Our current housing finance system is a mess. It’s laden with moral hazard, and likely to implode with enormous losses to be absorbed at taxpayer expense. All our current policies are geared toward saving our banking system from financial ruin and making loan owners comfortable with their fate. As with any policy initiatives that distort the natural market, the current system is loaded with unintended incentives that permit people to game the system for their personal advantage. Today we look at how using an FHA loan to game the system provides advantages that offset the high cost of the FHA insurance.
In Monday’s post, Loan modification defaults soar 24%, can-kicking fails, I found a very astute observation from an industry insider working in loss mitigation. It provides a helpful overview of just how messed up our system really is, and it points the way to how people can use FHA loans to their advantage.
FHA just recently revised their modification guidelines to basically throw out any relevant ratios (Housing Ratio, Total DTI) Essentially we all see this as a sign of, “For the love of god just get some payments coming in on these mods”. We see clearly that their liquidity is drying up and they are getting crushed by claim payments, particularly on short sales where they’ve insured the full balance of the mortgage and are taking enormous losses. They’ve basically decided, as you stated above, that these squatters making some payment is better than none at all. The crazy thing is, it’s just like the housing bubble, where anyone who could fog a mirror was offered a loan. Now FHA is offering anyone who can fog a mirror, a mortgage modification, completely irrespective of their ability to pay (for instance, giving people with a 70% housing ratio a mod, instead of foreclosing on them because they clearly cannot afford even the reduced payment)
They are now extending and pretending, within the extend and pretend program itself. FHA’s insolvency is a 100% certainty.
17% of FHA loans were delinquent in September. A bailout is coming. There is a recent article in the LA Times that made the laughable contention that the FHA will not require a bailout. Given that the FHA is giving loans to Ponzis to reenter the housing market, I think it’s safe to assume an FHA bailout is coming, and it will be much larger than government officials contend.
And I can tell you from firsthand experience (I work in Loss Mitigation) that your assertions have been, and continue to be, dead on with regards to modifications and their abject failure. Banks never intended to help anyone, they are using loss mitigation as a way to restrain supply of foreclosed homes from the market, and squeeze blood from a stone. Anecdotally I can tell you (I do short sales myself) that 85% of the people who submit for a short sale, have been through MULTIPLE attempts at modifying their mortgage. They want to game the system, and the banks are happy to let them play their game, because being left to hold the bag is the greater of two evils. Were the banks in any position to liquidate the potential foreclosures without crashing the market, these people would have been out on their ass years ago.
The government has stepped into the morass to make loan modifications an entitlement, as if saddling a borrower with a debt 30% to 50% greater than the house is worth is a compassionate thing to do. The only reason banks went along is because it was in their best interest to do so — for now. Once prices get back near the peak, I suspect lenders will try to undermine the loan modification entitlement system because if there is collateral backing their loan, foreclosure is preferable to a loan modification.
What’s more disturbing to me, is the amount of people allowed to short sell their home, who purchased the property after 2009. We have people who closed in 2011 asking for a short sale. We’ve even had people state on the application, that their reason for default was, “Property value is below what I paid”. Strategic Default has now become the order of the day, thanks to permissive extend-and-pretend policies.
The banks deserve the problems with strategic default their actions created. In my opinion, strategic default is a moral imperative to prevent future housing bubbles. Lenders have conditioned an entire generation of borrowers to believe loan modifications are an entitlement and strategic default is a viable option when prices go south.
All in all, things IMO are getting worse, not better. If people who bought in 2011 are allowed to short sell on a whim, why not everyone going forward? The minute you have no equity, default. It’s the governments (taxpayer’s) job to ensure private property owners have positive equity in their homes in today’s America.
If anyone in this day and age doubts the existence of “Moral Hazard”, come to my office. I’ll show you the application for a short sale from a man who bought his home in December of 2011, and said he needs a short sale because, “Property values have declined and the home is not worth what I paid for it last year”. The fact that someone could make that claim with a straight face in 2012 shows you how far this situation has deteriorated, and it continues to get worse by the day.
Keep up the good work IR
FHA loans as a stoploss
Back in 2006 when I started publicly warning people not to buy homes due to the impending crash, I pointed out to people that there is no stoploss protection in event of a major decline in prices. Leverage works both ways, and the people who were making huge money on small investments were enjoying stellar returns. However, if prices go the other way, the losses are even more brutal.
Another commonly leveraged investment is stocks. People in a margin account can buy twice as much stock as they can afford by borrowing money from their broker. In the event stock prices collapse, the broker will close out an investor’s position before the account goes negative to preserve their original loan capital. There is no such stoploss protection in residential real estate. If house prices go down, people lose money until prices stop going down. They can easily lose many times their original down payment investment.
