The disappearing distress of 2023 is an important mystery to solve. It will shed light on what to expect in the distressed market of 2024, which in turn has important implications on the broader retail housing market.

The first step in solving the puzzle of the disappearing distress is fairly straightforward: the monthly conversion rate of seriously delinquent mortgages to completed foreclosures. In the pre-pandemic era of 2015 to 2019, this monthly conversion rate averaged 1.96%, according to an Auction.com analysis of data from the Mortgage Bankers Association and Attom.

It’s helpful to put this metric in context. Given 1 million seriously delinquent mortgages, one could expect 19,600 completed foreclosure auctions per month and about 235,200 completed foreclosure auctions per year.

But the monthly conversion rate dropped dramatically in the final three quarters of 2020 and all of 2021, averaging 0.27% over these seven quarters. That’s not too surprising given the nationwide foreclosure moratorium on government-backed mortgages in place at that time. What’s more surprising is the post-moratorium conversion rate, which has averaged 0.71% since January 2022, although it has slowly inched higher over this period.

Why did the conversion rate decline? One would expect it to bounce back to its pre-moratorium average quite quickly, and possibly to rise above that average temporarily due to a backlog of delayed distress tied to the moratorium. That is, in fact, exactly what happened in the aftermath of the hurricane-induced foreclosure moratoriums of 2017.

But the post-pandemic moratorium rebound has been anemic at best, a result of at least two major changes in the distressed-market funnel. The first change is the massive increase in foreclosure prevention resources made available to mortgage borrowers and servicers during the pandemic that still continue in some form. On the loss-mitigation side, the most prominent resource that has gained widespread adoption is the zero-interest second mortgage that can be used to prevent payment shock when a delinquent borrower gets back on track.

The two main loss-mitigation mechanisms used to deliver this option are payment deferrals (for loans backed by Fannie Mae and Freddie Mac) and partial clams (for loans insured by the Federal Housing Administration). Both programs have been expanded to apply to non-COVID hardships. This change to the distressed-market funnel is less likely to have a permanent impact because it’s doing what loss mitigation has always been designed to do: give homeowners temporary relief without solving the underlying issue that’s causing distress.

A potentially more permanent change are sales that occur after the foreclosure process has started but before the property goes to foreclosure auction. An Auction.com analysis found more than 150,000 pre-foreclosure sales in 2021, up 38% from 2020 to reach the highest level since 2014. And because other types of distressed sales declined in 2021 due to the foreclosure moratorium, pre-foreclosure sales represented a record-high 64% of distressed sales for the year (as shown on the chart above).

This trend continued in 2022 after the moratorium ended. Pre-foreclosure sales once again accounted for 64% of all distressed sales for the year. And because pre-foreclosure sales involve a transfer of ownership from a distressed homeowner — drastically reducing the likelihood that the property will return to the foreclosure funnel in the near future — this could represent a more lasting change for the delinquency-to-foreclosure conversion rate. ●

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That’s according to a survey of more than 50 representatives from leading mortgage servicers and government agencies conducted this past June at the Auction.com Disposition Summit. Ninety-two percent of survey respondents expect their organization’s completed foreclosure volume to increase in 2023 compared to 2022.

What is driving these expected increases? Rebounding roll rates should push more delinquent mortgages into foreclosure status while nudging more active foreclosure inventory into foreclosure auctions.

Survey respondents, on average, expect a 6.4% monthly roll rate from serious delinquency to foreclosure start in the second half of 2023. Applied to the 483,000 seriously delinquent loans (at least 90 days overdue) reported by Black Knight as of May 2023, this would translate into about 30,000 foreclosure starts per month. From January through May, foreclosure starts averaged about 29,000 per month, according to Black Knight. (There were about 527,000 seriously delinquent loans in the first five months of the year.)

The estimated 6.4% roll rate would be an increase from the 5.5% average during the first five months of the year — and well above the average roll rate of 4.7% in 2022. For further comparison, the average roll rate during the pandemic-triggered foreclosure moratorium (April 2020 to December 2021) was 0.4%, while the average roll rate in 2019, prior to the pandemic, was 8.7%.

While the roll rate from serious delinquency to foreclosure start had already started to rebound in the first half of 2023, the roll rate from active foreclosure inventory to completed foreclosure auction remained close to its pandemic-era lows. This rate averaged 2.9% during the first five months of the year, down slightly from 3.4% in 2022 and only slightly above the 2.8% average monthly roll rate in 2021, when the nationwide foreclosure moratorium on government- backed mortgages was still in effect.

According to an Auction.com analysis of data from the Mortgage Bankers Association’s National Delinquency Survey, there were approximately 943,000 mortgages that were seriously delinquent or in foreclosure at the end of first-quarter 2023. That was only slightly higher than the 916,000 loans in these categories as of first-quarter 2019. But foreclosures accounted for only 24% of this bucket in Q1 2023, compared to 44% in Q4 2019.

