Government and lender solutions focused on loan modifications and short sales
Based on their recent behavior, it’s safe to conclude the government and the banking cartel believe they can resolve all their ills through loan modifications and short sales. Despite a huge shadow inventory of delinquent loans, lenders have slowed their foreclosure processing, and they show no signs of picking up the pace despite the recent increase in delinquencies likely caused by people opting for a free ride. I believe lenders will ultimately be forced to push out committed squatters in a foreclosure, but I also believe that lenders will also try and fail at every other alternative first.
The push for loan modifications
Lenders have good reasons to pursue loan modifications. If these failing programs could be made successful, they would help two ways. First, loan modifications ostensibly reduce foreclosures, but in reality, they only delay them. About a third to a half of all loan modifications fail, and many of those that apparently succeed end up as short sales. The track record of loan modification programs is one of proven failure. Second, loan modifications lower the borrowers monthly debt service which frees up more disposable income to stimulate the economy. I have long been an advocate of lower house prices to accomplish the same end. Since lower house prices causes lenders to lose money on foreclosures and short sales, this isn’t a policy option they favor. Super low interest rates and loan modifications have the same effect, but that policy also strongly encourages more imprudent borrowing in the future. Borrowers were already prone to take all the debt offered to them, they are encouraged to take on even more considering the government has a proven willingness to reduce the cost if the burden becomes too onerous.
Americans continue to refinance with new loans the same size or smaller than the loans they are replacing. Freddie Mac’s third quarter refinance analysis shows that 54 percent of homeowners who refinanced during the third quarter of 2012 took new loans of approximately the same size as the old and 29 percent brought funds to the table to reduce their mortgage balance. The aggregate 83 percent is only slightly below the record 85 percent of non-cash out borrowers in the fourth quarter of 2011.
The 17 percent of homeowners who took out a new loan more than 5 percent larger than the old loan, Freddie Mac’s definition of a cash-out refinancing, is the same as in the second quarter and the third quarter of 2011. These numbers are a vast departure from cash-out percentages during the period from Q4 2005 to Q3 2007 which always exceeded 80 percent.
Homeowners who refinanced reduced their interest rate by an average of 1.7 percentage points or a savings of about 31 percent in interest rate, the largest percent reduction in the 27 years Freddie Mac has been tracking the data.
This report is the fantasy of everyone who wants to see Americans move away from a culture of Ponzi borrowing toward an economy based on less debt service and more disposable income. The numbers can’t get any better than that. More people actually paid down mortgage balances than increased them. Amazing! Further, the decrease in debt-service payments is at record levels. What could be better?
Short sales as a backup plan
When loan modifications fail, or if the loanowner needs to move, the only options are squatting, short sale, and foreclosure. Squatting is favored by borrowers who want to get a free ride, and many delinquent mortgage squatters have been living payment-free for five years or more. However, these non-performing loans are not a viable solution for the banks and investors who loaned the money, so eventually they will take action to resolve the situation. Short sales are favored by lenders over foreclosures because they generally recover more capital in a short sale. Short sales are favored by politicians over foreclosures because they are voluntary. Both short sales and foreclosures result in a family abandoning their precious homes, but the short sale is much less emotionally charged because the sellers are leaving by choice; therefore, politicians get less heat from advocacy groups and disgruntled former owners if a property is sold short.
Although there are still some snares and drawbacks for participants, one of the federal government’s most important financial relief efforts for underwater homeowners started operation on Nov. 1.
It’s a new short-sale program that targets the walking wounded among borrowers emerging from the housing downturn: owners who owe far more on their mortgages than their current home value but have stuck it out for years, resisted the temptation to strategically default and never fell seriously behind on their monthly payments.
This may open the door to sellers who want to get out from their underwater mortgage but feel they can’t because they can still afford the payments. Many borrowers will opt for the strategic short sale instead of a strategic default to reduce their debts. Why not sell and buy the cheaper house across the street? This may help bring inventory back to the market.
Here’s how the program works.
