Maury Seldin, The Hoyt Group (www.hoyt.org)
Foreclosure Essay with a Strategic Approach
This essay is excerpted from Chapter 4 of the SCRC Program Report, Chapter 4 of SCRC Program Report
Foreclosure? The
A Strategic Approach to Averting a Crash in the Housing Market and its Fallout
Mortgage lenders, and representatives of mortgage lenders, consider foreclosure as an option when mortgage borrowers are in default. Mathematical models used to assess the profitability of the options may consider, in addition to foreclosure costs in legal expense and time, potential damage to the property and expected price to be realized. In order to reduce the costs the lender may offer cash for keys, i.e., a payment for a deed in lieu of foreclosure.
Each case may be considered on its merits, but what may turn out to be profitable on an individual case may be less profitable when considered as part of a portfolio of mortgages. The analogy to the card game of bridge is that the right way to play the suit may be the wrong way to play the hand.
In bridge, control of the hand in terms of constraining leads of the opposition, as well as timing, is critical in making the contract by taking a sufficient number of tricks. Taking the most tricks in a suit (spades, hearts, diamonds, or clubs), by having the highest card of the suit led or the highest trump, may be influenced by the way the suit is played. But, sometimes playing to maximize the number of tricks in a suit entails the risk of losing the lead to an opposing player who can defeat the contract by leading a suit damaging to the declarer (winner of the bid for the contract).
The analogy for foreclosures is that by foreclosing, or taking a deed in lieu of foreclosure, the lender adds another house to the local market and that market may already be flooded. The result may be to further depress already depressed prices and adversely affect the some of the rest of the mortgage portfolio, even in other geographical areas not competing with the houses in the subject property’s market.
One may think that one more house on the market is not going
to make enough difference to negate the mathematical model used to weigh the
benefits and costs of becoming the owner of the property upon which their
has been a default; the right way to play the suit. However, one should consider
the classic case of the
The idea here comes in two major parts. The first is to avoid a crash in the local market of a subject property. The second is to avoid a cascading of local market housing crashes. At first glance, many people will consider both cases as being remote possibilities, especially the latter.
Policy makers could wait until the possibilities seem less remote. The problem is that the longer the wait and the less remote the more difficult it becomes to avert. One could make mathematical calculations that would weigh the chances against the costs, but as with catastrophic events, even low probabilities are of little comfort if the catastrophe strikes. Thus, prudent decision makers, when insurance policies are not available or realistic, may take preventive action even with probabilities not favoring the odds of caution. The “go-for-broke” strategy takes the chance. The Minimax strategy constrains the level of risk and maximizes within those constraints.
In order to develop such a strategy it is essential to work with local data that identifies the high risk areas. The discussion which follows is a first step in developing such a strategy.
I have talked with AU about getting a copy of the dissertation by Chuck Shinn that contains a methodology used to better characterize local areas and the best so far is copying selected pages, and we have the methodology.
That is an approach to the first part. The second part, cascading, is more difficult to tackle because of the problem of identifying tipping points before they happen. Forecasters do well in extrapolating from the past, but the turning points may arise in different patterns because of differences in people’s responses, among other things. It may be a case of emergence…
Enlisting the cooperation of industry is an important part of the SCRP strategy. The January symposium discussed in the next chapter Chapter 5 was part of that effort. However, the situation is so dire that the federal government’s approach of voluntary cooperation is likely to change with the change in administrations comes January 20, 2009. In the meantime, the states have taken action.
Before turning to a discussion of an approach of working with the states it is useful to consider the nature of the proposed housing market model. Here is one memo that encompasses many memos.
December 2, 2007 revised to December 3, 2007 – This is also an excerpt from Chapter 4
Discussion Draft of
A Model for use in Averting Market Catastrophe
By Maury Seldin
The Wall Street Journal of December 1-2 carried a front page story regarding the criticism of the “government-led plan to freeze interest rates on certain troubled subprime home loans.” The story further reports “The plan is being negotiated by the Treasury Department and a coalition of mortgage-industry participants, including lenders, mortgage counselors and servicers -- the companies that collect mortgage payments. Many of the particulars need to be worked out, including how long the interest-rate freeze would last and which subprime borrowers would be eligible for relief.” It also notes “Interest rates on about two million adjustable mortgages are scheduled to jump over the next two years, threatening many of those borrowers with foreclosure.”
