The Effect of State Foreclosure Laws on Loan Losses: Evidence from the Mortgage Insurance Industry
SEVERAL RESEARCH EFFORTS have focused on the effect of state laws on various aspects of credit markets. James (1984) found that the managerial efficiency of banks was adversely affected by state laws which restrict corporate acquisition of bank stock. Barth, Cordes, and Yezer (1986) found that state laws which restrict the exercise of credit remedies for personal loans in delinquency or default result in the imposition of net costs on all borrowers. Meador (1982) and Jaffee (1985) analyzed the effect of state foreclosure laws on mortgage rates. They found that contract rates were generally higher in states where the law extended the length and expense of the foreclosure process. Alston (1984) revealed that the farm foreclosure moratorium legislation during the 1930s led to fewer farm loans and higher rates in states which enacted such legislation. Clauretie (1987) has indicated that lenders' choice of either seeking a foreclosure or employing a nonforeclosure alternative is affected by state laws. He demonstrated that foreclosure rates on conventional loans are higher (lower) in states that facilitate (hinder) the foreclosure process.
An important implication of his findings is that foreclosure rates cannot be taken as a measure of risk per se. High rates may simply reflect the low cost of foreclosing in those states with facilitating laws. If this is so, dollar losses could actually be less in those states. To date, no research has focused on the losses incurred by lenders (or mortgage insurers) due to differences in laws that regulate the foreclosure process. That will be one purpose of this research.
A related topic of inquiry concerns the relationship between foreclosure laws and incentive conflicts in the mortgage insurance market. There are major differences between private (PMI) and government (principally, FHA) mortgage insurance practices. These differences and the legal climate within the various jurisdictions combine to produce an incentive conflict between lenders and insurers. It will be shown that state foreclosure laws result in a differential risk according to the type of mortgage insurance for which the lenders contract. The evidence on the effect of state foreclosure laws on loan losses and on the incentive conflict will be taken from the claim experience of all private mortgage insurance companies and a large sample of claims made to the Federal Housing Administration.
In the following section we describe the basic differences in jurisdictional foreclosure laws and how they affect risk in mortgage lending. We also outline the nature of private and government mortgage insurance and indicate how differences here create an incentive conflict which results in a differential shift in risk. In the second section we propose a model to test the effect of foreclosure laws and the incentive conflict on risk. The empirical results follow in the third section. A final section offers a conclusion.
1. FORECLOSURE LAWS AND INCENTIVE CONFLICTS
Cost of the Foreclosure Process
To appreciate the effect of foreclosure laws on the cost of foreclosing and liquidating properties one need only review the various cost elements involved. They can be divided into three categories: transaction costs, property costs, and opportunity costs. Transaction costs include those that result from the foreclosure process or the liquidation of the property and include attorneys' fees, trustees' fees, sheriff's cost of sale, brokers' commissions, revenue stamps, and title charges. Property costs include property taxes, hazard insurance, utilities, and repairs and maintenance. Opportunity costs include the interest foregone on the investment value of the property. These three costs will be larger when the size of the loan and the length of the foreclosure and liquidation process are greater. (1) A foreclosure process which requires the greater use of the court system and extends the time period for liquidation of the property will impose larger property and opportunity costs on the lender or the lender's insurer. Such laws are described as follows.
State Foreclosure Laws
State foreclosure laws differ in three major and many minor respects. In this paper we concentrate on the major differences. We believe that modeling the many minor differences would not produce sufficiently different results to warrant the complications involved. (2) The first major difference is between a judicial (court action) and nonjudicial (power-of-sale) procedure. With the judicial procedure the lender must proceed through the court which acts on a complaint, issues a decree, and stipulates what notices should be provided. Where foreclosure laws can proceed by power-of-sale, the liquidation of the property often occurs quickly through a trustee with little legal expense. (3) In these states a deed-of-trust rather than a mortgage is the instrument which frequently secures the property.
A second major difference lies in the provision for a statutory right of redemption. This is a period (generally …