One of the often overlooked consequences of the current mortgage crisis and the accompanying rash of foreclosures across the country is its impact on the collateral value of houses.
Additionally, we need to consider how that will affect borrowers in the future.
Before we go into these impacts, let's take a quick look at what collateral actually is.
Collateral is a provision within a loan that helps to increase the likelihood that the borrowed amount will be paid back in full.
If at any time the borrower defaults on the terms of the loan, the stated collateral may be seized by the lender in order to repay the debt.
The benefit to borrowers in general is that loans become easier to obtain with better terms and rates.
This is a fairly effective strategy in cases where the value of the collateral is relatively stable or increasing, when the property can be seized expeditiously, and when the collateral property can be easily sold.
However, in the case of home loans none of these factors have hold true in recent years.
Value of the Collateral Property Unless you've been hiding under a rock, you know that the value of homes has been plummeting across the country.
While historically lenders have been able to view homes as a relatively safe investment due to their somewhat predictable ascent in value, this price insecurity is making it more difficult for lenders to assess the value of the collateral backing their loan.
The end result is that the value is significantly lessened from the bank's point of view, which increases their risk in making a loan.
Ability of Lender to Repossess Collateral Another factor impacting the value of homes as collateral is the ability of lenders to repossess them.
Because homes are not actually in the possession of the banks, and are usually occupied by either the borrowers or others to whom the borrowers have rented the property, the bank must initiate a foreclosure process in order to repossess the collateral.
The time required for completion of a foreclosure has increased substantially during the mortgage crisis, from around an average of 9 months in 2006, to around 20 months this year in 2010.
While this increase in time to foreclosure might buy borrowers a bit more time to work out a solution with the bank, it does have a longer-term implication for borrowers down the road.
Namely, the fact that foreclosure is taking longer increases the costs for banks, and the risks associated with these costs are bound to be passed on to borrowers in the future.
Lack of Home Marketability The third factor decreasing the value of houses as collateral is their current lack of marketability.
Once a foreclosure has been completed, it is likely that the bank will still have to hold onto the property for another 7 to 12 months before it will be able to sell it.
This again substantially increases costs for the bank, and the risks associated with making a loan.
Conclusion What is fairly certain is that the decreased reliability of houses as mortgage collateral is going to cause investors on the banking side to attribute greater risk to mortgage loans.
This will be felt by borrowers in the form of higher interest rates and decreased lending availability.
Hopefully, these factors may help to encourage banks to work with distressed borrowers in getting their mortgages back on track and avoid foreclosure altogether.
Of course, whether or not this will actually happen remains to be seen.