The Wall Street Journal of the previous day, November 30, reported “Treasury officials say financial institutions are likely to set criteria that divide subprime borrowers into three groups: those who can continue to make their payments even if rates rise, those who can't afford their mortgages even if rates stay steady, and those who could keep their homes if the maturity date of their mortgages were extended or the interest rates remained at the teaser rates. Only the third group would be eligible for help.” It also noted “The creditors are likely to look at whether the borrowers have equity in their homes, despite falling house prices, and whether their incomes are holding steady.”
It is an admirable effort and obviously subject to a lot of criticism, especially from those with vested interests. However, some action is critical, not only as a matter of justice to parties involved, but because the impact of the crisis is reverberating to affect many innocent people. The major risk is a recession or worse. [Emphasis added.]
These comments on the program under development by the Treasury and the mortgage-industry coalition are designed to refine what seems to be a blunt instrument into something somewhat more surgical. The essence of the strategy is to prevent a cascading of the downturn in housing prices. Cascading occurs when homes not in foreclosure because of inappropriate financing are abandoned to become foreclosed upon. [Emphasis added.]
The widely noted case is that of “Tammi and Charles Eggleston [who] never took out a risky mortgage, never borrowed more than they could afford and never missed a monthly payment on their neat, three-bedroom colonial in the Cleveland suburbs. But that hasn’t prevented them from getting caught in the undertow of the subprime mortgage mess now submerging this town.” That was reported in a New York Times article of September 2, 2007 titled “Can the Mortgage Crisis Swallow a Town?
The foreclosure process results in a diminution of the value of the house both directly and indirectly. Directly it can, according to some estimates, run up to twenty percent or more depending upon stripping and/or vandalism. Foreclosure costs vary, but can be substantial leading some lenders to use a cash for keys approach, i.e., pay the defaulting borrower to go with a deed in lieu of foreclosure.
Indirectly the foreclosure causes a loss in value to the foreclosed upon house when it adds to an excess supply of housing in the neighborhood and further depresses an already depressed market. Some lenders may be prepared to take that additional loss, knowingly or unknowingly. The cascading occurs when numerous lenders are prepared to take the loss and it compounds, possibly adversely affecting their other loans. That impact is direct and significant in the neighborhood of the subject properties. It may also be significant for mortgages held on houses in other cities, but seemingly indirect, if the local downturns generate a recession and foreclosures in other cities are generated because prices there were adversely affected by recession and/or fear. The classic case of individuals looking only at their own short term interest instead of considering how others will also view their own case and the combined effect is that of grazing on the London Commons in an earlier era. Without an agreement among the ranchers or regulation limiting the grazing, the open land was overgrazed, destroying it for all. The incentive for the individual rancher was insufficient to voluntarily restrict his grazing. So it may be with mortgage foreclosures, thus requiring some intervention.
Metro areas in some states (such as
The surgical refinement is to identify and analyze a series of local markets that may be subject to state policy change as a supplement to “The plan [that] is being negotiated by the Treasury Department and a coalition of mortgage-industry participants, including lenders, mortgage counselors and servicers -- the companies that collect mortgage payments.” That plan, worked out as best as it can, should proceed while the local analyses are conducted and the dangers of cascading are assessed by local area.
Since foreclosure practices vary by state, and occur under state law, the state has clout more surgically applicable. Ohio, after an unsuccessful attempt to get cooperation from mortgage lenders has not only gone to the path of changing regulation, but the courts are requiring evidence not always required in foreclosure procedures of other state in the case of securitized mortgages. States can use Draconian measures in regulating foreclosures and possibly in dealing with the holders in due course issue where fraud is alleged. If disaster appears imminent, any lender would be wisdom challenged, to say the least, not to be cooperative.
