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.

>;

Previously:
More Foreclosures, Please . . . (March 25th, 2010)

~~~

Tomorrow: Psychology of Renting and Rising Mortgage Rates

Category: Foreclosures, Real Estate

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

23 Responses to “Foreclosures: A Decade Long Overhang (Part 4 of 5)”

  1. Herman Frank says:

    “….. The United States may end up with a total of 8-10 million foreclosures when before we are finished….. But it is a wrenching painful process that has not been easy to live through ……”
    Read the above very slow to yourself – and think “Pain? Me? No way!” And you plug the earphones of your Ipad/Iphone/Ipod (note the “I”) firmly in your ears, crank up the music, and go back to zombie-land.
    If only there were fire-side chats, a presidential address to the nation, a congress to be taken serious, a senate ready for action. But no … “the zombie-land phenomena has taken over!” Everyone cranks up his/her own music to shut out everyone else.
    The 90%-movement needs to step in and will have to get arms and legs, and a head right too, so as to come to the sobering conclusion that the party is over, the credit card is maxxed out, and that a period of sweat and tears is ahead for us to dig ourselves out of this big hole filled with pickles.

  2. Petey Wheatstraw says:

    Structures that have sat vacant and unmaintained for a year or more are, in many cases, uninhabitable. in many cases, the cost of returning them to a habitable condition negates any benefit a low foreclosure price might have had in the first place.

    Someone needs to take a real loss on these properties.

  3. BennyProfane says:

    What happened to the Boomer migration to Florida and Arizona? You would think that the rich and spoiled elders would be descending onto these markets like locusts on a farm field, gobbling up all of the incredible bargains for their last days in the warm sun. Maybe they aren’t as rich as some would want you to believe, and their major asset, the house, is underwater and HELOC’d to the neck, and the kids with babies can’t afford to even think of buying the MacMansions that will scatter the landscape like monuments to excess for years, much like the grand old homes in older urban neighborhoods that have devolved into crack houses and/or rooming houses for immigrants. Everybody is just stuck in place in whatever they bought seven years ago, thinking that the game of musical chairs would never end.

  4. flocktard says:

    Couple of thoughts: on Florida, if I actually LIKED the lifestyle down there, I WOULD swoop down and pick up a property for pennies on the dollar. I have family living in South Florida, and you would be shocked how much house your dollar can buy. I am actually tempted, but Florida is a place where one goes to die, and and I ain’t there yet. But 200k can buy you a mini palace.

    I think that as long as deductibility for mortgage interest and property taxes remains, sensible people will do the math and see that owning is often cheaper than renting. As long as the landlord is getting the deductions that he or she is not passing along to the tenant, people will make a value judgment. Renting a house is not the same as renting an apartment. Those are two different markets, and I believe eventually the floor will be found, albeit in certain areas sooner rather than later.

  5. Petey Wheatstraw says:

    flocktard:

    I don’t think a mortgage deduction can be taken on rental property. I could be wrong, but I don’t think so.

  6. [...] Quote of the day Posted on April 5, 2012 by thecrosspollinator From the Big Picture: [...]

  7. The banks could stem the price drops by taking more initiative to preserve properties. The lack of electricity in a lot of homes leads to water infiltration and temperature damages in extreme conditions. Also, incentives from the banks, not the government, for investors could help sustain stable pricing and stimulate the market. Investors are still leary of purchasing for fears of dropping prices. One can put a contract on a foreclosure or short sale and have the prices drop below the contract price by the time settlement occurs because of lengthy approval processes. For being for profit companies, the banks, in general, leave a lot of $$$ on the table and lose a lot. This in turn leads to lower prices and we all suffer the consequences by having our values drop.

  8. [...] –Foreclosures: Barry Ritholtz has dedicated a series of blog post to the housing market. Today he looks at foreclosures. “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.” [...]

  9. BennyProfane says:

    @Tim Montoya-Realtor

    “This in turn leads to lower prices and we all suffer the consequences by having our values drop.”

    I can see how a realtor would be concerned about a frozen market, but “we” don’t all suffer, especially renters with cash in hand. Oh, and young, first time buyers who were staring at an incredibly bubbled and bloated market benefit greatly, too.

  10. Jim67545 says:

    Consistent. Here the housing bust is portrayed as an insidious trap by bankers into which innocent and oblivious families fell, only to find themselves coming to as owners of homes they could not afford, having unwittingly put their signature on applications with no income or assets listed, etc. You would think that this kind of kidnapping would be prosecuted!!

    Then, having found themselves unknowingly sucked into this situation, they are now knowingly avoiding home ownership? I suppose it’s possible.

    Sarcasm aside, the above should include the impact of growing two income households and the unemployment which accompanied the bust. The best of loan underwriting and the most complete application is no defense for a situation where the borrower loses his/her job and the family income is cut in half (two jobs) or entirely. There was a self-reinforcing cycle at work here.

