Foreclosure Regimes

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Real estate lenders underwrite risks in a variety of ad hoc ways. One is to impose different standards on different property types. The typical owner-occupied single-family dwelling may rightly be seen as a very different risk than a loan on raw land. One common metric for managing risk in these types of investments is the loan-to-value ratio.


Default triggers a legal action for foreclosure. In the United States, lender remedies are governed by state law. Thus, the time necessary to complete a foreclosure varies by jurisdiction. The lender's decision to grant a loan must include the conditional probability of default and how the loan-to-value ratio changes during the default procedure. Borrowers default when they perceive no economic benefit remains. If value is falling prior and during foreclosure, together with accumulating unpaid interest, eventually the loan balance may exceed value, leaving the lender with a loss.

Three conditions are illustrated. The first assumes a 12% fixed default interest rate. Default interest rates are usually an additional amount above the loan rate. Use the second pane to set different default interest rates. Finally, the third pane displays the special case of land. Typically, in economic downturns, land suffers first and most. Since the potential decline in value for land is more precipitous the initial loan-to-value ratios are lower for this segment.


Contributed by: Roger J. Brown (November 2019)
Open content licensed under CC BY-NC-SA


Some states provide for out-of-court remedies, such as the trust deed system, where an independent trustee is empowered to conduct a public sale of property to resolve a default. In other states, the foreclosed borrower has a redemption period after default in which he can reclaim the property. The analysis here shows how long the lender must allow for these legal remedies to run their course. In a climate of falling property values, the lender's exposure to loss grows as time passes and the loan balance rises.

All three tabs measure the time elapsing (along the axis) prior to the loan balance exceeding the property value, during which time the foreclosure must be resolved either by cure or sale to a third party if the lender is to avoid a loss. In the "12% default interest" tab, the lender rate is fixed and value changes at a monotonic decline at the annual compounding rate where growth is a negative value) set by the slider. In the "vary default interest" tab, the user may change the default interest rate, which exacerbates the problem, as interest rates rise during times of falling value (again using ). For "land," because of its greater sensitivity to economic downturns, the fall in value is exponential and governed by a decay rate set by the user as "severity of decline in value," , where is a whole number from 1 to 10 inversely related to the severity of decline.


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