2014 will see the “Rise of the Short Sale”

When people bought homes during the housing bubble, they often used toxic financing terms like teaser rates, negative amortization, and other parlor tricks to get themselves into a home they couldn’t afford. Their plan (assuming they had one) was to refinance into a new loan in a few years when their payments skyrocketed. Ostensibly, they were going to get stable financing in the future, but realistically most would have opted for another toxic loan to keep their costs down while they made huge profits on appreciation. The process was known as serial refinancing, and many people fell for it. The false assumption they shared was that another toxic loan would always be available. The credit crunch rudely exposed the folly of that belief.

Right now, many people who’ve obtained loan modifications believe that when the terms of their modification change (most changes to terms are temporary) they will be offered another loan modification on favorable terms. Repeated loan modifications is the latest incarnation of serial refinancing. If borrowers are still deeply underwater, they might be offered another because the bank will want to continue kicking the can, but if the borrowers aren’t underwater, the serial refinancing of loan modifications will abruptly end.

Lenders don’t want to make loan modifications. Loanowners and lenders agreed to the price of money (interest rate and payment) when the promissory note was signed. If delinquent borrowers had equity, lenders would foreclose on them and get their money back. Since so many are so far underwater, the banks can’t foreclose on them and get all of their money back, so it’s in the bank’s best interest to cut deals, amend loan terms, kick the can, and pray these borrowers will make payments until prices come back. At that point, things change back in favor of the banks, and their motivation to be accommodating and make loan modifications will vanish. Many people have come to view loan modifications as a new housing entitlement. It won’t be. The moment borrowers are no longer underwater, the entitlement will be rescinded by the banks. Remember, they would rather foreclose and get their money back so they can loan it to someone who will make payments based on the original contract terms.

With house prices rising, many borrowers have equity again, and many others are quickly approaching the surface. As one might expect, banks are getting less accommodating as borrowers approach the surface. Apparently, bank compassion is only extended to those borrowers who might cost the bank money in a foreclosure. Today, with the help of our contributing lender, Soylent Green is People, I want to take a detailed look at one specific loan modification so everyone can understand the terms and the implications for the market going forward.

The $200,000 crack shack with $500,000 in debt on it

The subject of the loan modification we will examine is a crack shack in LA: 1626 BRIDGE St East Los Angeles, CA 90033. It was purchased on 5/1/2007 for $465,000. Soylent Green is People described it this way:

The 2007 purchase note was $441,000 at a rate was 9.0%!. They refinanced a few months later at a new loan rate of 7.375% and a new balance of $453,000 (Thanks Countrywide!) . BofA stepped into the mix in late 2010, modified the note, adding $50k or so onto the balance which might be a combination of late fees and interest. The “savior modification” is amortized over 39 years, had a 3.0%, 3.250%, 3.50 stair stepping of the mortgage rate annually. We’re coming up on the 4.0% rate step which I’m sure one part of the reason why the house is being listed now and short sold.

The loan is a 39 year term with a 9-year interest-only period followed by a conventional amortization.

During the nine-year interest-only term, the interest rate rises from 3.0% to 5.95%, and the payment escalates from $1,263.94 per month to $2,506.81 per month. After the interest-only term ends, the loan converts to fully amortizing, and the payment rises to $3,014.94 for thirty years.

For a complete reading of the loan modification document, please see full PDF of this document from the public record below.

Download (PDF, Unknown)

Can Kicking Revealed

Over the last year or two, I described loan modifications as can-kicking many times. It’s hard to fully grasp what that means until you dig into the details. Do you see how the lender dictated these terms in such a way as to buy time and maximize profits?

First, by loading up the balance with over $50,000 in junk fees, the lender will make an additional $50,000 if the borrower hangs on until prices lift him above water.

Seocnd, by making the loan be interest-only, 100% of the payment is income. None of the loan is return of capital, so profits are maximized.

Thrid, by increasing the payment gradually from $1,263 to $3,014, the borrower is made to slowly endure the pain until they can’t take it any longer. If you drop a frog in boiling water, it will jump out, but if you slowly increase the water temperature over time to boiling, the frog will stay in the water until its death. So it is with loan modifications.

