In normal times, the disclosure that mortgage lenders have cut corners in foreclosing on delinquent borrowers would have been a ho-hum item to the media. But these are not normal times. The foreclosure rate hasn’t been higher since the Great Depression of the 1930s; we are in the midst of an election period; and much of the electorate is angry.
The news has stoked public outrage and converted the item to front-page status. It has also stimulated attorneys general in 50 states to investigate (when has that ever happened before?), fanned the lust of class-action lawyers, and encouraged some politicians to call for a wholesale moratorium on foreclosures.
While deficiencies in foreclosure procedures are inexcusable, it is unfortunate that public and political outrage has become fixated on it. From all indications, the deficiencies in foreclosure procedures have inadvertently caused injustice to a very small number of borrowers in default, if any.
Other servicing shortcomings that are deliberate rather than inadvertent, and that affect millions of borrowers, have been neglected (I will elaborate on that next week).
Overlooked in the frenzy over deficiencies in the foreclosure process is the collateral value of mortgages, which is central to the housing finance system.
The ultimate effect of anything that reduces the collateral value of houses is higher mortgage interest rates and more restrictive lending terms. As an important corollary, reduced collateral value pushes the weaning of the system from its current dependence on government-supported funding further into the future.
Value of collateral: Houses are the collateral for mortgage loans. The purpose of collateral is to increase the likelihood that the loan amount will be repaid. If the borrower doesn’t pay it, the lender will recover the unpaid amount by selling the collateral. The payoff to the borrower is lower rates, better terms and larger loans.
To illustrate this point, I recently shopped for a personal loan — one without collateral — and a mortgage loan. On the personal loan, I found I could borrow up to $25,000 at rates ranging from 8 percent to 17 percent, for three years. In contrast, using my house as collateral, I could borrow up to $400,000 at 4 percent for 30 years.
The difference is slightly exaggerated because the personal loan would come from a private lender while the mortgage loan would be funded by Fannie Mae or Freddie Mac, which are now parts of the federal government. A private lender today might charge me as much as 6 percent on the same mortgage because the value of my collateral has declined over the last four years and is likely to decline further.
Factors affecting collateral value: They are stability of value, accessibility to the lender, and marketability. U.S. Treasury bills in the custody of the lender are perfect collateral because their value stability is very high, the lender has immediate access to them, and they can be sold for full value very quickly. Houses, in contrast, are far from perfect collateral.
Stability of value: For many years, this was viewed as the principal strength of house collateral because house prices generally rose. However, the sharp decline in prices associated with the financial crisis has changed attitudes. Investors have learned that house prices can decline, which means that the collateral value of houses is lower than it was before the crisis. This source of declining collateral value is likely to last for many years, perhaps decades.
Accessibility to lender: House collateral also suffers from lack of accessibility. This is the major weakness of house collateral, and it is getting weaker every day.
House collateral is not in the custody of lenders because borrowers live in their houses (or rent to others who live there). Lenders can acquire house collateral only when the borrower defaults and the lender executes the legal process called foreclosure, which takes time.
During this period, the lender is not getting paid and the value of the property may deteriorate because the owners about to be dispossessed no longer care. The longer it takes to acquire possession, the higher the cost. The time period is longer in states in which foreclosures must go through a state court.
In 2006, the lag between borrower default and foreclosure was about eight months in California, a non-judicial state, and about 10 months in Florida, a judicial state. This year, it was running about 18 months in California and 22 months in Florida, reflecting the large volume of foreclosures and the various loan modification and state mediation programs designed to avoid foreclosure, which in many cases merely postpone it.
In the months ahead, the lag will increase further as a result of the recent voluntary moratoriums by some large lenders examining their foreclosure procedures. If government imposes industrywide moratoriums, the impacts will be even larger.
Part of the impact on collateral value of the longer period required to access houses should be temporary, disappearing as the economy improves and the backlog of foreclosed houses shrinks to manageable proportions. However, mandatory foreclosure moratoriums are more likely to have a permanent effect by establishing a moratorium precedent that will adversely affect investor expectations going forward.
The accessibility of collateral is also affected by the administrative costs of acquiring the collateral. Servicers tried to minimize these costs by taking procedural shortcuts, including lost-note affidavits when the note could not be found, and mortgage assignments attesting to transfers of ownership when such transfers were not recorded anywhere else.
They now face a significant (though one-time) cost of cleaning up questionable documents issued in the past, and they have to develop and install better procedures going forward, which will raise costs permanently.
Marketability of collateral: The marketability of houses is also low, in the sense that it takes longer to sell for their full value than is the case with, say, gold or marketable securities. Date on sales of existing homes collected by the National Association of Real Estate Brokers indicate that the period-to-market is seven to 12 months, with the higher level reached in recent months.
This indicates that lenders who have had loans in the foreclosure queue for 19-22 months may wait another seven to 12 months to sell — unless they cut the price enough to make the houses attractive to investors who will hold them until they can sell at full value. However, there is no reason to believe that the period-to-market has increased permanently.
In short, the collateral value of houses has declined as a result of the financial crisis, and the costs associated with fixing deficient foreclosure procedures will reduce it further. A wholesale moratorium on foreclosures would make matters worse, perhaps much worse.
This is bad news for borrowers. Looking ahead, mortgage loans will be viewed by private investors as riskier, and they will look for higher rates and more restrictive terms to compensate. The easiest way to prevent this is to retain the current system of having the federal government assume the default risk on 95 percent of all mortgages, which will require that plans for phasing out Fannie Mae and Freddie Mac be shelved indefinitely.
The better approach would be to strengthen house collateral by creating a nationwide electronic property and mortgage registration system to replace the current system in which responsibility is shared by more than 3,000 counties. I will be writing more about this in due course.