Jan172013

California records over one million foreclosures

Everyone active in the real estate market today laments the lack of available inventory. Orange County housing market prices are rising due to the restricted inventory. Banks go “all in” betting on success of loan modifications to resolve their prior bad loans. In the interim, delinquent mortgage squatters are enjoying their free ride. It’s unlikely that conditions will change in 2013. Foreclosures are likely to be fewer in number, not because the banks lack delinquent borrowers, but with the disincentives to foreclose and the new constraints from the Homeowners Bill of Rights, lenders will opt to permit squatting and allow a few short sales for those delinquent borrowers willing to gracefully exit their properties. Despite the falling foreclosures, California recorded its one millionth foreclosure late last year. Sean O’Toole of ForeclosureRadar.com took that opportunity to review the conditions that created the million foreclosures seen so far.

Introduction

On November 26, 2012, ForeclosureRadar recorded its millionth California foreclosure sale since January 2007. While we acknowledge that foreclosures are painful and unpleasant, this milestone also means a million underwater homeowners have escaped a prison of debt.

I will take it a step further. I believe Foreclosures are essential to the economic recovery.

In addition, the millionth foreclosure sale points to steady strides toward recovery in the housing market and provides an excellent launching pad for a retrospective on the California foreclosure marketplace:

  • Pre-2008 – The California Housing Market Collapses, Foreclosure Market Changes Drastically:We start with the peak of the California real estate bubble in 2007 and describe how a normally functioning foreclosure market changed drastically due to record numbers of homeowners defaulting on their mortgages. Foreclosure filings surged in 2007 and 2008.

California Foreclosure Trends - 2007 and 2008

Source: ForeclosureRadar – www.foreclosureradar.com

  • September 2008 – Housing Crisis Explodes, Massive Government Intervention and Foreclosure Limbo:We then look at how the near collapse of the U.S. financial sector in 2008 ushered in massive government intervention in the foreclosure process that lengthened the time to foreclose. While most analysts were predicting a massive “foreclosure wave” that would devastate the housing market, we forecasted “foreclosure limbo” due to never-ending government intervention.

Source: ForeclosureRadar – www.foreclosureradar.com

Sean was right. The tsunami of foreclosures never materialized. What was little noticed at the time was the federal governments relaxation of mark-to-market accounting rules in early 2009. This allowed the banks to hold bad loans on their books without harming their regulatory capital ratios. This launched the amend-extend-pretend policy banks have been relying on every since. Sean had the foresight to see that this change would create the foreclosure limbo known as shadow inventory we still have today.

On the heels of TARP, the federal government launched an alphabet soup of foreclosure-mitigation programs. California also launched several anti-foreclosure initiatives. The most significant:

  • The Housing and Economic Recovery Act, passed in 2008.
  • California Senate Bill 1137, passed in July 2008 and taking effect in September 2008.
  • The Making Home Affordable (MHA) mortgage modification programs or refinance programs, launched in 2009. These programs included the Home Affordable Modification Program (HAMP), Principal Reduction Alternative (PRA), Home Affordable Refinance Program (HARP), FHA Refinance for Borrowers with Negative Equity.
  • California Foreclosure Prevention Act, passed in February 2009.

While well-intentioned, these measures did little to help homeowners but did (via a process we called “HAMPered ”) allow banks to avoid losses by delaying foreclosures. In California, the foreclosure process lengthened even further.

Source: ForeclosureRadar – www.foreclosureradar.com

Many loanowners still suffer the delusion that loan modification programs and other government measures were designed to help them. They weren’t. These programs were all designed to help the banks by permitting them to kick the can and delay loss recognition.

As the time to foreclose climbed steadily and the spread between the number of notice-of-default filings and foreclosure sales widened, many forecasters predicted a massive foreclosure wave (foreclosure inventory) would crush the California real estate market. We disagreed, recognizing that fundamentals were no longer in play as the foreclosure process became politicized.

Source: ForeclosureRadar – www.foreclosureradar.com

The forecasts proved incorrect due to the lack of political will and financial capacity to foreclose on everyone who was delinquent on their mortgages.

That is exactly why no foreclosure wave materialized.

Instead, a foreclosure limbo caused by state and federal government interventions became the norm.

