Cleveland Federal Reserve Estimates Impact of Fast-Tracking Foreclosures in OH, PA
On March 6, the Federal Reserve Bank of Cleveland published an economic commentary authored by Kyle Fee and Thomas J. Fitzpatrick IV, titled Estimating the Impact of Fast-Tracking Foreclosures in Ohio and Pennsylvania.
Estimating the Impact of Fast-Tracking Foreclosures in Ohio and Pennsylvania
Kyle Fee and Thomas J. Fitzpatrick IV
All the signs in the housing market seem to be pointing the right way, except the amount of time loans are spending in the foreclosure process. Foreclosure fast-tracks for vacant homes in foreclosure may help reverse that trend.
In recent months housing markets have shown real signs of life: home prices, home purchases, and housing starts are up, while foreclosure inventories, foreclosure starts, and loan delinquencies are down. But in states that handle foreclosure through the courts (rather than nonjudicial trustee’s sales), the lingering effects of the foreclosure crisis may be costing taxpayers money and dragging down the recovery. In those states, the amount of time loans are delinquent before they enter foreclosure and the amount of time loans spend in the foreclosure process are rising.
Anecdotally, many explanations have been offered as to why this is happening. Loan modification programs may explain some of the increase in duration, as lenders work with borrowers in an attempt to modify the loan while the borrowers are delinquent or in foreclosure instead of proceeding to judgment. State-specific requirements, such as the lender having to produce the original note and mortgage may delay or prevent some foreclosures on delinquent loans. Shrinking budgets may be making it difficult for the courts overseeing the cases or the sheriff’s offices overseeing the property auctions and deed transfers to process foreclosures in a timely way. Selective foreclosure, which avoids low-value properties, may also be a contributing factor, shifting the costs of those properties from the lender to communities and taxing districts.
These problems are intensified when a home that is in the judicial foreclosure process is vacant. States with judicial foreclosure have longer foreclosure timelines than nonjudicial states. When the home is vacant, the cost of the extended judicial foreclosure process has no corresponding benefit, generating deadweight losses.
Recently, some judicial foreclosure states have passed laws that attempt to “fast-track” foreclosures if the property has been abandoned by the homeowner, and others have begun considering similar fast-track laws. This Commentary explores the economic reasoning behind fast-tracking and estimates the size of the deadweight loss that could be eliminated by creating an effective foreclosure fast-track in Ohio and Pennsylvania, two states in the Federal Reserve Bank of Cleveland’s District.
The Judicial Foreclosure Process
Requiring that foreclosures be conducted through the courts is a policy decision that has passionate advocates on both sides of the issue. Those that do require it—judicial foreclosure states—have decided that certain safeguards are required before real property can be taken from an owner by a creditor because of a default on a secured loan or by a taxing authority for failure to pay property taxes. In these states creditors and taxing authorities must proceed through the courts, which make sure they have the right to foreclose and the borrower has no legal defenses to foreclosure.
Legislatures have decided that protecting the rights of property owners is worth the higher cost of judicial foreclosure relative to nonjudicial foreclosure. These costs may change depending on whether homes stay occupied or are vacated by the owners during the foreclosure process. When a home in foreclosure remains occupied, the costs may only include the lost value of the creditor or taxing authority’s capital investment in the property (which does not earn a return during the foreclosure process), the litigation costs of all parties to the foreclosure, and the court’s time. But when a residential property in foreclosure is vacant, this calculation may change.
When the foreclosure sits vacant, there are additional costs to the creditor or taxing authority due to the accelerated depreciation of unoccupied homes, which are less well maintained and more likely to be vandalized or, in some cases, stripped of metal to sell for scrap. There are additional costs to the community when unoccupied homes create health and safety hazards and cause surrounding homes to lose value. In states that allow deficiency judgments such as Ohio and Pennsylvania, there are potentially further costs to the vacated homeowners, who will be liable for the difference between the price the creditor or taxing authority eventually receives for the home and the unpaid loan amount. Finally, any loss in property values will hurt municipalities or school districts funded in whole or in part by taxes on the value of real property.
Who bears these costs, in the end, depends on whether the foreclosure is completed. When the foreclosure is abandoned, costs are imposed on the community and taxing districts. The abandoned property is not easily rehabilitated due to the lender’s lien on the property. When abandoned properties are taken through foreclosure and sold, these costs are born primarily by the lender through rehabilitation costs or lower sales prices.