Moving further down the funnel, 18,000 properties went through foreclosure auction in Q1 2023, representing 8% of the 227,000 in active foreclosure inventory. By comparison, there were nearly 48,000 completed foreclosure auctions in Q4 2019, or 12% of the 406,000 in active foreclosure inventory.

Survey respondents expect an average monthly inventory-to-auction roll rate of 6.6% for the second half of 2023. This would be up from an average roll rate of 2.9% during the first five months of the year and well above the average rate of 1.7% during the foreclosure moratorium. It would also be much higher than the rate of 4.6% in 2019.

If these expectations turn into reality, it could result in a significant uptick in completed foreclosure auctions during the second half of the year. Applied to the 229,000 properties in foreclosure inventory reported by Black Knight as of May 2023, this would translate into about 15,000 completed foreclosure auctions per month — two-and-a-half times higher than the 6,000 monthly average in 2022. ●

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These trends are evident in a March 2023 survey of nearly 450 Auction.com users from across the country. The vast majority of these buyers are local community developers who purchase fewer than 10 investment properties per year. Forty-two percent of the buyers surveyed described their local market as “overvalued with a correction possible.”

That was the most common answer among four possible market descriptions in the survey, but it was down from the 55% share of buyers who described their market that way in a 2022 Auction.com survey. Meanwhile, the percentage of buyers who described their local housing market as having “soft fundamentals with select opportunities” more than doubled, rising from only 11% in the 2022 survey to 24% this year.

Broken down by U.S. region, the survey data paints a more nuanced picture of where acquisition opportunities are beginning to emerge as the result of a home price correction already in progress in some overvalued markets. The West region had the highest percentage of buyers who characterized their local market as overvalued (51%), but that was down from the 63% share in the 2022 survey. A home price correction is already in full swing in some Western markets, particularly in coastal California.

Many neighborhood developers in the West expect this correction to continue in 2023. Forty-three percent of West region respondents said they expect flat or declining home prices in their local markets this year, the highest among any region and up from only 7% who expected flat or negative price growth in 2022. Nationwide, nearly one-third of local developers who bought via Auction.com were expecting flat or declining home prices in their local market in 2023. That was nearly double the 17% share from the prior year’s survey.

Continued home price declines in 2023 are likely to open up more purchase opportunities for local investors, which may explain why more respondents are describing their markets as having “select opportunities.” The West, which had the highest share of buyers who forecast price declines, also saw the largest increase in buyers who described their local market as having select opportunities.

Buyers had the most aggressive acquisition expectations for 2023 in the two regions with the highest expectations for price declines in 2023: the West and the Southeast. In both of these regions, 90% of buyers said they expect their investment property purchases to increase or remain the same in 2023, tied for the highest rate among the four regions.

The typical exit strategy for these distressed property acquisitions is also changing as a price correction becomes the expected reality for an increasing number of local community developers. Half of all buyers surveyed in 2023 said their primary exit strategy is to renovate and resell homes to owner-occupants, down from 61% in 2022. Meanwhile, 39% of auction buyers said that renovating and holding properties as rentals was their primary business strategy, up from 32% last year.

The percentage of buyers who report buy-and-hold as their primary strategy was highest in the Southeast (44%) and West (39%). These are also the two regions with the highest shares of buyers who anticipate home price declines in 2023. ●

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By the end of the year, national home prices declined by 9% from their peak in May 2022, with a deeper drop in some markets. Foreclosure-auction sellers who made proactive pricing adjustments experienced an immediate lift in sales performance, with the sales rates jumping by about 10 percentage points from October to December, according to Auction.com data. Sales price execution relative to estimated market value slipped by about 4 percentage points for these sellers, but that was roughly on par with the 3-point drop for sellers who did not proactively adjust their pricing, and the latter group did not benefit from a 10-point jump in the sales rate.

Partly as a response to rapidly weakening demand from distressed- property buyers, the average credit bid at foreclosure auction fell to 70% of the estimated as-is property value in Q4 2022. This 70% credit-bid-to-value ratio was down 3 percentage points from the previous quarter and down from 75% one year earlier, marking the lowest level on record for Auction.com data that goes back to first-quarter 2015.

The credit bid is similar to a traditional-auction reserve price and represents the lowest amount the seller is willing or able to accept in order to sell the property to a third-party buyer. The credit bid is capped at the maximum amount owed to the foreclosing entity, but that entity may choose to lower the credit bid if they are willing to accept less than what is owed. The as-is value represents the estimated value of the home in its current condition, based on an exterior evaluation of the home. An interior inspection is generally not possible prior to the foreclosure auction.

Credit-bid-to-value pricing at foreclosure auctions had previously jumped to a new record high of 83% in Q4 2020, shortly before the peak of the pandemic-triggered retail-market housing boom. Annualized price appreciation for existing home sales topped out at 24% in May 2021, according to Attom Data Solutions. This figure was the highest on record for data going back to 1997.