As to the pending agreement being negotiated between the Treasury Department and a coalition of mortgage-industry participants, “Many of the particulars need to be worked out, including how long the interest-rate freeze would last and which subprime borrowers would be eligible for relief.” That however will give some breathing space to avoid an acceleration of foreclosures leading to cascading.
Cascading and
As academics we build models to forecast outcomes. Models as abstractions are necessarily removed from reality, but to the extent that they give good representations of relationships they may assist obtaining better forecasts of outcomes than alternative approaches.
The key is in understanding the system. In so doing it is useful to know that decisions as actually made are not necessarily rational. Furthermore, group decisions as reflected in market behavior are not simply aggregations of would be individual decisions in that decisions of others impact one’s own decisions. This understanding involves an application of behavioral economics and an application of the science of networks.
We are looking to understand the system behavior that may result in a downward spiraling of house prices occasioned by a cascading of foreclosures. One foreclosure in a neighborhood adds one house to the local market, but so do a lot of other events. An excessive number of houses added to the market will not only cause prices to drop substantially because of the relationship of available supply to demand, but also may induce other homeowners to offer their houses for sale while they can still get a price better than what they think prices will sink to. It will also discourage would be buyers from entering the market because by waiting they will be able to buy cheaper.
Foreclosures come into play because they force houses onto the market and send a negative signal as to the future as well as adding to the supply of the present.
In order to understand this system it is useful to consider home owners and lenders as nodes in two systems that are subsets of a number of larger systems. These are two intertwined systems. The homeowners are players in the housing market and while they are the nodes, the linkages are the connections among the homeowners. They compete in acquisition and disposition and would be buyers are nodes in this market system. As with the stock market, when it looks hot a lot of people rush in with the price rise feeding on itself. The story is told that Bernard Baruch avoided getting hurt in the Great Depression because he started to sell out his stock holdings when the man shining his shoes gave him stock market tips.
The mortgage lenders have a more complex system than the homeowners since the mortgage originators shifted from holding the mortgages to securitizing them. The system was lucrative, in part because of the incentive pay for originating more profitable subprime mortgages – some of those mortgages should never have been created. The parallel story to the Bernard Baruch story was told to me by a colleague who told about the woman who came to clean someone’s home and said something to the effect, here take my business card from my other business, I can get you a good mortgage if you are in the market.
The nodes in that system are the servicers (including their employees and agents making loans) and the players in the structure of bundling loans, slicing them into tranches, and the investors. These are sub-networks, with the investors in a larger network of capital markets. That capital market crisis is what triggered international interest in the debacle.
The science of networks deals with the commonalities of systemic structure of linkages that form networks. Networks are composed of nodes that are connected. The distribution of the frequency of connections among the nodes in a system is not random. There is an interdependency within the system with the strength of ties among nodes varying. This is significant in that the predictability of the behavior of the system is dependent on understanding the underlying principles of the system. Thus, Treasury making arrangements with the coalition of mortgage-industry participants, including lenders, mortgage counselors and servicers involves key players. Moving the leadership may facilitate the group as a whole, and then the players not in the coalition may find that attempts to enforce their contract rights meet with such resistance that they go along with the changed pattern.
If the coalition effort breaks down, and it is left to the states, the states hardest hit may take Draconian measures frustrating foreclosure such that they stave off the cascading problem, but the industry will get some long term changes that are undesirable. There is a great difficulty in avoiding situations where the solutions to short term problems linger on as long term arrangements. Thus, it is in the financial sectors interest to work something out without it being forced upon them. They would do well to consider some self regulation as an industry, increase transparency and information systems, and a variety of changes that would level the playing field. There are a lot of failed companies in the penalty box and we keep reading about top executives who have lost their lucrative positions because of the humongous financial losses by their companies.
