Feb262015

Duh! Excessive mortgage debt causes high foreclosure rates

High foreclosure rates are caused by many factors, but by far the largest is a high loan-to-value ratio because it limits the borrowers options in default.

Option_ARM_PlagueDefaults are loan disease. There are many causes of the disease, from unemployment to loss of market value, but there is only one symptom that lenders care about — defaults. Patients in good health cure from disease more often than those in poor health. Borrowers with equity cure at better rates than those who are underwater or facing a rental savings enticement, and many who see better futures in different circumstances will walk away from the debts and succumb to the loan disease. In borrower’s terms, the cure for loan disease is delinquency; unfortunately, for excessive lenders borrower delinquency is death.

Curing Default

There are many factors that influence who will cure their loan and who will not, with the borrower’s equity position being among the most important.done_making_payments

When people have equity in their homes, they cure at very high rates because either the loan servicer will modify the loan or force a sale. Delinquent owners generally choose to sell and obtain their equity rather than lose it to foreclosure; therefore, borrowers in default with a low Loan-to-Value (LTV) will cure either by loan modification or open market sale at nearly 100% rates.

As LTVs get higher, percent equity or equity position gets lower; as the equity position gets smaller a number of negative factors work together to lower cure rates quickly:

  • Lenders feel less security extending credit.
  • Loan modifications are more difficult to obtain.
  • Success of loan modifications declines.
  • It becomes more difficult to sell, particularly when equity falls to zero.
  • Absent faith in appreciation, borrowers have little incentive to cure.
  • If savings by renting is significant, borrowers have incentive not to cure.

cure

The combination of these factors means that cure rates fall off to nearly zero as homeowners go underwater. If borrowers fail to cure their loans, lenders chose between allowing the delinquent borrower to squat (living payment free), or the lender must foreclose; therefore, the same factors that cause cure rates to drop cause foreclosure rates to increase.

While it may be common sense that excessive debt causes distressed sales and foreclosure, apparently policymakers are either ignorant to this fact or intentionally ignoring it because recently policymakers have pushed for lax lending standards and low down payment loans. CoreLogic conducted a study to ensure neither policymaker excuse is valid.

Ability-to-Leverage Drives Foreclosure Risk

Despite A Static Homeownership Rate Last Five Decades, Default Risk Exponentially Higher

Sam Khater, February 02, 2015

Leverage is known to play an important role in loan default, but while theoretical research on leverage exists; to our knowledge there has been virtually no long-term data driven empirical analysis on the impact of leverage on residential foreclosure. … This is an especially timely topic given that policy makers have recently attempted to thaw the tight lending environment by reducing the price and expanding the quantity of low down payment real estate credit.

The minimum down payment should be at least 10% to provide a buffer for lenders to greatly reduce risk of loss. If a borrower lost his or her job the day after closing escrow and couldn’t afford to make payments, they would have to put the property on the market and sell.

Since the buyer was the most aggressive bidder on the property, they will need to discount the property to find a new buyer, perhaps 2%. Further, as a seller they will have to pay various closing costs and fees which will cost another 2%. And last but not least, they will have to pay an agent to sell their house, so that’s another 6% gone. If you add those costs up, the total loss will be about 10% of the initial purchase price.

At any down payment level under 10%, owners can’t sell the property if the become financially distressed; if they can’t complete an equity sale, they likely become a foreclosure.

CoreLogic research highlights four key findings.

First, while homeownership rates today are the same level as five decades ago, foreclosure risk is two to three times higher.

khater_forclosure_fig2_large

Second, the primary driver of default risk over this period has been leverage. Leverage has played such a strong role that has rendered changes in income and savings as insignificant drivers of default from a long-term macro perspective.

Since the beginning of the foreclosure debacle, many have tried to spin the crisis as one of unemployment. I’ve consistently maintained the problem was one of debt, and it’s most debilitating manifestation, Ponzi borrowing. A great many people became dependent upon fresh infusions of debt to supplement their income, a Ponzi scheme. When these borrowers were all cut off at the same time during the 2007 credit crunch, millions of personal Ponzi schemes simultaneously collapsed, and the loss of this demand debilitated our economy and lead to millions of foreclosures.

