As the foreclosure crisis continues to stagger on, economists are starting to worry about the ripple effect all those sunken home loans will have on local housing demand in the future.
Homeowners who undergo foreclosure are almost always locked out of the housing market for a period of years. What a borrower may not realize is that even if they manage to avoid foreclosure through a short sale or deed-in-lieu transaction, the hit to their credit score may be just as deep as if they had been foreclosed upon.
That means that for every foreclosure or distressed sale that occurs, a former homeowner is removed from the pool of potential homebuyers, and they likely won’t be able to get back in for several years – at least not with a federally-backed mortgage. It’s a worrisome problem that local lenders will have to prepare for in coming months.
“The deterioration in mortgage credit quality today is going to continue to weigh on the housing market for the next several years,” said Celia Chen, a senior director at economic analysis firm Moody’s Economy.com. And that will “dampen the demand for housing,” she said.
Disturbing Ratios
Given the unprecedented nature of the foreclosure crisis, exactly how big the impact on demand will be remains an open question.
One way to gauge the magnitude of the impact of foreclosures on demand might be to look at the ratio of foreclosures to sales, since the number of sales is a good measure of total demand, and each foreclosure represents at least one potential buyer removed from the demand pool.
According to sales and foreclosure data provided by The Warren Group, publisher of Banker & Tradesman, in 2008 there were 12,424 foreclosures in Massachusetts, and 60,465 sales, a rough ratio of five sales per one foreclosure. In 2009, there were 9,269 foreclosures, and 60,326 sales, or about one foreclosure for every six sales.
Through May of this year, the last month for which complete data is available, there have been 6,107 foreclosures and 22,938 sales – a rate of more than one foreclosure for every four sales, a considerably more drastic ratio than in prior years.
Other forms of distressed sale, such as a deed-in-lieu or short sale, are also likely to remove borrowers from the demand pool and are not reflected in the foreclosure numbers. But outside factors also have a large influence, such as new people moving into or out of the state or people moving out of their parent’s home or a rented apartment to purchase their first place.
“We must be losing households,” speculated Karl “Chip” Case, professor of economics at Massachusetts’ Wellesley College and co-creator of the Case-Shiller Home Price Index, who said he has been trying to figure out the precise impact of so many foreclosures. “For sure immigration is down, and emigration is way up. For sure many would-be owners are crowding rental inventories, [and] many are moving back with Mom and Dad.”
Keeping Score
According to Fair Isaac, the credit reporting agency which compiles credit scores, foreclosure, short sales and deed-in-lieu transactions all have a similar impact on a borrower’s FICO score, reducing it by as much as 100 to 150 points, in addition to whatever hit it may take from late payments on other bills. Rebuilding a credit score after such a drop can take many months.
Even if a formerly troubled borrower is able to bounce back quickly and begin building a good credit history right away, government agencies like Fannie Mae and the FHA, which insure or otherwise back a major portion of the nation’s mortgages, generally require a lapse of several years before they’ll back a new loan.
For borrowers who’ve been through a foreclosure prompted by extenuating (and documented) circumstances like job loss, Fannie requires a gap of at least three years. If someone intentionally walks away from their mortgage obligation, also known as a strategic default, they will not be eligible for a Fannie Mae loan for seven years, under guidelines released last month.
The rules are a bit more forgiving toward borrowers who’ve been through a short sale – they must wait two years rather than three – but that’s only if buyers can put 10 percent to 20 percent of the purchase price down on a new home.
That may be a tough task for people whose last homes were underwater at the time of sale, forcing them to start saving from scratch to come up with the substantial deposit.
Recovery Period
Bill Hylan, counseling manager for Massachusetts at the Boston regional office of Consumer Credit Counseling Services of Southern New England, said three years is a more typical time frame for borrowers to be able to raise their score and save for a down payment – if they can manage to reduce their debt load and stay current on other bills.
“A lot of people, once they go into foreclosure, kind of give up the ghost on everything,” Hyland said. “If a lender looks at it and sees the only real damage is the foreclosure [and] everything else is being taken care of, that may help.”
Ultimately, demand recovery may depend less on the borrower’s desire to own a home and more on lenders’ willingness to work with them.
Some local mortgage lenders, who will soon have to deal with a wave of homeowners with blemished credit, said the two-year window for financial recovery might be enough.
In the case of a foreclosed borrower who had formerly had sterling credit, by keeping their credit reports “squeaky clean for two years,” it’s possible for a borrower with damaged credit to obtain a loan, said Amy Tierce, president of Fairway Independent Mortgage in Needham.
But whether there’s hope for more average borrowers will depend on whether lending standards stay tight. Issuing any mortgage is “pretty tough [with a total credit score] under 650,” Tierce said. “620 is your absolute bottom.”
Data released recently by Fair Issac showed approximately 25 percent of Americans have credit scores below 600, a 10 percent increase from historic norms.
