I have written extensively on strategic default. I have been an advocate of strategic default because it is generally the best financial decision for a family. When a loan owner is underwater and making payments far larger than the cost of a comparable rental, they are throwing their money away on mortgage interest to support a depreciating asset. That’s pretty stupid.
One reason millions of underwater loan owners don’t strategically default is because they perceive it as immoral. We have debated this issue at length in the astute observations of this blog, but it comes down to a simple choice between competing values. Is a borrowers promise to repay their debt a greater moral obligation than their need to provide financial stability for their family? In my mind the key distinction is who the borrower values more, the bondholders of the bank, or their own family. One of the two is going to suffer financially.
Loan owner options
When a loan owner is underwater, and they want to get out from under the weight of their mortgage obligations, they have three options: (1) keep paying, (2) strategically default, or (3) short sell the property. Most of the discussions about strategic default have focused on the first two options, pay or default because short sales take forever, and because the borrower is often forced to chose between the first two options anyway. However, lately lenders have been more willing to approve short sales, probably due to the increased incentives under HAMP II and the losses they must document under the robo-signer settlement. Banks will now approve short sales in as little as 20 days.
Lenders are frightened about the prospect of millions of underwater loan owners strategically defaulting because the losses would be staggering.The new shift to short sales raises unsettling problems for the banks. What if the millions drowning in debt decide they want to short sell? The strategic short sale is advantageous for the same reasons strategic default is. Those that short-sell today will be able to repurchase at the bottom, and they will have equity far sooner than if they hold on to their existing bloated mortgages. And now that lenders are willing to approve short sales, it’s likely that millions will chose that path.
Short sales are morally acceptable
Short sales have little or no stigma associated with them. Unlike strategic default, short sales are completely acceptable despite the fact there is basically no difference between the two. In a short sale, the borrower is failing to live up to the promises they made to repay the lender according to the contract just as in a strategic default. The one and only difference between a short sale and a strategic default is permission from the lender. In a short sale, the lender agrees that paying them less is okay. In a strategic default, the lender makes no such concession.
Apparently, getting permission from the lender to break the contract makes it morally acceptable. Lenders don’t want to approve short sales. They want all their money back. The only reason they are approving these sales is because they feel they have to. The underwater borrower has tremendous leverage. If the lender does not want to approve the short sale, the borrower can always strategic default and leave the lender holding property worth far less than the loan balance. In my opinion, the concession under duress is not freely given and therefore not morally pure. Short sellers don’t worry about such nuances. Short sellers don’t have issue with taking advantage of the lender’s weakened bargaining position to force a unilateral contract change totally in favor of the borrower.
Perhaps a short sale is like a loan modification on steroids. Loan modifications are morally acceptable, right? They suffer from the same coercion problem I outlined above, but borrowers have come to view these unilateral contract changes in their favor as an entitlement. A short sale is a mutually agreed upon loan modification where the lender takes less than the outstanding balance as payment in full. Loan modifications, and short sales are both unilateral contract changes forced on lenders under duress. These are substantive changes to the initial agreement. At least a strategic default doesn’t change the agreement. In the mortgage, the borrower agrees to give up the property if they quit paying under the terms of the note.
Despite the variety of moral ambiguities with strategic default, loan modifications and short sales, the consensus of opinion on the subject is simple. Most borrowers believe strategic default is wrong, and short sales and loan modifications are right. So be it.
Mortgage debt relief law set to expire at the end of the year
CHICAGO (MarketWatch)—An increasing number of homeowners who are underwater on their mortgage are selling their homes by short sale, and that could become an even more popular option during the rest of the year.
That’s partly because of a law set to expire at the end of 2012 that offers tax relief for homeowners who sold their home in a short sale or have had some other sort of mortgage debt forgiven or canceled, such as in a foreclosure or modification that included principal reduction. While there are efforts in Washington to extend these tax benefits, it’s hard to guess whether they’ll be renewed.
The tax forgiveness will almost certainly be extended, but the threat of an expiring deduction will be used by realtors to get more people to short sell their properties.
So those who think they might be able to take advantage have been stepping up, while they still can.
“Everybody [considering a short sale] needs to talk to a CPA and see if now is the time for them to get off the Titanic and in a lifeboat before this law expires,” said Marge Peck, associate broker and co-owner of Discover Arizona Real Estate in Mesa, Ariz. The company specializes in short sales. “I’ve just hired more staff. We’re prepared for the tsunami of people saying ‘I’ve waited long enough, nothing’s going to change.’”
That’s capitulation. Loan owners have been holding out hoping for principal reduction or the return of inflated market prices. Lenders have been eager to foster false hope in borrowers to keep them paying and make the banks look solvent. The strategic short sale may be a sign of final capitulation.
… Without the current tax law, if the bank forgives that amount the borrower is underwater, such as through a short sale, they’d be subject to pay taxes on that forgiven amount, since the Internal Revenue Service regards it as income.
… “Of course, the concept always strikes people as strange. They’re struggling and trying to get debt forgiven and then are hit with a tax,” Luscombe said.
It may strike them as strange, but debt forgiveness is income. At one point, these borrowers were given a lot of money by a lender who hoped to get it back. This money was not taxed as income at the time because the borrower was supposed to repay it. However, when the borrower doesn’t repay it, it was a gift of free money from the bank that should be treated as income.
To help taxpayers during the housing bust, Congress passed the Mortgage Debt Relief Act of 2007, removing that tax burden. …
The law has been renewed once already, Luscombe said. Trade groups such as the National Association of Realtors are currently lobbying for the relief to be extended once more.
