Are U.S. Home Foreclosures Caught in a Never Ending Vicious Cycle?

The housing sector is the root cause of the current credit crunch. For more than a year the economy has been suffering from a severe recession and home foreclosures are rising day after day. As the economy worsens further and unemployment level increases foreclosures are bound to skyrocket as well. In this scenario, preventing closures has become one of the key goals of the Obama administration.

However reduction of foreclosures is not easy for many reasons. The main reason being that people who cannot afford to pay mortgages should not have bought the homes in the first place. Efforts to keep those folks in their homes will not succeed unless the “underwater” values of their homes are erased and their loans redone with heavy cram-downs (reduction of principal owed) and interest-rate changes. Even then it is possible that loan modifications will not help when folks can’t pay their mortgages due to losing jobs, unexpected expenses, etc.

So in order to understand how the foreclosure crisis is impacting the overall economy, I reviewed a recent position paper from IMF titled “Foreclosure Mitigation Efforts in the United States: Approaches and Challenges”. In this paper the authors argue that the burden of restructuring mortgages must be borne by the taxpayers since foreclosures play a key role in adverse housing market dynamics.

With foreclosures rate reaching the highest levels since the Great Depression, the paper adds “With house prices falling, lending standards tightening, unemployment rising, and interest rate resets in the pipeline, foreclosures are projected to go even higher”.

The following diagrams nicely illustrate the vicious cycle of falling home prices and its relationship to the overall economy:

Housing Feedback Loop (click to enlarge)

Housing Loop and Macro-Financial Linkages(click to enlarge)

Foreclosure starts and inventory started rising at an alarming rate after 2007 as the diagram shows below.

Foreclosure Starts and Inventory (click to enlarge)

Source: IMF

Comments

[Drew Horn:]

I agree with others who say that house prices are still artificially high. My feeling is that another 25% reduction in the median house price is needed to make it affordable to the median income family.

There isn't an obvious plan for the future because our system of government and business is fully focused on the short term leaving the "long run" future to accidental "democratic" consensus. People who feel that we live in an economic "jungle" where only the crafty (who exploit the uneducated) will succeed have been running things for close to 100 years and have brought us to the current mess. Capitalism is very useful but, carried too far, is destructive. We need good leaders to provide direction but so far, I haven't seen one I trust.

Mar 01 08:24 AM

[Jon Smirl:]

There are three groups losing their homes:
1) Never could afford it. You are a renter equivalent, you don't pay your rent you get evicted.
2) Unexpected income loss. Temporary help should benefit these people. Aid them via increased unemployment benefits.
3) My house is underwater.

The last group is the one making me mad. I know of two couples that purposely triggered foreclosure because they were underwater. They were both able to make their payments, they just decided they didn't want to any more since they weren't making money.

To get a feedback loop there has to be a cause and effect. Declining house values do not impact the first group. Their payments were fixed when they signed the mortgage. This group can contribute to downward prices, but there's no feedback. Changes in neighborhood values don't change the initial fact that this group never could make their payments to begin with. This group was on a path to lose their home from the day they signed their mortgage.

The second group can also contribute to downward prices but again there's no feedback. For the most part the job loss that is getting this group in trouble is not related to the decline of house prices in their neighborhood. There's no feedback other than a weak one via the whole economy.

The third group has an extremely high feedback component. By purposely triggering foreclosure they send prices in their neighborhoods down further. They also talk to their neighbors and brag about how they beat the system and got out of underwater loans. They encourage their neighbors to do the same by telling them how stupid they are to continue making payments on underwater loans.

The problem in the diagram is the "more negative equity" linkage. That linkage only impacts group three. There are no margin calls on home loans, that link is a psychological one.