Governments accomplished this by borrowing trillions, effectively putting a floor under housing prices via low interest rates and tax credits. All that borrowing, along with forcing banks to jump through hoops and issuing foreclosure moratoriums, represented a government policy we called “extend and pretend.” Foreclosures were allowed to trickle into the marketplace at a rate that kept housing prices from reaching a natural market-clearing level and made bank losses manageable.

Source: ForeclosureRadar – www.foreclosureradar.com

  • 2009 – Real Estate Investors Command Center Stage:Real estate investors took center stage in 2009 thanks to dramatic price declines. Rising affordability and strong return on investment encouraged investors to return to the California market. In many areas, house payments were lower than rents for the first time in years. This activity rapidly eliminated the shadow inventory of bank-owned properties.

Source: ForeclosureRadar – www.foreclosureradar.com

  • 2010 Through 2012 – Foreclosure Controversies, Settlements and More Government Intervention:Several controversies related to the foreclosure process emerged in 2010, such as the “robo-signing” and “MERS” scandals, which further extended the time to foreclose and created myriad opportunities for attorneys. By May 2011, the time to foreclosure averaged 350 days. In 2012 banks enter into major settlements to resolve this issue. Government intervention continues with California Homeowner Bill of Rights.

The banking cartel won. I didn’t think they could pull it off, but through massive intervention by the government on their behalf and endless amend-extend-pretend policies, they have managed to to an artificial floor under prices that appears to be durable.

  • The Real Problem – Negative Equity: Despite the continued focus on foreclosures, the real problem continues to be the negative equity created during a massive and unsustainable credit bubble. While significant progress has been made in eliminating negative equity through foreclosure, short sales, and principal balance reductions, too many borrowers still owe more than their homes are worth.

For 2013 we expect California too see a continuation of the housing market recovery that began in 2009. Demand will remain strong thanks to low interest rates and affordability. Foreclosures will likely continue to decline as increasing numbers of homeowners and lenders agree to short sales or principal-reduction loan modifications. The continued lack of inventory will continue to put upward pressure on prices. Unfortunately, the 2 million underwater homeowners in California ensure that we still have a long way to go to achieve a truly healthy housing market.

This is where I differ somewhat from Sean. Although I believe lenders will continue loan modifications and short sales to delay loss recognition, I also believe we will see an increase in foreclosures in 2013 as soon as lenders meet their obligations under the settlement agreement. At that point, short sales are no better for them than foreclosures, and they still have a large backlog of delinquent mortgages that are mostly committed squatters. The only way they will resolve these bad loans is through foreclosure because the owners have no incentive to participate in a short sale when doing nothing allows them free housing.

The Real Problem – Negative Equity:

Since the early days of the crisis, governments launched one initiative after another to stop foreclosures, seemingly oblivious to the fact that the real problem all along was negative equity , borrowers owing more than the market value of their homes. Instead of being the problem, foreclosures are actually part of a solution because they eliminate negative equity.

By May 2011, the foreclosure process had grown to 350 days. At this point it had become glaringly obvious that these delays were the only real accomplishments of the government interventions. In fact, we believe government officials and their backers in the banking industry actually want delays because even though they let some non-paying homeowners stay in their homes — in some cases for years — they also let banks push their mortgage losses into the future.

I wrote about this phenomenon in April of 2008 in Bailouts and False Hopes. These programs were never intended to benefit loanowners, their only real purpose was to save the banks, and if they could dupe a few loanowners into making some additional payments, all the better. These programs helped the banks buy time and obtain a little more revenue, and it helped the politicians deflect political pressure that they weren’t doing enough to save loanowners.

So what keeps most underwater homeowners paying their mortgages when all these non-paying homeowners are getting a free ride for a year or more? The answer looks to us a lot like Russian roulette. So long as lenders keep foreclosing on at least a handful of homeowners every month, then those who can pay their mortgage will be afraid to stop. Those who risk the non-paying route find themselves playing what we’ve called “foreclosure roulette,” wondering each month if they will spend another month freed from their mortgage obligations, or finally take the “shot” and be forced to move.

Roulette is a nice analogy, but this tactic should be called out for what it is: terrorism. Random violence to keep the herd spooked is a terrorist tactic designed to force compliance with a terrorist’s demands. When bankers started foreclosing on random borrowers to instill fear in the general population of borrowers who might strategically default, they resorted to terrorist tactics.

