Foreclosures and Delinquencies: Is the SubPrime Market Causing a Banking Crisis
For the past few months, the general press has publicized the woes of the subprime market. The subprime market is populated by people who typically have low credit scores and histories of payment delinquencies, charge-offs or bankruptcies. These borrowers could not qualify for favorable interest rates and thus, pay higher rates.The question raised in this discussion is whether the problems created by the “subprime meltdown” will trickle into the general economy. These problems are manifested in both asset quality and foreclosed properties. The answer to this is that asset quality (as measured by noncurrent loans) does not appear to be a problem in the banks occupying the Stateline region.
When one evaluates the financial statements of the community banks that serve the region, it is clear that loan asset quality has not diminished in the recent months. This analysis uses two measures of loan asset quality. The first measure is noncurrent loans as a percent of total loans (NCL/L). Noncurrent loans are those loans that are either more than 90 days delinquent or are nonperforming.
In Figure 1 (and the corresponding Table 1), it is clear that loan delinquencies are not rising. While they may be rising at the large money center banks (such as Citicorp or Bank of America), local community banks have been successful in avoiding the negative impact of the subprime market. Since most first mortgages are sold on the secondary market to large national and international investors (such as mutual funds and insurance companies), the local bank may hold some risk in their bond portfolio. However, this should be a diluted risk that benefits from diversification.
The second measure looks at foreclosed properties held as assets on the balance sheets of community banks. Figure 2 draws a similar picture regarding foreclosures. In Figure 2 (and Table 2) there is the appearance of some adverse impact on the asset quality of the financial institutions due to foreclosed real estate held on the books of the bank. In Jefferson County, the amount of assets tied up in foreclosed real estate has risen to 0.2 percent of assets from about 0.05 percent. This four-fold increase is interesting. However, it is critical to note that the run-up is entirely held on the books of one financial institution in Jefferson County. A similar pattern emerges in Lafayette County. As a result, it is important to recognize that, while the issue appears to be a reflection of the banking system, it actually is a problem in a few specific banks. This means that any credit crunch caused by the tightening of credit due to a cautiousness regarding bad loans is most likely to occur with the individual bank, not the whole population.
The story that evolves out of Figure 3 (Table 3) is more critical. It shows that there has been a dramatic rise in foreclosure filings within the five county region. This is especially notable in Walworth County, where in the first quarter of 2007 there were 124 filings, a rise of almost 50 percent over 2006. It was almost a doubling of the number of foreclosures filed in the first quarter of 2004. While the nature of underwriting and loan packaging should prevent a serious negative impact on the regions community banks, it could have a serious impact on the local real estate market.
If, as these researchers believe is the case, the foreclosures within the county are localized into a small number of neighborhoods, this disruption could cause serious harm to the fabric of the neighborhood. The first impact would be the increased supply of homes on the “for sale” market. As shown in an accompanying article in the Stateline Economic Report, home sales are depressed over the previous years. Adding additional homes into an already soft market creates the risk of depressing home prices (something that has yet to occur). This loss of real and perceived wealth may create a reduction in consumer confidence and lower consumer spending. This would then spill into the overall market as less demand for all products and a reduction in the growth of the gross domestic product.
A second impact of a localized problem would be to transform owner occupied neighborhoods into rental markets. While rental markets serve a strong and valuable service to the community, there is evidence that owner-occupied housing witnesses faster appreciation and is cared for in a more considerate fashion. Consider the impact that 190 foreclosures will have on Rock County (and note that this is a quarterly number). It is reasonable to expect that professional real estate investors would be a likely bidder on these properties. If this is the case, these properties may filter down into the rental market. Even if the bank purchases the home, it will be sold into an already depressed market with many sellers and limited buyers. In the case of Walworth County, where foreclosure filings have increased by almost 100 percent since the first quarter of 2004, this increase in “for sale” homes adds to a market where the number of homes selling is currently on the decline.
The third difficulty this foreclosure market creates is the dislocation of families and children from neighborhoods, schools and jobs. While this is a sociological problem, there are severe economic consequences to this disruption. As a result, government and financial institutions should give pause before determining that foreclosure is the best solution to a temporary financial difficulty.
The final issue that arises in the “subprime meltdown” is the restriction on the demand side of the equation. The subprime market introduced families and buyers into the market that were formerly prevented from participating. As it was noted in Stateline Economic Report #2 “According to the United States Census Bureau, homeownership rates in Wisconsin have risen from 66.7 percent of households in 1990 to 68.4 percent in 2000 to 72.9 percent in 2003. Apart from the simple growth in population, there has been a shift in the demand for owner-occupied housing.” Part of this increase can be explained by the emergence of the subprime market, which allowed additional families to participate in the process. In turn, part of the appreciation in real estate in recent years can be attributed to this increase in participation and demand.
If a credit tightening occurs, these numbers may begin to return toward their earlier levels. The impact of the reduced demand for owner-occupied housing will be lower price appreciation because the number of potential bidders has fallen. It is this transmission mechanism that will cause the actions of poor borrowers to affect the wealth of excellent borrowers.
The authors thank the editors of www.ForeclosureWI.com for their valuable assistance in collecting the foreclosure data.