Written by:  Michael Thaler

What to do when you are upside down (underwater) in your home.

Large numbers of people owe 50% more on their home than what it is worth.  Many owe double.   In places like California loan balances exceeding three times the value of the property are fairly common.   Many people are throwing good money after bad in dealing with the situation.   Numerous terms have been devised to describe people in this situation.  The best one is:  These people are “under house arrest”.  They can never sell their home and either have to keep paying the ransom to stay, or escape to freedom.

Terms

Underwater -  You owe much more than the home is worth

Upside Down -  See underwater

Short sale – Where the misguided owner agrees to go through the trouble and inconvenience of listing and showing the house for sale even though he/she won’t get any benefit.    The bank agrees to take market value and release their security against the property..

House Arrest – Where you feel you have to stay in your underwater home due to misguided advice or belief

Shadow Inventory -  The unknown tens of thousands of homes owned or about to be owned by the banks.  No one knows what this total is.  There is no doubt it will have a deleterious effect on the market as these homes hit the market.   This includes homes already acquired and those that will be acquired when the lenders decide to take over more inventory of those properties where the owners have already walked.

Strategic Foreclosure – Where you make a sound business and financial decision to stop wasting money on feeding a dead horse and let the bank foreclose since they don’t want to modify the balance.

Kash for Keys -  After the foreclosure the bank will usually give the now former owner $2,000 to $5,000 if they vacate peaceably.  This saves the bank time and money spent for an eviction.  In some states the eviction process can take two months or more.  Not only does this program save the banks money, it assures them the house will not be “damaged” when the occupant moves out.

Non-recourse -  In virtually all states, a loan used to purchase a home is “non-recourse.  The only recourse a lender has is to take the property.  They can’t seek a personal judgment against the borrower.  In the non-judical states (see below), there is no personal judgment against the borrower once the lender has foreclosed on the property.  It makes no difference whether the loan was used to purchase the property or was a refinance loan.

Free rent – The money that is saved when the lender doesn’t want to work with you .  You stay “rent free” for anywhere from 9 months to 2 years or more.  Banks wait until you are 3 or 4 months delinquent before starting a foreclosure.  Even in fast states, it takes 4 months to foreclose.  Then the bank has to give you a Notice to vacate.  Since banks don’t know how to handle things efficiently, you should be able to count on at least a year.

Judicial foreclosure – What happens in the 23 states where foreclosures are required to be processed through the Court system.  This requires untold time and reams of paper, even in cases where the owners have walked long ago.   Most eastern states use this system, although there are exceptions like Georgia.  Lawyers have had a field day in these states by alleging malfeasance in processing the red tape.

Non-Judicial foreclosure – Used in most states.  All that is required is to record a Notice and mail it to the owners and others who have an interest in the property.  When the actual sale time approaches, notices are sent out again, often recorded, and, in most cases, as a throwback to times before the internet, publish a legal notice in obscure papers.  These papers, knowing publication is required have doubled and tripled their publication rate for “legal” notices.  In most states the process takes three to six months

Bankruptcy  (Bk.) – A way to delay a foreclosure, even if you really can never pay.  Filing a Bk can buy an owner 3 to 6 months of free rent.  This forces the lender to go to the Bk Court and obtain an order to allow the foreclosure to proceed.  A Bk does hurt the FICO score much more than a foreclosure.    Unless you have to file a Bk for other reasons, it never pays to file just to get a few months of free rent.

1.

Should I try and get the Bank to modify the Loan?

The answer is NO!

From the beginning, this proposal, the way it was (and still is) set up was a loser for both lender and the borrower.  The few modifications that have been done, after months of red tape, only reduced the payments, and sometimes the interest.  Nothing was/is done about the fact the loan balance is still twice or more the market value of the property.  Why continue to pay double for the same house your neighbor just bought next door?

Say you owe $300,000.00 on a home where the identical home next door just sold for $145,000.00.   If the bank would reduce your loan to $145,000.00, not only could you afford the payments, it would make sense for you to stay.  It would make sense for the bank for several reasons.  They wouldn’t miss out on collecting payments for the 5-8 months it takes to foreclose, they don’t have to worry about having to do repairs prior to putting the home on the market, and they avoid having to pay about $10,000.00 in selling costs.

The banks won’t modify the loan balance because they are gambling a significant number of borrowers will continue to pay even though it makes no economic sense.  On March 8, 2011, the largest lender, Bank of America, announced that they should NOT be mandated to modify loan balances.  Their excuse, “It would be unfair to the people who are continuing to pay.”   In other words, they think there will be more than enough suckers who will keep paying to make up for the ones who do the smart thing and “walk”.

