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Not long ago, economists and housing market experts worried about there being too many foreclosures. Now they’re worried foreclosures aren’t proceeding fast enough, thanks to the robo-signing fiasco that prompted a moratorium on foreclosure proceedings at many major banks.

If you’re up to date on your mortgage payments and just watching from the sidelines, the foreclosure mess may look like something that only matters to other people. True, a lot of foreclosed properties dumped on the market at fire sale prices can push down home prices. But housing markets are localized, and high foreclosure rates are concentrated in some previously inflated markets, so why worry about foreclosures if your neighborhood is doing OK?

Well, unfortunately, one of the byproducts of the foreclosure mess is the nationwide damage it may create to the perception that homes make good collateral. That perception could cause lenders to hang on to the tight lending policies they adopted in the recession, and perhaps keep interest rates higher than they’d be otherwise.

An analysis by Jack Guttentag, emeritus professor of finance at the University of Pennsylvania’s Wharton business school, starts with a look at just how beneficial collateral can be.

Guttentag says he recently shopped for two loans. On the first, a personal loan with no collateral, lenders offered up to $25,000 for three years at rates ranging from 8% to 17%.  But for a mortgage application that used his home as collateral he was offered up to $400,000 at 4% for 30 years. It’s a dramatic difference considering that he reported the same income and credit score to qualify for each type of loan.

Obviously, collateral is valuable because it gives the lender something that can be sold to cover losses if the borrower stops making payments. A key factor is the ease with which the asset could be converted to cash. For lenders, the ideal collateral would be something like gold or short-term government bonds that could be sold with a few clicks of a mouse. A home is not quite as good because of the time and expense involved in wrangling it from the borrower and selling it.
For mortgage lenders, conditions have definitely become worse, says Guttentag, citing California and Florida, two of the hardest hit states. In 2006, it took about eight months after a borrower default for the lender to complete a foreclosure in California, and about 10 months in Florida. Now it takes 18 months in California and 22 in Florida.

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Once the foreclosure is complete, it can take another seven to 12 months for the lender to sell the property, and even then the price may not be enough to cover the borrower’s debt, as home prices have declined across the country. Widespread problems with foreclosure paperwork are now making the foreclosure process take even longer.

“In short, the collateral value of houses has declined as a result of the financial crisis, and the costs associated with fixing deficient foreclosure procedures will reduce it further,” Guttentag writes.

“A wholesale moratorium on foreclosures would make matters worse, perhaps much worse. This is bad news for borrowers. Looking ahead, mortgage loans will be viewed by private investors as riskier, and they will look for higher rates and more restrictive terms to compensate.”

Only a few years ago borrowers could get loans with nothing down. But now, most lenders require down payments of at least 20%, which can be a tough hurdle for many to overcome. Homeowners are less likely to default if they have a lot of money tied up in the property, and lower loan-to-value ratios make it easier for lenders to sell properties at a price that will cover the outstanding debt.

As the housing market improves, lenders would be expected to ease down payment requirements to compete for business, but that may not happen for some time if lenders worry that homes aren’t the solid collateral they used to be.

It also may continue to be tough to get a mortgage if you have less than sterling credit. And although foreclosed properties may look like bargains, in a neighborhood that has suffered lots of foreclosures, it may be hard to get a loan even if your credit is excellent.

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