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July 06, 2010
The Ostrich Effect
I read an interesting blog last week regarding why banks and other investors who hold mortgage debt refuse to initiate foreclosure proceedings on their defaulted loans. Several theories were floated about as to why this seemingly contradictory practice would occur. In other words, why would a mortgage holder allow a borrower to live in a property long after the borrower stopped making payments? Who, besides the borrower, benefits from that scenario?

You can read the blog at for a comprehensive list of reasons the author provides. One theory I’ve developed over the past few months is what I call the “Ostrich Effect”. This phenomenon asserts that if a problem is simply ignored, it should, at some point in the future, take care of itself. Just like an ostrich can avoid falling victim to its predators by burying its head in the sand (well, at least the ostrich is convinced it can), these lenders attempt to postpone the inevitable losses they will incur if/when they complete the foreclosure action.

The Ostrich Effect is irrefutably problematic for mortgage holders that are public companies (that must answer to shareholders) or investors who have lent money to investment funds to purchase the loans. How long can a company hide its defaulted loans that are undoubtedly underwater until the lions (shareholders and investors) show up to survey the financial landscape? Commonly, lenders are only required to write down the value of their assets once the properties have gone through foreclosure and the current (and almost always much lower than the lender’s cost basis) value of the property is ascertained.

In the blog I reference here, one poster commented “Increased foreclosures would lead to forced acknowledgement that the value of homes in general is lower than currently assumed; accurately pricing the assets on banks’ books would lead to realization that most of the big banks are insolvent.” The writer goes on to say “Foreclosures will continue at the pace that allows banks to only recognize losses that their profits cover without leading to insolvency.”

To bolster my claim, consider this statistic, courtesy of LPS Applied Analytics: The average borrower in foreclosure has been delinquent for 438 days before actually being evicted, up from 251 days in January 2008. In Florida, the average property spends 518 days in foreclosure, second only to New York’s 561 days.

So…the borrowers benefit by living in their homes rent-free for up to two years (sometimes even longer) before the lenders get around to completing the foreclosure. At that point, lenders are forced to recognize their losses (even if the losses aren’t realized yet), and their management has to deal with unhappy shareholders and investors whose returns are negatively impacted by all the writedowns.

Quite a quandary, indeed. To all those lenders out there unwilling or unable to face the music on all your defaulted loans, I offer you this simple solution: Here’s a shovel, there’s some sand…get to work.

Make it a great week.


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