Third, the stabilization in foreclosure rates in the 1970s and 1980s was driven by high inflation rates, which propelled nominal home prices and reduced aggregate LTV, thus lowering default risk – a reminder of real estate’s role as a hedge against inflation.

yellen_raise_ratesThis is another reason the federal reserve will not raise interest rates in 2015. Inflation is good for borrowers and lowers default risk for lenders when the system is plagued by excessive debt.

Fourth, the centerpiece of government regulations to help make the mortgage market safer for consumers was an income based ability-to-pay rule manages delinquency risk, but is less aimed at the market’s foreclosure risk.

Quite honestly, I have no idea what they are talking about here. The ability-to-repay rules manage delinquency risk by ensuring borrowers have the ability to repay, something lenders didn’t care about during the housing bubble. If borrowers don’t become delinquent, they don’t end up in foreclosure, so it seems to me that managing delinquency risk does manage foreclosure risk.

The Role of Leverage in Default Risk

Given that homeownership rates today are at similar levels as the early 1960s, what has driven the higher foreclosure rates? … The LTV ratio and unemployment rate stood out as the most important variables, with the LTV ratio by far being the most important variable.

This should not be surprising because the higher the LTV, the more the borrower’s options are limited. If they can’t cure, and if they can’t sell, foreclosure becomes a likely outcome.avoiding foreclosure

To illustrate the impact of the home price recovery on foreclosure rates, the model was used to break down how much of the recent decline was due to price increases versus all other variables combined. Between 2011 and 2014, foreclosure rates fell by 1.5 percentage points and the rise in prices has accounted for 1.4 percentage points of the decline. In other words, 91 percent of the drop in the foreclosure rate is due to the drop in leverage via higher home prices. Unemployment and the remaining variables accounted for the small remaining portion of the decline.

This is a classic error of correlation not being causation.

Yes, foreclosures declined significantly from 2011 to 2014, but rising home prices was not the reason — the real reasons foreclosures declined is because lenders changed policies. Prior to 2011, lenders processed foreclosures at a rate greater than the market could absorb, so house prices fell. In 2011, lenders changed their policies and began aggressively modifying loans or allowing borrowers to squat to stop foreclosure and to stop flooding the MLS with supply.

The change in lender policy toward foreclosure was the real cause of the decline in foreclosures, not rising home prices. In fact, the CoreLogic analysis puts the cart in front of the horse: house prices went up because foreclosure went down, not the other way around. The data clearly shows the decline in foreclosures and MLS inventory preceded the bottom of house prices in March 2012, and a cause must precede the effect.no_foreclosure_creepy

Conclusion and Policy Implication

CoreLogic findings illustrate how important leverage has been both historically and in today’s recovery. While leverage is the dominant driver of foreclosure trends, the unemployment rate captures the impact of short-term economic cyclical fluctuations.

This conclusion — backed by hard data — should put to rest the bogus claims that the waves of foreclosures was caused by unemployment.

A less important but still influential factor has been periods of accelerating inflation, which ease the burden of the monthly mortgage payment and masked the rise in leverage via higher nominal home prices. Interestingly, the savings rate and household income were not at all important, which was a surprise given that traditional underwriting focuses on affordability.

It is somewhat surprising that a high savings rate wouldn’t have buffered more borrowers, but it is not surprising at all that income was not a factor because bad loans of all sorts were given to every income bracket. Perhaps this study will definitively establish that it was not a subprime housing bubble, but rather a broad-based financial mania embraced by all income brackets.

Over the next year the continuing improvement in prices should help further reduce leverage, but the renewed emphasis on low down payment lending may in the future beyond 2015 lead to an increase in leverage.

Bankers want to start the party all over again. They need to qualify more borrowers at higher prices to bail out their bad loans from the last bubble, so they lobby for relaxed standards on government-backed loans to take out their bad bubble-era loans. If the new loans go bad in another bout of delinquencies, lenders really don’t care because they won’t feel the pain of the losses — the taxpayer will.

sandbags


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