New loss mitigation practices will prevent future house price busts
Future housing busts will be busts in sales volume, not in price.
When lenders make loans, they far prefer borrowers to repay those loans; in fact, their entire business plan relies on it. As long as borrowers are current with their payments, lenders are happy and making money. When borrowers don’t make their payments, the end result is a distressed sale. If there are enough of these, market prices go down dramatically, causing significant lender losses.
Lenders know this too, so when distressed loans become an overwhelming problem, they devise can-kicking methods including loan modifications, mark-to-fantasy accounting, and when all else fails, they simply allow the delinquent borrowers to squat without paying a dime.
Below is the lender decision tree for delinquent borrowers. Today we will explore this diagram in some detail and discuss the ramifications of the decisions lenders make.
Once a borrower stops paying on the loan, the first step in the process is to attempt a loan modification. Many borrowers are using this step as a place to game the system for more time in the property. If the loan modification is successful, then the borrower is made current and everyone is happy. Very few loan modifications are successful mostly because it isn’t in a borrower’s best financial interest to get temporary relief and sustain the huge debt. Loan modifications are the first step in the amend-pretend-extend dance.
The next option is a short sale. This process generally goes nowhere because banks no longer allow them if the borrower has any assets, which most do. If a borrower petitions for a short sale, the lender demands a list of all assets, and they demand the borrower to liquidate their assets prior to approval of any short sale. It’s a defacto bankruptcy liquidation, so most borrowers simply wait for home prices to return to peak values. Restoring collateral value is one of the primary reasons lenders and the Federal Reserve are obsessed with reflating the housing bubble.
Many distressed sellers do not bother to attempt a short sale. First, for those with non-recourse loans, they are foolish to attempt a short sale because buried in the terms of the sale is the abandonment of their non-recourse status. Plus, why would they go through the hassle? The magnitude of the loss doesn’t impact the borrower, so there is little incentive for them to participate in the short sale process. Once they decide they are not going to sell and obtain any equity, most people stop paying and stop responding to lender inquiries. If borrowers don’t care enough about the property to communicate with the bank, they certainly are not going to get involved in a short sale process.
If a short sale does go through, it is still a distressed sale. It is a sale that probably would not be occurring in the market if the borrower were not in distress. These should be inventory added to the organic inventory of people moving for other reasons. One of the side effects of the lack of equity is that about 25% of our organic sales inventory is removed from the market. People are trapped in their homes.
Squatting and shadow inventory
Once loan modifications and short sales fail, the only options available to lenders are within the foreclosure process. At this point, borrowers are not making payments, and contractually, lenders have the right to force the sale of the property at public auction. Prior to the Great Housing Bubble, it was inconceivable that lenders would allow borrowers to squat in houses once it became obvious they were not going to repay the loan.
Since lenders know that foreclosing on everyone at the same time would cause them catastrophic losses in addition to crushing home prices, they are choosing not to do anything. More than one-half of all delinquent borrowers have been delinquent for more than three years. Squatters are everywhere.
The reason lenders are allowing widespread squatting are twofold:
- Lenders hope that people in this category will cure their loans with a loan modification. Nobody believes this is the cure to the problem, not even the lenders. This is the mechanism for effective can-kicking.
- The government benefits by having fewer homeless and no rioting in the streets. The twenty-first century’s version of squatter’s rights is allowing delinquent homeowners to stay in their homes. It prevents Hoovervilles and provides significant economic stimulus through the temporary elimination of housing expenses. It also totally screws renters who don’t enjoy such benefits.
Shadow inventory is foreclosure’s purgatory. It prepares delinquent borrowers for the singularity of trustee sale.
For lenders to recover their bad loan capital, they need house prices to rise back to peak levels before they liquidate. They created all the necessary conditions for this to occur.
First, they got regulators off their back with mark-to-fantasy accounting. Their capital ratios show a false solvency which keeps them in business.
Second, they got Bernanke to lower interest rates to zero to greatly reduce their carrying costs. Yellen sustained this policy. Since lenders don’t pay depositors much, and since they can borrow from the federal reserve for nothing, they can afford to sustain a portfolio with a significant percentage of their loans non-performing.
Third, they needed a way for borrowers to raise their bids. Bernanke’s lowering of interest rates was a two-for in this regard. The low interest rates allowed them to sustain bad loans, and it allowed future borrowers to bid more for properties.
Fourth, they needed to collude to withhold inventory from the MLS to create an artificial shortage of properties so potential buyers would be forced to use their new-found buying power to bid prices higher. The necessary collusion came from the settlement agreement designed ostensibly to benefit loanowners.
The effect is to restrict local inventories and cause competition among would-be buyers. Ask anyone active in the market today, and they will tell you that the competition is fierce because so little of the MLS inventory can actually transact. The few reasonably priced properties garner much attention. Buyers often have to bid over ask and accept onerous terms. Many sellers offer at WTF prices nobody can afford, so they are effectively out of the market.
The effect of these conditions is to create limited inventory for the lenders to sell their own properties at inflated prices. If inventory is restricted enough, even a depleted buyer pool can be enough to push prices higher, which is exactly what happened. This policy benefits the banks who don’t want to write down losses, so it will continue. In fact, this policy was so effective, it is now standard loss mitigation procedure across the industy.
When we inflate another housing bubble, which we probably will eventually, the next bust won’t be a large decline in price. Instead, with these new loss mitigation procedures, prices will remain high, mortgage rates will drop to record lows, and sales volumes will slow to record lows. For as much as realtors suffered during the last bust, the next one will be far more painful.