  11. Greg0658 says:

    “Renting a house is not the same as renting an apartment.” ya a yard for the dog and ability to make LOUD stereo

    on 200K mini palaces – is clear title cleared up ? could be true but proceed with caution on each parcel

    rent or own ? I think it boils down to planting oneself with the ability to do so – and messness with the turf

  12. louis says:

    “The weak can never forgive. Forgiveness is the attribute of the strong.” – Mahatma

  13. Greg0658 says:

    doh – I saw right at the click – edit: meshness

    and since I’m remembering more now – if the mic was on here “Barry you are the best” teacher in recent years

  14. mathman says:

    i don’t see America ten years from now being even remotely similar to today. We’re running out of cheap energy (if we haven’t already done so) so, as was pointed out above by the ever inciteful Petey Wheatstraw, it’s going to be finanacially difficult to rehab these structures and (even if they were in good shape to start) heat/air condition them for habitation going forward (i.e. in ten years it may well be near impossible unless the buyer was independently wealthy). As we’re seeing an increase in weather related and earth-originating disasters there may be little to nothing left by 10 years time. Tornado swarms, flooding, years of drought, earthquakes, volcanic action on top of the ususal entropy will eliminate many homes, whether they’re inhabited or not. Indeed, the decision to rebuild on an inundated coastline, repeatedly impacted areas like Tornado Alley, or in a drought zone or flood plain will become only more difficult as insurance companies fail to renew contracts due to too much risk (or it will become another very expensive proposition for the intended occupant/homeowner to add to the list).

    On top of all that we have radiation problems, pollution, non-maintenance of infrastructure surrounding said homes, and ever-higher real estate taxes to cover all the vacant sites. It looks more and more like we’re in a death-spiral/societal collapse from which we won’t emerge anywhere near where we are now.
    These ARE the “good ol’ days” so enjoy what you have while it lasts.

  15. whskyjack says:

    Interest on a rental property mortgage is a business expense and there is a limit on the amount of loss you can claim to offset other taxes owed.

    Jack

  16. whskyjack says:

    Petey

    In older areas,(64126 area code) someone is taking a real loss on some of these properties. I’ve seen a 75% reduction or more in price on decent properties and on junkers that should have never had a loan against them the banks are paying to have them taken off their hands.The going rate to community development non profits is $7 to 10 thousand dollars., the local cost of demolition.

    Jack

  17. Petey Wheatstraw says:

    whskyjack:

    My worry is that the loss isn’t reflected on the banks’ balance sheets. The loss was socialized, and we will take the hit.

  18. [...] Part 4 of 5 in The Big Picture housing recovery series: Foreclosures! [...]

  19. Frilton Miedman says:

    Petey Wheatsraw, spot on with the observation that the losses were socialized.

    (In best Kudlow impersonation)

    Five steps to “free market prosperity”

    1. Bribe political officials (campaign funds) for the removal of Glass-steagall, CFMA & deregulation.

    2. Pump housing prices via an unregulated mortgage market by pushing mortgage & equity liar loans as free money with the goal of defaults as the objective.

    3. Pay off ratings companies to fraudulently rate leveraged derivatives based on those liar loans while obscuring important details about their components from public view. (CDO’s comprised of 90% liar loans, while rated triple A, up to 2008 only industry insiders were aware of this)

    4. Short said market without disclosure to the public while selling CDO’s like hotcakes…..later claiming the role of “market maker” in your defense.

    5. for good measure, restrict disposable incomes by cornering oil futures at the height of seasonal consumption, jacking gas prices to tip the onslaught of defaults for a market that’s teetering as is.

    Result,
    Years, maybe decades of foreclosures, underwater mortgages, high unemployment, devastated middle class net worth & deleveraging, massive deficits with Neocons targeting those who can’t afford political bribe money to pay for it.

    The difference between a good salesman and a good con-man, the con-man never has to leave town.

  20. [...] All last week, we looked at the Housing Recovery theme, challenging the arguments and assumptions of the Residential Real Estate bulls. Last Monday, we began with Debunking the Housing Recovery Story, looking at the huge overhang of Shadow inventory. On Tuesday, it was a Reality Check on Home Affordability. Wednesday, we looked at valuations in the Problem With Home Prices. And on Thursday, we discussed Foreclosures: A Decade Long Overhang. [...]

  21. [...] All last week, we looked at the Housing Recovery theme, challenging the arguments and assumptions of the Residential Real Estate bulls. Last Monday, we began with Debunking the Housing Recovery Story, looking at the huge overhang of Shadow inventory. On Tuesday, it was a Reality Check on Home Affordability. Wednesday, we looked at valuations in the Problem With Home Prices. And on Thursday, we discussed Foreclosures: A Decade Long Overhang. [...]

  22. [...] -PART 4: Foreclosures: A Decade Long Overhang [...]