House prices depend on bank policies toward delinquent borrowers

The house price crash and subsequent bubble reflation was heavily influenced by bank policy.

bankerMost people assume house prices are the result of market forces determined by supply and demand from individual homebuyers and home sellers. The reality is that policies at the major banks, particularly policies related to delinquency and foreclosure, often become so important that they overshadow the activities of everyone else.

Back in September of 2010, I first observed that How The Lending Cartel Disposes Their REO Will Determine the Market’s Fate. Today I want to revisit that post and update it based on what we learned over the last five years.

The insane lending practices of the housing bubble abruptly terminated in a credit crunch in August of 2007. Shortly thereafter, borrowers began defaulting in droves, and lenders followed their standard loss mitigation procedures and foreclosed on several million borrowers and liquidated the inventory. The result of this policy was an epic price crash from late 2007 through early 2009. Through aggressive intervention in the housing market including mortgage rate reductions engineered by the federal reserve and a series of tax credits to buyers offered by the government, a false rally was initiated in mid 2009 that continued through the expiration of the tax credits in mid 2010.

Many people believed the crash was over by mid 2010 because removing the supply temporarily stabilized prices. Most people who carefully watch housing markets agreed that a cartel of lenders controlled the market through its ability to control supply. Since lenders were permitted to hold non-performing loans on their books, which allowed delinquent borrowers to squat, lenders controlled the flow of properties through the foreclosure process. REO_StockpileAlso, they controlled the approval of short sales; therefore, they controlled the flow of properties through the short sale process. Since distressed sales of foreclosure properties and short sales were a significant percentage of market sales, lenders controlled the bulk of the supply on the market.

Ultimately, lenders did gain full control of the market and eliminated the distressed inventory by a combination of aggressive loan modifications, permissive attitudes toward squatters, and denial of short sales in late 2011, but from mid 2010 through early 2012, house prices fell for 18 consecutive months while lenders worked to remove the distressed supply.

I believed this cartel would fall apart partly because all cartels are inherently unstable, and partly because the Government Expedites Foreclosures, Threatens Banking Cartel., and foreclosure processing at HUD and the FHFA (the GSEs) did greatly impact the distressed inventory supply. The article below from the Wall Street Journal is one of the better descriptions of the problem in the mainstream media in 2010.evil_banker_bunny

Banks’ Plans for Foreclosed Homes Will Drive Market


The speed at which house prices fall over the next few months could depend less on mortgage rates and Americans’ appetite for home buying than on how banks decide to manage the huge number of foreclosed homes they own or may take from delinquent borrowers in the near future.

Unlike home owners, banks often are much quicker to slash prices to unload properties quickly.

This has certainly been true in the past, but lenders seem much more willing to emulate homeowner denial this time around. Loan owners are quick to lapse into denial on the false belief that prices will quickly rebound. We explored that phenomenon in Contrarian Investing and the Psychology of Deflation. works_for_meLenders are usually pressured by regulators and investors to process their non-performing loans and dispose of their REO. Because this inventory problem is so large, the groups that usually pressure disposition are embracing a hold-and-hope strategy largely doomed to fail.

The upshot is that, the more homes being sold by lenders, the faster prices tend to fall. That pattern was clear over the past two years: Price declines that began four years ago accelerated rapidly in 2008 as banks dumped foreclosed properties at fire-sale prices. By January 2009, the share of distressed sales had soared to 45% of all sales nationally; it was even higher in hard-hit markets such as Phoenix, according to analysts at Barclays Capital.

Even though mortgage defaults kept mounting, housing markets began to stabilize early last year as low prices and government interventions broke the downward spiral. Policy makers spurred demand for homes by holding down mortgage rates, offering tax credits for buyers, and extending low-down-payment loans through the Federal Housing Administration.

This is the squatting problem. We didn’t have much squatting prior to 2008 because lenders processed their foreclosures in a timely manner. When they saw what this did to markets like Las Vegas, they stopped processing these foreclosures. Since subprime defaulted first, they were foreclosed on, and since the alt-A and prime mortgages defaulted later, and since those mortgages are much larger, lenders have opted to let those delinquent owners squat.

The government also attacked the supply problem. Regulators relaxed mark-to-market accounting rules, giving banks more flexibility in valuing certain real-estate assets and removing some of the impetus for banks to quickly foreclose.

expired_creditThis is mark-to-fantasy accounting. For a more detailed explanation please see: Lender manipulation of MLS inventory is remedy for housing bust.

