what is the likelihood they will return to homeownership?
To answer this question, the Federal Reserve Bank (the Fed)’s economists tracked a sample of mortgages from the first quarter of 1999 to the fourth quarter of 2011. They then singled out the point at which a mortgage balance was satisfied and the trust deed mortgage was reconveyed.
Editor’s note —The Fed’s researchers used national data, thus their sample of defaults included both nonjudicial and judicial foreclosures. However, the type of foreclosure had surprisingly little relationship to when borrowers returned to the mortgage market. In fact, judicially foreclosed borrowers returned to borrow again more quickly than their nonjudicially foreclosed counterparts. The difference was within one-to-two percentage points.
Borrowers were split into two diametrically opposed groups based on their mortgage payoff history:
- borrowers who were in good standing on their mortgage prior to payoff; and
- borrowers who were subject to a foreclosure or short sale.
Editor’s note — For simplicity, we will refer to borrowers who lost their homes to foreclosure or short sale as foreclosed homeowners. The Fed’s data takes into account both types of former homeowners, but does not analyze a distinction in behavior between them.
35% of borrowers in good standing had taken out new mortgages within the 12-year sample period. That means nearly 70% did not return to buy a home by obtaining purchase-assist financing.
In contrast, only 13% of foreclosed homeowners had taken out new mortgages within the 12-year period. Since our concern is whether these foreclosed homeowners return to buy a home, let’s delve further into the Fed’s research.
The effect of the Great Recession
The 12-year sample period encompasses the credit crunch of the Great Recession. To review the recession‘s effects, researchers compared foreclosed homeowners’ return to the market before and after the Great Recession hit.
Foreclosed homeowners were separated according to the year of their foreclosure:
- 2001 and 2003, in the thick of the housing boom; and
- 2008, during the Great Recession.
Accordingly, 2001 and 2003 foreclosed homeowners were four times more likely than 2008 foreclosed homeowners to buy a home (with a mortgage) within the first three years after a foreclosure or short sale.
Editor’s note — Why only three year time periods? Data for 2008 defaults does not extend further than 3.75 years beyond the default date.
What accounts for the difference? 2001 and 2003 foreclosed homeowners had subprime mortgages at their disposal. The loose underwriting standards of these loans gave even foreclosed homeowners easy access to new mortgage money. In contrast, 2008 foreclosed homeowners were stonewalled in the credit crunch.
Though more likely to return to homeownership than 2008 foreclosed homeowners, the majority of 2001 and 2003 foreclosed homeowners did not return within the sample period. Only 25% of the 2001 and 2003 foreclosed homeowners returned to the market to buy again within three years, even with thriving economies and readily available financing.
Credit scores play a role
Researchers then sliced up the pool of foreclosed homeowners by credit score at the time of mortgage origination:
- prime foreclosed homeowners with credit scores higher than 650; and
- subprime foreclosed homeowners with credit scores of 650 or lower.
Following the foreclosure or short sale, both prime and subprime foreclosed homeowners’ credit scores dropped below 600.
However, by the end of the 12-year sample period, around 35% of prime borrowers had taken out new mortgages. Only 10% of subprime borrowers had taken out new mortgages.
Why did prime foreclosed homeowners fare so much better than subprime foreclosed homeowners?
This is a crucial question since a large chunk of the loans made and foreclosed on during this recession and recovery was subprime loans. If credit scores are a factor, this will direct future buyer behavior.
And as it turns out, credit improvement plays a pivotal role in determining which foreclosed homeowners return to the market. Foreclosed homeowners who increased their credit scores by more than 100 points were more likely to return to the market within five years of their default.
Further, another Fed research paper found that credit score recovery was slower for recent foreclosed homeowners (2008-2010, in this second study) than earlier (2001-2006) foreclosed homeowners. The recent foreclosed homeowners were subject to economic fallout of the financial crisis. Sudden unemployment or underemployment created a long-term economic problem for many households, and persisted after the foreclosure or short sale.
The sustained lack of income created a vicious feedback loop: lack of income led to delinquency, delinquency led to more expensive credit, more expensive credit led to lack of disposable income, which led back to delinquencies…and so forth.
Pre-default behavior impacts recovery
In theory, credit score recovery can occur as soon as two years after a major derogatory credit event if the defaulter pays all his other bills on time. [See first tuesday Form 217-1]
But how many homeowners took stock of their situations and prepared for default?
Not many. Lack of meaningful government guidance, post-bust, left homeowners to navigate the crisis on their own. Most negative equity homeowners continued (and continue) to pay on their underwater homes.
Consider the impact: homeowners who pay on their underwater homes are basically losing their money. They merely divert money away from paying other bills, and expose themselves to risk. This risk is realized when an economic shock – lost job, ill health, divorce, etc. – hits. They’re left with their money depleted, and no home equity or additional savings to show for all their mortgage payments.
Recovery from this situation is much more difficult than had the homeowner put his financial house in order, then strategically defaulted.
Mortgage reform, FHA impact
The return of foreclosed homeowners will also be impacted by the availability of Federal Housing Administration (FHA)-insured mortgages.
FHA-insured mortgages have taken over the role of subprime lenders in providing low-down-payment financing for those with low credit scores. Many of these will include some of the most recent batch of foreclosed homeowners, ready to take another stab at homeownership.
The FHA anticipates it will add $11 billion of loans in 2013, down slightly from its projected 2012 total. As its share of the mortgage market decreases as it has for a couple of years, so will access to mortgage funds for foreclosed homeowners. This will slightly decrease the rate at which foreclosed homeowners return to the market.
However, the FHA’s influence will be tempered by its solvency problems. The FHA will likely need a bailout from the federal government in 2013. In order to balance out its role as a mortgage titan, it will be tightening its own purse-strings by increasing its mortgage insurance premiums.
Homebuyer demand will return
The Fed’s analysis looks at the nature of the defaults of the recent past to determine future demand. The housing recovery we have experienced thus far corroborates their findings. It will take a long time for foreclosed homeowners to return to the market, longer than it has taken in the past. Instead of 15 years, it may be 20, or even more, before some return. Most may not return at all, and opt to be tenants.
This does not mean that demand is dead, or the real estate industry is in decline. It’s merely a reality check. The pace of homeowners added during the boom was simply not sustainable, and it won’t be recreated in the recovery. Instead, expect more renters, and more opportunities for branching out into property management.
San Francisco Federal Reserve Bank: Credit Access Following a Mortgage Default
Federal Reserve Board of Governors: Foreclosure’s Wake: The Credit Experience of Individuals Following Foreclosure