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When borrowers stop paying their mortgages, banks don’t want to foreclose because with so many so far underwater, the bank’s losses would be enormous; in fact, it would put most banks out of business. That simple truth drives every aspect of banking and government policy. Loanowners want to save their homes, but bankers and politicians really don’t care about them. Bankers and politicians want to save the banks. No matter how crazy many of the policy initiatives coming from Washington and Wall Street may seem, if you remember the basic dilemma that banks face, even the silliest disguised bailout makes perfect sense.

By late 2008, house prices were crashing hard, and millions of borrowers were defaulting on their home loans. If the banks had continued foreclosure processing under pressure to maintain their capital ratios, they surely would have become insolvent or gone bankrupt. As a result, in April of 2009, banking regulators allowed banks to report the values of their loans based on bogus loss modelling rather than current fair-market value. This gave lenders the appearance of solvency even if they lacked the substance of solvency. It was (in my opinion incorrectly) considered more expedient, politically palatable, and less costly than mass nationalization of our banking system.

With mark-to-fantasy bank accounting in place, banks no longer needed to foreclose on delinquent borrowers due to pressure from regulators. However, lenders still wanted to get paid on their bad loans, so they began cutting deals. Borrowers were offered lower payments under temporary terms if they stayed on as renters from the bank. Although borrowers still had their names on title, many had no equity, and their payments were much higher than a comparable rental property. Many in such circumstances strategically defaulted, and as I noted, borrowers who strategically defaulted early on made the best choice.

Over time, many of the loan modifications granted in the early years defaulted, some vintages defaulted at rates of 80% or higher. Of the 18 million granted loan modifications, less than one million are still in effect. As it turns out, many of these people simply can’t afford the debt burdens placed on them, and both the cost and the politics of bailing loanowners out were horrendous. Many on the political left favored widespread principal forgiveness giveaway programs. This was eagerly embraced by loanowners, but the thought of giving away more than a trillion dollars to the most irresponsible among us had little appeal to the political right, and anyone else who realized they were footing the bill for something that had no benefit to them.

As each new loan modification program failed, it became more apparent that something other than the altruistic desire to help struggle loanowners was at work. The loan modification programs were really being designed and promoted by the banks that wanted to extend their foreclosure timelines as long as possible in hopes that rising prices would restore collateral value behind their bad loans and prevent them from losing a trillion dollars. So far, in California where prices are rising rapidly, the policy is working. In the Northeast where prices are still inflated because no significant foreclosure processing has occurred over the last six years, this policy is not working very well today.

New Mortgage Modification Program Can’t Stop Further Housing Collapse

Here We Go Again

On March 27, 2013, the Federal Housing Finance Administration (FHFA) announced the introduction of still another mortgage modification program. Entitled the Streamlined Modification Program, it was intended to enable distressed borrowers to more easily qualify for a modification.

Unlike the HAMP modification program, borrowers will not have to show any financial hardship whatsoever in order to qualify. If their first lien is owned or guaranteed by either Fannie Mae or Freddie Mac, the only requirement is that they be delinquent for 90 days or more and complete a 3-month trial period. Also – they cannot be delinquent for more than two years and cannot have had two or more previous modifications.

As Mike recently quipped, Defaulting on your home now includes automatic enrollment into a loan modification program. There is a price to be paid by these borrowers. Missing three consecutive loan payments will trash their FICO scores; however, it seems likely that millions of borrowers will quit paying their mortgages in order to qualify.

Nice deal, huh? The obvious criticism is that it will only encourage borrowers to default in order to qualify. FHFA’s answer is that it will minimize losses to Fannie and Freddie by reducing foreclosures. Really?

The argument that giving away free money will minimize losses is so ridiculous, it doesn’t even pass the giggle test. This argument is merely a justification for giving away billions of dollars in an attempt to buy votes from loanowners.

The program was supposed to begin on July 1. But on May 12, FHFA announced that the program would become effective immediately. Servicers are required to send modification offers to all eligible borrowers.

The Failure of HAMP

The government’s HAMP mortgage modification program was begun in the spring of 2009 at the height of the credit crisis. Although they had expected it to help as many as 3 – 4 million distressed borrowers, only 816,000 permanent modifications were still outstanding at the end of March 2013.

