All this week, we are looking at the Housing Recovery theme, challenging assumptions that make up the bullish argument. Monday, we began with Debunking the Housing Recovery Story, starting with Shadow inventory. On Tuesday, it was Reality Check on Home Affordability. Yesterday, we looked at the Problem With Home Prices.
Today in part 4, we take a closer look at Foreclosures — how many more are likely to occur, and what that means for future of any Housing recovery.
Before we get into the details of Foreclosures, a caveat: As housing analysts, market strategists, economists, we need to separate the concept of foreclosure from the recent robosigning scandals. The foreclosure scandal, as we have pounded on in these pages for 2 years, was a systemic institutionalizing of perjury and fraud, perpetrated by criminally inept bankers, and approved by a corrupted government. For today, we are concerned with the economic impact of foreclosures; our legal concerns are only as they impact the end of recent foreclosure abatements.
Foreclosures: In brief, foreclosure is a remedy for the breach of a contract involving the enabling loan to purchase residential real estate. The recent negotiations was to settle the un-prosecuted mass banker felonies. Wonks of all stripes (mostly) know these are two very different things. To do our analyses correctly, we need to separate the two.
Just for today, we shall ignore the criminal doings of bankers, and instead, focus on the economic repercussions of the contract aspect of foreclosures. As we shall see, foreclosures are an important part of the post-credit crisis housing market and recovery.
This morning, we shall focus on three areas:
1. Pricing impact
Foreclosure is a 3 step process: Delinquency occurs when a home owner makes late payments, fails to make monthly payments in full, or misses payments entirely. Default is defined in the mortgage note or by statute, typically when owners are 60-90 days behind their payment schedule. Foreclosure is the legal process by which the collateral for the mortgage loan — the house – is reacquired by the bank and then sold to pay off the loan shortfall. (A similar process exists for cars, RVs and boats, using bank liens and repossessions).
From an economic perspective, I consider foreclosures this housing cycle to be the mirror image of the no doc liar loans. These allowed unqualified buyers into the marketplace as purchasers, and this artificially goosed prices. The abdication of lending standards to generate sufficient mortgage volumes to meet securitizer demand was the reason. Regardless, it tilted the Supply/Demand balance, and led to an unprecedented run up in housing prices. That led to the creation of a huge amount of new housing supply. (Funny how rising prices drive supply higher).
After climbing that mountain to the 2006 peak, the housing market has spent the past 5 years working its way back down the north side from the summit. As any skier will tell you, the north side is cold, icy and dangerous. That is why I call the unwind process the mirror image of the boom — it is the nasty side of the mountain. Just as ill considered loans made to people who could not repay them drove prices 3 standard deviations too high, foreclosures are performing the opposite function by driving prices too low.
This is, surprisingly, a good thing.
Foreclosures — at least when they are legally prosecuted — perform a very important function. They ultimately work to the benefit of a housing market to cleanse the excesses, restore the supply/demand balance, bring prices to where new buyers become interested. Lower prices eventually create some stability. According to the lawyers, real estate agents and appraisers I spoke with, distressed sales are discounted anywhere from 20-35% versus an identical owner-occupied sale. The precise amount varies, depending upon the home, the price point, condition, location, etc. However, the bottom line is that foreclosures lower prices, and that is ultimately part of an economic healing process.
To better understand why this is so, consider the chain of purchasers that makes Real Estate a somewhat unique transaction: For many home sales to take place, a series of interdependent events must occur. Newlyweds buy a starter home from a married couple with a 2 year old and another on the way, who want to buy a larger home with more room for the kids from a couple who are trading up to an even nicer home (better school district, too). They purchase their house from someone who is moving to a house with a water view — and that seller moves to some giant manse on 4 acres.
Anything that prevents that first transaction from occurring — from too high prices, bad comparables/appraisal, no mortgage availability, etc. — gunks up the entire RE market.
The good news is that foreclosures are driving prices to where that first purchase in this chain is increasing possible. It comes, of course, at a wrenching, disruptive cost. Foreclosures tend to drive prices, not just for a single home, but for entire neighborhoods. Any distressed sale at a significant discount has a huge effect on subsequent local sales. Real estate agents point to many contracts falling apart due to these poor comparables; bank appraisers see low priced home in the same neighborhood, and are unwilling to lend appreciably more than that. They demand a bigger down payment, which most buyers lack, and soon thereafter, the deal falls apart. Hence, a foreclosure in many markets tend not only to lower prices, but drive down sale volumes as well.
All of which leads is to the upcoming increase in foreclosures.
For the past year, while the Robosigning giveaway settlement was being negotiated, Banks had voluntarily stopped most of their foreclosure machinery. Those foreclosure departments have since been revamped (now, mostly legal!) and are starting to process delinquencies and defaults again. Thus, we should expect to see a significant increase in foreclosures as a percentage of total existing sales (in 2011, foreclosures were 24% of EHS).
If there is a silver lining, its that lower prices brings out buyers. As we showed yesterday, the national median price remains somewhat elevated from historic means — but that is the average. In specific markets, prices have fallen so far that the bargain hunters are out. We have heard anecdotes from people in Southern Florida, California, Vegas, even the Detroit area. Beyond the anecdotes, we see some signs of bargain hunters in the statistics. All-cash sales rose to 33% of transactions (NAR), with investors purchasing 23% of all homes (NAR).
But bargain hunting and a sustainable turnaround are not the same thing. There are many good reasons to believe that the 5.5 million foreclosures we have seen are barely halfway through their full course. The United States may end up with a total of 8-10 million foreclosures when before we are finished.
Therein lay the Psychology factor. Once we begin to see an increase in foreclosures, the data is going to be far less accommodating. Monthly prices start falling, fear levels rise, and a viscous cycle could begin. Consider the recent college grads, who typically form each wave of first time buyers. From their perspectives, this whole housing thing must seem absurd. Their observations about home ownership is not the American Dram, but rather, a nightmare. Yale professor Robert Shiller worries that we have lost an entire generation of potential home buyers. He fears that we have the potential of decades long stagnation, as bad as Japan.
Ultimately, lower prices brought about by foreclosures help to restore normalized pricing and encourage first time buyers. But it is a wrenching painful process that has not been easy to live through. All of the data that I review strongly suggest we are not yet through it.
Until we clear much of these foreclosed homes, a sustainable recovery is unlikely to appear.
More Foreclosures, Please . . . (March 25th, 2010)
Tomorrow: Psychology of Renting and Rising Mortgage Rates
This post originally appeared at The Big Picture and is posted with permission.