Nov142012

Pent-up demand from boomerang buyers may not materialize

A big part of the bullish sentiment toward real estate is the believe that former owners who lost their houses in foreclosure will return in droves to mop up the supply of shadow inventory and push prices higher. But what if they don’t come back? What if they were so burned by the experience that they choose a lifetime of renting instead? A recent study from the federal reserve suggests this may be the case. Almost 75% of those who lost their homes to foreclosure may never return, and if they don’t the so-called recovery may be much weaker than the bulls expect.

Credit Access Following a Mortgage Default

By William Hedberg and John Krainer — October 29, 2012

Borrowers who default on mortgages return to the mortgage market at extremely slow rates. Only about 10% of borrowers with a prior serious delinquency regain access to the mortgage market within 10 years of their default. Borrowers who terminate mortgages for reasons other than default return to the market about two-and-a-half times faster than those who default. Renewed access to credit takes even longer for subprime borrowers with a serious delinquency on their record.

Several million people were evicted from their former residences after a foreclosure. The assumption is that most of these former owners would return to home ownership after their credit recovered. If only 10% come back, it will take much longer to absorb the shadow inventory, and appreciation will be tepid at best.

If former owners return and purchase as owner occupants, they will bid prices back up to their historic relationship between the cost of ownership and rent because they are not buying to obtain a return on their investment. If these owners do not return, most of these houses will remain in the hands of investors who require a steep discount as compared to owner occupants because they want an immediate financial return. The difference in price is usually about 30%. This price difference will translate to lower appreciation rates across the country as the substitution effect drags down the best performing markets as the laggards languish.

Historically, the U.S. mortgage default rate has varied in the range of 0–2% over the economic cycle. However, default rates broke dramatically from this historical pattern in 2006. At the peak of the housing downturn, the aggregate default rate climbed to about 10% of mortgages. In certain geographical markets and for certain types of mortgages, such as loans to subprime borrowers, the rate exceeded 25%.

What happened to borrowers who defaulted? On the plus side, defaulting borrowers potentially got some financial breathing room. Housing expenditures are typically about 30–35% of total household income. For many overstretched borrowers, defaulting on a mortgage and becoming a renter reduced housing expenditures considerably, although the quality of their living quarters was lower.

The reduced housing cost is the primary motivator for strategic default. Some don’t even consider this strategic default, merely distressed default. Whatever you want to call it, people stopped paying their mortgages, and even when they went back to renting, their monthly expenses were greatly reduced. This was a predictable result of people paying more than rental parity prices for anticipated appreciation that never materialized.

Furthermore, the extended period between mortgage default and foreclosure allowed many borrowers to remain in their homes for a while rent-free. …

Nice of the authors to acknowledge the squatter’s stimulus.

Of course, foreclosure is far from a positive for most borrowers. One need only look at the estimated home equity of U.S. households to realize that borrowers perceive default to be very costly. The share of homeowners with mortgage balances exceeding the value of their houses is estimated to be about 20%. Many of these underwater borrowers appear to have a financial incentive to default. The fact that most do not default suggests borrowers see other costs to walking away from their mortgages.

One of the main costs is that access to credit is restricted for borrowers who have defaulted. … For mortgage borrowers, Brevoort and Cooper (2011) find that those who went through a foreclosure in the recent housing crisis experienced sharp drops in their credit scores, which appear to be long lasting. Moreover, these borrowers are more likely to default on other types of debt.

The main reason more underwater borrowers do not default is due to their credit addiction. Many have speculated it’s due to their moral convictions about meeting their financial obligations, but that isn’t the case. Most are simply not ready to go back to a pay-as-you-go lifestyle, so they continue paying bloated mortgages even when it’s not in their best financial interest to do so.

The Equifax data confirm that a prior mortgage default has a large effect on future access to mortgage credit. Figure 1 shows the rate at which borrowers with different credit histories return to the mortgage market following a termination or exit. …

The blue line in Figure 1 plots the rate for returning to the mortgage market for borrowers with no prior defaults or foreclosures. We do not know why these borrowers terminated their mortgages. They could have moved, or adjusted their housing expenditures by trading up or downsizing. Or they could have paid down their mortgages and now own their houses outright. We might expect that most borrowers who have paid off their mortgages will never return to the market. Indeed, 12 years after a termination, just above 35% of borrowers with no prior defaults have taken out new mortgages. This number may seem low. But, as the red line in Figure 1 shows, it is much higher than the average rate at which borrowers with prior defaults return to the mortgage market over the same time horizon.

