The Walls Keep Tumbling Down: Foreclosure Flap and Other Housing Industry Woes
After suspending foreclosures in the U.S. in order to review cases that may be flawed by procedural errors or fraud, major mortgage companies have injected new uncertainty into the country's already weak housing market. While few of the homeowners under scrutiny are likely to avoid foreclosure, the freeze adds additional confusion and delays recovery of the troubled housing sector, according to Wharton faculty and real estate analysts.
The foreclosure flap is the most recent of many setbacks for the troubled industry, even as a new generation of potential buyers is rethinking the traditional dream of homeownership. "Buying a home doesn't make sense for a large proportion of the population," says Wharton real estate professor Fernando Ferreira, noting that ownership reduces the flexibility to pursue work in other regions and ties up cash in a down payment that might be used for better investments. "We forgot these lessons in the housing boom. But I think the new generation is learning them -- at least for the next five to 10 years."
After discovering that employees violated procedures while attempting to process a crush of foreclosure cases, three of the nation's leading mortgage servicers -- J.P.Morgan Chase, GMAC and Bank of America -- are holding off on further action in 23 states that require foreclosures to undergo judicial review. One GMAC "robo-signer" acknowledged signing off on as many as 10,000 cases a month, even though the law requires the signer to review all documents personally. Bank of America later extended its halt to foreclosures in all 50 states.
Wharton real estate professor Susan Wachter says the foreclosure freeze might temporarily buoy prices by keeping foreclosed properties off the market and could give some families another chance to come up with enough money to save their home. However, she expects that most of the now-stalled foreclosures will eventually move forward. "This will only delay the market clearing process."
According to Wharton real estate professor Georgette Chapman Phillips, lenders may be guilty of shoddy paperwork, although she stops short of calling it fraud. Lengthy delays or overturning foreclosures based on improper documentation, she adds, would create new levels of moral hazard that might lead even more homeowners to stop paying their mortgages. "This is a horrible mess created by the banks and the secondary market. It's sloppiness, but the borrowers are not asserting fraud in the lending of money. We can't ignore that, at the bottom of all this, the people who were foreclosed upon didn't pay their mortgages."
The Key Driver: Jobs
The questionable cases are part of a backlog of more than 1.2 million loans that are in the process of foreclosure in the United States, according to RealtyTrac, a housing data firm based in Irvine, Calif. In addition, another 900,000 properties taken back by banks remain on lenders' books, while five million more loans are seriously delinquent. The National Association of Realtors reports that distress sales, including foreclosures, made up 34% of all existing home sales in August.
"The only way to clear prices is by getting rid of the foreclosure backlog, but that will take a long time to work out. It's still a multi-year process," says Wharton real estate professor Joseph Gyourko, adding that 20% to 25% of all U.S. homes are worth less than what their owners owe lenders. "Every one of them is a candidate for default and foreclosure. It will just take a while to work through."
While housing is always highly cyclical, Gyourko says the current prospects for recovery are hampered by extremely low levels of activity throughout the market, including new housing starts and sales volume. And the current slump is different from others because it is driven not only by imbalances in the sector, but also by larger economic problems. "This recovery is different. It's slower than normal.... You won't get much pickup in housing market activity -- buying and selling -- until you get job growth." Wachter agrees: "The key driver in housing is still jobs."
Rick Sharga, senior vice president at RealtyTrac, says the latest foreclosure problems represent a "breach of trust" but will have little effect on the final resolution of cases. "It really is more of a temporary delaying issue." The foreclosure reviews will probably add 60 to 90 days to the process, Sharga predicts. This could cause foreclosures to be delayed an additional 6 to 18 months and string out the adjustment in home prices by that amount of time, according to residential mortgage tracker Access Mortgage Research & Consulting. While Chase has disclosed that 56,000 cases are under review, the other companies have not said how many foreclosures will be delayed. Some of the states with the largest numbers of foreclosures -- including California, Nevada, Arizona and Michigan -- are not ones that require formal judicial review for a lender to take back possession of a property.
