Today’s loan modifications are tomorrow’s distressed property sales
Lenders’ loan modifications temporarily alleviates borrowers’ financial distress from oversized mortgages, but the terms of loan modifications increases borrower costs over time. Families feel pressure to sell as the payments on their loan modifications increase, and the rising cost of keeping the property will force more supply on the market.
Lenders designed loan modifications to maximize lender profits while giving borrowers feeble hope of clinging to their family homes. Lenders only began granting loan modifications in response to the deluge of defaults that began when subprime borrowers faced resets on their 2/28 toxic loans issued during the bubble. Lenders foreclosed on those borrowers per the lenders prior loss mitigation procedures and swamped the market with foreclosures that pounded prices back to the 1990s in some markets. Lenders braced for a second wave of defaults when alt-a and prime borrowers with similar toxic mortgages faced reseting and recasting loans, but instead of foreclosing on those delinquent borrowers and pushing prices even lower, lenders began kicking the can with loan modifications and allowing deadbeats to squat.
Starting in 2009, lenders began modifying loans in large numbers to avoid more distressed sales. It took lenders three years to gain control of MLS inventory by modifying loans and stopping foreclosures. Finally, they also stopped approving short sales, so with the distressed inventory removed from the market, the MLS inventory completely dried up, and with a little additional demand from all-cash investors, house prices bottomed and rebounded dramatically over the last two years. It’s critically important to recognize that removing distressed sales from the current market does not remove the distress. Lenders merely deferred the problem for another day, and the backlog of distressed inventory still must be resolved.
What do I mean by distressed inventory? If these borrowers have loan modifications, why would they still be a future distressed sale? Distressed inventory is a property that must be sold because the owner can no longer afford to keep it. Banks don’t want to manage real estate; they want to manage loans, so they sell property whenever possible rather than hold it as an asset, making their sales distressed. Borrowers who can’t afford payments are also distressed sales because they don’t want to sell, but since the financial pain is chronic, the only relief they obtain is from selling the property and extinguishing the debt on it. When excessive debt compels borrowers to sell for financial reasons when they would not otherwise sell due to family circumstances, their for-sale properties are distressed inventory. That’s what’s coming.
Last year I spoke with a loanowner who doesn’t make enough money to afford the house he currently owns. We talked about his situation and options, and here is what he told me.
First, like most loanowners, he and his family are emotionally attached to their property. They want to stay because it’s a nice home they’ve decorated and customized to their tastes; they don’t want to move, and if given the chance, they will stay in their family home.
One of the reasons many loanowners don’t want to sell is because they will endure the unceremonious fall from entitlement. By definition, people who can’t afford their homes are living beyond their means. If they sell and find a rental, they will be forced to live within their means in a property they can afford. For most loanowners, that means taking a step down the property ladder; nobody wants to do that. So unless they are forced to, people won’t voluntarily sell a nice house to move into one they consider substandard. When combined with the emotional attachments of home ownership, most people will chose to struggle and fight rather than capitulate and sell.
Another reason this loanowner doesn’t currently plan to sell his house is because he couldn’t buy another one. His credit is trashed because in order to get his loan modification, he had to stop making regular payments. The missed payments ruined his credit score. If you extrapolate that circumstance to the millions of borrowers who applied for a loan modification, and you begin to understand why owner-occupant loan applications have been so low for so long.
Second, this loanowner wasn’t being compelled to sell due to the cost. With his loan modification, his monthly cost of ownership is lower than a comparable rental. With his 2%
temporary teaser rate, his payment is very low (more on that below). As long as his monthly costs are lower than a comparable rental, it doesn’t make sense for him to sell and rent.
When I asked him what happens when his interest rates starts to rise back up to the contract rate, he said one of two things would happen. Either he would be offered another loan modification, or he would be able to refinance into a low-interest rate mortgage. I didn’t press him on the how realistic that was.
It’s not very likely he would be offered another loan modification unless the property were still severely underwater. The serial refinancing of one teaser rate to another died with the collapse of the housing bubble. Banks are willing to deal now because the property has no collateral backing, but the loan modification entitlement will be rescinded as prices near the peak.
