With State AGs and the Federal Government pushing to further extend the mortgage foreclosure process for late borrowers, one might assume that these government officials believe that further delay has no costs, and is at most a transfer from the lender to the borrower. Judging from the results of a recent working paper, by economists Shuang Zhu and Kelley Pace at Louisiana State, they would be wrong. Further foreclosure delays impose significant costs, not just on the economy and lenders, but also on other borrowers.

Zhu and Pace start with the observation: “The longer the period between first missing payment and foreclosure sale, the more valuable the default option becomes. The borrower preserves the option to either keep defaulting or cure the default in the future. Since this option value grows with the foreclosure period, longer expected foreclosure periods increase the propensity to default on mortgage loans.”

As state and local law govern the foreclosure process, the authors examine differences across areas to see if such differences in delay impact the rate of foreclosures. Interestingly enough, they do find that the longer are delays, the greater is the foreclosure rate.

Given that lenders understand that delays are costly, this is likely to show up in the price of the mortgage. Zhu and Pace find that with each additional six month delay in foreclosure, mortgage rates increase by 10 basis points. As delays are running an extra year or so now, mortgage rates are higher by about 20 basis points due to government efforts to extend the foreclosure process. This might seem small, but its also the amount many claimed Fannie Mae and Freddie Mac lowered rates by. Clearly the costs of delaying foreclosures are not borne just by the banks, but by anyone hoping to get a mortgage. For those who would respond “but mortgages are cheap” — they are only cheap due to cheap money. The spread of mortgage rates over Treasuries is actually about 20 basis points above its historical norm.

Also of interest is that Zhu and Pace, using S&P/Case-Shiller house price futures, find that in cities where borrowers have lower future home price expectations, they default at a greater rate. I believe this lends some support to the notion that we should stop trying to hold up prices and let them hit a point where up is the only direction. The paper is full of interesting findings, and also includes a useful literature review of the default literature.