The model under development is not focusing on that network other than identifying the critical locations in which state and local government will move to stave off cascading and identifying the players on the lending side. The measures that the state governments might take are not in the model, nor are the potential institutional reforms. The focus is on identifying the local markets at risk and the characteristics of the property owners and the identification of the mortgage holders. The analysis of the dynamics of that market, especially looking to mortgages that are scheduled to reset within a couple of years or so is the critical aspect of the model. Identifying the lenders or their representatives who control the foreclosure decision is part of the model insofar as reducing the foreclosure rate to be out of the range that excessively depresses an already depressed market.
Developing the Model
The ideal model would be one that forecasts price. The key questions are how far down will prices go and how long to the turning point. A supplemental question is how long for a recovery to some previous point, probably to where it would provide security for a lender or be comfortable enough to wait, or for a homeowner to stay with house through the drop in price.
Simplistic views would use a raw comparison of market value to debt as indicating when it pays to hold. That ignores transaction costs and emotional attachment. A further consideration is that owner has a put option at the amount of the debt and a hold option for an increase because of volatility in the market. So even if the equity isn’t “in the money,” even after a transaction cost consideration, there is a value to the option because of expected or potential price rise during the period of the option.
Lenders/investors ought to be at least educated enough to know that it is worth comparing the net loss on a current foreclosure option with the cost of some forbearance on what they contracted for, adjusted down to at least what would be the opportunity cost of what they could now get for the money. I expect that they have some models to determine what they could get by foreclosure and some expectation of the future, but I seriously doubt that they have any good models to forecast future prices.
I doubt that first because the difficulty of forecasting future house prices probably ranks with forecasting interest rates. Structures change and so even sophisticated econometric models have difficulty with changed underlying conditions. More importantly, the decision to foreclose is similar to the grazing decision in the London Commons. That decision along with decisions of others will reverberate back to the price. Thus, unless there is a good guess as to what others will do, it is problematic to forecast the price with any accuracy worth its salt.
I took a look at a couple of books that I co-authored a long time ago (measure in decades), but they were not useful in dealing with the science of networks approach, probably because they were written about the time the science of networks was just getting started. So, unless we can come up with a model that identifies turning points, the best at this stage may be to look for shifts in trends and judgmentally deal with the turning points by adopting a strategy that recognizes uncertainty in the turn but utilizes an acceptable level of risk of the timing of the turn in reaching the related decisions.
By doing this with a number of local areas a pattern may emerge that provides enough historical date of structural changes associated with rising foreclosure rates and the related variables that influence price and price turning points to be able to develop an econometric model that will deal with forecasting turning points bases on the variables underlying the price change. I don’t know how many or how long, but the priority is to deal with it judgmentally with these variables underlying price change.
The two most common indicators used in the resale market may well be (1) the number of houses on the market as a percentage of the total number in the sub-market area and (2) the length of time on the market. Both indicators are at a point in time, but a time series will indicate a trend. The trend may be at a modest rate of change that is not increasing. But, if is there is an increase in the change in the rate of change (increase) it will not take long to get to a crash.
These two indicators, and there may be others, deal with historical and current conditions. The critical variable in forecasting future conditions is the resets of rates in mortgages that will push the houses onto the market, either voluntarily or by foreclosure. This may be the next to hardest data to get. The hardest may be the motivations of the players in the process and understanding and classification of the paradigm within which they will make the decision.
The motivations obviously refer to the home owners and the lender/investors and their representatives. But, it also refers to potential buyers. The judgmental models alluded to in the endnotes can be used to forecast the demand generated by economic growth and associated demographic activity. There are probably econometric models that may do a more accurate job, but these are based upon reason and historical patterns that included emotion that may vary over time. We could use some behavioral finance types to fine tune such models. However, the most important element in generating the turning point for a cascading is the resets that push an excessive number of houses onto an already saturated market. Thus, the other analyses may be done and integrated, but the strategy is to stop the bleeding which is an excessively increased supply of housing put on an already depressed market.
The locational focus for these models is the metro area and/or the neighborhoods within which the houses are most competitive. Neighborhood delineation can be quite a task, and data availability on that basis a severe problem. Census tract data is a good delineation for inventory of stock, but other data are most easily obtainable by zip codes, but zip codes change. The simplest approach is to assemble the data of different types using whatever geographical classifications are used by the source and then working with overlays of some sort to have a surrogate for the submarket area. That system can be refined by using a unique parcel identification system.