Meanwhile, the Obama administration put in place an ambitious program to modify mortgages.

The Home Affordable Modification Program has fallen short of its goals. So far, fewer than 500,000 loans have been modified, below the target of three million to four million. Yet the program served as a “closet moratorium” on foreclosures that stanched the flow of bank-owned homes to the market, said Ronald Temple, portfolio manager at Lazard Asset Management.

The result: The share of distressed sales fell by November to 25% of home sales, and prices stabilized. After rising in the winter, the distressed share fell to 22% in June, before bouncing to 30% in July.

The problem is that these measures are wearing off. Demand plunged this summer after tax credits expired, and unsold homes are piling up.  …

bears_were_rightOf course the market did roll over after the tax credits expired just as many predicted.

The next leg down in prices “isn’t going to be the foreclosure-induced freefall where you just had inventory coming out the wazoo, and it was going to be sold one way or the other,” said Glenn Kelman, chief executive of Redfin Corp., a real-estate brokerage.

He was right that we did  not have a mass forced auction that pounded prices back to the stone ages, but we endured pricing pressure until this supply cleared from the market 18 months later.

Prices also have come down so much already they have less distance to fall. During the housing boom, prices inflated much faster than incomes rose, thanks to speculation and lax lending. The ratio of home prices to annual incomes reached 1.6 at the end of June, which is below the ratio of 1.88 from 1989 to 2003, according to Moody’s Analytics.love_las_vegas

By those metrics, prices are actually undervalued in markets that have already seen huge declines, such as Las Vegas, Phoenix and Los Angeles. But Moody’s data show that prices remain “significantly overvalued” elsewhere, including Boston; New York; Seattle; Orange County, Calif., and Charlotte, N.C. Markets in both camps face supply imbalances that will pressure prices for years.

Moody’s was right on. Las Vegas was too low relative to incomes, and Orange County was much too high. I went out to Las Vegas and bought properties due to this value imbalance.

While more tax credits aren’t likely, policy makers could still attack the supply problem by, for example, taking foreclosed homes off the market and renting them out.

An idea I endorsed in From Squatting to Renting: Another Solution to Stabilize Housing. This later developed into the REO-to-rental business model that ultimately bought thousands of residential homes before prices became too high.

Ultimately, market fundamentals will prevail “and any attempt to get around that will only be short-term,” said Susan Wachter, a professor of real estate at the University of Pennsylvania’s Wharton School. But officials should be prepared to intervene anyway, she said, if psychology spurs a downward spiral “where price declines are feeding further price declines.”

deflation psychologyYou mean if deflation psychology takes over? Good luck combating that one: Contrarian Investing and the Psychology of Deflation.

That leaves few attractive options. Prolonged intervention could backfire by creating uncertainty that keeps buyers on the sidelines. Extending foreclosure timelines also risks inducing more borrowers to default and live rent-free.

The amend-extend-pretend policy has been a fiasco: After Eight Years of Squatting, Who Absorbs the Losses?.

Letting the market take its medicine sounds more appealing than it did 18 months ago. But it risks saddling taxpayers and the banking system with billions more in losses and trapping more borrowers in homes on which they owe more than the house is worth.

Kudos to Nick Tamiraos for such a lucid description of the problem, and of the problems associated with all the bad solutions that have been implemented to solve the problem though mid 2010.

The housing market bottomed in early 2012 because lenders stopped foreclosing and started can-kicking with loan modifications. They morphed must-sell shadow inventory into can’t-sell cloud inventory, and it worked.


Inventory evaporated, institutional investors entered the market, and the balance of supply and demand favored the reflation of the housing bubble; we entered a gilded age of low housing inventory. The situation is the same today, and it’s likely lenders will keep this policy in place until collateral backing returns to their bubble-era bad loans.

It’s important to notice here that both the bust and the reflation rally that followed were largely driven by lender’s policies.tomorrows_bankers

First, the housing bubble was caused by lenders making loans with toxic terms they invented to borrowers who were not properly screened through underwriting procedures they circumvented.

Second, lenders facilitated and deepened the crash by following their loss mitigation procedures in response to the delinquencies on the unstable loans lenders never should have originated.

Third, lenders then modified their loss mitigation policies to remove the distressed supply from the MLS and create an artificial shortage of supply, a shortage that persists to this day.

Hopefully, we are back to a Housing market where prices are expensive, affordable, stable, and boring, but if we do have unnecessary excitement going forward, you can comfortably rely on the fact that it will be a direct result of some future change in lender policy.


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