According to the latest report from the TARP Inspector General, more than 26% of all permanent modifications had already re-defaulted. Over 1 million trial modifications had been canceled due to non-fulfillment of the terms by the borrower.

So more than a quarter of all so-called permanent loan modifications fail, and another quarter to a third never make it to permanent status. Over half the people who try fail.

Keith Jurow has been a regular contributor to Global Economic Intersection and Business Insider for three years. His new real estate subscription report – Capital Preservation Real Estate Report – launches at the end of May.

As early as April 2010, the Congressional Oversight Panel reported that more than half of borrowers who had received a permanent modification under HAMP were seriously underwater. Their average loan-to-value ratio (LTV) was 145%.

Even worse, this percentage included only first mortgages. The Obama Administration had estimated that roughly half of all at-risk borrowers were also saddled with second liens on their property. So the true LTV for borrowers under HAMP was clearly much higher.

Last week I wrote about how negative equity is keeping homes off the market. Mark Hanson has been writing about how the underwater figures published by Zillow understates the problem because it doesn’t factor in sales and closing costs, nor does it consider having anything left over for a move-up. Zillow finally started reporting effective negative equity last month. However, Zillow also doesn’t pick up second mortgages or HELOCs. When you factor in the balances on those loans, the housing situation becomes even worse.

Then in March of 2011, this same panel reported that recipients of permanent modifications were still badly underwater. They also emphasized another serious problem. After the modification, borrowers still had an average debt-to-income ratio (DTI) of 60%. This meant that 60% of their total income was being spent on servicing their debts. That debt burden was unsustainable for most homeowners.

As if the problem of effective negative equity and subordinate mortgages wasn’t enough, many of the borrowers who were put in these circumstances were  Ponzis living on the infusions of debt to pay their bills. Ponzis don’t really care about how much debt they have as long as someone is willing to give them more of it. The profusion of credit cards, car loans and leases, and student loans has made the debt burdens of the Ponzis unbearable, and with no lender willing to support them with free money, many Ponzis have imploded, and many more will later on.

Mortgage Modification Problem Goes Well Beyond HAMP

In June 2012, the credit reporting firm Trans Union issued the results of a study based on an examination of 600,000 borrowers from its enormous database who had received a mortgage modification between January 2008 and July 2011. It found that nearly 6 out of every 10 borrowers had re-defaulted within 18 months after receiving the modification.

The problem of re-defaults goes well beyond HAMP modifications. There are roughly $900 billion securitized mortgages outstanding which are not guaranteed by Fannie or Freddie. Take a good look at this shocking graph from TCW showing the re-default rate for loans modified in different years.

Source: TCW

You can see that in the early years of modifications, nearly 80% have re-defaulted. For the most recent years of 2010 – 2011, the percentage is already approaching 40% and headed higher.

According to mortgage modification data provider HOPE NOW, more than 18 million mortgages have been either modified or provided with some so-called “workout solution.” You can imagine what the percentage of mortgages considered seriously delinquent would be had these not occurred.

Hope NOW publishes these cumulative numbers to make is look like they are really helping people. The entire program is a political facade, a farce really. If 18 million people have been helped, then 18 million people defaulted on their mortgages and have bad credit. That’s a huge chunk of the potential buyer pool who will not be contributing to demand for a while because they don’t have the qualifying credit score. Some have suggested we solve that problem by merely lowering the qualification standards. What those advocates ignore is that these potential borrowers don’t have the financial discipline to maintain home ownership, and they shouldn’t be given loans.

Why Should This Time Be Different?

The obvious question is why should the new streamlined modification program have results much different than the HAMP program or any of the others? It will focus on the same pool of home buyers who bought or refinanced during the bubble years of 2004 – 2007. More than half of them own properties which are badly underwater and nearly half have second liens as well.

Is there any plausible reason to expect that borrowers who receive a modification under this program will re-default less than those with permanent HAMP modifications? Perhaps those who dreamed up this new program really believe that the economy is strengthening. As they see it, homeowners with a reduced mortgage burden will be less likely to default in an improving economic climate.

