Feb142013

Lender manipulation of MLS inventory is remedy for housing bust

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 are reduced dramatically which causes 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 in shadow inventory.

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.

 

Loan Modifications

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.

Short Sale

The next option is a short sale. This process generally goes nowhere because Banks Refuse to Recognize HELOC and Second Mortgage Losses. To give a sense of scale of this problem, consider this (2010 data): “Together with Citigroup the banks hold about 42 percent of the $1.1 trillion in second-home liens. Unlike first mortgages, they are typically not bundled and sold off to investors but kept on the banks’ books. The biggest home-equity lender in the U.S. is Bank of America, holding some $138 billion in such loans. Wells Fargo has about $123.8 billion of home-equity loans.” These loans are all going to go bad, and it will decimate the banking industry when these losses are finally recognized. Restoring collateral value to second mortgage liens is one of the primary reasons Bernanke and the fed are obsessed with reflating the housing bubble.

Short sales are not going to be the final resolution of this problem for one main reason: 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 having 11.2 million properties underwater 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 have failed, 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. Now that loan delinquencies are still five times the historic norms in the United States, lenders are overwhelmed by the volume. And since lenders know that foreclosing on all those people will cause them catastrophic losses on their second-home lien portfolios in addition to crushing home prices, they are choosing not to do anything. More than one-third of all delinquent borrowers have been delinquent for more than a year. Squatters are everywhere.

The reason lenders are allowing widespread squatting are twofold:

  1. 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.
  2. 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. Too bad it 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.

Limited Inventory

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. Since they don’t pay depositors much, and since they can borrow from the federal reserve for nothing, they can afford to sustain a portfolio with greater than 10% 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 allow them to sustain bad loans, and it allows 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 usually offered by lender REO departments get 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. Many properties are short sales that linger for months with twenty offers waiting for the second lien holder to accept a loss. When it doesn’t happen, the property heads to foreclosure.

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, lenders capture the most motivated buyers. That is the way monopolies, oligopolies and cartels operate. Unfortunately, since this is a cartel, and since there is a huge shadow inventory, each cartel member gains advantage over the others by releasing more inventory. Once prices start nearing the peak — and borrowers approach the threshold of equity — foreclosures will pick up again, and many loanowners who withheld their properties because they didn’t want to be a short sale will list them to get out from under their debts.

Until the spigot of inventory is opened wider, the flow of properties will be slow, prices will remain inflated, and shadow inventory and squatting will continue unabated.  The Ponzis inflated house prices with their quest for appreciation income, and now inflated prices are supported by allowing the Ponzis to squat in their castles of debt. This benefits the banks who don’t want to write down losses, so it will continue. In fact, the way it looks now, it will be the final solution to the housing mess.