If a loanowner has equity again, even a tiny amount of it, and the terms of the loan modification increases the borrowers costs, the borrower can ask for another loan modification, but it’s unlikely they would receive one. Why would the bank cut them a deal once they bank can get paid in full from a sale? It would be better for the bank to force the old owners out in favor of a new one who will pay the full current rate on a home loan.
This loanowner also thought he could get a low-rate mortgage. Given his bad credit, it’s unlikely he will be given any mortgage much less a low-rate one.
Basically, he is in denial. He is living on borrowed time, renting from the bank, and reacting to temporary circumstances and hoping something will work out. Right now his incentive is not to sell, so he doesn’t. However, his cost of living will continue to escalate over the next few years, and as the value of his property is nearing the amount he owes, the rising cost of his housing will ultimately push him out. Either that, or he will endure a lifetime of bank servitude with every available penny going toward debt service on a house he really can’t afford.
My conclusion is that inventory will be slow to come back to the market. It will be predicated less on loanowners getting above water and more on them facing increasing borrowing costs due to changes in the terms of their loan modifications. That will happen slowly and be staggered over time, which is what the banks want. Perhaps some of these borrowers will hold out long enough to recover their credit scores or even obtain equity, but since many of these borrowers got in trouble with excessive mortgage equity withdrawal, a sale and repurchase will not be a move up; in fact, loanowners are stepping down the housing ladder.
Typical example of exploding loan modification
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.
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.
Second, by making the loan interest-only, 100% of the payment is income. None of the loan is return of capital, so profits are maximized.
Third, 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.
Fourth, 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.
Gone today but here tomorrow
Loanowners are in no hurry to list and sell their homes because the terms of their loan modifications favor staying put. Further, they are underwater, so lenders won’t approve the short sale without getting paid back in full, and Uncle Sam wants to tax any forgiven debt just in case the lender does approve the short sale. Loanowners have a huge incentive not to sell and a big disincentive to sell, so they don’t list and sell their homes. This is why there is so little for sale on the MLS today, and it’s also why prices went up so strongly over the last two years.
However, as the loan modification example above shows, these circumstances are ephemeral. Families feel pressure to sell as the payments on their loan modifications increase. Rising prices is also lifting many of them above water, clearing away the disincentives to sell. But even in those circumstances where prices haven’t risen enough, the rising cost of keeping the property is going to force more supply on the market.
Lenders managed to avoid a deepening disaster by deferring distressed sales to future years, but don’t believe the mainstream media narrative about these distressed sales going away; these distressed sales have merely been delayed, and when they come back to the market, it will be another weight holding back any further rises in house prices. Lenders got their reflation rally, so the bank-promoted pump-and-dump scheme was a complete success for the banks. We can only hope that those of us who buy in the future don’t get caught in another bubble inflated to bail out the banks from the last one.
2715 East VILLA VISTA Way Orange, CA 92867
$798,000 …….. Asking Price
$399,000 ………. Purchase Price
6/11/2002 ………. Purchase Date
$399,000 ………. Gross Gain (Loss)
($63,840) ………… Commissions and Costs at 8%
$335,160 ………. Net Gain (Loss)
100.0% ………. Gross Percent Change
84.0% ………. Net Percent Change
5.9% ………… Annual Appreciation
Cost of Home Ownership
$798,000 …….. Asking Price
$159,600 ………… 20% Down Conventional
4.29% …………. Mortgage Interest Rate
30 ……………… Number of Years
$638,400 …….. Mortgage
$155,356 ………. Income Requirement
$3,156 ………… Monthly Mortgage Payment
$692 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$166 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$4,013 ………. Monthly Cash Outlays
($765) ………. Tax Savings
($873) ………. Principal Amortization
$247 ………….. Opportunity Cost of Down Payment
$220 ………….. Maintenance and Replacement Reserves
$2,842 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$9,480 ………… Furnishing and Move-In Costs at 1% + $1,500
$9,480 ………… Closing Costs at 1% + $1,500
$6,384 ………… Interest Points at 1%
$159,600 ………… Down Payment
$184,944 ………. Total Cash Costs
$43,500 ………. Emergency Cash Reserves
$228,444 ………. Total Savings Needed