A good example is a 45 unit condo building just off downtown Oakland. Working class people paid approximately $260,000 to $310,000 for single and one bedroom units ranging in size from 600 to 980 sq. feet..   So far, more than 35% have walked.  The B of A, and Chase probably hold nearly 1/3 the loans between them.   Albeit an extreme example, I was able to buy one of the $300,000 units for $62,100.00 on the Courthouse steps in June of 2009.   This was a Washington Mutual/Chase loan.  Their subsequent foreclosures were for more money.    Some lenders decided to take the property back themselves, rather than discount the price at foreclosure.  In those cases, due to inefficiencies, many of them remain on the market for 4-10 months because they are way over-priced.

One unit where the owners walked was totally stripped.  Every cabinet, plumbing fixture, wall heaters, appliances, carpet and even some window hardware was gone.  It costs the bank thousands to fix it before they could sell it.

The point is, IF the bank had modified the loan balance, even to 100% of the present value, the owners would have stayed.  They saw how futile it was to keep feeding a dead horse.  I maintain that as years go by, a fair number of people in this building will want a family and need a larger home.  Since they will still owe much more than what they owe, they will “walk” at that time.  They will have no choice.  The failure of banks to modify loan balances will, in the long term, come back to bite them.  On the other hand, they will have collected extra money, and maybe by the time they have to take over the property, it will be worth somewhat more than it is in today’s market.

There are at least two units where the B of A is the lender and the owners are trying to sell via “short sale”.  In one case the owner left and stopped paying, but is under the misguided opinion that she is better off going through the red tape involved with a short sale.  The B of A does make the owner and the brokers jump through hoops.  Initially, they had the chutzpah to ask the owner to pay $5,000 in cash and sign a personal note for $10,000 before they would approve any short sale.  California is a non-recourse state.  Like most states, there is no recourse, after a foreclosure, to collect from the borrower.

In the other unit where the owner still lives and is paying, she says she is old school and tries to pay her debts.

One negative of all this that affects all the owners in the building is the fact that these people are not only failing to pay loan payments, they aren’t paying the condo homeowner dues.  This means the people that are left have to make up the shortfall.  This is a major problem in Florida where a large part of the housing stock is condominiums.  The laws in Florida actually make it easy for a non-paying owner.  For example, if the condo association pays for premium cable service for everyone included in the dues, they have to continue to provide the premium services like HBO and internet to the person who isn’t paying.  And, since Florida is one of the 23 states where foreclosures are run through the Court system, the non-payer has often been able to stay, “rent free”, since the crash more than two years ago.

Should I do a Short Sale

Why bother?

The hit on your credit for a Short Sale is the same as for a foreclosure.   Some banks will allow the owner/seller to get a few thousand dollars out of the deal.  Most will not.   The owner is almost certain to get that same amount by simply waiting for a foreclosure to conclude and get paid under the “kash for keys” program.  Admittedly, there have been a few cases where the bank will agree not to turn in a bad report to the credit bureaus.  You will be money ahead if you simply stop paying the bank and wait and then wait some more.  On the $300K loan example above, we can assume the payments would be well over $2,000.00 a month including taxes and insurance.   I know a woman in Miami who I told to stop paying two years ago.  The bank hasn’t even initiated foreclosure proceedings!  She has saved herself nearly $50,000.00 or more!   She is paying the HOA dues because she feels she is still getting services and doesn’t want something for nothing.  If the bank would agree to a balance modification she would be paying on her mortgage as well.

.    There are also a few cases where the bank will agree not to turn in a bad report to the credit bureaus.

The situation where banks are allowing great numbers of Short Sales, but not offering a loan balance modification makes no sense.    If the property has a loan of $300K and can sell for $145K that means after commissions and closing costs the bank will net about $130K.   If they allow the soon to be former owner to get some money, the net will be less.    Everyone would be better off if the bank modified the loan balance at least down to the $145K present home value.  Even lowering it to $140K would put all parties ahead of where they would be with a Short Sale.  This is even more true when compared with going through foreclosure.

How does a foreclosure affect your credit?

The Fair Isaacs Company (FICO) will not disclose what effect what different actions have on your “score”.  Various web searches of real life postings seem to indicate it may be between 85-150 points.  A few posts said close to 200.   Obviously, if your credit is otherwise perfect, the hit wouldn’t be too bad.  This assumes all other payments are on time and your credit cards aren’t maxed out.

