The Effects of Foreclosure on Banks
When a bank forecloses on a home, the foreclosure has both direct and indirect effects on the bank. Foreclosure occurs when a borrower defaults on payments and the bank exercises its legal right to sell the home and use the proceeds to settle the debt. The ability of banks to raise funds through foreclosure sales depends on the overall state of the housing market.
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Foreclosure Expenses
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When a bank forecloses on a home it immediately incurs significant legal costs associated with the foreclosure proceedings. In some instances, banks have to hire contractors to refurbish homes before foreclosure sales because failure to do so inhibits the ability of the bank to sell the home for its true market value. Banks are liable for taxes and other expenses such as homeowner's association fees after a foreclosure occurs. Ideally, the eventual sale of the home should more than cover these costs but in some areas with high foreclosure rates, homes sell for below value and banks incur losses.
Loan Portfolio
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If a bank forecloses on a home, it loses the income derived from the mortgage interest payments. Banks use deposited funds to finance mortgages, and if a home owner defaults on payments, the bank must find other funds to pay the interest it owes the bank depositors whose money financed the loans. Banks deplete cash reserves to make interest payments and diminished cash reserves limit the ability of banks to write new loans.
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Home Prices
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When a foreclosure occurs, it does not directly impact the cost of houses in the surrounding area because appraisers cannot legally take the sales of distressed homes into account when assessing home values. However, prospective home buyers can use knowledge of recent foreclosures as a bargaining tool to drive down home prices. If home prices fall significantly, existing mortgages on other nearby homes may exceed the actual home's value, which means banks are at risk of further loss if those homes go into foreclosure.
Mortgage-Backed Securities
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Many banks buy mortgage-backed-securities from investment firms. These interest paying bonds are tied to bundles of mortgages written by other lenders. When foreclosures occur, interest payments are disrupted, and the value of the mortgage-backed bonds decreases. The loss of interest means banks have to use cash reserves to cover shortfalls, and the long-term loss of the bond's principal directly effects the balance sheets of banks. Lenders must make loans to generate profits but if the lenders are short of cash because of other bad loans then they are reluctant to make new loans, and the banking system grinds to a halt.
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