Bankers’ Circle of Life: principal reduction programs and unintended consequences
The Bankers Circle Of Life – principal reduction programs and unintended consequences.
Banks have had it good for the past couple of years. They’ve feasted on taxpayer subsidized capital, allowed accounting tricks to book phantom profits, and transferred privately created risk to the public’s balance sheet with nary a whisper of protest. Many responsible home owners continue to enriched said same bankers by paying mortgages that can never be refinanced into today’s lower rates. By owing more than the present value of their property, many home owners are trapped in a cycle that often ends in financial ruin.
The final insult to those who chose to live up to their promise to repay instead of living large through leverage will soon be here. How do I know this to be true? Since Irvine lives in the shadow of the House of Mouse, I thought it best to re-tell a family favorite to help illustrate how we got here, and what our inescapable future might look like.
In 2003 homeowners from far and wide came to see what special thing NAr-Fiki was revealing to the people of the USALands. Holding for all to see as an example of our bright future was Home Ownership, the offspring of King Conforming.
As Home Ownership grew older, King Conforming took him up to the highest point of the land – Peak Equity – and showed him a bountiful future. “Someday you’ll be a part of the Circle of Life. You’ll buy a home, pay off the loan, have plenty of equity to share with your children, and eventually see them become a home owner just like you.” That’s how it’s supposed to work out.
Unfortunately things began to go the wrong way in the USALands. Bankers ran out of loan programs that allowed greater fools to purchase homes at ever inflated prices. People began to panic. A mad rush to the exit began.
Home prices fell, crushing King Conforming. The only Big Cat left alive after the stampede was Home Ownership’s mean old Uncle “Sam” and the banker cartel.
During the Great Recession, Uncle Sam and his minions pushed Home Ownership out of the USALands. Jobs were few and far between. Prices were tunneling their way to the center of the earth. Only a few places seemed hospitable to relocate to. Eventually Home Ownership found the OC Oasis, a land flowing with milk an honey. There he made a few friends – the chatty Rodent and a well fed Pig. Home Ownership marveled at the lifestyles Rodent and Pig had – swimming pools with waterfalls, eating out more than in every night. How could they pay for their life of luxury? “Home Equity Ponzia” said Rodent. “It’s a wonderful thing”. Home Equity Ponzia, ain’t no crying shame”. “It means “No Worries” exclaimed Pig. Home Ownership was a little unsure of what all this meant and so didn’t dive in to debt along with his new neighbors.
As time went on life in the OC Oasis wasn’t going as planned. He wasn’t fully employed, things were getting a bit tight financially. In a vision one night King Conforming appeared telling Home Ownership that since he paid his house loan on time, certainly there were programs available that might make things easier, but they could only be obtained by going back to the land that Uncle Sam ruled. Even old NAr-Fiki came by, reminding Home Ownership that strategic default was a shameful, bad thing.
In the USALands, things were now worse than ever. Uncle Sam tried every trick in the book to get home prices back on track, but nothing was working. The remaining residents faced either unfit loan modifications or a lifetime of serfdom.
Home Ownership asked Uncle Sam to force his minions to let up on his loan terms, but to no avail. “Change?” asked Uncle Sam… “What is this hopey change you speak of? My banker cartel can’t profit from changing your loan terms so why would we do it?” Home Owner tried down to the last ounce of his strength and legal capacity to wrest control of his financial future from the bankers clutches but alas, it wasn’t to be.
Home Ownership was surprised to see his friends Rodent and Pig sitting next to Uncle Sam. ” Whatever remains after my bankers are done with you”, sneered Uncle Sam, “will be given to these two”. “Hey”, Rodent and Pig sang in unison, “We’ve got to maintain our lifestyle somehow. HomeEquity Ponzia!” Uncle Sam’s last words to the cornered Home Owner were chilling – “That’s how the Circle of Life really is, baby!”
And so the bankers devoured Home Ownership. The End.
Hey, I didn’t say the story would had a happy ending. This isn’t some friggin’ fairy tale.
Principal reduction plans are coming to USALands. Uncle Sam and his banker minions have several programs in place to get this started.
We’ll focus in this post on what may become the biggest, baddest one of all, but first:
The Why Question.
Why are bankers going to reduce principal? What benefit might there be for them? The answer to this question is fundamental in understanding the reason for these programs. Like any complex story, it’s best told when the details are simplified. The following is a close approximation of why PA loans will start in earnest, but not a scenario that fits all circumstances. Also, we’re going to use a few assumed names along the way for copyright avoidance illustration purposes.
In 2008 Bank of Albania (BA) was given incentives by the Government to absorb the assets of the troubled mortgage lender Capital Wagon (CW), one of many marriages of convenience during those days. Venture capitalists also began to purchase from the FDIC mortgage debt from other failed banks over the past few years. The companies essentially paid a net price of .20 cents on the dollar or less for these troubled mortgage assets. Some assets turned in to REO’s, some loans were modified to keep the regulators and Congress at bay, but a vast number of these loans are simply not performing, threatening to swamp the survivor institutions balance sheets.
HUD created several programs to help facilitate mortgage relief for income distressed home owners, but it is the FHA Short Refinance / Negative Equity program that will be used to cycle the remaining private non-performing loans into taxpayer guaranteed debt.