It is too soon to know what long term effect a foreclosure may have.  Virtually all landlords will completely ignore a foreclosure on a prospective renter’s credit report if everything else is ok.   It may be hard to apply for a mortgage loan for some time, but even if you have to pay an extra 1% or even 2% on a loan, you are still ahead of where you would be paying on your previous over-inflated loan.   Besides, rents are now extremely low because many people have decided to rent their homes rather than sell in today’s depressed market.  These are usually people who have an old low mortgage or own the property clear.

Warning:  If you do decide to rent, make sure that you don’t pay first month, last month and deposits only to find out the owner is a couple months away from losing the home.  Doesn’t happen often, but it does occur.

I was brought up to honor my obligations – the “Strategic” Foreclosure

The decision to walk from a property that is underwater should be made on purely financial grounds.  Businesses do it all the time.   Businesses often file a Bankruptcy to get out of paying leases and even to get out of labor contracts.  They close up the non-performing stores so that the business can survive.   The term “Strategic Foreclosure” has recently become part of a financial advisor’s lexicon because more and more people realize it is the smart thing to do.  Those that “see the light” often look upon people who are continuing to pay double as saps.

At the beginning of the real estate crash, so called experts tried to scare people into staying under “house arrest” and suffer, financially, just to save their credit score.  A major proponent of this was the TV “expert” Suze Orman.  She harped on the “saving your credit score” theme for months.  It then occurred to many people she may have a conflict of interest by promoting this attitude because she had (has?) financial ties to the FICO Corp.  (fka Fair Isaacs, Co.)   It has been some time since she advocated that people should break themselves, financially, and stay in an “underwater” home.

Also, it is generally thought that if the big name financial “gurus” had even hinted at the fact people should think twice about continuing to feed a bad deal, rather than cutting their losses short, it would have made a bad situation worse.   In effect, giving people bad advice helped the banks make billions, while staving off taking losses on their bad loans, at least for a while.

Why are the Banks making so much money if they made all these bad loans?

In the olden days, up until less than 10 years ago, banks and savings and loans would have to account for a bad loan if it became 90 days delinquent.  These bad loans were called “scheduled items”.  Regulators made sure extra reserves were set aside to cover these anticipated losses.  In the rare case when the bank did acquire a property via foreclosure, their accounting sheet would have to show a “reserve for losses”.  Today, the banks don’t have to show a loss until the asset is sold.   Thus, they can still show that $300K loan on the $145K home as a $300K asset until it sells.   They still set aside reserves for losses, but it is now mainly up to the bank to decide how big a reserve to make.

The mainstream press has written about the tens of thousands of homes that the banks have already acquired and simply sitting on them rather than selling.  The term used for this is the “shadow inventory”.  The banks excuse is, which does have some validity,   that it would greatly depress the market even more if great numbers of properties were put on the market.  Of course when the properties do sell, they would have to show the true loss at that time.

There are also untold numbers of properties where the owners didn’t bother waiting for a foreclosure to start or complete, and just moved on.  These homes and condos are sitting vacant with the bank not even bothering to start or complete a foreclosure.   There are a couple reasons for this.  One, they already have enough inventory, and two, if they do acquire title, they then have the liability of being a property owner (damage suits, weed abatement, and in the case of condominiums, sizable dues assessments each month.)

History of Home Buying

In the early part of the 1900’s, home ownership wasn’t as common.  Home loans were hard to get and they were mostly written for short terms like 5 or 10 years.  When the 1929 crash caused many commercial banks to fail, the FDIC was formed to insure small deposits.  A year later, the FSLIC was formed for insure deposits at savings and loans.  In those days the idea was that short term loans, like for businesses, would  be made by banks.   Banks also made car loans – 3 years being the standard length.

Savings and loans (S&L) were mandated to make home loans.  They were required to have at least 70-80% of their loan portfolio in loans on single family residences.  The loans were required to be made in their “home” area.  The rest could be on apartments and a small percentage on land.   For a long time, the standard length of a home loan was 25 years.  The standard down payment was 20%.    In many cases the buyer could pay 10% down and the seller would carry a 2^nd mortgage back for 10% of the selling price.  The S&L would loan the other 80%.  They were a major source of home loans.   People with savings would make deposits in an S&L because they paid more interest.  A “bank” is where you kept your checking account.  It wasn’t normally a place where you kept your “savings account”.