At first, we suspected banks chose their foreclosure targets at random. Then we realized that there may be a method to the banks madness. We found that banks were taking longer to foreclose on jumbo and second mortgages that were more likely held as portfolio loans rather than ones they serviced for others. Perversely, this resulted in borrowers who took out the biggest loans, on the nicest houses, with the largest lines of credit to live rent-free for the longest amount of time, in some cases years.

That is moral hazard. The more prudent you were, the more likely you were to get foreclosed on. The most outrageous HELOC abusing Ponzis were the ones given the most time to squat. Which group do you think we will see more of next time around?

While governments were actively ignoring the reality of negative equity, they grew especially fond of loan modifications because they allowed people to stay in their homes. Unfortunately, early loan modifications were great for banks but terrible for homeowners. A typical loan modification reduced mortgage interest payments and extended the loan’s term, but left the homeowner underwater. We believe these loan modifications were the most toxic loans ever made. More recent loan modifications have included principal balance reduction, which helps address the real issue, negative equity.

Despite all their efforts to extend and pretend, banks do want to clean up their balance sheets and have become increasingly supportive of short sales. Short sales as a percentage of distressed property sales have been on the rise.

As I pointed out above, banks only became fond of short sales when these were counted against their foreclosure settlement obligations. Particularly in a rising price environment, short sales provide less recovery of capital because the bank is selling at a lower price locked in several months earlier.

How big is the negative equity problem? According to CoreLogic, more than 10.8 million homeowners nationwide, or 22.3%, owe more than their homes are worth and are at risk of default. We estimate that in California, underwater homeowners number more than 2 million.

To get a sense of the dollar amount involved, we can use the Federal Reserve’s Flow of Funds Z.1 data to compute excess mortgage debt, an excellent proxy for negative equity. If we assume a healthy housing market has a debt-to-value ratio of 42%, then using the Q3 2012 Federal Reserve Z.1 data data, excess mortgage debt is about $2.3 trillion nationwide and about $500 billion in California. While the size of excess mortgage debt is down from an estimated $3.2 trillion in early 2009, we still have a long way to go. If excess mortgage debt continues to be extinguished at the rate of about $250 billion per year, it is likely to be another three or four years before the foreclosure crisis recedes and the California real estate market returns to a more normal state.

Source: Federal Reserve – www.federalreserve.gov

Conclusion

The millionth foreclosure sale comes at a time when the California real estate market is eliminating negative equity and showing signs of growth. Without government intervention, the foreclosure process would have been much faster but far more painful. Preventing that pain has come at immense cost to the taxpayer: The federal debt has nearly doubled from $8.7 trillion at the beginning of 2007 to $16.4 trillion at the end of 2012 and the Federal Reserve’s balance sheet has more than tripled from $860 billion to $2.9 trillion. Massive government borrowing is simply a form of delayed taxation that will have to be repaid. Has the price tag to rescue the banks and the housing market been too high? Only time will tell.

It depends entirely on who you ask. If you ask the banks, their answer is obviously yes. If you ask the wealthy who will see the value of their stored savings evaporate in the inevitable inflation to come, they would say no. Loanowners will say that no price is too high, particularly since they get the lion’s share of the benefits while only paying a small portion of the cost. If you ask seniors and others who rely on interest rate payments, they will say no because they have been screwed.

While our crystal ball beyond this year is murky, for 2013 we expect California’s housing market to continue the recovery that began in 2009. Demand will remain strong thanks to widespread affordability and the Federal Reserve’s push to keep interest rates low. Foreclosures will likely continue to decline as increasing numbers of homeowners and lenders agree to short sales or principal-reduction loan modifications. In some areas, lack of inventory caused by anti-foreclosure efforts will drive prices higher. The 2 million underwater homeowners in California, however, ensure that we still have a long way to go before we have a truly healthy housing market in California.

Prices are likely to rise in 2013, perhaps a lot. Supply is so low relative to demand that today’s buyers are being forced to outbid one another to get properties. Since interest rates are so low, buyers have the ability to raise their bids and still obtain the necessary loans to close the deals. As long as these conditions persist, prices will go up.