With almost 3 years from mortgage default to foreclosure sale, borrowers benefit but we all lose

Recently on these pages I reviewed a recent New Jersey Appellate Division ruling that makes mortgage lenders "dot their i's and cross their t's" to prove that they have the right to foreclose. This, along with recent scandals about "robo-signing", the flood of foreclosures, and budget cutbacks in state government, has created an enormous foreclosure backlog statewide.

The extent of the problem is astonishing. Recently, a respected partner at one of New Jersey's largest foreclosure law firms told me that statewide it is taking an average of three years from the start of the foreclosure process to foreclosure sale. I recently came across a February 12, 2011 article in the Press of Atlantic City which confirmed this. Quoting statistics compiled by Realty Trac, the article by Business Editor Kevin Post notes that in the last quarter of 2010 it is taking 849 days from the initial court filing to the date of property repossession. (Press of Atlantic City, "Bottom Lines: Foreclosures in New Jersey now take an average of 849 days").

For the homeowners whose home is being foreclosed, this is a boon of sorts. For up to three years, they enjoy the benefit of living in their home "rent free". And if the mortgage is a first mortgage, the chances of their ever being pursued for any unpaid balance after the home is sold are slim, due to a short time for the lender to file such suits (called deficiency actions), and the cloud on title any such suit will place on the property which the lender has sold or will want to sell as soon as possible.

For many borrowers, this allows them time to put their financial house in order, and to accumulate the cash they will need to move and pay rental security deposits.

For the rest of us in the long term, the result is nothing to be glad about. While there are a lot of reasons for the current mess and a lot of blame to go around, in the long run it is the investors in these bad mortgages, and also the rest of us who are fortunate enough not to be facing foreclosure, who will be the ones to pay the piper. That home mortgage financing might not be available to everyone who applies is not necessarily a bad thing. A return to the more careful and stringent lending that was the norm 25 years ago would not be a bad thing. Due to securitization, the pain of the resulting losses is spread among a large number of investors. However, those investors likely include pension funds and for them the losses will be felt down the road by the pensioners whose money is not there when they need it. To the extent the investors in these bad loans include mutual funds that you or I might have invested in, the pain comes back to us.

Most importantly, where is the money for the home loans of the future going to come from? The investors in today's bad mortgages were willing to invest because they were told the investment was safer than it really was, and because they were willing to ignore risk because it was spread out by pooling of larges numbers of individual loans into multi-tiered investment trusts. Given the painful dose of reality now upon us, one can hardly be surprised if future investors in mortgage loans are going to extract a higher risk premium which will then translate into higher cost for borrowers of the future.

This will help to depress the real estate market for a long time to come. The real estate boom of recent years was fueled by an influx of lots of money trying to find a place to invest. This made it easier for less and less qualified borrowers, to buy real estate. That larger pool of buyers increased demand greater than the supply of real estate to purchase. Thus, prices rose. And these price increases led to a self-fulfilling expectation of ever-rising future prices that fuelled more and more speculative buying and borrowing.

Now, just the opposite has happened. Everyone expects that prices will continue falling. That expectation keeps buyers out of the market waiting for the bottom.  The bottom will be reached  when the prices are low enough to attract enough buyers (besides just well-heeled bottom-fishing investors and those who can pay large sums of  cash) so that demand equals supply. Attracting  those additional buyers requires availability of financing.  If money is harder or more expensive to come by, that will inevitably delay the day when we reach the real estate bottom.

Another cost to all of us derives from  having houses in foreclosure for years at a time. Financially strapped homeowners knowing they will not be keeping their homes are not going to improve them. That improvement is one factor that increases property values. They will also defer needed maintenance. This is how neighborhoods and ultimately communities deteriorate. The effects are going to be long-lasting.

And of course, lower property values ultimately yield lower property taxes paid to local government, already hard-hit. Higher tax rates or larger budget deficits have to follow. Less money for schools and needed services means lower property values and a lower quality of life for all of us. Higher taxes will solve that problem, but higher taxes decrease property values.

The ripples of the current crisis are widespread and will be with us for a long time. The solutions will require some major adjustments in the system of mortgage lending, and some creative and cooperative thinking by both the borrower and lender communities. Whether this will happen anytime soon is very much in doubt. My experience is that lenders, constrained by pooling agreements which have no provision for dealing with these types of problems, cannot or will not consider deals that given the reality on the ground make good business sense. Sensible proposals which would  have given bankruptcy courts the power to deal with this mess have been vigorously fought by the lending community. Regulations that might prevent a repeat of the speculative bubble that got us here are being fought by the same interest groups.  What is clear is that business as usual has to change. Whether that will happen anytime soon is anybody's guess.