Recovering from foreclosure: Prime vs. subprime borrowers and strategic defaults

Even though a foreclosure remains on an individual's credit history for seven years, the credit score can recover in as little as two years, but there’s a hitch. Given how much credit is granted by instantaneous electronic access to credit bureau credit scores, this strikes me as a remarkable result. According to Fair Isaac, if a borrower keeps all of their other credit obligations in good standing, their FICO score can begin to rebound in as little as two years. The trick is to keep that single negative item — the foreclosure — "isolated." However, economic research suggests that most borrowers who experience a foreclosure don't manage to do that. According to Kenneth P. Brevoort, senior economist at the Federal Reserve Board, and Cheryl R. Cooper, research associate at the Urban Institute, foreclosure is accompanied by significant credit score declines, and credit scores remain depressed even after the information on the foreclosure is removed from the credit record. They presented their results in a paper "Foreclosure's Wake: The Credit Experiences of Individuals Following Foreclosure," delivered to last month’s symposium on Mortgages and the Future of Housing Finance sponsored by the Federal Deposit Insurance Corp. and the Federal Reserve System. The research incorporated credit records from one of the three national credit bureaus, drawn at quarter’s end from the first quarter of 1999 through the first quarter 2010, for more than 11.7 million anonymous individuals (an identifying number allowed them to track individuals anonymously over time). From those, they identified approximate 371,000 individuals that appeared to have a new foreclosure. (They also identified 117,000 who were 120 days past due at some point, but did not enter foreclosure.) The authors cited previous research that simulated credit score calculations under the assumption of a foreclosure, but no changes in other credit obligations. Under those conditions, a hypothetical borrower with a 680 pre-delinquency FICO score might see an 85-point decline; a borrower with a pre-delinquency FICO of 780 might see a decline of 160 points. Brevoort and Cooper's research indicates that foreclosed borrowers experience much sharper declines in the credit scores calculated by their source: 170 points for a borrower with a 680 pre-foreclosure score and closer to 200 points for a borrower with a 780 pre-foreclosure score. The difference reflects changes in other debt service (credit card, auto loans, etc.). When they examined performance on other credit obligations, they found that delinquency rates in credit cards and auto loans increased substantially around the foreclosure period, peaked shortly thereafter and remained elevated for years thereafter. This pattern had a relatively stronger impact on prime borrowers (they used 660 as the lower boundary for prime). Once foreclosed on, prime borrower scores recovered to previous levels much more slowly than those of subprime borrowers. After two years, only 10% of prime borrowers returned their credit scores to pre-delinquency levels. After about seven years, the share of fully recovered borrowers was around 40%. By contrast, more than 60% of subprime borrowers recovered their scores to pre-default levels after two years; after eight years, the recovery rate was about 94%. In other words, prime borrowers credit behavior undergoes a clear change with the foreclosure. Brevoort and Cooper consider three explanations. One, foreclosure alters a borrower's financial circumstances in a way that makes delinquency more likely (credit is harder to get and more expensive, wealth or a wealth-building asset has been lost, etc.). Two, a trigger event such as divorce, illness or loss of income, has lingering effects on a borrower's ability to service debt. Third, the foreclosure may change borrowers' perceptions of creditworthiness, removing the stigma of delinquency and foreclosure, or having a low credit score may reduce the incentive to make on-time payments. Each of these explanations fits the sort of anecdotal, "human interest" tales of foreclosed borrowers that abound in the mainstream media. What the authors could not accomplish, with the credit bureau data they had, was to assess the likelihood that foreclosures in their sample were strategic defaults. However, they seem to have this inquiry in mind for future research as they note, "we can identify those areas where house prices have fallen most substantially. One might expect these areas to have a larger percentage of strategic defaulters than areas with less house price depreciation. If borrowers in these areas appear to have better post-foreclosure credit experience, then one might attribute some of this difference to the presence of strategic default." Can we also hope that future credit scoring models adjust scores downward for presumed strategic defaults? Linda Lowell writes a regular column, called Kitchen Sink, for HousingWire magazine. Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.