Aren’t they all bad banks?
Banks like BA will create a “bad bank” (BBA) – a place to dump off load their CW legacy assets at perhaps .40 cents on the dollar. That’s a nice profitable return (since their cost basis was .20 COTD) that BA conceivably could use to declare itself a “Well Capitalized” bank again.
BBA will now contact the home owners and offer them an FHA Short Pay refinance. Imagine a home owner getting a call from their loan servicer that goes something like this:
BBA – Hi, is this Mr. Refi Rodent?
RR – Yes it is.
BBA – I see you owe us $500,000 on a Stated Income 5/1 ARM.
RR – You mean the loan I’ve not made the $2,700 payment on for the last two years, The one with a rate of 3.2%?
BBA – Certainly! Here’s what I’d like to offer you. We see that home values in your area are now at $350,000. What if we cut your principal balance by $175,000 down to $325,000 and give you a 6.0% 30 year fixed loan. The payment would be $2,260. You owe less, your payment is reduced by $440, and all we ask is that you re-start to pay your loan for the next 60 days while we process this principal reduction. Deal?
RR – Frak YAH!
So in a few quick months BBA has turned a non-performing, un-sellable $500,000 loan (that cost them $200,000 when “purchased” from BA) into a shiny new easily re-sellable recourse FHA loan at $325,000 which you and I now are on the hook for as a taxpayer. My guess then is that BBA will in turn sell the loan back to BA at .80 cents on the dollar ($260,000) which makes the “Bad Bank” look like a pretty savvy operator. BA now has a 6.0% rate loan on their books which cost them originally around $100,000. The Bankers Circle of Life!
Remember this important factoid: The banks paid the market value of these loans or $100,000. The borrower is paying on the contractual value, or $500,000. When an FHA Short Pay refinance is transacted, the home owner is not getting a reduction in principal equal to the value of the loan, according to the bank’s valuation of the asset. The home owner is actually increasing the amount of their debt from the $100,000 assumed value to $325,000 present value based on current home prices. What happens tomorrow if the value of homes drops by another 20%? That’s the FHA Short Refinance borrowers Circle of Life. Their best course may be to again stop paying their loan. Rescue came to them once before. Whose to say it won’t happen again?
Some loan service companies offering these negative equity refinances will add a 5 year clawback provision. If there is a principal reduction of $100,000 and you sell at a higher price than current value, the home owner will have to give up the gain. After 5 years pass the feature sunsets. I’d be happy to wait 60 months before pulling the rip cord and bailing out if it meant I could sell for a gain, wouldn’t you?
The borrowers who will have these offers made to them are those who took out Alternative Financing (ALT-A) or other now toxic portfolio loans, not traditional FNMA Agency 30 fixed rates. The Government created the Home Affordable Refinance Program (HARP) for those mortgages. These loans simply had the rate and not the principal balances reduced. Loan to Values under HARP were capped at 125% which does not help you if you purchased in parts of the Inland Empire or pretty much anywhere in Kern County. You’re stuck with the loan balance and the rate from 2006 unless you strategically default. Thanks for playing.
As principal reductions begin to spread, the social consequences will be catastrophic. When your neighbor comes over to share their excitement about their BA loan balance reduced by 35%, what will BA’s response be when you phone to get the same deal? That call will go something like this:
Responsible Home Owner: Hi, I’ve got a $417,000 30 year fixed loan that I didn’t refinance. My rate is 6.0% but values are such that I cannot fit within the HARP guidelines. The neighbor across the street just refinanced with you and got a lower balance. I’d like to do the same thing.
BA – I see that your loan is owned by Fannie Mae. Take it up with them.
Responsible Home Owner – But you made the loan, you take the payments, and you just refinanced someone I can see from my living room window lounging in his back yard pool. What’s the deal?
BA – I’m sorry, We actually bought this loan from another bank that wasn’t us even though we did have the loan originally. Besides only special cases can use this program. Would you like to open a new CD account with us? Our new rates are .00011013 percent for 60 month!
Responsible Home Owner – FFFFFRRRAAAACKKK YOOOOOOO!
Why should Responsible Home Owner continue to make their house payment at that point? Is it made out of guilt, obligation, or shame? To be honest, I’d have real doubts why I should fork over good money after bad if my neighbors got a consequence free haircut on their loan balance.
What now happens to property values? Well for one lets say values remain flat. The FHA Short Pay home owner decide to put their home on the market at the same time you do. Their sale will be an “Equity Sale” at a market price. Yours will be a Short Sale that might not close. If values fall further, their home will might also be a Short Sale, perhaps even an assumed FHA loan. Yours will likely become an REO. If values increase, you might eek out a slight profit and rent from there on out. Their gain will go towards the purchase of a better home in a nicer neighborhood.
In a world where principal forgiveness, unevenly and inequitably applied, becomes normative, the responsible will end up as waste byproduct in the Bankers Circle of Life. You can’t fight the coming principal reduction wave. It’s reach will stretch not just through the financial world, but down to the very streets we live on. It’s simply the amplified end point of a national policy of that enforces zero consequences for any actions.
Hakuna Matata er… HomeEquity Ponzia to all.
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