Keeping It Real (Estate): Don't Ban Foreclosures!

This post first appeared on Minyanville and Cirios Real Estate.

Banning foreclosures is starting to gain momentum in Washington: This isn't good.

Barack Obama, the current frontrunner in the race for the White House, recently floated a plan for a 90-day moratorium on foreclosures by certain banks, along with other initiatives to revive the economy.

While Obama’s heart may be in the right place with respect to homeowners, current efforts to stem foreclosures by making it harder for banks to take back houses are largely misguided. Preventing banks from exercising their rights as debt holders could have negative consequences for all homeowners. For the ones facing foreclosure, a moratorium is likely to delay in the inevitable.

Mortgage rates are kept low largely because banks can repossess a home if the borrower stops making payments. Even if a homeowner declares bankruptcy, the bank can still take back the house. It may seem cruel, but it’s one of the primary reasons banks are willing to give out hundreds of thousands of dollars in support of home ownership.

By taking away their loss mitigation tool, or even by threatening to limit their ability to foreclose, banks will demand a higher return for the risk they undertake in lending. This means higher interest rates, tighter qualification requirements and home prices far lower than they are today.

We must find effective ways to limit the damage of the housing market’s collapse without endangering the eventual recovery of one of America's most essential markets.

Case in point: California. The epicenter of the housing market’s implosion recently enacted legislation forcing lenders to jump through additional hoops before starting the foreclosure process. Aimed at finding common ground between lenders and troubled borrowers, the state saw a dramatic 62% drop in notice of default filings -- which mark the start of the foreclosure process -- a month after the new law took effect.

On the surface this may sound encouraging, but digging deeper, it appears the data simply reflect a brief interruption in the prevailing trend. Sean O’Toole, founder of research firm ForeclosureRadar, told Housing Wire:

Given the significant negative equity now occurring in most California foreclosures, modifying loans to affordable levels either requires large principal balance reductions, or extending the unsustainable teaser rates that created the foreclosure crisis in the first place.

Wide-scale adoption of large principal balance reductions also poses significant risks, as they are likely to encourage non-defaulting homeowners to default in the hopes of securing similar reductions. As such, either type of loan modification is likely to result in increased default, and/or foreclosure activity in the future, a consequence clearly not intended.

Foreclosures are a necessary, if painful, aspect of the housing cycle - and a requisite part of any sustainable market recovery. And while there are measures the government can take to prevent foreclosures without sacrificing the necessary price discovery the market so desperately needs, they must not be banned outright. Not even for a few months.

The guilty are being punished, albeit slowly.

Bank of America (BAC) recently had to fork over $8 billion to settle lawsuits filed against Countrywide, which it purchased earlier this year. Fannie Mae (FNM) and Freddie Mac (FRE) are being sued by angry shareholders who felt they were misled about the companies' financial strength. Bear Stearns is gone, as are IndyMac and Lehman Brothers. And While this may offer little solace to upside-down homeowners, it's evidence the free market is still functioning (however deep it may become buried under government intervention).

Significant increases in mortgage regulations are already in the works: A more restrictive set of rules is the only sure bet in today’s housing market. However, in so doing, it's important that we not block out an entire subsection of the population - those with poor or undeveloped credit, who are nonetheless worthy of and responsible enough to own a home.

These distinctions were badly blurred and blatantly exploited during the boom, but that’s not reason enough to preclude millions of deserving families from realizing the American dream of homeownership in the decades to come.