Most importantly, there is no obvious beneficiary of these costs. Communities and taxing districts face the externalities associated with vacant property: lower surrounding home values, increased crime, and reduced property tax collections. Homeowners who leave properties vacant are essentially resigned to the fact that they cannot dispute the right of the creditor or taxing authority to take the home through the foreclosure process, and as such gain no benefit from its use. Lenders receive no benefit from the judicial foreclosure process above the benefits they would receive through a nonjudicial process.
These deadweight losses—costs without corresponding benefits—are what legislatures in judicial foreclosure states have attempted to address by creating foreclosure fast-tracks. At least five states have created foreclosure fast-tracks for private mortgage foreclosure on abandoned property since 2010.1 Ohio created a private mortgage foreclosure fast-track for tax-foreclosure in 2006,2 and the Ohio legislature is considering a pilot foreclosure fast-track for properties abandoned by the homeowner.1 But there has been no economic analysis to determine the potential impact of a well-designed foreclosure fast-track.
Assuming a Close-to-Ideal Foreclosure Fast-Track
We estimate the potential for savings that an efficient and effective foreclosure fast-track could provide in Ohio and Pennsylvania. The savings would come from shortening the amount of time that vacant properties spend in foreclosure and eliminating the deadweight losses lenders suffer. To estimate these savings, we need to know three things: how many foreclosures might be affected (the number of homes in foreclosure that sit vacant), the daily deadweight losses associated with these homes, and time that could be shaved by fast-tracking.
Unfortunately, there is no single database that has all this information, so constructing our estimate is a multi-step process. We start by making several assumptions. We assume that an ideal fast-track for private mortgage foreclosure would only apply to homes in foreclosure that owners have vacated, it would be used on 100 percent of those properties, and it would cut the total foreclosure time—specifically, from the time the foreclosure is filed with the court to the point where the lender takes ownership of the property—down to two months.
The validity of these assumptions depends entirely on how the law is written. Typically, foreclosure fast-track laws require more than simple vacancy in order to qualify for the fast-track, which protects against the fast-track being misused but may prevent all vacant foreclosures from being eligible for fast-tracking. In some cases, qualification is based on criteria that would correlate with a vacated home (shut-off utilities and housing code violations, for example), so generally there should be a high correlation between vacancy and fast-track qualification. Additionally, once a foreclosure judgment is issued, the fast-track would have to transfer the property to the lender directly, or an expedited foreclosure auction and deed transfer process would be required.
A 100 percent utilization rate of a foreclosure fast-track also depends on how efficiently the process is designed: the faster and easier it is to use, the more it will be used. It is worth noting that a common anecdotal complaint by creditors’ counsel is that recently-passed foreclosure fast-tracks are difficult to use.
Another practice that may prevent 100 percent utilization is strategic foreclosure. Strategic foreclosure refers to foreclosures that are started but never completed or foreclosures that are never started because the lender determines that the home has little value. They usually occur when the home sits vacant and depreciates to the point that it would cost more to foreclose upon and maintain than could be recovered by selling the property. There is some empirical evidence suggesting that this has occurred in very weak markets.4 And anecdotally, local governments and communities have reported an increase in foreclosures that start but are never completed. A foreclosure fast-track does not completely address strategic foreclosure. It may lower the cost of foreclosure for lenders, but if the property has an extremely low net present value, lowering the cost of foreclosure may still not be enough to make completing the foreclosure worthwhile. A fast-track law could be constructed with features that ensure foreclosures that have started are completed, but the response to that might be to not initiate foreclosure on low-value properties, in which case the problem will persist.
Finally, bringing the fastest foreclosures down to two months also seems possible. The quickest foreclosures in Ohio and Pennsylvania are completed typically in five to six months (figures 1 and 2). This is a measure of the time that loans spend in foreclosure before they enter the lender’s real estate owned portfolio or are sold. In the case of vacant foreclosures, a fast-track could move the process down to a single hearing, and if the homeowner does not respond to the foreclosure filing, the property could be directly transferred to the lender or move to an accelerated sale. This process would be similar to the fast-tracked property tax foreclosure framework currently used in Ohio.
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