In a continuing effort to bring to light all sides of this housing crisis, I have an ongoing series here on Monday’s called Battling the Banks. Today, my special guest poster is Joe Parsons, a real estate broker in Dublin, CA. You can follow him on Twitter HERE and read his blog here.
Who’s to blame?
How did we get into this mess? Was it really Bill Clinton’s fault? After all, one of the goals of his administration was to increase the rate of home ownership. Did he really force lenders to loosen their standards to such an irresponsible and ultimately disastrous level? And if it wasn’t Bill Clinton, who is really responsible for the crisis? And what options are available to suffering homeowners?
First, you should understand how mortgages work. When you apply for a mortgage, you hand over a lot of personal and financial information. This documentation is reviewed by an underwriter who approves your loan. You sign your name dozens of times and a few days later, the lender wires the money to escrow. Your part of the process is now complete; all you have to do is keep making the payments.
The money the lender gives you is not theirs; it comes from a special line of credit, a “warehouse line.” The lender sells your loan to an investor (Fannie Mae and Freddie Mac are investors) for a small profit. That is the business lenders are in: originating and funding loans that they can sell to the investor for cash. The investor earns their return through the long-term payment of principle and interest.
In November 1999, the Financial Services Modernization Act (Gramm-Leach-Bliley) was signed into law. The financial services industry had lobbied for years for the right to consolidate investment banking, commercial banking and insurance. They found an ally in Sen. Phil Gramm (R-TX). The passage of this law was arguably the catalyst for the creation of the toxic mortgages that led to the near-collapse of our financial system and the disastrous loss of equity for millions of homeowners.
Once Gramm-Leach-Bliley became law, Wall Street banks like Goldman Sachs said to the mortgage lenders, “You can fund a loan for 100% of the property’s value (no down payment), take the borrowers word for how much money they earn (stated income), how much money they have in the bank (stated asset), and will buy those loans from you, even if they have a poor history of meeting their financial obligations (low credit scores).” Lenders started handing out mortgage money at an unprecedented rate. With these loose-as-ashes lending standards, the delivery driver making $8.00 an hour could put on his application that he made $10,000 a month to buy the $600,000 house he couldn’t even begin to afford.
The investor purchasing that “sub-prime” mortgage bundled it together with thousands of others just like it to form a type of bond called a Mortgage Backed Security (MBS). These bonds were still very risky, worse than “junk bonds” so, in order to make these investments palatable to institutional investors and pension funds, the investment banks put a type of insurance policy, called a Credit Default Swap, on the bonds. They paid an annual premium of around $40,000 per million dollars of bond value. If the bond went bad, they’d get the whole million dollars from the insurance company that issued the policy. The term “Credit Default Swap” refers to swapping the risk of default for the premium paid, shifting the risk to the insurance company.
This worked fine until real estate prices stopped going up at their breathtaking rate. The people who had
lied about overstated their income couldn’t sell their homes when they ran into financial trouble, so foreclosures started to happen at an increasing rate, like a giant snowball.
As the mortgage bonds started to go bad, the insurance company (you may have heard of American International Group, or AIG) had to pay on the credit default swaps they’d sold. They didn’t have enough cash, so they went to Hank Paulson, Treasury Secretary (and former CEO of Goldman Sachs). “We can’t pay off on all these bond defaults, and if we go bust, we’re so huge that it will ruin the global economy.” Mr. Paulson agreed, and bailed them out to the tune of $183 billion from the taxpayers.
As more properties went into foreclosure, real estate values plummeted. People who had legitimately qualified for their mortgage and made cash down payments saw their equity evaporate. When interest rates fell, they couldn’t refinance because they had no equity. The Obama administration created the Home Affordable Modification Program (HAMP) which was intended to help some 5 million struggling homeowners. The loan servicers (banks and investors) were given incentives for their participation, but they had considerable leeway in their interpretation of the guidelines. Some banks tell homeowners that they must be at least 90 days delinquent to be eligible, then turn them down. Others have repeatedly lost paperwork. To date, there have been fewer than 550,000 permanent modifications under HAMP. Those few homeowners who have successfully reduced their payments through the program are still faced with negative equity. Their home, once seen as a safe investment, is now “a rental with debt.”