Mar 01 08:44 AM

[User 310740:]

I read your comments and all you want is cheap housing, there is none. I am a builder, at todays prices we are breaking even, our contractors are breaking even, our suppliers are losing money. BUT when we file for a permit the county and/ or state get the same impact fees, hookup fees, taxes, etc.., In Virginia this adds over $40,000. to the price you pay for the home. Now lets add the new finance requirements the banks are forcing. Builder pays 25 to 30% of land cost up front, Builder only gets a 60% construction loan, Housing value is falling faster than we can build it using more cash from the company to even be in the business. Then you all want cheap houses, with hardwood floors, granite counters, and luxury items. Well it doesn't add up unless I get an investment banker to do the math for me. To make affordability we need to buy land in bulk and build in a mass production environment, today we can not, we need to borrow at reasonable terms to build, today we cannot, we need the market to buy the homes we build at the pace we have to build at to create a more affordable house, today you cannot, we need the local governments to forgo the impact fees, and hook up fees to allow lower priced housing to happen, they will not and lastly we need mortgage rate at a price that bank can actually make money lending them out in responsible way, today at 5% the banks lose money on every mortgage. There is a lot of issues here that need fixing, cheap houses is not the answer, less consumer wants, less fluff, less fees, more lending, and rebuilding closer to the cities makes better sense than building out. No body wants to buy a CHEAP house they want a safe well built affordable house.

On Mar 01 07:21 AM Yamu wrote:

> Let prices fall. Their height is unwarranted and not backed up by
> fundamentals, any money that's being poured into keeping them artificially
> high is ultimately wasted the US is already running a huge deficit,
> every dollar needs to be spent at maximum value. Do not waste it
> in trying to keep houses prices artificially high. This whole thing
> is so sickening, just let those prices fall.

Mar 01 08:54 AM

[Firat Ünlü:]

There's a difference between cheaply-priced houses and cheap houses. So far house prices are above the long-term medium for no fundamental reason, in fact they're at the current level for reasons that are due to market interference and people riding that wave by flipping them as long as it's profitable. What I want is houses priced at a level that is justified by fundemantals and in alignment with the long-term trend.
Artificially-inflated house prices made some areas of the economy larger than would be justifiable, these areas now need to shrink to their true size.
Keeping a bubble inflated has never worked out, neither have price controls (which is what the government wants to do in a way).

Mar 01 09:22 AM

[EEB:]

I applaud the author's efforts to provide a dynamic model of the foreclosure situation. I understand the sentiment of those who simply want the market to work off the excesses of the past decade. If the foreclosure crisis were isolated from the rest of the economy, then that would be fine. Unortunately, it is not. I think that another flow chart taking rising unemployment into account is needed. It seems that now foreclosures hurt the banks and that hurts the broader economy and that is increasing unemployment and that is increasing foreclosures and so on. That is the broader loop that I see.

Housing prices are still too high, but the scary thing is the accelerating decline. Just letting the market play out is very likely to result in a depression. Some government intervention is needed, and that doesn't mean we still won't have a depression. I think that only our most irresponsible past presidents from both parties would not intervene in some way.

However, I do agree with the author that reducing foreclosures will not be easy. Loan modification schemes are not working, and, in my opinion, all the schemes to increase demand are not likely to work either.

As I've stated elsewhere on Seeking Alpha, the government should just start buying a bunch of houses. Some will be held for years. Reducing the supply in this way would stabilize prices or at least drastically reduce the rate of the decline in prices. This would eventually reduce foreclosures.

Mar 01 09:26 AM

[Harry Tuttle:]

There is no one "cause" that explains anything as complex as the US and/or Global economy.

The problem of housing is rather simple. At current prices there aren't enough buyers to clear the inventory.

The solutions is rather simple as well. One can reduce the prices, reduce the inventory (by destruction, for instance), increase the purchasing power of the potential buyers, and/or increase the number of potential buyers.

The government, of course, only considers the last two alternatives because the first two are not popular. Unfortunately, the number of potential buyers if controlled by demographics (not much one can do about that).

Since the chances of restoring the aggregate purchasing power (and its expectations, since buying a house is a multi-year commitment) to that of 2006 are slim to none, I am afraid that there is little that can be done.

The sad true about the economic cycle is that, no matter what we try, it always seems to reassert itself. That was valid in the 30s and it seems to be valid today.

Mar 01 09:28 AM

[Under the R...:]

Part of the problem is that the new home builders (ie: Pulte Homes) were still doing zero down mortgages using a gift thru a third party to cover the down payment even after all the sub-prime mess stated unraveling. We have a long way to go.

Mar 01 09:38 AM

[prudentinve...:]

I remember that in the 1980's, an astonishing statistic used to be repeated often in credible news sources (if memory serves, this included the WSJ): "The land of the Imperial Palace in central Tokyo is worth more than all the real estate in California.". Having run around the perimeter of the Imperial Palace in my fitter days, I can attest that it is a very sizable area, but worth more than California? C'mon guys! The rest of this story is now known history.

