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The Six D's of Home Foreclosure - Sean O'Toole

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  • The Six D's of Home Foreclosure - Sean O'Toole

    The Six D's of Home Foreclosure

    Count them out before using foreclosure statistics to determine housing market and economic conditions. Early in the down-cycle, use properties sold back to the lender insead.

    by Sean O'Toole

    If you are watching foreclosure news for clues on the housing market and economy, there are three key things you need to know. While foreclosure activity is rising it remains at historically low levels. Foreclosure statistics can be misleading as a housing market health and economic indicator because there is a base rate of foreclosure that has little to do with the economy or the housing market. Finally, the foreclosure information we really need to make economic assessments isn’t available.

    On the first point, RealtyTrac, DataQuick and others have reported a 28% year over year increase in foreclosures for Q1 2006. While this is a significant up-tick, foreclosures are still low. DataQuick which has been tracking foreclosures since 1992 says that California foreclosures, for example, peaked in Q1 1996 at 59,897. In Q1 2006 there were 18,668, less than 1/3 of the peak. These data taken alone support the popular press notion of a “soft landing” for housing, as this level of foreclosure can easily be sustained without itself causing much impact on the market.

    The problem with using these numbers alone to measure the state of the real estate market is that most reported foreclosure numbers only represent the first step in the foreclosure process, not the actual number of properties that are foreclosed on, that is, sold at auction. Only around 5% of homes that start the foreclosure process end up foreclosed on. The rest resolve it other ways.

    To understand why certain properties reach the end of the foreclosure line and are actually sold at auction while most do not, we need to divide the owners into two groups, those with equity and those without. In California, foreclosures without equity have largely been non-existent for the last four years. With 20% year over year appreciation, the foreclosure process takes long enough that by the time a property actually came to sale it had sufficient equity for there to be no good financial reason for it not to have been sold by the owner prior to foreclosure sale. Yet even with this rapid appreciation and resulting “equity” increase, some properties still wound up at auction. While most of us equate foreclosure with financial difficulty caused by the economy, there is a base rate of foreclosure activity caused by personal financial problems that homeowners have no matter how well or poorly the economy is doing. We need to understand this foreclosure base rate before trying to draw economic conclusions from foreclosure activity, and an increase in foreclosures outside this base rate is what we need to pay attention to as an economic indicator.

    Why does foreclosure happen other than simple inability to make the payments because of, say, job loss? I attribute it to the six D’s: Death, Disease, Drugs, Divorce, Denial and Duty.

    The D’s range from the tragic-comic to the tragically unfair. An example of the unfair and tragic is the last D, Duty. The fulfillment of Duty to country is an all too common cause of foreclosure. I had personal contact with a case, a serviceman returning from Iraq. He had fallen behind in making is condo association payments after being called to duty and forced to close his consulting business. While on active duty, the association couldn’t foreclose thanks to the Soldier’s and Sailors Civil Relief Act of 1940 (SSCRA). However, the SSCRA only delayed foreclosure while the debt continued to mount and it only provided 90 days of protection after his active duty service ended. Clearly not enough time to restart a business, make regular payments and save enough to cure the back payments. Frankly, it’s disgraceful that this country allows this to ever happen. I wound up lending him the money he needed to stay out of foreclosure.

    At the other end of the spectrum are the tragic-comic cases. An example is a gentleman I met who was making great money in the construction business, had a nice house, payments he could afford, and a drug addiction. Now when you ask him why he stopped making his house payments, he’ll tell you quite sincerely that did so in order to buy his girlfriend a top of the line breast augmentation, in his words, “a boob job.” He further explained that the procedure runs from $4,000 to $20,000 dollars and that he really needed to get her the best possible. Now, had he not been a drug addict and had been thinking clearly, he would have used a home equity line, like so many others have. Tweakers like this guy, and other drug users, are a mainstay of the foreclosure business. Clear thinking is not their strong suit.

    Beside Drugs, Death is another common cause of foreclosure. The husband passes away and the wife he leaves behind has neither life insurance to cover the payments nor the professional skills needed to gain employment to generate enough income. Divorce: the husband refuses to pay and the wife that refuses to move and sell. Disease: mental illness, Alzheimer’s, and other diseases that impair reason, ability or simply the will to take care of things. But the most powerful of all is simple Denial, a sincere belief that foreclosure can’t or won’t happen to them, leading to a lack of preparation for any one of the other six D’s.

    We need to eliminate these base foreclose cases from the numbers before making an economic evaluation because there isn’t a correlation between the Six D’s foreclosures and the health of the housing market and economy. Instead we need to look at properties that sell at auction without equity. Almost all of these sales are the result of real financial problems experienced by otherwise clear headed, fully functional property owners. The growth and decline of this group of foreclosures correlates to the strength of the housing market and economy.

    In these non-equity cases the homeowner either paid too much, never had equity, and has decided to walk away, or they’ve borrowed all the equity out while trying “save” their home. Again, equity has increased so rapidly in California the last four years that these situations have rarely occurred.

    Unfortunately none of the foreclosure data providers currently offer this analysis. A relatively easy method is to separate homes purchased by 3rd parties (typically indicates sufficient equity to profitably resell) and those that receive no bid and go back to the lender (insufficient equity to resell).

    For example, look at the following chart for a county in northern California:

    While the number of Notices of Default is clearly trending up, it remains low and un-alarming by historical standards. Same for the total number of properties sold at auction. However, the number of properties sold back to the lender (due to lack of equity) far surpassed those sold to 3rd parties for the first time in four years in April 2006. I believe this to be a far more telling leading indicator than any other foreclosure statistic, yet it is presently unavailable from the current foreclosure data sources.

    Stay tuned here at while we track this indicator.

    Related: Refi loans could prove costly in foreclosure

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