According to RealtyTrac, foreclosure filings -- including default notices, scheduled auctions and bank repossessions -- were reported on 338,836 properties in the U.S. in August, up 4% from July, but down 5% from August 2009. One in every 381 U.S. housing units received some form of a foreclosure filing during the month. Sharga suggests that 2011 will be the peak year in bank repossessions, and that "2012 will be a little better....In 2013, we could see foreclosure activity drop significantly [as] we deal with getting through the overhang of foreclosed properties."
Of the 900,000 foreclosed homes now owned by banks, only a third are on the market, he notes. Banks are carrying homes on their books because of delays in processing the volume of paperwork and also because of state laws that put a six-month hold on sales as a way of giving owners a last chance to pay back their loans. Another factor, Sharga says, is banks' unwillingness to take title to foreclosed properties because new accounting rules would require the homes to be valued at their current market price. In many cases, the amount would be less than the outstanding loan, diminishing the bank's financial statements.
While some forecasters have suggested there are as many as eight million homes in the so-called "shadow inventory" of properties waiting to come on the market, RealtyTrac estimates that the total number of distressed properties that will change hands as a result of the financial crisis will top out at 3 million to 3.5 million. According to Wachter, when homes are sold in foreclosure, they go for 40% to 50% less than in a standard transaction between homeowners.
As the possibility of abuse in the foreclosure system comes to light, state and national officials are bearing down on the industry with calls for new investigations. In Maine, for example, residents have filed a class action suit against GMAC. In Florida, the attorney general is investigating a mortgage processing company and four foreclosure law firms over allegations of improper paperwork. And on Tuesday, White House spokesman Robert Gibbs said the Obama administration supports state efforts to investigate foreclosure procedures, but would not call for a nationwide moratorium on foreclosures. "We want to take the just and necessary steps to ensure that the process is being followed legally," he said in news reports. "At the same time, we don't want to see broader harm done to the housing market and to the housing recovery."
Even though problems with foreclosures are surfacing, plaintiffs will find it difficult to prove damages if they would have been foreclosed on anyway, Sharga notes. "But stranger things have happened in court," he adds. For example, it is possible that a judge might demand new affidavits for foreclosures completed in the past three years, "in which case, all the wheels come off the bus. That would really stress out the system." Reversing foreclosures retroactively, when a new owner is in possession of the property, would lead to "potential complexity that is mind-boggling. But I'm not aware that this would become an issue."
The current uncertainty has turned attention to title insurers that are supposed to guarantee that the seller of a home is indeed the true owner. One title insurance firm, Old Republic National Title Insurance, told its brokers not to write policies on foreclosed Chase properties. The American Land Title Association, in a statement, cites a list of defenses for a buyer who may have bought an improperly foreclosed property; for example, the new owner could state that he/she purchased the property "in good faith." Wachter says title companies are not liable. "It is actually the bank or the securitizer of the loan that permitted the faulty procedures that will be responsible."
Wachter also reports that banks are becoming more open to loan modifications or short sales in which the homeowner agrees to turn over the property without going through the foreclosure process. She says banks are discovering that short sales are probably the least costly way to resolve delinquent loans, although they still face the risk of an owner going back on the agreement -- triggering a foreclosure action.
Meanwhile, housing remains more affordable as a result of low interest rates and weak housing prices. In the second quarter, the National Association of Home Builders/Wells Fargo Housing Opportunity Index was at its highest level nationwide for the sixth consecutive quarter since the index was created nearly 20 years ago. The index implies that 72.3% of all new and existing homes sold in the second quarter were affordable to families earning the national median income of $64,400. As for home prices, the S&P/Case-Shiller Home Price Index shows continued increase in its 20-city composite which, in July, was up 3.2% from the same month a year earlier. However, that is a slower rate of increase than in June when it rose 4.2%.