These days you read that a 1500 sq.ft slab-ranch in the SF area is worth over a million dollars. In NYC a hairdresser bought/sold a 3500 sq.ft condo from Joe Shmoe for 20 millions of dollars. A 2000 sq.ft. 1960's shack in Martha's Vineyard is on the market for 3 millions, etc. Can the outcome be any different?

Attempting to prop up such absurdities, as Japan tried, is likely to continue distorting our economy to the extent that it never recovers. I can already hear the chorus "... but Japan did not throw in enough good money after bad...", and I disagree. Japan tried very hard, and indeed succeeded in slowing down real estate deflation, but at the cost of twenty years of stagnation.

To shorten this recession, prices must adjust to realistic levels, and the sooner the better. Prudent people will then feel comfortable buying real estate, with a reasonable down payment, and with realistic, above-inflation mortgage rates. If this means that foreclosures must run their course, so be it, and the system should help those who suffer foreclosure to resume normal lives, within their means. The alternative is a totally distorted economy and decades of sub-par growth or stagflation.

Mar 01 10:02 AM

[prudentinve...:]

You make many good points, given your direct knowledge and experience in building. However, in reading your excellent post, the only conclusion I reach is that people only want to buy housing that they cannot afford. I don't think that it should be the obligation of the rest of society to subsidize their unrealistic wants.


On Mar 01 08:54 AM User 310740 wrote:

> I read your comments and all you want is cheap housing, there is
> none. I am a builder, at todays prices we are breaking even, our
> contractors are breaking even, our suppliers are losing money. BUT
> when we file for a permit the county and/ or state get the same impact
> fees, hookup fees, taxes, etc.., In Virginia this adds over $40,000.
> to the price you pay for the home. Now lets add the new finance requirements
> the banks are forcing. Builder pays 25 to 30% of land cost up front,
> Builder only gets a 60% construction loan, Housing value is falling
> faster than we can build it using more cash from the company to even
> be in the business. Then you all want cheap houses, with hardwood
> floors, granite counters, and luxury items. Well it doesn't add up
> unless I get an investment banker to do the math for me. To make
> affordability we need to buy land in bulk and build in a mass production
> environment, today we can not, we need to borrow at reasonable terms
> to build, today we cannot, we need the market to buy the homes we
> build at the pace we have to build at to create a more affordable
> house, today you cannot, we need the local governments to forgo the
> impact fees, and hook up fees to allow lower priced housing to happen,
> they will not and lastly we need mortgage rate at a price that bank
> can actually make money lending them out in responsible way, today
> at 5% the banks lose money on every mortgage. There is a lot of issues
> here that need fixing, cheap houses is not the answer, less consumer
> wants, less fluff, less fees, more lending, and rebuilding closer
> to the cities makes better sense than building out. No body wants
> to buy a CHEAP house they want a safe well built affordable house.
>
>
> On Mar 01 07:21 AM Yamu wrote:

Mar 01 10:12 AM

[antiquecarman:]

Comment from John Smirl, above, is very interesting. Group three he describes, "my house is under water" (but I can still make the payment) is indicative of what I consider the real underlying issue. This is a decay of morals in the US and probably other countries. We just don't honor our commitments anymore, unless it is to our advantage. Hey guys, you promised to pay the loan, period. Where is your integrity? People who can pay their loan should pay their loan. When a country's morals decay, everything else follows. History has proved that many times.

Mar 01 10:29 AM

[Jon Smirl:]

On Mar 01 09:28 AM Harry Tuttle wrote:

> The problem of housing is rather simple. At current prices there
> aren't enough buyers to clear the inventory.
>
> The solutions is rather simple as well. One can reduce the prices,
> reduce the inventory (by destruction, for instance), increase the
> purchasing power of the potential buyers, and/or increase the number
> of potential buyers.

I don't think that's what is happening here in Florida. There are plenty of buyers floating around. 95% of them are just waiting for the market to fall further.

There are brand new two bedroom, two bath condos with two car garages here for under $200,000 and no buyers. Same condos were $250,000 last year. Buyers think they will be $150,000 next year.