Well, at least that used to be true…
Now in an era of short sales as an entitlement, borrowers and speculators have no downside risk beyond their initial down payment. As Schizlor points out above, if values go down, people simply petition for a short sale, and the lender absorbs the loss. And when that loan is an FHA loan, the lender simply passes the loss on to the US taxpayer.
The incentive here is clear. Everyone should put the minimum possible down payment on a property to minimize their own exposure. If prices go down, they can petition for a loan modification, a short sale, or simply strategically default with no financial repercussions.
FHA loans as a tool to maximize return on investment
There is a strong secondary incentive to put the minimum down when buying real estate. When you calculate return on investment, the denominator is your investment. The smaller this number is, the higher the return. A 3.5% down payment provides six times the return of a 20% down payment. It;s not the great deal zero-down speculators had going during the bubble, but it’s not bad.
FHA loans are best if you might have to move
Shevy and I always tell people they should rent rather than buy if they think they might need to move in three to five years. Our reasoning is simple, since commissions and closing costs are about 8% of the sales price, it takes at least two years if not longer for houses to appreciate enough to get back the down payment. If a buyer needs to move during that time, their down payment is at risk. This is true irrespective of the financing used, but why should a buyer risk their own money when the FHA will assume more than half this risk for them? Given the uncertainties about future home prices, and the potential to need to move, a buyer is well served by passing off as much risk as possible to the FHA and the US taxpayer.
Other FHA Loan benefits
One of our regular commenters, Perspcctive, mentioned these additional advantages in yesterday’s post:
There are additional benefits to going with an FHA. There are many programs to help you if your income declines, including forbearance. There’s also a streamline refi that allows a quick refi with no appraisal or income checks. The MI is expensive on a 30-year loan (1.25% soon to be 1.35%), but worth the cost if you’re a marginal buyer maximizing your purchasing power and stretching your budget (and therefore can reasonably anticipate using many FHA homeowner aids).
An additional benefit I failed to mention, is that the FHA has a policy of not seeking deficiency judgments (when they’re available). So if you refi into an FHA in CA, there’s an added benefit. However, starting in 2013, CA law allows a “continuous purchase money” character to remain. i.e. If the refi after 2012 refinances only the remaining principal from the purchase mortgage, no deficiency is available. If any cash is taken in a cash-out refi, then that amount is subject to a deficiency judgment.
This system needs to be changed
The above is the best advice I can give a buyer in today’s market — and that pains me. It’s terrible that our system encourages both bankers and buyers to pass their losses on to the US taxpayer. As one of them, it’s infuriating to see how our government’s policies to coddle the banks has created a system where both bankers and borrowers can pass their bad bets on to all of us. Unfortunately, that’s the reality of life. Despite the high cost of FHA insurance, I will probably get one of these loans when I finally buy a home. Why not?
I don’t like putting the US taxpayer at risk, but our government encourages it, so I might as well take advantage.
So should you.
Thanks for the reverse mortgage money
I hate reverse mortgages. It’s a way for banks to make huge fees and interest payments and give seniors very little in exchange. It warms my heart to see bankers lose their asses on these deals. The former owner of today’s featured property got a $300,000 reverse mortgage on 12/18/2007. I hope she took all her cash as a lump sum.
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Proprietary OC Housing News home purchase analysis
$135,000 …….. Asking Price
$75,000 ………. Purchase Price
6/6/1995 ………. Purchase Date
$60,000 ………. Gross Gain (Loss)
($6,000) ………… Commissions and Costs at 8%
$54,000 ………. Net Gain (Loss)
80.0% ………. Gross Percent Change
72.0% ………. Net Percent Change
3.3% ………… Annual Appreciation
Cost of Home Ownership
$135,000 …….. Asking Price
$4,725 ………… 3.5% Down FHA Financing
3.45% …………. Mortgage Interest Rate
30 ……………… Number of Years
$130,275 …….. Mortgage
$55,270 ………. Income Requirement
$581 ………… Monthly Mortgage Payment
$117 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$34 ………… Homeowners Insurance at 0.3%
$136 ………… Private Mortgage Insurance
$560 ………… Homeowners Association Fees
$1,428 ………. Monthly Cash Outlays
($49) ………. Tax Savings
($207) ………. Equity Hidden in Payment
$5 ………….. Lost Income to Down Payment
$37 ………….. Maintenance and Replacement Reserves
$1,214 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$2,850 ………… Furnishing and Move In at 1% + $1,500
$2,850 ………… Closing Costs at 1% + $1,500
$1,303 ………… Interest Points
$4,725 ………… Down Payment
$11,728 ………. Total Cash Costs
$18,600 ………. Emergency Cash Reserves
$30,328 ………. Total Savings Needed