Foreclosures + Strapped Consumers = Double Counting?

Friday, November 6, 2009

Houses reflection-edit 2We know the dismal foreclosure picture: empty houses, bank losses, and displaced households, struggling to make ends meet. But, wait. Back up to those bank losses. They are the result of mortgage balances not being fully paid by the foreclosed house sales. But that only looks at the bank’s balance sheet. What about the displaced household’s finances? The bank’s loss is their gain. No longer does the homeowner have that mortgage albatross on an underwater house. And, to the extent their new housing expenses drop, their budget improves.

The Wall Street Journal had a recent article pointing out foreclosure’s silver lining: “Household Debt Can Hasten Recovery, When It Goes Unpaid” (October 27, page A-23). Through foreclosure, the house is lost, but so is the burdensome mortgage. Thus, the consumer’s balance sheet and budget suddenly improve. The proportion of income going to debt payments and rent has been dropping significantly and is projected to continue doing so.

And what about households’ other albatross, consumer debt? The same accounting applies to bankruptcies, which are also growing (and about 2/3 are Chapter 7, in which debts are eliminated). Bank of America’s $1 billion credit card write-off last quarter is a $1 billion drop in consumers’ debt owed.

Does this mean consumers whose liabilities are wiped out will ramp up spending? Not necessarily. Experts believe many will be careful not to get into a debt bind again, meaning they will control their expenses. But they will be in better financial shape, with a better foundation for the future. The speed and size of bank write-offs means this household financial improvement is happening quickly and meaningfully.

Another surprise – households going through foreclosure and/or bankruptcy are not viewed as deadbeats for years, with no access to mortgages, consumer loans and credit cards. Rather, their credit scores can be acceptable, even rising after their debt is expunged. Many websites explain this dynamic – just search for “credit score after foreclosure” or “credit score after bankruptcy.”

So, consumers are not as beat down by debt as we’ve thought. Foreclosure and bankruptcy laws are helping households get a “fresh start” (*) and, in so doing, shoring up their finances for future growth.

(*) “Fresh start” is a key consideration in bankruptcy law. Here is the Supreme Court’s 1934 ruling supporting that principle: “[Chapter 7] gives to the honest but unfortunate debtor … a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt. (Local Loan Co. V. Hunt, 292 U.S. 234, 244.)

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November 2009