I suspect those condos cost more that $150,000 to build. The market clearing prices here may be below construction costs.

Why do you want to buy now if you expect properties to be 25% lower next year? The rational thing to do it rent. The market is flooded with rentals and they are priced very attractively.

Mar 01 10:41 AM

[Burticus:]

"The housing sector is the root cause of the current credit crunch."

WRONG!!! Privately-owned central banks given legislative fiat to print the $#!+ out of counterfeit paper currency, then artificially manipulate interest rates is the root cause. Until this and all other central bank monsters are slain (and their ultimate owners and boards publicly hanged as an example), the real root cause eliminated forever and a system of sound money backed by precious metals restored, only global poverty and slavery will reign.

Disclosures: Long silver, gold, steel, lead and food.

Mar 01 12:25 PM

[Summer Sea:]

One moment please.... you forgot about all the people whose homes were rebuilt after hurricanes Katrina and Wilma. Some people were fully insured for a replacement home, insurance companies took it upon themselves to depreciate the homeowners home value instead of replacing the home, leaving homeowners with two mortgages or one huge jumbo mortgage. In most cases that I'm familiar with, the new mortgages are adjustable and left homeowners really underwater.Also, banks gave these loans and people had to qualify for them.

The majority of people had nothing but good intentions when they purchased their home, and most likely at the time they were making the money to support the loans.


On Mar 01 08:44 AM Jon Smirl wrote:

> There are three groups losing their homes:
> 1) Never could afford it. You are a renter equivalent, you don't
> pay your rent you get evicted.
> 2) Unexpected income loss. Temporary help should benefit these people.
> Aid them via increased unemployment benefits.
> 3) My house is underwater.
>
> The last group is the one making me mad. I know of two couples that
> purposely triggered foreclosure because they were underwater. They
> were both able to make their payments, they just decided they didn't
> want to any more since they weren't making money.
>
> To get a feedback loop there has to be a cause and effect. Declining
> house values do not impact the first group. Their payments were fixed
> when they signed the mortgage. This group can contribute to downward
> prices, but there's no feedback. Changes in neighborhood values don't
> change the initial fact that this group never could make their payments
> to begin with. This group was on a path to lose their home from the
> day they signed their mortgage.
>
> The second group can also contribute to downward prices but again
> there's no feedback. For the most part the job loss that is getting
> this group in trouble is not related to the decline of house prices
> in their neighborhood. There's no feedback other than a weak one
> via the whole economy.
>
> The third group has an extremely high feedback component. By purposely
> triggering foreclosure they send prices in their neighborhoods down
> further. They also talk to their neighbors and brag about how they
> beat the system and got out of underwater loans. They encourage their
> neighbors to do the same by telling them how stupid they are to continue
> making payments on underwater loans.
>
> The problem in the diagram is the "more negative equity" linkage.
> That linkage only impacts group three. There are no margin calls
> on home loans, that link is a psychological one.
>

Mar 01 03:02 PM

[wldgrdnr:]

Housing prices were WAY overinflated to start with and this is what started the domino effect....this housing bubble burst is actually bringing housing prices closer to what they should have been to start with...there is just no way houses could have continued in that upward spiral....the nasty loans banks gave to make housing affordable to folks just added to the mess...it would have been better to let those houses go empty to start with than trying to have everyone and their brother qualify for loans that they obviously could not afford...

My advice? If you possibly can, go buy one of those cheaper than cheap houses...buying up those houses will help reverse this trend

Mar 01 03:38 PM

[driftwood2:]

Unfortunately, the only way to create money unhindered by debt in our stupid monetary system is for defaults to occur. Defaults are actually necessary to keep our financial system going.

Mar 01 04:08 PM

[Jugheadjack:]

Nothing goes up forever. Let the real estate speculators take a bath. Nobody ever subsidized my stock or fuitures losses. Tulipmania

Mar 01 10:17 PM

[THofler:]

Nice housing feedback diagram, although I have two corrections. I agree with the previous post that negative equity only leads to delinquincy and foreclosure for "group 3" people. Still, that is a link.

But, while delinquincy and foreclosure does lead to tightened credit (though mostly through bank losses) tightened credit does not lead to delinquincy and foreclosure. After all, if you are considering delinq/forecl then you already have the credit and don't need (or shouldn't get) any more.

