Housing recovered because lenders stopped foreclosing on delinquent borrowers

Many people erroneously believe housing recovered because lenders ran out of delinquent borrowers to foreclose on. They didn’t. Instead, they stopped foreclosing in order to dry up the inventory to drive prices back up.

When lenders make loans, they far prefer borrowers to repay those loans; in fact, their entire business plan relies on it. As long as borrowers are current with their payments, lenders are happy and making money. When borrowers don’t make their payments, the end result is a distressed sale. If there are enough of these, market prices are reduced dramatically which causes significant lender losses.

Lenders know this too, so when distressed loans became an overwhelming problem, they devised can-kicking methods including loan modifications, mark-to-fantasy accounting, and if all else failed, they simply allowed the delinquent borrowers to squat in shadow inventory.

Below is the lender decision tree for delinquent borrowers. Today we will explore this diagram in some detail and discuss the ramifications of the decisions lenders make.

Loan Modifications

Once a borrower stops paying on the loan, the first step in the process is to attempt a loan modification. Many borrowers used this step to game the system for more time in the property. If the loan modification succeeded, then the borrower became current and everyone was happy. Very few loan modifications succeeded mostly because it wasn’t in a borrower’s best financial interest to obtain temporary relief and sustain the huge debt. Loan modifications were the first step in the amend-pretend-extend dance.

Short Sale

The next option was a short sale. This process generally failed because banks stopped approving them in 2011. In a short sale, any second mortgage liens were extinguished, and this caused such large losses at the banks that they had to quit approving them if they wanted to survive.

To give a sense of this problem’s scale, consider this tidbit from 2010: “Together with Citigroup the banks hold about 42 percent of the $1.1 trillion in second-home liens. Unlike first mortgages, they are typically not bundled and sold off to investors but kept on the banks’ books. The biggest home-equity lender in the U.S. is Bank of America, holding some $138 billion in such loans. Wells Fargo has about $123.8 billion of home-equity loans.

These loans all went bad, and it would have decimated the banking industry if these losses were recognized. Restoring collateral value to second mortgage liens is one of the primary reasons lenders and the Federal Reserve were obsessed with reflating the housing bubble.

Short sales were not going to be the final resolution of this problem for another reason: many distressed sellers did not bother to attempt a short sale. First, for those with non-recourse loans, they had no incentive to attempt a short sale because buried in the terms of the sale is the abandonment of their non-recourse status.

Plus, why would they go through the hassle? The magnitude of the loss doesn’t impact the borrower, so there is little incentive for them to participate in the short sale process. Once they decide they were not going to sell and obtain any equity, most people stopped paying and quit responding to lender inquiries. If borrowers didn’t care enough about the property to communicate with the bank, they certainly were not going to get involved in a short sale process.

Squatting and shadow inventory

Once loan modifications and short sales failed, the only options available to lenders were within the foreclosure process. At this point, borrowers were not making payments, and contractually, lenders had the right to force the sale of the property at public auction.

Prior to the Great Housing Bubble, it was inconceivable that lenders would allow borrowers to squat in houses once it became obvious they were not going to repay the loan. Back in 2011 when loan delinquencies were ten times the historic norms in the United States, lenders were overwhelmed by the volume. And since lenders knew that foreclosing on all those people would have caused them catastrophic losses on their second-home lien portfolios in addition to crushing home prices, they chose to do nothing. More than one-third of all delinquent borrowers were delinquent for more than a year. Squatters were everywhere.

The reasons lenders allowed widespread squatting were twofold:

  1. Lenders hoped that people in this category would cure their loans with a loan modification. Nobody believed this was the cure to the problem, not even the lenders. However, it bought them time while prices recovered, so it was necessary.
  2. The government benefitted by having fewer homeless and no rioting in the streets. The twenty-first century’s version of squatter’s rights was allowing delinquent homeowners to stay in their homes. It prevented Hoovervilles and provided significant economic stimulus through the temporary elimination of housing expenses. Unfortunately, it totally screwed renters who didn’t enjoy such benefits and paid for it through diminishing returns on their savings and taxpayer bailouts.

Shadow inventory is foreclosure’s purgatory. It prepared delinquent borrowers for the singularity of trustee sale.

Limited Inventory

For lenders to recover their bad loan capital, they needed house prices to rise back to peak levels before they liquidated. They created the necessary conditions for this to occur.

First, they got regulators off their back with mark-to-fantasy accounting. Their capital ratios showed a false solvency which kept them in business.

Second, they got Bernanke to lower interest rates to zero to greatly reduce their carrying costs. Since they didn’t pay depositors much, and since they could borrow from the federal reserve for nothing, they could afford to sustain a portfolio with greater than 10% of their loans non-performing.

Third, they needed a way for borrowers to raise their bids. Bernanke’s lowering of interest rates was a two-for in this regard. The low interest rates allowed them to sustain bad loans, and it allowed future borrowers to bid more for properties.

Fourth, they needed to collude to withhold inventory from the MLS to create an artificial shortage of properties so potential buyers would be forced to use their new-found buying power to bid prices higher. The necessary collusion came from the settlement agreement designed ostensibly to benefit homeowners that actually bailed out the banks.

The effect is to restrict local inventories and cause competition among would-be buyers. Even now, five years later, the competition for limited inventory is fierce due to the lack of the MLS inventory. The few reasonably priced properties get much attention. Buyers often have to bid over ask and accept onerous terms.

Once prices approached the peak — and borrowers approached the threshold of equity — many loan owners who withheld their properties because they didn’t want to be a short sale listed them to get out from under their debts.

Until the spigot of inventory is opened wider, the flow of properties will be slow, and prices will remain inflated. This is the new normal.

The Ponzis inflated house prices with their quest for appreciation income, and now inflated prices are supported by allowing the Ponzis to squat in their castles of debt. This benefitted the banks who didn’t want to write down losses, so it became the final solution to the housing mess.