It recently grabbed headlines that 35% of borrowers who terminate their mortgages never return to the market, but it’s actually much worse than that. Only about 10% of those who terminated their mortgages through default — which means both short sales and foreclosures — return to the market within 12 years.

Figure 2 shows the rates at which borrowers who defaulted on mortgages in 2001, 2003, or 2008 returned to the market. The figure plots the cumulative percentage of defaulters who have a new mortgage within a given number of quarters after their last default.

The rate of return to the mortgage market was much better for people who defaulted early in the housing bubble because from 2004 through 2007, lending standards were essentially eliminated, so any of those cohorts who wanted to buy were allowed to do so. With the return of sane lending standards in 2008, only a very small percentage of delinquent borrowers were given access to mortgages.

Even though a short amount of time has passed since the 2008 cohort defaulted, their return to the housing market appears to be significantly slower than for cohorts that defaulted in the two earlier years. …

However, the 2008 cohort’s slow return to the mortgage market could also reflect tight credit supply. The mortgage finance system was severely disrupted during the financial crisis of 2007–08. The 2009 and 2010 mortgage default cohorts look very similar to the 2008 group, although they are not shown in Figure 2. By contrast, the credit environment for the 2001 and 2003 cohorts was very different in the years after their defaults. Loan terms were generally easy and subprime mortgage lending boomed.

Economic growth was solid and interest rates low in the decade following the 2001 recession. But Figure 2 shows that, even in these good times, it took a long time for defaulted borrowers to return to the housing market. About two-thirds of the borrowers in the 2001 cohort had still not come back within 10 years.

This crushes the hypothesis that boomerang buyers will fuel the next housing boom.

Figure 3 shows the rates of return to the mortgage market according to the borrower’s initial credit score. Borrowers who defaulted in any year within the sample are included and are divided into two groups: those with credit scores above 650, labeled prime, and those with scores of 650 and below, labeled subprime. The credit scores used are borrowers’ first scores after taking out mortgages on which they eventually defaulted.

Since it’s very difficult for someone with a credit score of less than 650 to obtain a loan, the above result is not surprising. Further, since most short sales and foreclosures drop a borrowers credit score between 120 and 160 points, most people who stopped making mortgage payments and ended up leaving their properties have credit scores under 650. This is the primary reason demand for mortgages among owner occupants remains flatlined at 1990s levels.

Interestingly, the experiences of the subprime and prime groups in the two years following foreclosure are similar. This is probably because the borrowers we label as prime are no longer in that category after foreclosure. Indeed, Brevoort and Cooper (2010) show that, regardless of pre-foreclosure credit score, the typical borrower who goes through foreclosure ends up with a credit score below 600….

It’s a common myth that short sales don’t harm credit scores as much as foreclosures. Both outcomes have a very bad impact on FICO scores.

What explains the timing of the return to the mortgage market?The rate at which borrowers get new mortgages after defaulting on a mortgage is low. Only 30% of borrowers who defaulted in 2001 had taken out another mortgage within 10 years. What explains the pace of return to the mortgage market? Overall economic conditions appear to play an important role in allowing borrowers who have defaulted to return to the market. When we control for factors such as local unemployment rates and past house price appreciation, we find that these variables influence the rate at which defaulters come back to the mortgage market. Overwhelmingly though, the best predictor of when a defaulting borrower returns to the market is the change in the borrower’s credit score. Our research finds that, after five years, borrowers who return to the mortgage market after a default have experienced a more-than-100 point increase in their score.

The only way the borrower pool is going to increase is if lenders reduce FICO score requirements, or borrowers must work diligently to raise their FICO scores. Since it isn’t likely FICO score requirements will drop, and since it takes a long time for most people to raise their FICO scores, demand for housing will remain weak for a very long time.

Conclusion

Evidence suggests that the process of regaining creditworthiness is lengthy. Borrowers who terminated their mortgages for reasons other than default returned to the market about two-and-a-half times faster than those who defaulted. This has important implications for the housing recovery. The improvement in the housing market is often assumed to reflect significant pent-up demand. But an estimated 4 million foreclosures have taken place since 2007. The consumers who went through those foreclosures will return to homeownership only gradually, suggesting that mortgage supply will also be a factor in the housing recovery.

The pent-up demand of boomerang buyers is a myth, and anyone counting on those buyers to return in large numbers is deluding themselves.