Foreclosures Drag on U.S. Recovery

• Rising home foreclosures are weighing on the housing market, dampening prospects for a U.S. economic recovery.

• Government efforts to break the downward cycle of foreclosures and falling prices have had limited success to date.

• Loan modifications need to improve in both quantity and quality to keep the number of foreclosures from rising further.

• If foreclosures exceed our baseline forecast of 3.6 million this year, the housing correction will be longer and more painful.

Foreclosures pose a major obstacle to recovery for the U.S. housing market and thus the broader economy. President Obama's Housing Affordability and Stability Plan is designed to limit the number of foreclosures; the efficacy of the loan modification portion of this plan is the linchpin to our house price outlook. Thus far, the plan, called the Home Affordable Modification Program, has modified few loans. However, it has been in operation only since mid-April, and we remain hopeful that it will achieve its goals.

Conditions in the mortgage market continue to worsen, despite lower rates and earlier policy measures (such as Hope for Homeowners and Hope Now) to stem foreclosures. According to the Office of the Controller of the Currency and Office of Thrift Supervision mortgage metrics report for the first quarter of 2009, the number of foreclosures in progress rose 22% from the fourth quarter and 73% from one year ago. Disturbingly, conditions deteriorated most for prime borrowers.

Rising joblessness, sinking equity

While the end of many foreclosure moratoriums in March may partly explain the increase in foreclosures, sinking equity and rising job losses are now causing pain for many households with good credit. About 15 million homeowners, or 30% of those with a first mortgage, are under water—they owe more on their loans than their homes are worth at current market prices. While many of these homeowners have a longer-term view and will continue meeting their mortgage payments, those without jobs and income may find walking away an attractive option.

Foreclosures depress house prices through three channels: increased supply, discounting, and the neighborhood effect. In the first case, additional inventory comes on the market when homes are foreclosed, adding to supply just as the recession is curbing new household formation, keeping demand for housing weak. Second, banks typically discount the price of foreclosed properties to encourage quick sales. Foreclosed homes also are often damaged, reducing their value. None of the conventional price indices capture this effect.

Finally, foreclosed properties drive down prices for nearby homes, regardless of whether they, too, are distressed. Simply being located next to a foreclosed property renders a home less desirable. This is reflected in overall house prices: According to a recent Federal Housing Finance Agency survey,California house prices excluding foreclosed properties had fallen 36% from the market peak through the first quarter of 2009, not much different than the 41% decline in the FHFA price index that includes foreclosed properties.

Tracking the downward spiral

The continued rise in foreclosures points to further declines in house prices, despite the recent firming in gauges such as the FHFA index, median prices, and the S&P/Case-Shiller 20-city index. Falling home prices in turn push more homeowners under water. Greater negative equity increases the risk that a household will fall into foreclosure and decreases the likelihood that a loan will be successfully modified, thus perpetuating a downward spiral. This relationship between foreclosures and house price depreciation is evident in metro area data between 2005 and the first quarter of this year. The larger the increase in a metro area's foreclosure rate during this period, the more significant the decline in area house prices.

The cycle of house price depreciation and foreclosures is precisely what policymakers have been trying to break through various loan modification programs. These efforts are ramping up, with a growing number of loans modified. And with the Home Affordable Modification Program just under way, the quality of modifications is also improving. However, this program will have to grow still more effective in coming months to match our baseline expectations.

Data from the Hope Now Alliance show an increase in the number of borrowers who initiated a formal repayment plan. In April and May, an average of 144,000 borrowers started the process, a 26% increase from the average in February and March and a 46% increase from a year ago. Still, the process is lengthy, and not all those seeking a repayment plan will be successful in modifying their loan. The number of completed modifications fell compared with February and March and continues to fall far short of the number of foreclosures started.

At the current pace, modifications are in line with the Moody's Economy.com baseline assumption of 1.5 million to 2 million modifications over the next three years. However, modifications need to be substantive to be effective. A large share of loan modifications, nearly 46%, left the monthly loan payment unchanged or higher. Less than 2% of modifications involved a reduction of principal.

The low quality of loan modifications is behind the disappointingly high redefault rate for modified loans and indicates that the Hope Now and Hope for Homeowners programs did not get at the root of the problem. According to the OCC and OTS, the redefault rate on loans modified in the first quarter of 2008 was more than 50% one year later. Moreover, loans modified in subsequent quarters have slightly higher redefault rates three, six and nine months after modification. The fourth quarter of 2008 cohort offers a small ray of hope, with the three-month redefault rate slightly lower than for the third quarter of 2008 cohort. A higher share of modifications with reduced monthly payments accounts for the improvement.

The outlook is hopeful, but the progress of the Home Affordable Modification Program will need close scrutiny. The HAMP was designed specifically to place distressed borrowers into more affordable loans, so this share will rise in the coming months, and redefault rates of the newer modification vintages will fall. The number of modifications should also increase as HAMP gets into full swing. With the program in place, the peak pace of foreclosures will occur this year, with an expected 1.8 million foreclosure sales. As a consequence, house prices will stabilize in mid-2010, with a total expected decline in the Case-Shiller national price index of 39%.

The main risk to this outlook is that the modification process is still not as streamlined as hoped. Unless it improves, the number of foreclosures will exceed the 3.6 million anticipated foreclosure sales this year and next, and the housing correction will be longer and more painful than projected.