Returning to price, these are variables which will effect changes in offering prices. The offering price changes, and the actual price and other concessions accepted, will influence the quantity of houses taken off the market. The top down analysis of demand based on strength of the economy and willingness to commit to ownership will influence the absorption of the excess supply. Some of the previous homeowners may have doubled up, some become renters, some compromised with lesser housing in space and amenities (including mobile units), or left the market area. Some may be homeless. At attractive enough prices and reasonable financing some of the previous homeowners will with others who have been holding off return to ownership or upgrading and cause the turning point.
Econometric models can be helpful in this process. But, it will probably take more that a few cases of local area restraints and turning points to provide the data necessary for such models. Our efforts are now focused on selecting some areas to develop and apply a model that can be used to aid decision-makers in staving off foreclosures.
There are other parts of the Subprime Consortium research agenda that deal with best practices and other policy matters. At this point, we recognize that while on a level playing field the market can do a fine job of making such an adjustment; but, with the distortions of subprime loans and teaser rates, and the associated unrealistic expectations of continued rapidly rising prices, the adjustment can be unnecessarily severe. The strategy is to avoid the severity of cascading because it unnecessarily take the drop too far. The old pendulum story applies. And, just letting itself work itself out without intervention has deleterious side effects.
Strategy Development
The subject of strategy development is discussed in the two pre roundtable essays (referred to in endnote 3) and some related documents. These are available upon request.
Some of the enhancing inputs that may be included in the model are related to motivations. The series of motivations which our researchers might explore once we have sketched a model might be listed as follows: (1) continued ownership of the property became unattractive as an investment when the prices failed to continue to rise as anticipated, especially when the interest costs were scheduled to rise because of the reset., (2) continued ownership of the property became unworkable when the interest costs were scheduled to rise because of the reset (with the possibility that the borrower was naïve when making the loan or maybe misrepresentation by the lender’s agent)., (3) continued ownership of the property became unattractive because of fear of what was going to happen, not only to prices, but as to the character of the neighborhood as with the Maple Heights case.
The classification of borrowers, discussed in the coalition proposal in progress, may be used to sort out where the relief goes. The strategy is to assess how much risk can be borne and provide the extent of relief necessary within that constraint. There may be others entitled to relief because of fraud or misrepresentation. That should be provided on its own merits; however, it will have the favorable side-effect of lessening further price declines.
There are also proposals around that can keep houses of the market by changing the tenure relationship. Such arrangements would help and may be considered beyond the model development under discussion.
Conclusion
The federal government is on the right track and it is substantial progress from the initial efforts focused on the capital markets reported in the lead story of the August 20, 2007 Wall Street Journal, “How a Panicky Day Led the Fed to Act.” The state governments of some of the states hardest hit are in the picture and in a position to be the toughest on the mortgage investors because they control the investors’ remedy of foreclosure and possibly could have an effect through bypass of the holder in due course issue which would affect lender liability (a topic under research).
It may be that the industry participants were “circling the wagons” until the Treasury/coalition effort got underway. If so, it is not likely that focusing on defense rather than getting proactive in solving the problem would be a productive strategy for them or the nation, aside from being unjust to some borrowers. Housing unit speculators that understood their contracts but lost out because they guessed wrong deserve the discipline of the market. Investors that that got hit because they believed the ratings of their tranches can look for their own remedies and work on bettering their own strategies.
The Fed was right to intervene to prevent disaster in the capital markets, and the Treasury is right to intervene to prevent disaster in the housing market and the economy – and the health of the economy is at stake. The states are right to intervene for justice along the same lines, but have better tools that the federal government and can supplement federal government actions as appropriate for local conditions.
We, at the Homer Hoyt Institute have a long and strong relationship with
industry. We will hold a meeting at the
Well, I am retired (so I thought) and it is Sunday and the Jaguar game starts shortly, so this missive has to end in time to get it out on the heels of the WSJ story that triggered it.