But eventually this law is expected to expire. It’s just a matter of when: “This one is probably going to sunset at some point. It’s a question of whether Congress thinks this is the right time or not,” Luscombe said. …
It’s very unlikely Congress will put the screws to loan owners any time soon. They could just pass a law extending this tax break permanently for anyone will a loan from 2007 or earlier, but they won’t. By having to extend it every year, they can create false urgency to motivate sellers.
Short sales rising
Short sales made up 9.1% of all home sales in March, up from 7.39% in March 2011, 6.67% in March 2010 and 4.79% in March 2009, according to figures from CoreLogic, a provider of consumer, financial and property information.
Pre-foreclosure sales were up 25% in the first quarter, compared with the first quarter of 2011, according to a report from RealtyTrac….
“I think we will continue to see them go up,” Blomquist said. “It’s like the pattern you saw with the home buyer tax credit—the biggest spike is at the end of the deadline. I would expect to see a similar pattern with the pre-foreclosure sales.”
We will see more short sales this year, but as I pointed out in a recent post, banks cannot force a short sale.
But short sales don’t have to be for homes in the foreclosure process….
Underwater loan owners who are delinquent on their mortgages but who haven’t been served a notice are shadow inventory. Any sales from shadow inventory would be short sales. There are only a few ways a property escapes shadow inventory: (1) short sale, (2) cured loan, (3) foreclosure, and (4) rising prices. Since prices are not rising and since very, very few loans get cured, most shadow inventory ends up as short sales or foreclosures.
In fact, in six out of 10 short-sale listings her company takes on now, the borrower is current on his or her mortgage, Peck said. While banks may want a monetary contribution from the borrower in this case, the situation often means less damage to the homeowner’s credit score, she said.
Most underwater loan owners are still paying their mortgage. I didn’t realize that 60% of short sellers were current on their mortgage. I would have guessed it was much smaller. What’s the point paying when you know you are going to sell with no equity? Either way the loan owners credit is hurt. The common perception is that the credit score is hurt less, so people keep paying. What is 40 points on a credit score worth?
“I work with homeowners that brought properties at the wrong time because the market was sky high… now so many homeowners don’t know what to do,” she said.
Almost 16 million U.S. homeowners with mortgages were underwater in the first quarter of 2012, meaning they owe more than their home is worth, according to recent data from Zillow, a real estate website. But 90% of those underwater borrowers are paying their mortgage on time.
There’s still time
While short sales have notoriously taken a long time to complete, there’s still time for sellers to get these transactions done before the end of the year….
Lenders may be more open to approving these transactions, too….
Also, in June, new policies go into effect for Fannie Mae and Freddie Mac mortgages in an attempt to streamline short sales. Mortgage servicers will be required to review and respond to requests for short sales within 30 days of receiving a short sale offer, the Federal Housing Finance Agency announced in April. They’ll have to provide weekly status updates if the short sale is under review beyond those 30 days, and will need to get a final decision to the borrower within 60 days of the offer.
If the GSEs and the FHA are speeding up short sales, we will see many more of them this year. Short sales are another form of lender capitulation. They want to clear out their shadow inventory, and short sales and foreclosures are their only viable alternatives.
The former owners of today’s featured property are a familiar stereotype. They put nothing down, Ponzi borrowed as lenders offered them free money, then they walked away when the ATM machine was shut down.
- This property was purchased on 10/4/2001 for $249,000. The property records say they borrowed $249,000 and put nothing down.
- On 1/6/2003 they were given $68,700 in free money through a HELOC.
- On 12/2/2003 they refinanced with a $300,000 first mortgage and obtained a $37,500 HELOC.
- On 2/2/2006 they refinanced with a $417,000 first mortgage bringing their mortgage equity withdrawal to $168,000. Small timers by OC standards.
- On 10/22/2010 they were issued a Notice of Default, so they quit paying in July 2010 at the latest.
- They turned over the keys with a Deed in Lieu of Foreclosure on 9/27/2011, and the bank sat on the property until this spring hoping to time the rally.
La Habra Overview
Median home price is $268,000. Based on a rental parity value of $437,000, this market is under valued.
Monthly payment affordability has been worsening over the last 2 month(s). Momentum suggests worsening affordability.
Resale prices on a $/SF basis increased from $207/SF to $207/SF.
Resale prices have been falling for 12 month(s). Price momentum suggests falling prices over the next three months.
Median rental rates increased $75 last month from $1,739 to $1,814.
Rents have been slowly rising for 1 month(s). Price momentum suggests slowly rising rents over the next three months.
Market rating = 6
$332,500 …….. Asking Price
$249,000 ………. Purchase Price
10/4/2001 ………. Purchase Date
$83,500 ………. Gross Gain (Loss)
($19,920) ………… Commissions and Costs at 8%
$63,580 ………. Net Gain (Loss)
33.5% ………. Gross Percent Change
25.5% ………. Net Percent Change
2.7% ………… Annual Appreciation
Cost of Home Ownership
$332,500 …….. Asking Price
$11,638 ………… 3.5% Down FHA Financing
3.74% …………. Mortgage Interest Rate
30 ……………… Number of Years
$320,863 …….. Mortgage
$84,761 ………. Income Requirement
$1,484 ………… Monthly Mortgage Payment
$288 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$83 ………… Homeowners Insurance at 0.3%
$334 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$2,190 ………. Monthly Cash Outlays
($225) ………. Tax Savings
($484) ………. Equity Hidden in Payment
$14 ………….. Lost Income to Down Payment
$103 ………….. Maintenance and Replacement Reserves
$1,598 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$4,825 ………… Furnishing and Move In at 1% + $1,500
$4,825 ………… Closing Costs at 1% + $1,500
$3,209 ………… Interest Points
$11,638 ………… Down Payment
$24,496 ………. Total Cash Costs
$24,400 ………. Emergency Cash Reserves
$48,896 ………. Total Savings Needed
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