The Economics of Foreclosure

Written by: David Lereah   Tue, March 17, 2009 Foreclosure Situation

The Obama foreclosure mitigation plan offers hope for the future but the present foreclosure situation illustrates the magnitude of the problem it faces. Foreclosure filings in February were 290,000, up 6 percent from a month earlier and up nearly 30 percent from a year earlier. With the economy contracting and shedding a large number of jobs on a monthly basis, it is likely that the grim foreclosure situation will continue throughout the remaining months of this year.

One of the reasons for the jump in foreclosure filings was the expiration of several state and lender foreclosure moratoria, such as New York’s. It seems that the moratoria produced a backlog of foreclosure filings that are now hitting the market. This could mean more foreclosure filings throughout the year as other states and banks lift their moratoria.

Moratoria aside, a deteriorating economy and housing market are now primary causes for higher delinquency rates which, in an increasing number of cases, result in foreclosure. More homeowners are becoming delinquent on their mortgage payments (60 days and 90 days past due) because they have lost their job or are earning less income due to company setbacks. In addition, there are Alt A and option-ARM mortgage loans that are resetting to higher mortgage rates, making it difficult for some homeowners to make their monthly mortgage payments. In many cases, homeowners have the perverse incentive to walk away from their mortgage obligations because they no longer have equity in their home since the value of their property has dropped below the loan balance. The economics of the mortgage transaction breaks down—with no equity in the deal, the homeowner no longer has an economic incentive to meet his or her mortgage obligations, particularly when the mortgage payments increase due to mortgage rate resets.

Historically, delinquency and foreclosure rates rise in recessions and drop in expansions. Today’s recession is very deep and is currently general job losses. Consumer confidence has plummeted and home values have experienced substantial losses. Until the economy recovers, we expect foreclosure properties to continue to flood the marketplace. Although the Obama foreclosure mitigation plan is expected to reduce the pace of foreclosures, it is not expected to meaningfully reduce the level of foreclosures over the next several quarters.

To make matters worse, RealtyTrac estimates that there are about 1.5 million properties in the foreclosure pipeline that are not yet in the multiple listing service, MLS, databases. Banks are having a difficult time managing and selling the increasing number of foreclosed properties they are taking on. These properties will eventually be posted on the MLS and be available for sale in the open marketplace. We expect a steady flow of foreclosed markets to enter the selling marketplace for at least the next two quarters.

RealtyTrac also expects nearly three million homeowners to receive a foreclosure notice this year, with about half of those homes returned to the bank. Foreclosures are most assuredly expected to continue dominating the marketplace this year. The National Association of Realtors estimates that foreclosure sales comprise about 40 to 45 percent of existing home sales. Those sales are exerting strong downward pressure on home values since foreclosure properties usually sell at deep discounts relative to other properties. In addition, the foreclosed properties that do not sell become vacant homes which are usually associated with vandalism and poor upkeep, detracting from the appearance and safety of the neighborhood.

We certainly hope that the Obama foreclosure mitigation plan proves to be effective in reducing the pace of foreclosures. Unfortunately, there are factors that are contributing to a steady rise in foreclosures over which the Obama plan has little control. Today’s grim foreclosure situation is not expected to recover until the economy recovers. The cart does not come before the horse.


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