The 'F' Word: Foreclosure

September 29, 2006

After years of steady double-digit gains in prices, real estate seems like a can't-lose way to get rich. Unlike tech stocks (which seemed like a can't-lose way to get rich six years ago), home prices seem like they don't go down. Better still, you can buy in with somebody else's money, and keep all the gains for yourself.

Besides the history of positive returns, another reassuring factor some home buyers consider is that, worst-case scenario, they'll just give the keys to the bank and walk away. Heads, I win (home prices go up); tails, you lose (home prices go down).

I've heard this “logic” from home buyers entering the market at prices they know are a little stretched, I've read it in the paper, and I've heard it from economists and other experts. Even the doomsayers — warning of rising interest rates leading to banks taking over properties from adjustable-rate-mortgage-fueled home buyers — seem to think the worst-case scenario is handing over the keys to the bank. If only that were so.

While hedge fund managers can earn a 20% cut of profits on other people's money, yet suffer no loss of their own if things go sour, home buyers have no such protection.

Foreclosures — the process where banks and lenders repossess and liquidate the property securing a loan that the borrower defaults on in an effort to pay off the debt — have been at very low levels in recent years.

Even now, with so much data pointing to a slowing housing market, only about 1% of mortgages were somewhere along in the process of foreclosure, according to the Mortgage Bankers Association. This figure is even lower than seen during the hot economy of the late 1990s. While foreclosures are on the up-tick this year, most of the trouble is in lower-quality loans and in regions facing economic hardship, like around Detroit, or along Hurricane Katrina's path.

Foreclosure laws vary state by state, but broadly speaking, if you miss a few payments on your mortgage loan, the bank (begrudgingly, believe it or not — they would much rather see you make payments) will try to sell the property and pay off your debt. Normally, the house will sell for more than the outstanding debt.

House prices tend to climb over time, building up equity for the owner. Traditionally, homeowners have had to put down some percentage of the cost to buy a house. With 20% down, it would take a big crash in real estate for a bank to actually lose money on a home loan, which is the main reason most home buyers wind up paying such a low interest rate — barely above the rate the government borrows at, and lower than many U.S. corporations. The typical bank would rather loan you money at 6% than General Motors.

But what happens if the bank can't auction your house for what you owe? What if you buy a house for $200,000 with only $10,000 down (just 5% down, with a mortgage of $190,000) and you lose your job a few weeks after closing? What if the housing market turns south and your house can only be sold for $170,000? Are you out the $10,000 down payment, while the bank eats $20,000 ($190,000 loan less the $170,000 proceeds from sale)? Only in fantasy land.

The bank is going to try to squeeze you for the $20,000 you still owe them. The outstanding debt becomes a general unsecured liability to you, like a $20,000 balance on a credit card. At the very least, your credit report will get slammed — a big punishment in an era where everybody uses your credit report as a gauge of your credibility (even employers).

Worse, you may have to file for bankruptcy and liquidate any non-protected assets (like your 401k) to settle the debts and get the bank off your back. Trouble is, with last year's bankruptcy law changes, it is difficult for many to file for bankruptcy and just walk away from debts. While these changes did not bring back debtor's prison, those with median incomes or higher will have to seek credit counseling and likely get on a debt payment plan with the bank.

Until the last few years, foreclosure rates have been climbing steadily for decades. While many factors play a role in the foreclosure rate (unemployment rates, incomes, interest rates, divorce, health care costs — even availability of casinos) the government has found the top cause is loan to value ratios (LTV). In other words, as more of the percentage of a home purchase is paid for with borrowed money, the higher the incidence of foreclosure. In the 1950s, when lenders played it safe and required substantial down payments, foreclosures were even lower than today.

The second most important factor — and closely related — is rising home prices. With homes, a rising tide lifts all boats. Even the most overextended buyer with questionable credit and minimal job security is insulated from disaster when home prices climb 20% a year, creating instant paper equity where little traditional (down payment) equity existed.

Now that home price appreciation is leveling off, the ugly side from the growth of no-and low-money-down lending should rear its head.

In the 1990s, companies relied on double-digit stock market returns to hide problems with their pensions which resulted from a lack of real funding — problems that wouldn't have materialized if stocks kept going up year after year. Today, mortgage lenders and borrowers are playing an equally fiscally irresponsible game, relying on home price appreciation to hide the dangers of low-equity home loans.

In recent weeks, home builders have announced unforeseen declines in home buying activity. The inventory of homes for sale is at 10-year highs. Even the always-be-bullish National Association of Realtors has lowered their expectation for home price appreciation.

Just wait until banks start foreclosing on homes at 1990s (or worse) levels. Unlike today's picky sellers, banks will lower prices to get the sale. Those priced out of today's real estate market may get a chance soon. Just have some cash ready. Next time around, banks will want to see some more green.

While rising foreclosures have implications for home owners, buyers, and sellers, there is also something for fund investors to consider.

Today much of the outstanding debt is mortgage backed. When you borrow money to buy a home, that mortgage is often packaged with other people's mortgage and sold as a mortgage backed security. Some of these bonds are issued by quasi-government agencies like Fannie Mae and Freddie Mac, others by Wall Street firms.

These mortgage-backed bonds often find their way into bond fund portfolios. In fact, most bond funds own some of these bonds, notably bond index funds, as these mortgage bonds represent such a huge portion of total bonds outstanding. If the pace of foreclosures ticked up significantly – and the prices of homes fell enough that those who own these mortgage backed bonds would be inheriting property worth less than the outstanding debt (and mortgage bond insurers failed) these bonds could fall in price.

While its unlikely an investment in, say, Vanguard Total Bond Market Index (VBMFX) or Fidelity U.S. Bond Index (FBIDX) would fall precipitously, they could underperform lower fee bond funds that do not own as many of these types of bonds by a small margin, during a crisis. Vanguard Total Bond Market Index has 40% in mortgage-backed securities – 35% government mortgage-backed, 5% commercial mortgage-backed. These bonds are currently investment grade, meaning default risk is deemed extremely low by bond rating agencies.

Vanguard Intermediate-Term Investment-Grade (VFICX) or Vanguard Short-Term Investment-Grade (VFSTX) (MAXadvisor Powerfund holdings) have much smaller allocation to these types of bonds, relying mostly on corporate bonds. Funds with “treasury” in the name tend to avoid mortgage-backed bonds and corporate bonds.

Corporate America is likely going to prove to be a better credit risk than the average recent home buyer if we get a big fall in home prices.