Dec062013

Judicial foreclosure housing markets still on ice

Some say the world will end in fire,
Some say in ice.
From what I’ve tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice.

Robert Frost

Back in early 2009, I posed the question Will the market perish in fire or in ice? The housing market faced the band-aid dilemma: Is it preferable to remove a band-aid quickly and endure a brief moment of intense pain, or is it better peel off a band-aid slowly and endure less pain but over a much longer period of time?

Graph from 2009:

More than a theoretical and philosophical mind game, the band-aid dilemma was a real choice faced by lenders, legislators, and the federal reserve who were all applying band-aids to the housing market to stop the equity bleeding. Nearly five years past since I wrote that post. So how did it turn out?

Irvine followed the “Fire” scenario bottoming out at nearly the time and price level depicted in the 2009 chart. I didn’t count on 3.5% interest rates or the sudden removal of 20% to 40% of the supply, so the rebound has certainly been more energetic than expected. But the general pattern of prices in Irvine, as well as the rest of California was one of fire rather than ice, largely because California is a non-judicial foreclosure state. Foreclosure processing sprints easier and faster in non-judicial foreclosure states than it crawls in judicial foreclosure states. Due to differences in foreclosure processing speeds, the “Ice” scenario played out in the judicial foreclosure states of the Northeast.

Housing markets rebound faster when foreclosures proceed quickly

Home prices are rising faster in ‘nonjudicial’ states such as California, where foreclosures can be carried out without being tied up in court procedures for years.

By Kenneth R. Harney — December 1, 2013, 5:00 a.m.[dfads params=’groups=165&limit=1′]

WASHINGTON — Why have many of the local housing markets that were hit hardest during the bust — especially in California — bounced back so vigorously and quickly, with prices close to or exceeding where they were in 2005 and 2006?

And why have many others along the East Coast and in the Midwest had a slower move toward recovery, with sluggish sales and gradual increases in values?

The band-aid dilemma explains exactly why these two markets differ. California endured a deeper correction because it processed more foreclosures, but it also processed foreclosures quicker, so California’s recovery is more robust. The judicial foreclosure states wallow in their foreclosure mud. They delayed millions of foreclosures, so they forestalled the deep price drops, but now they face more pain whereas California moved past its suffering.

Though multiple economic factors are at work, appraisal industry experts believe that they have isolated a crucial and perhaps surprising answer: Real estate markets rebound much faster in areas where state law permits foreclosures to proceed quickly, moving homes with defaulted loans into new owners’ hands expeditiously, rather than allowing them to sit and deteriorate, tied up in court procedures for years. Prices of foreclosed homes in such areas typically are depressed and negatively affect values of neighboring properties, but they don’t remain so for lengthy periods because investors and other buyers swoop in and return them to residential use rapidly.

By contrast, in states where laws allow large numbers of homes in the process of foreclosure to remain in legal limbo, often empty and unsold, home-price recoveries are hindered because lenders are prevented from recovering and reselling the units to buyers who will fix them up and add value.

This was obvious and predicable several years ago. This insight required no army of experts to decipher after the fact as many housing analysis foresaw these consequences years ago.

Pro Teck Valuation Services, a national appraisal firm in Waltham, Mass., recently completed research in 30 major metropolitan areas that dramatically illustrates the point. All the fastest-rebounding markets in October — those with strong sales, price increases and low inventories of unsold houses — were located in so-called nonjudicial states, where foreclosures can proceed without the intervention of courts.

All the worst-performing markets — where prices and sales have been less robust and there are excessive numbers of houses available but unsold — were located in judicial states, where post-default proceedings can stall foreclosure completions for two to three years or even more in some cases.

Among the best-performing areas were California markets such as Los Angeles and San Diego. California is a nonjudicial state. Among the worst performers were Florida markets such as Tampa and Fort Myers, as well as parts of Illinois and Wisconsin. All of these are judicial states. …

Let me build upon this concept to make a prediction based on what we see today.

The fire and ice scenarios make the assumption that housing markets only recover when distressed inventory is fully processed through the system. It further assumes lenders process bad loans by foreclosure until no bad loans remain. When foreclosure processing finally stops due to a complete cleansing of bad debt, then house prices rise without future distressed sales overhanging the market. Since lenders abruptly stopped foreclosing in 2011 and instead kicked the can with loan modifications, foreclosure processing only halted temporarily, even in non-judicial foreclosure states. Of course, lenders believe they can resolve the remaining bad loans through equity sales at peak prices, but what happens if they are wrong?

Personally, I believe lenders will not resolve their remaining bad loans at peak prices. House prices must rise much farther in many markets to reach the peak, requiring many years even under the most optimistic scenarios. Therefore, I believe lenders will finally resolve their legacy loans by short sale or foreclosure (See: 2014 will see the “Rise of the Short Sale”). Further, I believe in a few years processing these delayed foreclosures and short sales will cause either a long-term flattening of prices or perhaps a multi-year decline while these can-kicked loans are finally resolved. Currently, few housing market forecasters foresee this outcome. When it happens, it will surprise many housing experts, and years after the fact, someone will conduct a study and conclude the downturn was caused by delayed foreclosures. Remember you read that here first.

Tom O’Grady, chief executive of Pro Teck, says the differing rebound patterns of judicial and nonjudicial foreclosure states jumped out of the study data dramatically.

“When we looked closer” at rebound performances state by state, “we observed that nonjudicial states bottomed out sooner” — typically between 2009 and 2011 — “versus 2011 to 2012 for judicial states, and have seen greater appreciation since the bottom,” typically 50% to 80% compared with just 10% to 45% for judicial states, O’Grady said.

Our hypothesis,” he added, “is that nonjudicial states have been able to work through the foreclosure [glut] faster, allowing them to get back into a non-distressed housing market sooner, and are therefore seeing greater appreciation.”

His hypothesis is correct.

California, for example, experienced severe price declines immediately after the bust hit in 2007 and 2008 — thousands of foreclosed homes flooded the market, depressing values of other real estate in the area. O’Grady calls this a “concentrated foreclosure effect” that is painful while it’s happening but relatively quickly purges the marketplace by turning over distressed units to new ownership.

The “Fire” scenario.

Judicial states, on the other hand, tend to be still struggling with homes flowing out of the foreclosure pipeline, prolonging the negative price effects on other houses for sale.

The “ice” scenario.

O’Grady noted that in nonjudicial states such as California, foreclosures now account for just 10% of all sales, and home listings amount to a four-month supply — well below the national average. In slow-moving judicial states, by contrast, 25% to 50% of sales are foreclosures, and unsold inventory represents a five-month to 10-month supply.

The take-away here? Though real estate prices are popularly thought of as reflecting the “location, location, location” mantra, inherent in that concept is something less well-known: State laws governing foreclosure affect market values and govern how well they bounce back after a shock. Prices take much longer to recover when foreclosures drag out for years.

Will the housing bust cause judicial foreclosure states to rethink their laws? Lenders saturated court systems in those states with foreclosures. The officials in courts and legislatures in these states observed this disaster first-hand. They must see the folly in continuing the old system; however, they may believe the ice scenario is preferable to the fire sale. If that’s the case, they may keep the system. What we perceive as a problem may be perceived by them as a virtue.