This article studies the loan-to-value (LTV) ratio of 162% as the median point where negative equity homeowners exercise their implicit put option and force their lender to take their underwater property.
The negative equity threshold and the point of no return
Nearly 2,500,000 California homeowners have a negative equity condition which imprisons them in houses that are black-hole assets. Each month of continued ownership sucks up sums of money in multiples of what the home would rent for – the home’s sole current value to the homeowner. Thus, a disconnect has developed between the primary use of the home to shelter the family and the secondary consideration as the family’s largest financial asset – due solely to the cyclical reversal of fortune for homeowners who bought or refinanced after 2002.
As upwards of 30% of California homeowners are now consumed by the negative equity trend which inverted the value of their home, the number of people choosing to walk away from their underwater properties is on the rise. Those rational homeowners who choose to walk away or strategically default (voluntarily defaulting on their home loan when they have the means to pay) account for nearly one out of every four defaults today in California and one in five nationally.
But what is the negative equity threshold at which underwater homeowners make the decision to strategically default and walk away from their upside down properties – even when they have the means to continue making their mortgage payments?
This question is aggressively addressed in the May 2010 Federal Reserve Board (the Fed) study “The Depth of Negative Equity and Mortgage Default Decisions” written by Neil Bhutta, et al. The Fed’s study of homeowners in the four sand states (California, Nevada, Arizona and Florida) concludes that a loan-to-value (LTV) ratio of 162% is currently the magic “median” tipping point at which half the homeowners in their sample concluded the financial benefits of defaulting outweighed the adverse consequences of continuing to pay on their mortgage.
The homeowners in the study made no down payment and financed 100% of their purchase, making them acutely vulnerable to the slightest future decline in property values. Close to 80% of these homeowners defaulted during the period of 2006 through 2009.
Two widely recognized hypotheses explain why homeowners default. Under the strategic default theory, homeowners default purely as the result of their home’s negative equity, independent of any other factors.
However, under the double trigger hypothesis, defaults occur after the combination of two deciding factors:
- negative equity, due to property value declines; and
- income shock, usually the result of job loss, or a disruptive life event, such as divorce, sickness or death.
In the instance of the double trigger theory, the owner’s motivation to default is clouded – the default does not occur on just rational mathematical grounds, a family balance sheet requisite of a true strategic default, but may be partially involuntary due to income loss and the inability to sell the underwater property. [For additional commentary on the use of a balance sheet as a financial yardstick to determine solvency, see the April 2010 first tuesday articles, The underwater homeowner, his future and his agent: a balance sheet reality check – Part I and Part II.]
The Fed’s study concludes that the study’s median homeowner who does not experience an income shock or disruptive event only strategically defaults on his mortgage (read: rationally defaults) if his level of negative equity is around an LTV of 162%. However, if the level of negative equity is significantly lower, say 110%, the average homeowner will not likely default unless the negative equity condition is combined with an income shock or disruptive life event, the double trigger theory. [For more information concerning the relationship between a homeowner’s negative equity position and foreclosure, see the October 2009 first tuesday article, Negative equity and foreclosure.]
Editor’s note – A negative equity homeowner is also more likely to strategically default if he has knowledge and awareness of others who have strategically defaulted. The legal escape route provided by a strategic default is greatly destigmatized when the homeowner personally knows of others who have done the same. So much for the rational homeowner…
Strategic default: a prudent (and legal) option
While 162% may be the median homeowner’s tipping point for a strategic default, we at first tuesday promulgate a more prudent choice for negative equity owners. Homeowners with an LTV exceeding 125% are hemorrhaging money; they are stuck in a long-term financial condition requiring them to crunch the numbers of their personal situation and give serious consideration to strategic default – for the future well-being of their family and California’s economic recovery.
Default is logical for 125% LTV homeowners as no temporary or permanent loan modification relief is available to most all underwater California homeowners. And even if they were to be granted a 30% loan reduction (which hasn’t happened and likely never will without the oversight of judicial intervention in bankruptcy), most will still not be made solvent. A homeowner realistically needs a 94% LTV (100% of value minus 6% for transactional expenses) just to break even on a sale (or equivalent purchase), let alone have any sale proceeds to apply towards the purchase of a replacement home.
