Foreclosure Madness

Foreclosure activity decreased in 84% of metro areas in the first half of 2011 relative to 2010. Across the U.S., foreclosure filings in the first half of 2011 were down nearly 30% from filings in the first six months of 2010. Unfortunately, the drop in foreclosures is not a sign of improvement in the mortgage market, but rather a reflection of the delays in filings.

The pace of foreclosures is likely to remain slow until large banks reach an agreement with government officials that establishes new loan servicing and foreclosure standards. The delay in foreclosures increases the “shadow inventory” of properties likely to be auctioned by banks. This not only increases supply and depresses future prices, but also contributes to the current price reduction trend as potential buyers rationally delay purchases until new supply comes on line. More ominously, the proposed resolution to the foreclosure mess may make it less likely the private sector will ever return to the home mortgage market.

Last year, it was revealed that servicers had improperly signed off on potentially hundreds of thousands of foreclosures. The impropriety came not from the foreclosures themselves – i.e. taking possession of homes where mortgages were being paid – but rather the process by which the foreclosures were approved. The unprecedented foreclosure volume led servicers to sign-off on thousands of foreclosures per month without carefully reviewing the details of each case, as required by law in judicial foreclosure states. The volume of seriously delinquent loans was simply too great relative to the legal requirements and the servicers decided to take short cuts. These short cuts have now triggered tens of billions of dollars in civil liability.

Since March, Bank of America, Wells Fargo, J.P. Morgan, Citigroup and Ally Financial (formerly GMAC) have been in settlement negotiations with 50 state attorneys general, the Treasury Department, Justice Department, and Department of Housing and Urban Development. The terms of the deal were supposed to be finalized in June, but talks continue to drag on as banks debate how to split the $20 billion cost of the settlement.

Another element slowing the settlement is banks’ demand that the government provide immunity from tangentially related mortgage issues. Specifically, banks want the government to “release claims” relating to improper loan underwriting. Bank of America reached an $8.5 billion settlement to resolve claims from investors in 530 residential mortgage securitization trusts sponsored by Countrywide, which Bank of America acquired. Bank of America also faces an additional class action suit filed by former Countrywide shareholders. A number of states are investigating whether similar suits can be brought against other banks for related issues.

The aforementioned $20 billion is supposed to go primarily to finance principal reductions on loan modifications, legal-aid, hotlines, web portals, education, outreach, and post-foreclosure relocation assistance. The proposal is also expected to increase the use of principal forgiveness in mortgage modifications financed by investor losses.

While the reduction in mortgage debt is likely to be helpful to the broader economy, it is very small relative to the amount of total negative equity and creates significant moral hazard problems. Worse, the proposal would also serve to further delay foreclosure proceedings by blocking the servicer from initiating foreclosure while a “good faith” trial modification evaluation is in process or the borrower’s application for a loss mitigation process is pending.

Creating new legal obstacles to foreclosure is likely to inhibit final resolution of the mortgage crisis by keeping more properties from reaching the market swiftly. Noncurrent loan growth has finally slowed considerably, but this proposal would keep millions of homes in modification limbo and leave the shadow inventory largely unchanged despite better loan performance.The current foreclosure backlog of 2.1 million homes suggests that signs of price stabilization in markets could quickly become undone.

In addition, the settlement fails to address the problem of second liens, which continues to be a key contributor to the overall problem of household indebtedness. The settlement terms suggest that second liens – generally home equity loans or “piggyback” loans used to finance down payments – would be written down in a manner roughly proportional to the first mortgage. This does not make any sense. Second mortgages are just that – secondary claims on the housing collateral. If the collateral value is insufficient to cover the principal balance on the defaulted first mortgage, the market value of the second mortgage should be zero. The notion of “proportionality” is as injurious to contract law and a future private sector mortgage finance market as efforts to deny creditors access to the collateral used to secure the loan.

According to the most recent Flow of Funds report from the Federal Reserve, U.S. households owe $9.987 trillion on home mortgages. This is down by more than $500 billion since the peak of indebtedness reached in 2007. The bad news is that the residential real estate that collateralizes these mortgages has fallen in value by more than $6 trillion since the peak of the bubble. And that includes the more than $1.5 trillion in new home construction undertaken from 2007 through the first quarter of 2011. The implied decline in the market value of the pre-2007 stock of real estate is $8 trillion, or about 35%.

Of the $9.9 trillion in mortgage debt, $925 billion consists of second liens. From 1991 to 2006, home equity loans outstanding grew by a factor of five, from about $200 billion to more than $1.1 trillion. During the bubble period, home equity loans outstanding grew by about $100 billion per year. Although the total amount of second lien debt outstanding has fallen 18% or $200 billion, from the peak (see footnote on L. 218), the real economic value of most of these loans is zero.

This lending was largely secured against rises in property values that have since vanished. Data from the Federal Reserve suggest that more than $3.7 trillion in equity was extracted from homes from 2002-2006. Homeowners essentially “cashed out” the rise in property values by taking on new mortgage debt. This is equivalent to a corporation taking out new debt to finance a large dividend payment to shareholders without the senior bondholders having any idea about the transaction. Now, these cash-out home equity lines of credit are being given the same claim to the housing collateral values as the original mortgages.

As e21 has argued previously, if the government is ever to extract itself from its dominant position in mortgage finance, it will have to make the asset class more attractive to potential investors. If lenders cannot access the collateral used to secure the loans because of new foreclosure delays, or later discover that their rights to that collateral have somehow become partially subordinated to a second lien, it is unlikely that discretionary risk capital will flow to finance mortgages at anything approaching current rates. Much of the desire today by government to help borrowers stay in their homes is noble, but it’s also likely counterproductive.