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JEL Classifications

Foreclosure

Foreclosure is the legal process by which a lender repossesses a home from a borrower. Legally, a mortgage is a type of repurchase agreement which transfers ownership of the property from the borrower to the lender, but gives the borrower the right to buy the property back by paying the outstanding balance on the mortgage. In the event that the borrower defaults on her obligations to the lender by missing periodic loan payments, the lender can extinguish or foreclose on the borrower’s right to repurchase the property. This description is oversimplified, and the precise legal status of the lender’s ownership stake depends on the type of mortgage and the jurisdiction, but the principle is always the same.

The foreclosure process starts when the borrower defaults on the promissory note, typically by missing a payment, although any violation of the contract – renting the property, for example – may constitute a default. The lender then has the right to demand full repayment or, in legal jargon, to accelerate the mortgage. Common law generally allows the borrower a period to correct the default and resume making periodic payments. Typically, this breathing space, known as the period of equitable redemption, lasts three months, after which, the lender has the right to foreclose. Even after the equitable redemption period, and in some cases after the legal foreclosure, the borrower still has the right to redeem the mortgage by repaying the loan in full including all arrears, fees, taxes and penalties.

In the USA there are two varieties of foreclosure: judicial and non-judicial. Some states allow both types of foreclosure and some allow only one or the other. Under judicial foreclosure, the lender must file a suit to initiate the foreclosure process. Under non-judicial foreclosure, the lender initiates the foreclosure process by exercising a power of sale clause without having to go to court. In most cases the lender will try to sell the property at public auction and use the proceeds to pay off the outstanding mortgage debt and any fees incurred from the foreclosure process. If the highest bid at the auction does not meet the lender’s reservation price, then the lender will legally repossess the property. The lender then adds the property to its balance sheet and puts the property up for sale through normal channels.

Foreclosure is not the only remedy the lender has to recover the obligations of the borrower in the promissory note. If the proceeds from the sale of the property fall short of those obligations, lenders can seek to recover the difference. Outside the USA, lenders generally have substantial powers to do this, while in the USA, the ability of lenders to obtain deficiency judgments (unsecured claims for the gap) depends on the state.

The Borrower’s Decision to Default

Economists generally model default as an option embedded in a mortgage contract. In the simplest theoretical setting, default gives the borrower the option to sell the house back to the lender for the outstanding balance of the mortgage. The borrower exercises this option by stopping payment on the mortgage. The academic literature on mortgage default has largely considered the borrower’s default decision to be similar to an investor’s decision on whether or not to exercise a financial option. Many studies, beginning in the 1980s, such as Cunningham and Hendershott (1984) and Epperson et al. (1985) used the option-based valuation models pioneered by Black and Scholes (1973) to study the default decision.

The default option model has been the source of some confusion among researchers and policy makers. What the model says is that the borrower should exercise the option when the value of the mortgage exceeds the value of the house. But many assume that the value of the mortgage equals the unpaid principal balance and then interpret the model as implying that any borrower with an unpaid principal balance that exceeds the value of the house, that is, who has negative equity, should default. But this interpretation is incorrect, since it ignores the value to the borrower of exercising future default and prepayment (repurchase) options, which are forfeited once the borrower defaults. The options to default or prepay in the future reduce the true cost of the mortgage to a level that is below the remaining principal balance. Consequently, a borrower with negative equity may benefit from waiting to exercise the default option.

The first generation of option-based valuation models assumed that all borrowers were identical (based on an assumption of perfect capital markets), and attempted to estimate the equity threshold at which default would occur (Kau et al. 1994). But the assumption of an identical threshold across borrowers is contradicted in the data. As a result, the literature has stressed the idea that there is something unaccounted for by these models that creates a significant amount of heterogeneity across borrowers in their decision to exercise the default option. An explanation involving heterogeneous transaction costs to defaulting emerged in the literature. Transaction costs include such factors as future limitations on credit availability, purchasing or sale costs, tax treatment, or even psychological costs to defaulting.

An alternative to the transaction costs explanation of mortgage default, first discussed by Riddiough (1991), posits that ‘trigger events’ – divorce, illness and spells of unemployment are the typical examples – make some borrowers more vulnerable to default. Gerardi et al. (2007) develop a simple model to formally explain the channel by which trigger events may lead to default. The authors argue that depending on their income prospects, financial situation and other factors, borrowers discount the future differently. The cost of funds is the relevant rate at which borrowers discount future payoffs and consumption, since it is the rate at which a borrower is willing to sacrifice future consumption for current consumption. The relevant cost of funds for a borrower with credit card debt for example is the credit card interest rate, while the cost of funds for a borrower with only riskless savings is the return on riskless savings. Differences in the cost of funds across borrowers are correlated with the individual-level shocks discussed above, because borrowers in financial distress are much more likely to borrow at high interest rates, and thus discount future consumption to a greater extent than financially sound borrowers. Since financially stressed borrowers discount future consumption at a high rate, they are more likely to default in order to increase current consumption (by the amount of the mortgage payment). Thus, the cost of funds provides a channel for the link between employment shocks, medical shocks and even family level shocks such as divorce, and the incidence of default.

The Lender’s Decision to Foreclose

When a borrower defaults, foreclosure is only one of many options that a mortgage lender can pursue. The foreclosure process typically imposes very high costs on the lender, including the opportunity cost of principal and income not received; additional servicing, legal and property maintenance expenses; and costs associated with property disposition, which often increase substantially during housing market downturns as demand shrinks and houses become harder to sell. As a result of these costs, lenders often have an incentive to explore alternatives to foreclosure.

An alternative to foreclosure that received a great deal of attention during the housing crisis of the mid-to-late 2000s is loan modification. A loan modification occurs when the lender permanently changes at least one of the terms of the mortgage contract (such as the interest rate, maturity date or remaining principal balance), usually in the favour of the borrower, so as to increase the probability that the borrower repays the mortgage. Another alternative to foreclosure is a preforeclosure, or ‘short’ sale, in which the lender allows the borrower to sell the house to a third party at a price below the outstanding mortgage balance (inclusive of sale costs and other fees). The lender can then negotiate an unsecured repayment plan with the borrower for the additional amount owed or can forgive the remaining debt outright (Cutts and Green 2004). Another foreclosure alternative, called a ‘deed-inlieu’, occurs when the borrower voluntarily surrenders the title of the house back to the lender in exchange for a release from all mortgage obligations. Relative to foreclosure, deeds-in-lieu reduce the time in which a borrower who has defaulted can live ‘rent free’ in the house relative to foreclosure, but they are often less costly to the borrower in terms of reduced access to future credit.

A foreclosure alternative that often works well for borrowers undergoing temporary liquidity problems is forbearance. In this case, the lender agrees not to foreclose for some given time period, during which the lender receives reduced payments from the borrower. The forbearance period is designed to be long enough to allow the borrower to find a new job or otherwise correct his or her financial problems. In return, the borrower agrees to a mortgage repayment plan that will, over a specific time period, bring the borrower current on the mortgage again. Springer and Waller (1993) explore the use of forbearance as a loss mitigation tool, while Foote et al. (2008) discuss the benefits of forbearance over loan modification when the potential default is caused by trigger events.

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