Foreclosures:

In a comment to my earlier post, a Commenter notes that foreclosures have risen dramatically over the past several months. This raises an excellent quesiton, and one that I was actually going to address in my initial post. It may be worth mentioning briefly why I don’t view foreclosure numbers as a particularly good metric for measuring financial distress. I thought it might be too distracting to discuss in the initial post, but since it was raised in the Comments I’ll go ahead and say a few words here.

Home foreclosures are analytically more complicated than consumer debt delinquencies and charge offs. There are two competing theories of foreclosures. One is a “distress” theory the other is an “option” theory. Under the distress theory, a rise in interest rates could cause an involuntary default and subsequent foreclosure, by making it more difficult to make monthly payments. The option theory views foreclosure as a rational economic “option,” which is that when you buy a house using a mortgage you also buy an option to default. When housing prices fall, economic theory predicts that more people will exercise this option to default and permit foreclosure. One would especially expect to see the exercise of such an option for “investment” properties, such as condominiums held as a speculative investment rather than for owner-occupancy. And if the loans are non-recourse, then this makes the option even more valuable. I discuss some of this literature in passing in my article on the bankruptcy crisis.

The empirical difficulty is disentangling the option theory from the distress theory, especially if there is a simultaneous rise in interest rates and fall in housing prices (the two being related, of course). A rise in interest rates would lead to increased foreclosures under a distress theory (because it will be more difficult for consumers to make their monthly payments), whereas a fall in housing prices would lead to increased foreclosures on an option theory.

If interest rates have stabilized, but housing prices have continued to fall, this would be more consistent with the option theory of foreclosure.

To the best of my knowledge, we don’t know the extent to which the recent rise in foreclosures is the result of investors exercising their default option to surrender their properties. I have seen reports that some cities that have had the largest rises and falls in residential real estate are also those that had the largest number of speculators, but this seems to be anecdotal.

Certainly consumer debt more generally has this option value built into it, but the value of the option is not as likely to vary over time as for real estate and real estate foreclosures.

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