This is the second installment of three-piece blog series from former Consumer Financial Protection Bureau Director Richard Cordray. The series challenges the industry on how it should think about foreclosures. Go here for the first piece.
Markets are shaped by the forces of supply and demand, buying and selling, and how they come into some sort of balance. Markets that operate properly tend toward a discernable equilibrium that is predictable and sustainable. But many things can disturb this equilibrium. We might say, paradoxically, that market forces are fragile in being liable to disturbances, but once disturbed they have a powerful tendency to recover an eventual balance.
But economic markets differ in the mechanisms that restore them to equilibrium after any notable disturbance. Some markets experience greater frictions that slow their recovery. In the pure models of academic economists, prices immediately (or at least quickly) adjust to achieve balance among buyers and sellers, the mathematics take their own course, and equilibrium is restored as the natural and seemingly inevitable state of the market.
As the Great Recession showed, however, that does not happen in any serious dislocation of the housing market. When a borrower falls behind on the mortgage, there is one ultimate method for collecting on the unpaid debt: foreclosure.
For as long as the borrower stays in the home without making the required payments, in violation of the mortgage contract, the loan-holder does not have the benefit of the bargain it has made. Not until the collateral — the home — is recovered can the loan-holder try to make itself whole by selling the home to someone else. That requires ousting the homeowner and getting back the legal title to the residence.
So, foreclosure is a legal process, subject to the frictions created by legal procedures. In this market, equilibrium is not produced by simply adjusting prices among buyers and sellers, which is a purely economic process. Instead, it is produced by a non-economic process involving courts, judges, laws, rules, attorneys, evidence, proof, and even appeals. All these processes are reasonably complex, and they take time to sort out.
Even in normal conditions, therefore, foreclosure is a cumbersome solution to the problem of the defaulting borrower. It can produce vacant and abandoned properties, because as soon as the residents receive notice that the house will be going into foreclosure, they face uncertainty about when they will be ousted, which prompts many to vacate the premises before getting thrown out.
Even with nobody in the home, it takes time to secure a court ruling and ultimately a sheriff’s sale. During this period, the property may be deteriorating, and its value is diminishing accordingly. In a normal economic cycle, therefore, this method of resolving the situation can be sub-optimal, but it works adequately if properties can be managed and the legal system can bear the workload.
But when the housing and mortgage markets collapsed on a greater scale a decade ago, the foreclosure process did not work at all as intended. The sheer number of defaulting borrowers led to a legal pileup. In some states, it took years to process the volume of cases. Even those states that allow foreclosures to proceed outside of the courts (about half of them) experienced delays in their legal processes. The costs of foreclosures rose with the extended time frames, and the problem of many vacant and abandoned properties producing permanent damage to untended structures reduced housing values even further.
Any concentration of foreclosures also produces another externality, by driving down property values in surrounding areas. A half-dozen foreclosures can drag down the whole neighborhood — even for those current on their mortgages with sensible terms — damaging their finances as well.
This creates a spiral of instability, with underwater mortgages impeding the sale of homes and refinancing of loans, causing even more economic hardship. Short sales became an improvised means to make the best of some bad situations. But many communities languished in these ways during the Great Recession.
One lesson we learned from the last crisis, therefore, is that in hard times it is especially important to view foreclosure as a last resort. As the ultimate collection tool, it is easily blunted. If properties get tangled for years in prolonged legal disputes, the drawbacks of foreclosure proceedings become magnified, which greatly hinders recovery of the underlying value of the collateral — and economic recovery overall.
The CARES Act reflects this shift in thinking by offering streamlined mortgage forbearance on all government-backed mortgages (almost two-thirds of the market) to anyone suffering hardship from the COVID crisis. Other loan-holders are being urged to do the same. But to succeed, this new approach must be executed effectively. So, we need to think further about how the dynamics of mortgage servicing can affect our conscious nationwide effort to minimize foreclosures.