Have All The Bad Loans Already Been Foreclosed?

U.S. foreclosure starts dropped to a six-year low in January, another strong indication that the U.S. housing market is recovering and the worst of the foreclosure crisis is behind us.

But what specifically is driving this decreasing foreclosure activity? Is it simply a matter of rising home prices pulling more troubled homeowners back from the brink of foreclosure? Or should the numerous foreclosure prevention efforts at the national, state and local level get the lion’s share of the credit for the slowdown in foreclosure activity?

While both of these are certainly helping to speed the descent, the fundamental factor driving the drop in foreclosures is better lending guidelines that don’t allow anyone with a reflection to qualify for a loan — not to mention anyone who can fog that reflection.

Since the financial crisis hit in full force in 2008 — triggered by loans gone bad in big numbers — the mortgage industry has got religion in a big way. And it’s not just talking the talk, it’s walking the walk as well, as evidenced by the declining foreclosure rate on loans originated in 2009 and later. 

Highest foreclosure rates still on housing bubble loans
More than 5 percent of still-active loans originated in 2006 were in some stage of foreclosure as of the fourth quarter of 2012 — the highest foreclosure rate of any year going back to 2000. That was followed by 2007 vintage loans with a 4.75 percent foreclosure rate, 2005 vintage loans with a 3.52 percent foreclosure rate, and 2008 vintage loans with a 2.95 percent foreclosure rate. The only other loan vintage with a foreclosure rate above 2 percent was 2004, with a 2.16 percent foreclosure rate.

The foreclosure rate on 2009 vintage loans dropped to 1.11 percent, and the foreclosure rate steadily decreases on loans originated in the three years since — all of which have foreclosure rates below 1 percent.

Of course a slightly lower foreclosure rate on more recently originated loans is to be expected all things being equal. Borrowers on these newer vintage loans have simply not had as much time to get into trouble and stop making mortgage payments. Still, the sharp drop from 2008 to 2009 foreclosure rates indicates a much higher quality of loan product.

So certainly the drop in foreclosure starts can in large part be attributed to better quality loans in recent years, providing less fuel for the foreclosure fire going forward. But the other side of that good news is the bad news that the housing market has not yet dealt with many of the risky loans originated during the dark ages of lending.

Bad loans lingering in foreclosure
To the contrary, 75 percent of all loans that are actively in the foreclosure process were originated from 2004 to 2008, while only 14 percent were originated from 2009 to 2012, and only 11 percent were originated in 2003 or earlier.

The mortgage servicing industry has not yet resolved these bad loans. And if the mortgage servicing industry has not fully dealt with those bad loans, it also means the housing market has not fully absorbed the impact of those bad loans.

Some of those non-performing loans will be directed into one of the many foreclosure alternatives now available to lenders: from loan modification to short sale to even sale of the loan at a discount to another entity who then can try to get that loan performing again.

But some are destined for foreclosure and will need to be foreclosed in the coming years, not to mention that some going into the loan modification bucket or nonperforming loan sale bucket will end up as foreclosures eventually.

That means foreclosure sales will continue to account for a historically high percentage of all residential sales in 2013 and 2014 — even after foreclosure starts have returned to historically normal levels.

Foreclosure sales are on track to account for about 20 percent of all sales in 2012, and I would expect a similar percentage for 2013. Only when that percentage drops below 5 percent can we conclude that the housing market has fully absorbed all the distress created during those dark days of the housing market in the mid-2010s.

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