To default is especially advantageous in California: California is a nonrecourse state, effectively relieving underwater homeowners of their excess purchase-money mortgage without the cost of a bankruptcy. Lenders who make mortgage loans in California well know they cannot pursue an individual to recover losses due to deficient property values on “bad” one-to-four unit, purchase-assist loans made to buyer occupants. Likewise, on recourse loans, such as refinances or equity loans, lenders cannot obtain a money judgment for any deficiency in the property’s value when they hold a quick, down-and-dirty trustee’s sale (in contrast to a time-consuming and expensive judicial foreclosure).
The promise to pay contained in the note for a loan which funds the purchase of a one-to-four unit residential property in California which the buyer occupies is unenforceable against the homeowner. When this type of loan is originated, the lender knows a trust deed foreclosure on the real estate is the lender’s sole source of recovery on a default. Thus, for underwater single family homeowners, default is not only a prudent financial strategy, it is sanctioned by law as no personal liability exists to allow the lender to collect any part of their purchase-assist loan, legally referred to as purchase-money loans. [California Code of Civil Procedure §580b]
Most importantly, a strategic default is the legal act a homeowner takes to exercise the put option they hold under all trust deeds. On default, the lender is forced by contract (the trust deed) to take the property in exchange for the amount remaining due on the loan – or the lender takes nothing. [CCP §726; for more information on the put option, see the November 2009 first tuesday article, California homeowners: exercising your right to default.]
I agreed with most of the loan modification proposal that our friend and colleague John Frangoulis wrote on September 15, 2010. However, I must add that any loan modification with interest only is not a good incentive for any homeowner or investor out there facing a loss in equity and a hardship that will not be able to make their mortgage payments. Mr. Frangoulis, out of most people, should know better since he is an FHA Loan Consultant and President of CAMP. Any interest only loan is a loan that will never be paid off.
The proposal would work if the Banks, the Servicers, the Treasury, the MBA, Fannie Mae, Freddie Mac, and the FHFA with the support of the President and Federal Government will get together and make up their mind that it is time to stop this pandemic of foreclosures, otherwise, by the end of 2012 there will be more than 13 million homes gone in foreclosure. This is more than 25% of homes in the U.S. that will be vacant and will destroy communities, people’s lives and their children. This will create a dip in the economy that will take more than a decade to recuperate. Millions of people will leave the cities and create phantom towns where there is nothing but wind, dust, depression, and lonely places like the old ghost town of the wild, wild, west. In turn, this will bring more crimes and vandalism to those communities making more difficult to recuperate and bring them back to a normal society of productive and responsible citizens.
I may also add that the loan modification process should be also open to honest licensed professionals to help people who don’t understand the criteria and guidelines of the programs. That for a flat fee payable after the paperwork is done, the homeowner pays and through follow up and negotiations, the professional can expedite and assured a trial period or the loan modification permanent approved, then the homeowner pays the final fee for a job well done. The flat fee should be a total of $3,000 payable half after the paperwork is done and ready to submit to the lender or servicer and the other half after the trial period is received by the homeowner or the permanent modification is complete.
All of these activities are done under a contract and under regulation of the DRE, Department of Real Estate to monitor and control any abuse by anyone who is not a licensed professional.
The loan modification is a transaction like a short sale or refinancing for a new loan and only a Licensed Real Estate Professional should be involve with this type of Real Estate Transaction.
Due to lack of regulation from Government Agencies, many people engaged in scams from invulnerable and desperate homeowners who were looking for help the last minute to save their homes.
We need to build trust again with the homeowners and the market if the Real Estate is going to survive and help the growth of the economy in the near future. We also need the Federal Government understanding of the issues and pass laws to help the consumer and the professionals who represent the consumer, not create laws that hinder and damage the relationship already build by professionals with consumers.
Many Government Agencies like Fannie Mae, Freddie Mac, and the FTC are creating laws that instead of helping the consumer and the professionals who work with the consumer for the Real Estate Transactions, they are damaging and hurting the consumer’s trust and the decision making process to refinance, buy, sell, or do a loan modification.
If this country depends on the Real Estate Market to survive its economy, then it makes perfect sense to pass laws to protect the consumer and the professionals who represent them. It is also time to put more than 250 thousand License Real Estate Professionals back to work to help build this economy again.
I pray to God that one day we see the light of Justice at the end of the tunnel and all the hard time we are living through will come to pass soon. God Bless all of us and God Bless America!