Is there any real prospect of the owner being willing and able to absorb these increases? At first, when the payments are still small and the property is underwater, the owner is willing and able. At some point later on, the property will not be underwater, and although the owner may still be able, the rising cost will eventually make them unwilling, and they will sell and give the lender their money back (plus the additional $50,000 in fees). This is the slow cost-push of changing loan modification terms.

Third, by ending with a fully amortizing loan at a much higher interest rate, on the slight chance that the borrower continues making payments into the amortization period, the lender is protected against rising interest rates, and they ensure a healthy profit on the loan.

If anyone thinks these loan modifications benefit the borrowers, they obviously haven’t paid attention to the terms. These terms are onerous, and they favor the lender exclusively.

A Lender’s view of the action

For sale Inventory is low because many “modded” loans stopped the natural foreclosure process. Very few of these non HAMP, private label mods have real principal reduction features. A few are about to see payments adjust to above market rates based on increased balances that remain well above the current value of the home. In 2009-2010 modding was all the rage. Flash forward to present day, thousands of these postponed foreclosures / modded mortgages are going to again slip into default. There hasn’t been enough equity gain since 2010 to sell over the banker boosted note balance along with the normal expenses of selling.

This is the ultimate dilemma lenders face. As I pointed out Potential buyers can’t afford peak prices at higher interest rates. It is what it is. Lenders will not be able to fully reflate the housing bubble before these deferred problems resurface. What will they do about it? Will they foreclose, allow a short sale, or continue can-kicking?

These borrowers – as everyone in the know said at the time – were becoming debt slaves, trapped in an endless cycle of certain default. 

2014 will see the “Rise of the Short Sale” as these modded mortgages begin to fail, but will we still have the tax relief laws and other foreclosure prevention programs available to rescue these sellers?  That’s the future as I see it, the part time, low wage economy combined with stalled appreciation will Terminate modified loan holders, and there isn’t going to be a “John Connor” around to save them this go around.

SGIP believes the short sale alternative will be the action of choice. It is less politically damaging than foreclosure because the borrower has to cooperate, and some believe this still gets a better price recovery than foreclosure, but I don’t believe that’s true any longer. With the hedge funds eagerly buying everything at auction, the discounts at auction are less than the discounts many short sales see. Banks will likely opt to foreclose on the more intransigent squatters and approve more short sales.

What about more can kicking? Lenders may opt for more serial refinance loan modifications to keep kicking the can. It’s worked well for them this far, and unless they have better places to deploy that capital (currently they don’t), then they may leave it tied up in the non-performing loan backed up by what they hope is rapidly appreciating collateral.

The market has enjoyed two years of steadily declining distressed sales, mostly due to these deferred problems disguised by loan modifications. Since these sales were merely deferred rather than avoided, we can expect more distressed sales to come to the market in coming years. It won’t be a tsunami of foreclosures, but it will be an additional weight on prices and an increase in for-sale inventory.

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3 HARBOR POINTE Dr Corona Del Mar, CA 92625

$2,668,000 …….. Asking Price
$2,195,000 ………. Purchase Price
6/7/2013 ………. Purchase Date

$473,000 ………. Gross Gain (Loss)
($213,440) ………… Commissions and Costs at 8%
$259,560 ………. Net Gain (Loss)
21.5% ………. Gross Percent Change
11.8% ………. Net Percent Change
47.8% ………… Annual Appreciation

Cost of Home Ownership
$2,668,000 …….. Asking Price
$533,600 ………… 20% Down Conventional
4.78% …………. Mortgage Interest Rate
30 ……………… Number of Years
$2,134,400 …….. Mortgage
$555,127 ………. Income Requirement

$11,173 ………… Monthly Mortgage Payment
$2,312 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$556 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$300 ………… Homeowners Association Fees
$14,341 ………. Monthly Cash Outlays

($2,374) ………. Tax Savings
($2,671) ………. Principal Amortization
$972 ………….. Opportunity Cost of Down Payment
$354 ………….. Maintenance and Replacement Reserves
$10,622 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$28,180 ………… Furnishing and Move-In Costs at 1% + $1,500
$28,180 ………… Closing Costs at 1% + $1,500
$21,344 ………… Interest Points at 1%
$533,600 ………… Down Payment
$611,304 ………. Total Cash Costs
$162,800 ………. Emergency Cash Reserves
$774,104 ………. Total Savings Needed
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