According to Wachter, a look at the city-by-city Case-Shiller data shows that homes in some markets are improving strongly while others are continuing to lose value. For example, the most recent data shows home prices are up in San Francisco (11.2%), San Diego (9.3%) and Los Angeles (7.5%) compared to the same month last year. At the same time, prices for the period are down in Las Vegas (4.9%), Charlotte (3.5%) and Tampa (3.2%). "Different markets are responding in different ways," Wachter notes. "The story now is that markets are bifurcating between the ones that are coming back and the markets that are very slow to recover."
Wharton real estate professor Grace Wong Bucchianeri says the collapse in housing is likely to result in a "temporary wait-and-see period" for households that do not own a home. "The rest of us might stop and think harder about what we are really trying to get out of owning our own homes -- whether it is freedom from rental fluctuations, control over our living space or prestige," she notes. "I am not sure how long-term this change will be; Americans have a long history of wanting to own their land and homes." Bucchianeri has studied the links between homeownership and happiness and discovered that people who own their own homes are not necessarily happier than others. She is now conducting a new study into what specific features of a home -- such as a pool or a driveway or more space -- potential buyers are willing to pay more for. "Hopefully we will be able to predict future changes in the desire to own our homes."
Homeowners who are disappointed with their decision to buy a home are only discovering what housing economists have always known -- a home should not be considered an investment, Gyourko states. Paying a mortgage can be a good way to save because it requires the discipline to make regular payments. But, he notes, a rise in the price of a home is less valuable than a rise in price for other investments, such as stocks or bonds. If a homeowner pays $100,000 for a house that appreciates in value to $200,000, the gain is not really $100,000; the homeowner would not realize the gain because he or she would still need to find a new place to live. A comparable home would also have appreciated as much, eating into the homeowner's gain. A stock that rose in value by the same amount would yield the full $100,000 gain upon sale, less taxes.
In the years leading into the crisis, Gyourko says, homeowners "fooled" themselves into thinking their homes were investment vehicles, and they leveraged the value of their homes to borrow new money for vacations, cars or college educations. "But that's risky. When prices dropped, these homeowners were underwater." The only time home price appreciation counts as savings is when the homeowner trades down in the quality of their housing, or dies and no longer needs a new place to live.
Homeownership also prevents workers from relocating to get a better job if they are locked into a home that cannot easily be sold. In a paper written with Ferriera, Gyourko found that between 1985 and 2007, people with negative equity in their homes were one-third less likely to move. "A lot of people are stuck," he says.
According to Ferreira, the market is close to being stabilized, but could continue to decline over the next two years; he does not expect a pick up in prices for five or possibly even 10 years. In addition, it is difficult to even forecast prices because so few transactions are occurring. Between 1980 and 1986, he says, the U.S. housing market recorded 600,000 to 800,000 home sales per year. That figure jumped to 1.4 million in 2005-2006. Now the market is down to 350,000-400,000 home sales per year, even though the nation's population has grown more than 30% since 1980.
Yet another problem that will weigh on the market in the future are those homes owned by people who are able to make their mortgage payments, or have paid off their loans, but would still like to move to a bigger or a smaller home, to a new neighborhood or to another state. These people, Ferreira says, have been holding off on listing their homes because the market is so weak. Eventually, he adds, they will grow tired of waiting and will put their homes up for sale, adding even more supply to the market and further depressing prices. "They can stick with the investment for now, but the reality is that eventually -- and that can be one, two or three years from now -- a lot of people will be tired of investing in housing and will sell for any price."
Over the long run, Ferreira predicts that housing will return no more than 3% a year, barely keeping pace with inflation. Going forward, he says, homes should be considered a place to live, not an investment. "I strongly recommend not using housing as a potential investment. Leave that for the speculators. If you buy a house, you should buy it for your own consumption. That's all you should care about."