There are no easy solutions to this problem, and the federal government, apart from posturing and creating programs that ultimately seem to be not much more than clever acronyms, has not been of much help. The reality is that a home whose equity has been eradicated by the self-serving actions of investors is not likely to recover any time soon. The distressed homeowner has a limited menu of choices today:
1. Complete a loan modification. A successful modification will initially reduce the mortgage payment to 31% of the gross monthly income.
2. Put the property on the market as a ‘short sale’ and ask the lender to accept less than the outstanding balance as full payoff. This will affect credit the same way a foreclosure will.
3. Give the lender a ‘deed-in-lieu’ of foreclosure. This means signing the property back to the lender to “avoid the humiliation of foreclosure.” Doing this at the urging of the lenders collector will save the lender many thousands of dollars, with no benefit to the homeowner.
4. Engage in a ‘strategic default.’ This means that the homeowner stops making the payment because the home no longer makes economic sense. Today, the foreclosure process often takes nearly two years from the first missed payment. The strategically defaulting homeowner saves the payment that is not being made, thus recovering at least some of the equity.
Lenders today often employ collectors who try to bully and shame the distressed homeowner into taking actions not in their best interests. It is important to realize that, under most circumstances, a lender cannot pursue them for any deficiency if the property ultimately sells for less than the balance owed. It would be prudent to consult a real estate attorney to learn the facts about what the lender can and cannot do in your state.
The lender may try to shame the homeowner. You have a moral obligation to make your payment, they’ll say even though your home may be worth many thousands of dollars less than the balance owed. This approach could be referred to as ‘asymmetrical morality:’ the homeowner has an obligation, where the lender has none. But when we enter into that contract (the mortgage) we do so with a reasonable expectation that the lender will not do anything to harm our investment. The fact is that the lenders (collectively) did cause the eradication of equity. They are receiving billions of dollars from us, the taxpayers, because they are Too Big To Fail, but they bear much of the blame for the crisis. Every homeowner should be keenly aware of their rights, and not be bullied by a lenders collector into doing something not in their best interests.
Joe Parsons has been a real estate broker since 1977. He is the owner of PFS Funding, a “boutique” mortgage brokerage in Dublin, CA. He can be reached through his blog: pfsfundingblog.com
For more information on how to submit a guest post in my ongoing series “Battling the Banks”, please contact me at melissabrodsky at sbcglobal dot net
I love this explanation. It was succinct and explained in easy to understand terms. It is the best thing I’ve read that explains what has been going on.
A couple of thoughts:
“Bully and shame the distressed homeowner”? I don’t think that is a very widespread practice. Any institution that does that can be nailed under the Fair Debt Collection Practices Act.
There is a small benefit to doing a deed in lieu, in that it at least shows up on your credit report as a voluntary reposession, rather than in involuntary one.
While it is true that in a judicial foreclosure state a foreclosure can take a year or more (longer in the case of the mortgagor being deceased) it can often take less. And if you live in an out-of-court foreclosure state it can take less than sixty days.
Joe Parsons says
Brad, while it’s true that FDCPA puts limits on what a debt collector can and cannot say and due, there are many practices that are at the fringes. Although a debt collector cannot use profanity or demeaning language, they can certainly convey that message in other ways–and many of them do just that. The most common tactic is trying to convince the borrower that not paying as agreed is immoral.
With respect to giving a deed-in-lieu: for purposes of being approved for mortgage financing at a later time, it will have exactly the same effect as a foreclosure. The borrower will not be eligible for new conventional financing for as long as 7 years. The waiting period is shorter for government loans: 3 years for FHA-insured loans, 2 years for VA.
Here in California, the statutory period for a foreclosure is four months from the time the Notice Of Default is recorded. The delays occur because the organizations servicing the loans delay beginning the process–sometimes for a year or more. I have been told by some knowledgeable people that the servicers (who receive a fee from the investor who actually owns the mortgage) are paid several times more in fees as long as a mortgage is delinquent, but not in foreclosure. I am researching this to determine whether it is true.