Foreclosures and Their Costs: Could They Have Been Avoided? The Case of California during the Mortgage Crisis

Abstract

The author analyzes a loan-level dataset of 1,528 defaults in California that led to sale of the property as “real estate owned” during the period from 2005 to 2017. In 898 cases (59%), lenders lost 43% of the initial loan ($89,877) on average, per foreclosure. In 942 cases (62%), borrowers lost 30% of the initial price of their home ($147,077), on average. The borrowers who ended up with a profit were those who increased their debt the most after the first purchase loan. Moreover, one in four borrowers generated an average profit of $115,856, while their lenders incurred an average loss of $93,114 precisely because excessive equity extraction transfered the downside risk to the lender. Two-thirds of all ARM borrowers defaulted within the first 3 years of the loan, implying underqualified borrowers at origination. This is an indication of predatory lending/borrowing practices that fueled the wave of foreclosures. The author finds that foreclosure discounts on REO sales in California were 35%, on average, with the highest discount appearing in 2009. Measures that prevent or limit cash-outs during a housing boom, and incentives to default during a housing bust, could help reduce foreclosures and their costs. TOPICS: MBS and residential mortgage loans, legal and regulatory issues for structured finance, financial crises and financial market history Key Findings • An analysis of 1,528 foreclosures in California shows that lenders lost $89,877 and borrowers lost $147,027, on average, per foreclosure during the 2008 mortgage crisis. One in four defaulting borrowers generated a profit, while their lenders incurred a loss due to excessive equity extraction. • ARM borrowers defaulted within the first 3 years of the loan, indicating that these borrowers were underqualified at origination. FRM borrowers defaulted later but used cash-outs more aggressively, leading to negative equity that motivated defaults during the crisis. • Foreclosure discounts were 35% in California, on average, with the worst discount occurring in 2009. Despite the volatility of HPI, every period of 12 years or longer since 1975 led to price appreciation, indicating that foreclosure should be avoided, as the recovery of the market always leads to capital gains.