The Spillover Costs of Foreclosure “There is no escaping the distributional question: Any solution to the housing crisis—including doing nothing—is a distributional question.”
--Foreclosure Crisis: Working Toward a Solution
Under most servicing agreements, parties faced with a delinquent mortgage need to do a strict NPV calculation on the return expected from foreclosure versus the return generated by a loan modification. What these calculations ignore are the externalities, or spillover costs, associated with foreclosure.
According to a report published by the Congressional Oversight Panel, here are just some of the costs:
- The 80 closest homes to the foreclosed property will see up to a $5,000 decline in property values;
- A single foreclosure can cost a city up to $34,000 through lost state and local tax revenue, urban blight and rising crime in neighborhoods with high rates of foreclosure;
- Social costs can be high including a decline in community ties when people are forced to leave their religious, educational and community organizations they turn to for support;
- Capital markets are also affected by the negatively reinforcing impact of foreclosures and declining home prices, possibly putting a financial institutions’ survival at stake if their asset value declines too far.
As the Congressional Oversight Panel concluded, “in short, foreclosure is an inefficient outcome that is bad not only for lenders and borrowers, but for society at large.”
Now you may ask, why is it the lenders’ responsibility to account for these costs when making a decision on whether to modify a mortgage? It’s a fair question and one without a right answer. The challenge is that when everyone ignores the externalities, the immediate costs to each lien holder continue to rise—as has been the case in the current market where housing prices in some markets have fallen up to 50%.
The challenge for credit unions is to make economically rational decisions for both the individual member in crisis as well as the institution and its other member-owners. Often this means factoring in some of the externalities listed above as well as your member’s personal relationship history. Today’s economic condition means the decision is no longer whether to modify a loan, but how to do it in the best interests of all parties involved.