Nobody expects this loan modification program to be any more successful and resolving bad loans. Success of these programs has never been defined by the number of borrowers it actually helps. Success has always been defined by how much banks can recover on their bad loans. If they can get a few more payments and delay foreclosure until collateral value matches the loan balance, then the bank considers the program a success. That is and always has been the only measure of success that anyone in Washington or Wall Street cares about, Main Street be damned.

Unfortunately, we have overwhelming evidence that underwater homeowners are much more likely to default than those who have equity remaining in the property. As I have repeatedly shown, the number of homeowners who purchased or refinanced during the bubble years boggles the mind. Take a look at this chart on refinancing originations during the bubble years of 2004 – 2006.

Source: Mortgagedataweb.com

In these three years, 27 million mortgages were refinanced.

That’s a lot of people who cashed out at the peak. It also helps explain why such a high percentage of borrowers are underwater.

Regardless of whether the refinanced loan was a first mortgage or a second lien, the overwhelming majority of these properties are underwater. That is the main pool of distressed borrowers whom the new modification will attempt to save.

The Terrible Burden of Second Mortgages

To get a sense of the enormity of the problem with which this new modification program will try to grapple, you must begin to understand the second lien disaster. In numerous articles, I have written about the burden of home equity lines of credit which has gone largely unreported by the media. Let me briefly explain the problem.

During the crazy bubble years of 2004 – 2006, millions of homeowners took out second liens to tap the growing equity in their home. Most were home equity lines of credit (HELOC). In California, it was not uncommon for banks to provide HELOCs of $200,000 and up. Some owners refinanced these HELOCs one or more times to pull still more cash out of their property.

If anyone doubts this, I’ve documented well over a thousand of these instances just on this blog.

In its 2004 report, the FDIC listed the ways in which banks were encouraging borrowers to open new HELOCs including providing automatic credit limit increases as the property increased in value. To increase the use of existing HELOCs, banks were actually charging “nonuse fees” on lines that were open but inactive.

Because qualifying standards were based primarily on the equity in the home, HELOCs were most attractive in those states where prices were rising rapidly – California, Nevada, Arizona and Florida. Homes had become a money tree which their owners could shake almost at will.

Homeowners opened an incredible number of HELOCs. Take a look at this chart from Equifax showing the total HELOCs outstanding from March 2008 through March 2013.

Source: Equifax

The green line shows that there were almost 15.5 million HELOCs outstanding in the nation at the peak.

The lunacy of HELOC borrowing was most apparent in California. During 2004 and 2005, a total of more than 1.4 million HELOCs were originated in California just for the purchase of homes according to figures I received from CoreLogic.

In those two years, borrowers in California would take out a HELOC to buy investment properties in other hot markets such as Las Vegas and Phoenix. While the loans were recorded as California HELOCs because the borrower’s property was in California, the purchased home was actually in another state.

When the housing market finally began to decline in 2007, banks were very reluctant to accept this change. They continued to shovel out millions of HELOCs. Equifax reported that a total of 4.6 million new HELOCs were originated in 2007 and 2008.

As late as the fall of 2009, a study published by Equifax Capital Markets found that 45% of prime borrowers with securitized first mortgage loans that were still current in July 2009 also had a HELOC. Worse yet, the average outstanding balance on these HELOCs increased steadily from roughly $83,000 in mid-2005 to $118,000 four years later.

If you add in installment second liens, there are a total of roughly 15 million second mortgages still outstanding on homes throughout the nation. I estimate that at least 90% of these properties are now underwater. This situation is rarely discussed in the media but presents a problem that no modification program can solve.

The problem with second mortgages and HELOCs is lost in the discussion of underwater borrowers. I believe this is intentional as the true hopelessness of the situation is being kept from the general public. Only recently has the bad news of effective negative equity been revealed to the populace. The next revelation will be that second mortgages and HELOCs make the problem even worse than what’s been reported over the last several years.

Moral Hazard

Allowing or encouraging borrowers to become seriously delinquent in order to qualify for a mortgage modification has become known as moral hazard. What sensible reason is there to eliminate the requirement that borrowers must show some financial hardship to qualify for a modification?

