Retrospective: ForeclosureRadar Records its Millionth California Foreclosure Sale

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Retrospective: ForeclosureRadar Records its Millionth California Foreclosure Sale

Written by Madeline Schnapp, Director Of Economic Research- ForeclosureRadar

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. 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.
  • 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.
  • 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.
  • 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 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.

 

Pre-September 2008: The California Housing Market Collapses. A Normally Functioning Foreclosure Market Changes Drastically

A combination of artificially low interest rates, loose lending practices and unsustainable price increases inflated the California housing bubble through 2006, when interest rates began to rise and home prices reached the limits of affordability. When the bubble popped in 2007, housing prices collapsed, leaving millions of homeowners underwater on their mortgages. Defaults skyrocketed as the economy tanked.

Early in of 2007, the foreclosure process — notice of default, notice of trustee sale and foreclosure sale — was still functioning normally, taking about 120 to 130 days to complete. By the beginning of 2008, notice of default filings jumped 58% while trustee sale filings and foreclosure sales surged 125% and 160%, respectively.

California Foreclosure Trends - 2007 and 2008

Source: ForeclosureRadar – www.foreclosureradar.com

 

The rapid increase in foreclosures throughout 2007 and 2008 and the hundreds of thousands of families in distress became a clarion call to government to “do something.” Meanwhile, in March 2007, Federal Reserve Chairman Ben Bernanke infamously remarked to Congress that, “….the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

By early 2008 the housing crisis began to mushroom into a global financial crisis. In March of that year, Bear Stearns, a leading Wall Street investment bank, collapsed and was acquired by JPMorgan, an early warning signal of the coming financial tsunami.

 

September 2008: Housing Crisis Explodes, Massive Government Intervention and Foreclosure Limbo

Defaults rose unabated through September 2008, the month when Fannie Mae and Freddie Mac, two government-sponsored enterprises that purchased mortgages, went into conservatorship, Lehman Brothers failed, AIG was rescued and Merrill Lynch was acquired by Bank of America. Goldman Sachs and Morgan Stanley became bank holding companies to take advantage of government bailouts.

As the crisis worsened, the U.S. government stepped in to prevent a global meltdown. The “rescue” had a host of bad side effects that essentially rewarded those who caused the crisis, left taxpayers to shoulder the losses and trapped millions in underwater mortgages. Two important federal actions marked the beginning of massive government intervention into the foreclosure process:

  • Federal Reserve Chairman Ben Bernanke and then-Treasury Secretary Henry Paulson asked Congress for $770 billion to fund the Troubled Assets Relief Program, or TARP, which saved by banks by purchasing “toxic” mortgage-backed securities.
  • An important new accounting change allowed banks to value bad mortgages at theoretical values based on computer models rather than current market values. These theoretical values known as “mark-to-model” allowed banks to record little or no financial loss on bad mortgages, even as housing prices in many areas of California had collapsed 50% or more.

The new mark-to-model accounting changes gave banks an incentive not to foreclose. In addition, Treasury Secretary Paulson, armed with TARP funds, provided an implied promise that the Fed or taxpayers would take bad loans off banks’ hands at a premium, if necessary. This accounting change was key to helping banks pass the stress tests. Almost immediately, foreclosure filings plummeted and the foreclosure process lengthened.

 

Number of Days to Foreclose Versus Notice of Default - January 2007 through December 2008

Source: ForeclosureRadar – www.foreclosureradar.com

 

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.

Number of Days to Foreclosure - January 2007 through December 2012

Source: ForeclosureRadar – www.foreclosureradar.com

 

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.

 

Quarterly Trend of Foreclosure Inventory - Number of Homes Preforeclosure, Scheduled for Sale, Bank Owned (REO) - Q1 2008 through Q3 2012

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. 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.

 

Monthly Trend in California Foreclosure Activity Notices of Default, Notice of Trustee Sale, Foreclosure Sales - January 2007 through December 2012

Source: ForeclosureRadar – www.foreclosureradar.com

 

Early 2009: Real Estate Investors Command Center Stage; Dramatic Price Declines Yield Strong Returns on Investment

By the first quarter of 2009, 25% of homeowners with a mortgage owed more than their homes were worth and an unprecedented 12% of homeowners with a mortgage were at least one payment behind. Meanwhile, housing prices plummeted. Overall, median home prices fell as much as 58.8% in California, while in the hardest-hit counties such as Merced, Riverside, San Bernadino and San Joaquin, price declines ranged from 60.2% (San Bernadino) to 71.9% (Merced). Prices plunged to the point where strong returns on investment were possible in California for the first time in many years.

Over the next three years, the percentage of foreclosure sales to a third party (rather than back to banks) began to increase. Strong investment activity helped clear inventory, move people into vacant homes and stabilize home values.

 

Monthly Foreclosure Sales - Sold to Bank Versus Sold to Third Party (%) - January 2007 through December 2012

Source: ForeclosureRadar – www.foreclosureradar.com

 

2010 Through 2012: Foreclosure Controversies, Settlements and More Government Intervention.

Several snags in the foreclosure process hit the scene in 2010 that offered no help to underwater homeowners but did cause ever further delays in foreclosures. By May 2011 the time to foreclose hit a maximum of 350 days.

In October 2010, several large banks including Citigroup, JPMorgan, WellsFargo, Ally Financial and Bank of America halted foreclosures due to an alleged widespread practice of improper foreclosures based on fraudulent paperwork. Dubbed “Robo-Gate,” the scandal referred to the alleged practice of mortgage company employees signing computer-generated documents in a robotic fashion without personal knowledge of the facts. This “robo-signing” problem centered on signed affidavits in judicial foreclosure states, but the fallout spread to non-judicial foreclosure states like California.

In addition, the Mortgage Electronic Registration System (MERS), which operates an electronic database the banks used to track mortgages packaged in mortgage-backed securities or traded among investors, was called into question. Many alleged this practice was improper or illegal and banks no longer had the right to foreclosure whether or not mortgage payments were being made.

While these scandals were popular fodder for the press and proved lucrative for litigators who launched multiple legal challenges to slow or stop the foreclosure process, underwater homeowners saw little relief amid ever-expanding delays.

In 2012 and early 2013, government responded to these scandals with two mortgage settlements that put more downward pressure on foreclosures and lengthened the time to foreclose. These settlements included:

  • The $25 billion National Mortgage Settlement, which provided 80,000 California homeowners with $8.9 billion in principal-reduction loan modifications.
  • On January 7, 10 major servicers reached an agreement with federal regulators to pay more than $8.5 billion over alleged foreclosure abuses. Eligible borrowers will receive anywhere from hundreds of dollars to $125,000, depending on the individual situation. In California, 788,000 homeowners in 2009 and 2010 received a foreclosure filing from these servicers and may be eligible to participate in the settlement.

In California the passage of the California Homeowner Bill of Rights, which took effect on January 1, 2013 prevents dual-tracking and is designed to further slow the foreclosure process.

While the stated purpose of these actions was to help homeowners by delaying foreclosures, the real beneficiaries have been the banks, which used foreclosure delays to limit losses. The unintended consequence of these actions became a lack of inventory and upward pressure on prices.

 

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.

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.

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.

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.

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.

Annual Trends of Total Property Values, Total Mortgage Debt (Billions of $) and Debt-to-Value Ratio (%) - 1995 to 2012Source: 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.

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.