Homeowner Protection at the Expense
of Low-Priced Mortgage Credit?

A Federal Reserve Finance and Economic Discussion Series working paper released in May titled "Foreclosing on Opportunity: State Laws and Mortgage Credit," investigates the relationship between state-level foreclosure laws and the dollar amount of accepted residential mortgage applications. In the report, economist Karen M. Pence finds that while many states impose restrictions on the ability of lenders to foreclose on defaulted mortgages in order to protect borrowers, the costs imposed on lenders by these restrictions may be passed on to borrowers and reduce the supply of mortgage loans.

The study uses 1994 and 1995 Home Mortgage Disclosure Act (HMDA) data at the census tract level. Because HMDA data are reported for metropolitan counties only, the study sample consists of over 1.25 million approved mortgage loan applications in 55 counties that are part of Census Bureau-defined metropolitan statistical areas (MSAs). To account for the regional variation in real estate markets—which, along with foreclosure laws, could influence mortgage loan volume—the study examines clusters of adjacent counties in various states and regions across the country. Just as real estate markets display regional patterns, so too do foreclosure laws. The author examines the impact of three legal processes that affect foreclosures: 1) judicial foreclosure; 2) statutory right of redemption; and 3) deficiency judgment. Judicial foreclosure requires lenders to pursue a property through the court system. Twenty-one states, for the most part located in the Northeast and Midwest, require this course of action. Lenders in the rest of the country can employ the "power of sale"—a non-judicial process in which the sale of the property is supervised by a trustee. Under statutory right of redemption, nine states allow homeowners to regain their property for the cost of the foreclosure sale price and expenses. Finally, a deficiency judgment against a borrower's non-mortgage assets may be collected by creditors. Allowed in most states, the judgment is equal to the lender's losses on the foreclosure.

The author's research indicates that "...in practice borrowers rarely exercise statutory rights of redemption and lenders rarely pursue deficiency judgments....[b]y contrast, judicial foreclosures affect every foreclosure in a state that requires the process." Therefore, while the study includes all three types of legal foreclosure procedures in its analysis, judicial foreclosure exerts the largest effect. Lender losses on foreclosures are estimated to be between 30 and 60 percent of the outstanding mortgage loan balance. States requiring judicial foreclosure impose costs on lenders such as: legal fees, foregone interest, and expenses associated with carrying a property, including taxes and maintenance. These costs increase with the duration and uncertainty of the foreclosure process and the duration varies among the states requiring judicial procedures. "On average, judicial foreclosures take 148 days longer than power-of-sale foreclosures; the difference between the quickest and most time-consuming states, according to Freddie Mac's guidelines, is 289 days."

Whether lender costs are specified in terms of the type of foreclosure process or differences in process time, the results are the same: "...borrowers in states with defaulter-friendly [foreclosure] laws face a reduced supply of mortgage credit." The study finds that mortgage loans are four to six percent smaller in defaulter-friendly states suggesting that "...defaulter-friendly foreclosure laws impose costs on borrowers at the time of loan origination [e.g., higher interest rates, larger downpayment requirements]." Pence concludes that the "largely unexamined tradeoff" between the protection afforded to distressed borrowers in states with stringent foreclosure laws and the costs imposed on lenders and then passed on to "...a much larger pool of borrowers" may attract "renewed interest...given recent increases in foreclosure rates."