I read the shareholder letter Warren Buffett released yesterday. Unbeknownst to me Berkshire owns Clayton Homes, one of the largest US home builders. Clayton finances all of their own mortgages. Buffett claims their delinq rate is only up to 3.6% from a basline of 2.9% and their foreclosure rate in 2008 is actually down. Why? From page 11,

"... most foreclosures do not occur because a house is worth less than its mortgage (so-called “upside-down” loans). Rather, foreclosures
take place because borrowers can’t pay the monthly payment that they agreed to pay.

... Home purchases should involve an honest-to-God down payment
of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified."

Wow, this is rocket science stuff! Alert the press!

I add my voice to those above; your house is underwater? Too bad you were unlucky or didn't think hard enough about the biggest expenditure of your life. Suck it up pal.

Here's my plan to resolve the housing mess. Get the houses out of financially weak hands and into strong with a carrot and a stick. Provide a tax deduction for an existing home purchase (by anyone) of $10K in 2009, $5K in 2010, then zero. And... starting in 2010 add partial recourse to home mortgages. Recourse on 10% of purchase price in 2010, 20% in 2011, etc. until 50% is achieved. That should motivate a few potential home buyers.

Mar 01 11:37 PM

[skitahoe:]

One fact seems to be forgotten in all this discussion, when all the dust settles we still need more housing then we currently have. Certainly the banks made loans to people who wouldn't qualify for the loans at the time, but with teaser rates they could pay presumedly until another loan would be available that they could not only qualify for, but afford.

The problem was largely bank initiated, and it was feed by the banks who instead of offering a hand when rates adjusted offered a foot to boot people out of their homes. While historically ARM's were offered at nearly a point below fixed, the banks tightened the screws and some times even raised the ARM's to levels equal to or even above the Fixed Rate Loans so people on ARM's or other teaser loans didn't have a chance when rates adjusted, the refinancing they were promised at the initiation of the loans on adjustment weren't there.

Part of the problem had to do with the fact that banks sold off the loans, so they really had little interest in assisting the homeowner who was unable to make the payments. The FED added fuel to the fire by not recognizing what was happening, lowering rates, and therefore making rate adjustments substantially lower. Even now, banks don't reduce rates until a specific date specified on the loan, if you had a loan that adjusted last April, you probably got a huge increase as the FED hadn't made any major moves downword prior to then, the fact that 6 months later they were down to the lowest rates ever, it doesn't matter, your rate won't come down till April. In short, if you're foreclosed before the rate goes down, they weren't providing much help.

What's sad is that if the rates available now were available one to two years ago many foreclosed properties wouldn't have been. Sure, some would, prices would have fallen some, and construction would have slowed down, but things wouldn't be nearly as bad as they are today. Much the same can probably be said if the SEC had done its job about the collapse of all sorts of companies.

Certainly there's enough guilt to go around, but the fact that when all the dust settles, when the economy on its way back up, when unemployments back down to 5% or so, and when the world outlook is far more positive, the need for more new homes will once again exist, and real estate prices will be on the rise again. As a resident of Los Angeles, it might be awhile before they're as high as they were a few years ago, but they'll also be nowhere near as cheap as they are today. Of course the key is keeping interest rates low, if the FED is foolish enough to raise rate substantially, the recovery will be shortlived.

Gary

Mar 02 02:25 AM

[cadoggy:]

People who walk away from underwater mortgages are not morally bankrupt. They are making a smart business decision for themselves and their families. They are living up to the terms of the contract (mortgage) that they signed by relinquishing their rights to use the property in question. All these remedies were clearly spelled out for both parties (lender and borrower) when the contract was signed.

And the reason non-recourse loans exist is because the banks should have the onus to make smart loans. The banks created fishy products that were unsustainable. The banks did the underwriting on these loans. And the banks made billions in profits during the 6 year run up!

Down with banks. Up with people.

Mar 02 01:04 PM

[Joist Full:]

Prices have stopped falling in Sacramento for the last 3-4 months. In fact they have gone up a bit from their bottom in Aug/Sep.
Now less and less foreclosed houses are listed on MLS (Sacramento) every day.
Either the banks have sold most of their inventory of foreclosed homes or they're not putting them on market for some reason.

Mar 02 05:00 PM