Dec032015

Rising interest rates could precipitate more foreclosures

By increasing borrowing costs for bankers, rising interest rates may force them to foreclose and resolve their non-performing loans.

squatter_scourgeMost borrowers over the last decade used fixed-rate financing, so rising interest rates will not cause their payments to rise and put them at risk of default and foreclosure. That is not how rising interest rates might lead to more foreclosures.

We also know that many loan modifications are facing interest rate resets that will increase the cost of ownership of many struggling borrowers. However, these loans will be can-kicked as necessary, so this is not how rising interest rates might lead to more foreclosures.

The real reasons rising interest rates could cause more foreclosures is more complicated than that. Rising interest rates change the equation for banks, and it may incentivize them to finish clearing out the delinquent trash.

3 conditions that changed for the banks

A number of conditions changed over the last few years to make it possible and desirable to foreclose on more borrowers.

First, a little known accounting practice instilled solvency and positioned the banks so that they could foreclose and not go out of business.  Over the last seven years, banks wrote down much of the bad debt on their balance sheets.banker

Standard banking regulation requires that nonperforming loans be classified as nonaccrual if principal and interest have not been paid for at least 90 days, except in cases where the lender has adequate collateral to cover the loan, which they don’t when the borrower is underwater.

Banks and lending institutions maintain reserves to cover nonaccrual-loan losses. When borrowers resume making payments on the loan, the cash is applied first to principal and then to interest. By applying more of the loan modification payments to principal, banks write down the value of these assets on their own books, preserving their own solvency.

This doesn’t impact the borrowers who often still owe prodigious sums irrespective of what the banks show internally. The bank may show $700,000 for their book value on a $900,000 loan because they’ve reserved $200,000 for future losses.

In short, banks can take the hit now that they couldn’t take before.

Second, lenders are not stupid; they recognize the problems of moral hazard, and with some borrowers going on seven, eight, nine, or ten years without making payments, lenders know they must crack down — they won’t give away free houses, particularly to delinquent mortgage squatters, so lenders will eventually be forced to resolve these bad loans, foreclose on these people, and recognize the losses.need_bonus

When lenders feel the cost of allowing squatting outweighs the benefits of waiting, they will foreclose more aggressively. Tepid appreciation, particularly in rural markets helps tip the balance in favor of foreclosure because waiting gains them less and less.

Third, rising interest rates pressures lenders to squeeze money out of non-performing assets. When lenders pay depositors nothing, they can sit on non-performing loans indefinitely because it costs them very little to do so; however, once money isn’t free any longer, waiting has a higher cost.

As appreciation slows down, as lender’s costs go up, and as lenders become strong enough to absorb losses, lenders reach a tipping point where foreclosure makes more sense than can kicking or squatting. When that happens — and it’s happening now — foreclosure processing will pick up speed, and the lingering effects of the housing bubble will finally be behind us.

National Home Prices 7 Percent Below Pre-Crisis Peak

Low-End Home Prices Now 4 Percent Above Pre-Crisis Peak

Molly Boesel, December 1, 2015

Home prices including distressed sales increased 6.8 percent year over year in October 2015 and remain 6.8 percent below the April 2006 peak.

The low-price tier increased faster than all other price tiers and is now 3.8 percent above its pre-crisis peak.

boesel_hpi_fig2_nov-large

Nevada home prices were the farthest below their all-time HPI high, still 30.4 percent lower than the state’s March 2006 peak.

Nevada will deal with reduced inventory working to inflate prices for many more years.

Prices are high enough to foreclose

In football each team hopes their offense moves the ball over the goal line so they can score a touchdown; however, if they fall short and it doesn’t look like they will make it, they will stop short of the goal line and kick a field goal. It’s not as desirable as a touchdown, but it’s still a positive outcome.

Similarly, in banking each lender hopes the value of their collateral will rise high enough for an equity sale to completely bail them out; however, if house prices fall short, and it doesn’t look like the bank will achieve full recovery, they will foreclose and get what they can before rising costs or falling prices reduce their recovery. It’s the optimum outcome given the circumstances.

foreclosure_tipping_point


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