In theory, deposits at S&Ls weren’t “demand” deposits.  That meant the S&L could require you to give “notice” before making a withdrawal.  In practice, that didn’t happen.  People had immediate access to their money whether it was at a bank or S&L.

S&Ls started to disappear in the real estate debacle of 1988-1990.  By the end of the real estate (and economy) crash of 2008, commercial banks had taken over virtually all the S&Ls.

Events Leading Up to the 2008 Crash

For most of the 20^th Century banks and S&Ls carried most of the loans they made on their own books.   The fact this was done made the lenders more responsible.  If they made a mistake, it would fall on them.   FNMA (Fannie Mae), although it was formed in 1938, only bought government backed loans, primarily FHA and VA insured loans.  This policy continued until the early 1970s.  About that time, another quasi government venture was formed, Freddie Mac.  The purpose of these “companies” was to make a secondary market for real estate loans.  This made it possible for primary lenders, which were still, primarily, S&Ls, sell off packages of loans and enable them to make more new loans.  FNMA received the authority to buy non-government insured loans about the same time Freddie was formed.

As a result of this change, banks were now encouraged to become more active in home lending.  Banks needed to remain liquid and this gave them the opportunity to make loans knowing they could easily sell them off to FNMA or Freddie.  Also, at this time, loan funding companies really grew in size and importance.  The largest was Countrywide Funding.  They would initiate and fund loans and warehouse them for a very short time.  They would bundle up a package of loans and sell them, mainly to Fannie and Freddie.  They made their money on loan origination fees and retained the loan servicing, which also generated sizable revenue.  In the years approaching the 2008 crash, Wall Street capitalists got into the picture and started dealing with loan packages as well.  The securitizing of loan packages is beyond the scope of this paper.

In summary, a major cause of the crash was there being no oversight in the loan origination process and the fact nobody cared.  Loans were made for 100% of the purchase price to people who had no ability to pay.  This “free” money brought hordes of people into the market which drove home prices way beyond what common sense said they should be.  Even people who should have known better, borrowed on homes they already owned.   These loans turned out not only to have onerous terms, but also were often greatly in excess of the true value of the property.

Today’s Lending Market

There now is only ONE lender in the country – the duo of Fannie and Freddie.  Virtually all lenders, be it Wells Fargo, B of A, or your local bank, follow the requirements set by those two agencies.   If a lender decides to try and set their own, sensible, guide lines, they do so knowing they will never have the chance to sell off that loan to anyone else.   The one size fits all does not lead down the road to sensibility when it comes to making sound loans.   The result, if you are turned down by one lender, you probably will be turned down by all lenders since they all follow the exact, same, guidelines.   They don’t allow for flexibility.

The Obama administration wants to shut down the F & F duo.  They have already cost the tax payers billions as a result of the bad loans they bought.  Their shut down plan would span 5 to 7 years.

A couple of examples of inflexibility would help illustrate the situation.  An investor buys a rundown property at foreclosure and spends several thousand dollars fixing it up.  Guidelines say lenders aren’t allowed to finance that house for anyone until 90 days has passed.   In addition, the investor is only allowed to make a limited amount of money.  And, receipts for all the money spent on the property have to be presented to the new buyer’s lender.

A second instance would be someone who has perfect credit, has been on his job for 12 years, but decided that a “strategic foreclosure” was the way out for him.  The fact that all bills were paid on time and that he made all payments on his previous home loan until he was told the lender wouldn’t do a modification makes no difference.  This is true even with a 20% down payment.  This would be a very sound loan that is rejected because it doesn’t meet the arbitrary guidelines.

Here are the average home loan rates over the past 40 years:

1972 – 7.38
1973 – 8.04
1974 – 9.19
1975 – 9.05
1976 – 8.87
1977 – 8.85
1978 – 9.64
1979 – 11.20
1980 – 13.74
1981 – 16.63
1982 – 16.04
1983 – 13.24
1984 – 13.88
1985 – 12.43
1986 – 10.19
1987 – 10.21
1988 – 10.34
1989 – 10.32
1990 – 10.13
1991 – 9.25
1992 – 8.39
1993 – 7.31
1994 – 8.38
1995 – 7.93
1996 – 7.81
1997 – 7.6
1998 – 6.94
1999 – 7.44
2000 – 8.05
2001 – 6.97
2002 – 6.54
2003 – 5.83
2004 – 5.84
2005 – 5.87
2006 – 6.41
2007 – 6.34
2008 – 6.03
2009 – 5.04
2010 – 4.69