naked capitalism

Remember a few months ago a big secret in plain sight was that many banks were awfully slow about foreclosing on deadbeat homeowners. Some of this was arguably not due to gameplaying but a function of overloaded servicing departments that were understaffed and backed up. But in many cases, the belief was that the delays were by design. Banks didn’t want to report higher levels of real estate owned (REO) which is where the homes wind up if no one offers more than the mortgage balance at the foreclosure auction. Some banks also may have preferred to keep homeowners in place, since a vacant property deteriorates and depresses values in the ‘hood. And some chose to present their strategies to flatter their financials as a benefit to homeowners, as Wells Fargo did last quarter in changing its foreclosure policies (and related accounting) to extend the process.

But the day of reckoning nevertheless eventually arrives. In this case, it is taking the form of banks having to unload increasing amounts of real estate, most often in markets that are continuing to deteriorate.

One thing that has surprised me about this housing market is that while there is decent data (given that real estate is local) on house price trends, there has been surprisingly little discussion, at least in the MSM and major blogs, of loss severities on foreclosures. Admittedly, banks probably don’t want to ‘fess up to how bad things are, but this is such an important element of the equation that I am surprised that it gets far less attention than it deserves (hint: anyone with knowledge is encouraged to speak up).

Losses are a function of home price appreciation (click to enlarge):

Now look at how high the losses are with merely 3% annual home price appreciation. Imagine what the losses look like with falling home prices.

Yet even the grim numbers reported in today’s Wall Street Journal seem better than what is implied by the chart above. Why? Probably because the houses that are selling out of REO are the ones that can be sold. We’ve heard stories of subdivisions in Cleveland being plowed under for farmland. That’s extreme, of course, but it isn’t hard to imagine that in some areas, the houses that don’t sell readily will eventually go for very distressed prices, potentially for as little as the value of the improved land.

From the Wall Street Journal:

The steep losses on sales of foreclosed homes are painful for banks and investors in the short run but should help clear the backlog. That would allow for an eventual recovery of the housing market and clean up the banks’ balance sheets.

I can’t resist interjecting. That cheery statement is technically correct (it all hinges on what one means by “eventually”), but that assumes the bathtub is draining faster than new water is coming in. With Alt-A and Option ARM resets occurring at high levels in 2010 and 2011, this crisis is far from over. And Housing Wire points out that a far higher proportion of Alt-As were retained on bank balance sheets than subprime, so banks are unlikely to “clear the backlog” anytime soon.

Back to the Journal:

One example of the deep price cuts on foreclosures: A 1,230-square-foot home in Corona, Calif., was sold by a unit of investment bank Credit Suisse in June for $198,000, down from $450,000 when the property sold in a regular transaction in December 2006.

“I do not think this is the time to be holding onto [foreclosed homes] and hoping for a better day,” Daniel Mudd, chief executive of Fannie Mae, said during a conference call Friday.

Banks and investors have grown more leery of the rising costs of holding onto vacant homes. Along with such expenses as insurance, lawn care and maintenance, banks are being hit with higher costs for complying with local regulations applying to vacant homes.

The price cutting may mean even deeper losses for banks, but in some areas price tags have fallen enough to entice bargain hunters back into the market. According to the S&P/Case-Shiller indexes, prices in Las Vegas, Miami and Los Angeles are back to 2004 levels, while those in San Diego have retreated to 2003 levels….

For subprime loans, those to people with relatively poor credit records, loss severities averaged 41% of the loan balance in 2005 and 54% in the 12 months ended in May, according to Fitch Ratings. For loans made in 2006 and 2007 that end up being foreclosed, severities are likely to average more than 60%, Fitch says. Analysts at Credit Suisse see a range of 63% to 71% on foreclosed subprime loans by late next year, depending on how far home prices fall.

Comparable historical data are sparse…

Losses on prime loans also are growing, particularly on option adjustable-rate mortgages, or option ARMs….Wachovia disclosed last month that loss severities on option ARM foreclosures averaged 36% in the second quarter, up from 32% in the first quarter. Fannie Mae says severities on prime and Alt-A loans (a category between prime and subprime) recently have reached 40% in California….

Financial institutions are acquiring homes through foreclosure much faster than they can sell them…

Not all foreclosed homes go for a song — even though the loss to the bank can be stiff. In the Las Vegas neighborhood of Summerlin, a foreclosed three-bedroom home, built in 1999, sold in May for $259,900, the original listing price, after just three days on the market….

Local governments are adding to the pressure on banks to sell foreclosed homes faster. Providence, R.I., recently imposed a property-tax surcharge on vacant properties to discourage banks and others from leaving them empty for long periods. Many cities now require banks to register the vacant homes they own and pay registration fees ranging from about $50 to $1,000.