Traditionally, short sales — where the lender agrees to accept less than the full amount owed and the house is sold to a new purchaser at a discounted price — are associated with extended periods of delinquency by the original owner. The new Fannie-Freddie program, designed by the companies’ overseer, the Federal Housing Finance Agency, breaks with tradition by allowing short sales for owners who are current on their payments but are encountering a hardship that could force them into default.
Eligible hardships under the new program run the gamut: job loss or reduction in income; divorce or separation; death of a borrower or another wage earner who helps pay the mortgage; serious illness or disability; employment transfer of 50 miles or greater; natural or man-made disaster; a sudden increase in housing expenses beyond the borrower’s control; a business failure; and a you-name-it category called “other,” meaning a serious financial issue that isn’t one of the above.
Over time the interpretation of what’s a hardship will become more lax as lenders are forced to accept any excuse offered to complete the sale.
What about the snares in the program? There are several that participants need to consider.
● Credit score impacts. Although officials at the Federal Housing Finance Agency are working on possible solutions with the credit industry, at the moment it appears that borrowers who use the new program may be hit with significant penalties on their FICO credit scores: 150 points or more. This is because under current credit-industry practices, short sales are lumped in with foreclosures.
According to Laura Arce, a senior policy analyst at the agency, the government is in discussions with the credit industry to institute “a special comment code” that would treat participants more fairly on FICO scores.
Why should they be treated any better? They didn’t repay their mortgage as agreed.
● Promissory notes and other “contributions.” In states were lenders can seek repayment of a loan balance owed following a short sale, Fannie and Freddie expect borrowers who have assets to either make upfront cash contributions covering some of the balance or sign a promissory note. This would be in exchange for official “waivers” of the debt for credit reporting purposes, potentially causing less damage to a seller’s credit score for the sellers.
So if you pay the lender something, they promise not to trash your credit score? I doubt many people are going to fall for that one.
● Second-lien hurdles. The program sets a $6,000 limit on what holders of second liens — banks that have extended equity lines of credit or second mortgages on underwater properties — can collect out of the new short sales. Some banks, however, don’t consider this a sufficient amount and may threaten to torpedo sales if they can’t somehow extract more.
This has always been the biggest impediment to completing short sales, and it will continue to be. Notice the payments are now up to $6,000. When these programs first started, it was zero, then it was $1,500, then it was $3,000, and now it’s up to $6,000. The banks should be forced to lose the entire amount as this is a second mortgage or HELOC, and the money was often used for consumer spending and debt consolidation. Fewer people would spend their houses if they weren’t encouraged to do so.
Foreclosures are inevitable
Personally, I believe loan modification and short sale measures will largely fail. They ignore some basic facts about human nature. First, borrowers generally benefit more from squatting than participating in a loan modification program or a short sale. Delinquent mortgage squatters have a zero cost of housing, and they will continue to pay nothing if they simply don’t participate. If they get a loan modification, then they must start paying for their housing again. Perhaps rising prices will inspire greed in squatters and compel them to pay with dreams of future equity, but for those who are deeply underwater, such fantasies will not motivate much compliance.
With a zero cost of housing, squatters have a huge disincentive to complete a short sale. First and foremost, if a squatter completes a short sale, they have to move into a rental and pay rent. Why would they want to start paying for housing when they currently have it for free? Also, during the short sale process, lenders actually demand repayment and expect squatters to give up cash or other assets to complete the sale. Why would a squatter do this? Saying no has no consequences as lenders rarely seek deficiency judgements in a foreclosure, so most squatters simply tell their lenders to pound sand. In fact, most short sales are merely a charade put on my borrowers to keep a foreclosure at bay and obtain many more months of free housing. Participating in the short sale process has degraded into a ruse to delay foreclosure for many borrowers.
In short, the government and lenders will try to resolve the millions of bad loans through loan modifications and short sales over the next several years, but their efforts will largely fail because the incentives are to squat and game the system for free housing. I’ve pointed out that delinquent mortgage squatters will miss the recovery rally, but they won’t care. The short-term benefits of squatting outweigh any long-term ramifications for what they do. And realistically, most of the people who are squatting today were Ponzis who live for the short-term anyway, so they will continue to make decisions based on maximizing short-term benefits. In other words, they will continue to squat until they are forced out in a foreclosure.