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.
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Before we get into the details of Foreclosures, a caveat: As housing analysts, strategists, economists, we need to separate the concept of foreclosure as it should be practiced from the recent robosigning scandals. This 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. Our discussion today is concerned with the economic impact of foreclosures; our legal concerns are mostly with the end of 2011 foreclosure abatement.
Foreclosures: In brief, a foreclosure is a remedy for a breach of the contract involving the enabling loan to purchase residential real estate. The recent negotiations was to settle the un-prosecuted banker mass 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
2. Inventory
3. Psychology
When a bank repossesses a a house via Foreclosure, it is a 3 step process: Delinquency occurs when a home owner makes late payments, or fails to make monthly payments in full, or misses payments entirely. Default is defined in the mortgage note or by state statute, typically when owners are ~90 days behind their payment schedule. Foreclosure is the legal process by which the collateral for the mortgage loan — the land and 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 repo men).
From an economic perspective, we can consider foreclosures during this housing cycle as the mirror image of the no doc liar loans. These allowed unqualified buyers into the marketplace as purchasers, radically increasing the demand, thus goosing prices artificially. The abdication of lending standards served a very specific purpose: To generate sufficient mortgage loan volumes to meet the needs of securitizers who were selling out of all of the Residential Mortgage Backed Securities (RMBS) they could create. This tilted the Supply/Demand balance a great deal, which then led to an unprecedented run up in housing prices. In response, Home builders created a huge amount of new housing supply.
Funny how rising prices can drive supply higher.
After climbing what became a mountain of higher prices to its 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 face 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 an 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 will eventually create stability. According to the lawyers, real estate agents and appraisers I have spoken with, distressed sales get discounted anywhere from 20-35% versus an identical owner-occupied home sale. The precise amount varies, depending upon the home, the price point, condition, location, etc. However, the bottom line is that foreclosures generally lower prices, and ultimately, that is part of any economic healing process.
To better understand why this is so, consider the chain of purchasers that occurs in residential Real Estate: 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. This is why RRE sales are unique transactions.
The good news is that foreclosures are driving prices to where that first purchase in this chain is increasingly possible. It comes, of course, at a wrenching, disruptive cost. Foreclosures tend to lower prices, not just for a single home, but for entire neighborhoods. Any distressed sale at a significant discount has a huge effect on most subsequent local sales. Real estate agents point to the many contracts that have fallen apart due to these poor comparables; bank appraisers see low priced home in the same neighborhood, and assume lower prices to be the norm. They are unwilling to lend at any levels appreciably higher than that. This leads to a demand for a bigger down payment –which many if not most buyers do not have. Soon thereafter, the contract for sale falls apart. Hence, a foreclosure in many markets tend not only to lower prices, but also drives down monthly sale volumes as well.
Which leads us 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 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 can bring 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 of such from Southern Florida, California, Vegas, even the Detroit area. Beyond the anecdotes, we can see 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 two different things. There are many good reasons to believe that the 5.5 million foreclosures we have so far brings us only to the 5th inning of this real estate cycle. We are, in my best guess, barely halfway through the full course of foreclosures. By the time this entire unwind is complete, the United States may end up with a total of 8-10 million foreclosures.
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 is not been easy to work through. And, all of the data I review strongly suggests we are not yet through it.
Until we clear out much of these foreclosed homes, a sustainable recovery is unlikely to appear.
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Previously:
More Foreclosures, Please . . . (March 25th, 2010)
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Tomorrow: Psychology of Renting and Rising Mortgage Rates
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