Doesn’t common sense tell us that some borrowers who can afford to pay their mortgage will strategically default so they can use this new program to obtain a better deal on the terms of their mortgage? Apparently common sense does not play a role with the policy makers at FHFA.

Edward DeMarco has been under tremendous political pressure from the left to give away free money. Perhaps this is his way of passing out a small favor to placate his critics?

I have talked more than once to spokespersons for Fannie Mae on this moral hazard question. Their answer is simply to give me the party line: We are trying to help delinquent homeowners stay in their homes and avoid foreclosure. Those investors who own these mortgages do not elicit the same concern by FHFA to get paid back what they are owed.

Note: You can learn more about Keith’s new Capital Preservation Real Estate Report by clicking here.

We have a policy driven housing market. Nothing about current pricing is based on fundamentals or a natural bargain between unencumbered sellers and unsubsidized buyers. Supply is being artificially constricted through loan modifications and restrictions on sale, and buyers are being subsidized with record-low interest rates. Since this a policy driven market, changes in policy either in Washington or on Wall Street has potential to strongly impact the housing market. While the performance of loan modifications programs has been dismal, they have accomplished what bank’s wanted them to do; they kept supply off the market until prices rose. In this regard, I foresee these programs will continue because it benefits the banks. The huge inventory of distressed sellers these loan modifications programs keep off the market are a dangerous market overhang. However, these  programs are keeping these properties off the market, and they will likely continue to do so. Success or failure depends largely on your point of view.

I think these programs suck.

The Greater Fool Theory

Today’s featured REO was purchased at the peak by a bagholder. She didn’t put much money down, but she was likely a Ponzi who needed prices to go up to get HELOC money to afford her payments. She defaulted after about one year of ownership, and she was allowed to squat for over four years, so I guess she got her money’s worth.

The previous owners bailed out just in time. They were Ponzis who took their $184,000 mortgage from 1998 up to $535,500 by 2007. They still managed to sell for a profit and walked away with nearly a $100,000 equity check.

What do you think the previous owners learned? I think they learned they could abuse their HELOCs, live well beyond their means, and still walk away whole and buy another property. Of course, they didn’t retain much equity for a move up, but Ponzis rarely care much about that. If they managed to get another property, they are probably eagerly awaiting the values to rise to the HELOC gravy train can begin rolling again.

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33631 BAYPORT Way Dana Point, CA 92629

$539,900    ……..    Asking Price
$675,000    ……….    Purchase Price
6/12/2007    ……….    Purchase Date

($135,100)    ……….    Gross Gain (Loss)
($43,192)    …………    Commissions and Costs at 8%
($178,292)    ……….    Net Gain (Loss)
-20.0%    ……….    Gross Percent Change
-26.4%    ……….    Net Percent Change
-3.7%    …………    Annual Appreciation

Cost of Home Ownership
$539,900    ……..    Asking Price
$107,980    …………    20% Down Conventional
3.77%    ………….    Mortgage Interest Rate
30    ………………    Number of Years
$431,920    ……..    Mortgage
$113,055    ……….    Income Requirement

$2,005    …………    Monthly Mortgage Payment
$468    …………    Property Tax at 1.04%
$0    …………    Mello Roos & Special Taxes
$112    …………    Homeowners Insurance at 0.25%
$0    …………    Private Mortgage Insurance
$335    …………    Homeowners Association Fees
$2,921    ……….    Monthly Cash Outlays

($312)    ……….    Tax Savings
($648)    ……….    Principal Amortization
$136    …………..    Opportunity Cost of Down Payment
$87    …………..    Maintenance and Replacement Reserves
$2,184    ……….    Monthly Cost of Ownership

Cash Acquisition Demands
$6,899    …………    Furnishing and Move-In Costs at 1% + $1,500
$6,899    …………    Closing Costs at 1% + $1,500
$4,319    …………    Interest Points at 1%
$107,980    …………    Down Payment
$126,097    ……….    Total Cash Costs
$33,400    ……….    Emergency Cash Reserves
$159,497    ……….    Total Savings Needed
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