Similar (albeit slightly lagging) trends show up in Auction.com data for real estate-owned (REO) property auctions. At these auctions for bank-owned homes, the average reserve-to-appraised-value ratio dropped to 99.7% in Q4 2022, down from a post-pandemic peak of 117.7% in Q4 2021. Between 2015 and 2019, however, this ratio averaged 81.6%.

Following the lead of sellers at foreclosure auctions, sellers at REO auctions began to lower their reserve prices and even accepted more bids below this level. In turn, this will eventually help to return more previously distressed properties to the retail market. It also will help lenders avoid the risk associated with holding properties, a risk that is elevated in a market with declining values.

Higher-volume sellers, including those who sell properties at foreclosure and REO auctions, are often the first to respond to a downshift in the housing market. This is because of their ongoing and repeated sales activity, which provides them with better intelligence on real-time market conditions. It’s also due to risk aversion to REO holdings in a cooling market, making them more willing to downwardly adjust their pricing based on data rather than gut instinct.

Retail sellers typically follow the lead of institutional sellers in a slowing market. This bodes well for retail home sales volume in the 2023 spring and summer purchase seasons. As more distressed-property sellers respond to the downshifting market and lower their pricing, more pressure will be put on retail sellers to do the same. This will result in more well-priced homes listed for sale during this year’s prime home purchase periods. ●

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Black Knight’s analysis, included in its August 2021 Mortgage Monitor report, looked at the rate of debtholders who became delinquent on their mortgage payments or what is called roll rates. The analysis looked at the loans that went from seriously delinquent status to foreclosure starts, as well as the roll rates from foreclosure starts to involuntary liquidations of a home — typically via short sale, foreclosure sale or deed in lieu of foreclosure.

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More than 900,000 mortgages in forbearance are scheduled to reach the end of their maximum 18-month term before the end of 2021, according to estimates from Black Knight. The foreclosure moratorium, meanwhile, ended this past July and has been replaced with a revised mortgage servicing rule from the Consumer Financial Protection Bureau (CFPB). This rule, which was scheduled to take effect Aug. 31 and expires at the end of this year, puts in place temporary procedural safeguards that will effectively postpone many foreclosure proceedings until at least 2022. 

The CFPB’s revised rule is not a blanket moratorium. It includes some important exceptions, including mortgages that were seriously delinquent prior to the pandemic; mortgages secured by abandoned properties; mortgages secured by investment properties or second homes; and cases where the borrower is unresponsive to servicer-outreach efforts. Given these exceptions, the CFPB rule provides a framework for servicers to gradually release the foreclosure backlog that has built up over the past 18 months. 

For many in the mortgage and housing markets, this steadily rising tide of foreclosure activity will be preferrable to the tsunami that could have occurred if the moratorium had abruptly ended without the bureau’s rule in place. The exceptions in the CFPB rule also serve as a template for sizing and timing the steady rise of foreclosure activity over the next several months and years. 

The first tide of foreclosure activity will come from the backlog of mortgages that were classified as seriously delinquent (90 or more days past due) prior to the pandemic. At the end of this past March, there were about 600,000 mortgages in this category, of which about 400,000 were protected from foreclosure by active forbearance or loss mitigation, according to Black Knight. The remaining 200,000 loans represented the first wave of pent-up distress likely to start or restart the foreclosure process once the moratoriums expired in July.

Another 325,000 seriously delinquent mortgages at this time were in active loss mitigation or were post-pandemic delinquencies not in forbearance, Black Knight reported. These will drive the second wave of pent-up foreclosures, which is likely to arrive in the first half of 2022. Although the second wave is potentially larger than the first, it’s likely that a smaller share of the second wave will actually make it to shore (i.e., start the foreclosure process) given the foreclosure-prevention lifeline represented by the loss-mitigation process.

This pattern is repeated in the third wave of pent-up foreclosure activity to roll in after the lifting of moratoriums. This wave will be driven by about 900,000 mortgages that exit forbearance in the second half of 2021. While some of these loans will go directly back into default with no loss mitigation, the vast majority are likely to enter the loss-mitigation waterfall. They will eventually migrate into a long-term foreclosure-prevention solution (such as loan modification) or will fail loss mitigation and start the foreclosure process.

Together, these three waves add up to nearly 1.5 million potential foreclosure starts flowing from the backlog of distress that was dammed up over the past 18 months by foreclosure moratoriums and forbearance programs. Assuming that home-price appreciation remains positive, however, a diminishing share of this pent-up distress will start the foreclosure process as the successive waves roll in, and an even smaller share will complete the foreclosure process. 

Foreclosure filings reached a historic low point of about 65,000 during the first six months of this year, according to Attom Data Solutions. This was down 61% compared to the first half of 2020.

If 25% of these 1.5 million potential foreclosure starts actually complete the process — which is the average ratio of completed foreclosures to seriously delinquent mortgages over the past decade — it would result in an additional 375,000 foreclosures. These homes would be added to the “business as usual” foreclosures that occur even in a healthy housing market (about 250,000 per year based on 2019 numbers) and would likely be distributed over the next three to four years. ●

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