Why the Housing Market Needs More Foreclosures
Business + Economy

Why the Housing Market Needs More Foreclosures

manley099/iStockphoto and TFT

The drumbeat of bad news about the U.S. housing market seems to grow ever louder: Home sales and housing starts keep dropping. The number of struggling homeowners and vacant buildings steadily rise. Yet some experts say there is one thing that might speed the market’s recovery:  more foreclosures.

The conventional wisdom is that foreclosures are bad for the economy. They force people from their homes, uproot lives, and destroy wealth by reducing housing prices. The Obama administration has spent much of the last two years trying to prevent foreclosures by coaxing banks to offer relief to overburdened home-owners rather than boot them from their homes. The idea was to help them buy time with loan-modification and principal-reduction programs so that housing prices would have a chance to recover. Meanwhile, the argument went, the job market would improve, borrowers would be able to make their payments once again, and neighborhoods would avoid the blight brought on by rampant foreclosure.

But those programs are largely seen to have failed, most notably the Treasury Department’s $30 billion Home Affordable Modification Program, or HAMP. Launched in March 2009, and funded by the Treasury Department’s TARP program, HAMP was designed to keep 3 to 4 million people out of foreclosure by giving banks incentives to offer them mortgage modifications. Two years later, it’s helped only about 500,000 people. Two weeks ago, House Republicans voted to kill HAMP, though the Obama administration has vowed to veto any bill that does.

Either way, the reality is that foreclosures are a symptom of economic trouble — not a cause. And nearly three years after the housing bubble burst, the U.S. finds itself in the uncomfortable position of needing more foreclosures, not fewer, before the economy can truly recover. Consider the performance of the housing market since last fall, when banks halted foreclosures over the robo-signing controversy, where banks in some cases were found to have improperly foreclosed on some homeowners. After rising through much of 2010, housing prices have turned around and steadily slid below their 2009 lows. In the fourth quarter of 2010, the U.S. National Home Price Index declined by 3.9 percent, according to the latest Case-Shiller report. And this week’s report from the National Association of Realtors shows the decline has accelerated sharply.  Existing home sales were down 9.6 percent from January to February, and the median price fell 5.2 percent month-to-month to $156,000, its lowest since April 2002. Meanwhile, purchases of new homes decreased 17 percent in February, to the lowest level since December 2003. 

To some experts, that’s an indication that the 2009 price bottom was a false one, propped up by government programs. The housing market will never truly begin to recover, until it finds natural its bottom. And while it may sound heartless, foreclosures may be the surest way to get there, according to some  economists. “Foreclosures are a necessary part of the healing process,” says Mark Zandi, chief economist at Moody’s Analytics. “And over the next two years, we’re going to experience a considerable spike in them.” Though some estimates are much higher, Zandi thinks 2 to 3 million more foreclosures will come through the system in the next two years. “The most severe ones are going to hit this year and in 2012,” he says.

From a macro point of view, it weakens the recovery to keep people in homes they can’t afford. Easy credit and loose lending standards brought upwards of 20 million marginal buyers into the housing market over the last decade. Many of these people really couldn’t afford their mortgage payments, and yet many of them remain in their homes, struggling to find a way to make it work. As housing prices continue to fall, those people end up owing more on their mortgages than their homes are worth. Even personal-finance advisors like Suze Orman see the logic of walking away from payments on a house that is worth far less than its mortgage.

The most recent data shows that some 11 million people are in exactly that position. That means 23 percent of all homes with a mortgage are underwater. And for every underwater mortgage, there are probably several more are on the brink. The people in these homes, facing devastating economic anxiety, aren’t participating in the broader economy. They’re not going out to eat, and they’re certainly not buying new cars. Instead, they’re worried about losing their homes, and in some cases, spending as much of their income as they can to hang onto a house they ultimately can’t afford.

In economic terms, “clearing” the housing market — allowing foreclosures to work through the system and getting rid of the excess inventory of homes — ultimately would be a boost for the overall economy. One of the strongest proponents of this view is economist Charles Calomiris, a professor at Columbia Business School and a leading authority on financial institutions. He makes a case for accelerated foreclosures by citing several economic costs of delaying the process; among them tamped down consumer spending, reduced new home construction, and tighter credit. Calomiris argues that delaying foreclosures creates uncertainty in banks’ balance sheets, potentially blocking channels of credit and undermining lending. Usually, according to Calomiris, when prices fall, banks have more of an incentive to quicken their pace of foreclosures. “[T]his is one of the strongest conclusions of recent research I have done,” he says in an email.

And yet, even as prices have been falling, the pace of foreclosures has ground to a halt. What used to take four or five months, can now take more than twice that long. In Florida, it takes an average of 307 days to foreclose on a home. In California, it’s over a year, up to 373 days. As a result, the pace of foreclosures has slowed to a three-year low. Foreclosure starts overall fell by 9 percent between the third and fourth quarter last year, from 339,000 to 310,000, according to the Federal Housing Finance Agency.

This slow down isn’t due to a sudden jump in the number of people making payments on their mortgages. In 2010, each of the four major U.S. banks, JP Morgan Chase, Bank of America, Wells Fargo and Citigroup, saw a double-digit percentage increase in the unpaid principal balance of residential mortgages that were in some form of foreclosure.

Rather, it is a result of the bitter fight between government regulators and banks over foreclosure abuses. The country’s 50 state attorney’s general currently are trying to slap the biggest banks with penalties that would require them to write down more than $20 billion of loan balances for borrowers with underwater mortgages. The banks are strongly pushing back, citing among their objections, the difficulties that come with principal reduction plans. “When you start helping certain people and don’t help other people, it’s going to be very hard to explain the difference,” Bank of America CEO Brian Moynihan said in a statement.

Bankers generate little sympathy these days, and no one would argue that consumers don’t deserve protection against unfair or precipitous foreclosure actions. While the robo-signing scandal was awful, the vast majority of foreclosures have been legitimate. And Moynihan does have a point. The track record of the mortgage modification programs has certainly less effective than hoped for. “Modifications are much more complicated than we first thought,” says Zandi. “And they can lead to issues of moral hazard where people start to default just to get the write down.”

If foreclosures continue to stall, they will build up in the system, and housing prices could fall further. That could lead more homeowners go underwater on their mortgages and more people to stop making payments. “It all leads to a pretty vicious cycle,” says Karl Case, economics professor at Wellesley College, and co-founder of the Case-Shiller Index.

Surprisingly, Case says he believes the worst of the housing crisis may already be over, and that prices may be “bouncing along the bottom right now.”  But he acknowledges that the opposite also may be true. And if it is, he says, and prices drop much further, foreclosures inevitably must increase and “the market will take care of clearing out all those properties we over-build and over-valued,” he says. As painful as that sounds, it may be just what we need. 

Related Links:
Home Prices Plummet Near Nine-Year Low Due to Foreclosure Glut and Short Sales (Daily Mail) 
Foreclosure Sales Stalled: Report (The Street)
Obama Administration’s Foreclosure Program Shambles Along (The Huffington Post)