Good Headline, Bad News On Foreclosures

The latest news on the housing market has been widely reported under the Associated Press headline “Home Repossessions Dive To 18-Month Low.”  Repossessions have dropped 28 percent from last October, and 12 percent from last November.  That sounds like good news!

Unfortunately, the major reason for the slowdown is that banks recently discovered serious problems with the tidal wave of foreclosure documents they’ve been filing.  As reported in the body of the AP story:

Several lenders responded to heightened scrutiny over the foreclosure process by temporarily ceasing taking action against borrowers severely behind in payments while they checked to see if their employees made errors in loan documents needed to complete foreclosures.

Some banks later announced plans to resume foreclosures, though at a more measured pace, in an attempt to ensure there aren’t any flaws in the process.

The foreclosure engine will most likely begin chugging along at full steam again in the first quarter of next year, as the paperwork snafus are cleared up.  There are about five million homes teetering on the edge of default, with mortgage payments at least two months past due.  In other words, the drop in foreclosures is due to banks hesitating to begin the process for procedural reasons, not any improvement in the underlying cause of so many mortgage defaults.

Why are there so many foreclosures?  High unemployment is obviously a factor, but the big reason is the collapse of the “housing bubble” that built up during the past fifteen years.  The bubble over-inflated because of “subprime mortgages,” a politically-ordained policy of relaxing lending standards to favored constituencies.  The idea was that tough lending standards were somehow racist, and also denied poor people their shot at the “American dream of home ownership.” 

Banks were therefore compelled to begin throwing out loans to people they previously would not have financed… and these were big loans.  The Fannie Mae saga is rife with stories of low-income workers scoring $200,000 or $300,000 home loans they couldn’t possibly repay.  In the final days of the bubble, Fannie May doubled down on this strategy, as David Reilly explained in an April 2009 article for Bloomberg News:

“Faced with growing numbers of homeowners unable to make mortgage payments, Fannie decided to fund loans to borrowers that were instant losers.

The point was to buy time. Even though those loans resulted in a $453 million loss, they helped keep troubled homeowners from defaulting. That meant Fannie for now didn’t have to make good on loan guarantees that may have cost it as much as $2.4 billion.”

Reilly says this “kick the can” strategy might have had some “perverse” logic to it, as a gamble that “today’s troubled borrower may be in better shape, if given time to wait for fractured markets to heal.”  It doesn’t look as if that gamble is paying off.

Why should it?  The surge of easy money from Fannie Mae created a massive boom in the housing market.  Builders scrambled to capture that money by pumping out houses… creating secondary crises along the way, such as the “Chinese drywall” issue, in which new homes have been rendered virtually worthless because they were built with substandard drywall, hastily imported from China.

This produced a tremendous increase in the supply of homes.  Several factors have combined to cut demand, including unemployment, the death of those easy Fannie Mae loans, and a general tightening of credit by nervous banks, coupled with rising mortgage rates.  There are fewer home buyers, and it’s harder for them to get loans.

When supply exceeds demand, prices fall.  This dramatically reduces the value of existing inventory… as you know very well, if you’ve been trying to buy or sell a home recently.  This, in turn, left a lot of those already-stressed home buyers “underwater” – the value of their home suddenly became far less than the balance of the huge mortgage they were already having trouble paying.  The result is a massive inventory that cannot easily be sold off.  Almost 23% of all homes are currently worth less than their mortgage balances.

These factors combined to produce an astonishing $1.7 trillion dollar drop in the overall value of the real estate market, according to Bloomberg News.  It is one of our most expensive lessons in the iron laws of supply and demand, and the sheer folly of attempting to control value through political command.  The number of people who could afford fine houses did not change because Democrats ordered Fannie Mae to make it so.  All we got was a dangerous illusion.  Reality comes in the form of five million new foreclosure notices waiting to roll off the printers, once the banks are confident they’ve been worded correctly.