The problem with any approach is the banks are like a big fat hog at the trough consuming it all. The moment the consumer is to get the slightest benefit, they are not interested and want to treat the consumer like a deadbeat. Problem is they have “educated” consumers that the risk of their wrath is not nearly as bad as the perception of it. Once educated, it will not matter what relief they finally agree to, a clear plan to avoid involuntary servitude tied to the debt is their educated agenda. No question, under current market conditions, it is better to walk away, take the credit hit for 3 years, rent, and come back to the market in 3 years buy under FHA when homes have stabilized at the bottom and get on with life. That is the better investment in a consumers future. Credit is so tight right now it really does not matter that you will not be able to secure credit for the next 3 years.
As a side note, I agree with Mr. Passantino, most of us should move to credit unions or local banks to do our banking and boycott the major banks. They have not done the public any real favors so the few nickels people are able to save should be kept local.
John Frangoulis wrote THE most comprehensive strategy for loan modifications. Now…how to get it adopted is the question. This is a no brainer approach to this insane Bank fraud on the homeowners. Shame on our so called leaders for fattening the bank’s profits while robbing the working class in a Senate backed white collar crime. We should all pull our money out of the banks and put it in local credit unions that support our own back yards and then see how the banks would court us & compete.
Loan Modification the Way It Should Be Done
FHA Secure, Hope for Home Ownership, Home Affordable Modification Program and other existing programs are not working.
The long term solution to our economic problems is wage and job growth. Our political leaders have approved massive economic stimulus plans with the goal of addressing this issue. Those plans will not work or at best will be severely dampened without massive foreclosure mitigation.
The current loan modifications are slow (60 to 120 or more days), cumbersome, based on income and sometimes value qualifications, and they are not working. Only a small percentage of the people applying for modification receive final approval. Many lenders will not even consider loan modification until a borrower is behind in payments. Lender loan modification departments do not have the staff to accomplish what needs to be done. It is our opinion the current process will be too little too late to save our economy. Conversely, a properly designed foreclosure mitigation plan would be a stimulus to the economy by reducing and stabilizing mortgage payments.
The process needs to be streamlined (in a sense similar to FHA and VA streamline refinances) in order to be bold and quick, and with implementation procedures that can adequately stem the potential projected 2.4 million foreclosures in 2010 and the many more that are following. It is estimated that we have seven million homeowners behind on their mortgage payments. It is estimated that 25% of all homeowners have a negative equity position. On Wednesday July 21st “Government watchdogs told a Senate panel that the Obama administration’s effort to help homeowners avoid foreclosure isn’t working and that the Treasury Department has failed to fix the program.” (Per Daniel Wagner, AP Business writer.)
The goal must be to significantly reduce mortgage payments such that the borrower can stay in their home, thereby letting the market correct the equity problem over time. The program needs to be available to the vast majority of homeowners in order to address the many loan programs that are either now causing or will in the future add to the foreclosure problem. Most of these adjustable rate mortgage (ARM) loans have adjustment criteria that when the loan adjusts, the homeowner will no longer be able to make the mortgage payment.
If enacted our proposal will resolve the housing crisis, unfreeze the credit market and at the same time provide a most needed economic stimulus boost. President Bush and at a large degree President Obama have offered programs that bailed out the Banks and Wall Street in the hope that they will then bailout Main street. Our proposal will bailout Main street first and then Main street will provide the needed economic activity to bailout Wall Street.
As you are aware the US economy is in its worse crisis since the Great Depression. The housing bubble was the major factor in creating this crisis.
Since we have written our loan modification proposal the economic crisis has deteriorated greatly. Also a new disturbing factor should be considered. It is socially no longer a stigma to walk out from your home and to have a foreclosure on your record. In 2007 a study indicated that 95% of homeowners were willing to keep their homes if they can afford the payments even if the mortgage on their homes was greater than its value. In 2008 we saw the emergence of “buy and bail”. Buying a new home and bailing out of the old one. In 2009 we saw the emergence of “strategic foreclosures”. People with negative equity position will let their property go into foreclosure even though they could afford the monthly payment. These new social phenomena along with the unpopular Bank bailout programs have tremendous implications on the number of foreclosures and on any attempted rescue plan.
In most places today it makes economic sense for people to walk out from their mortgage, rent for a while and they are happy to hear that three years later they can buy again.
One of the key parts of president Obama’s Home Affordable Modification Program Guidelines is the concept of the “Net present value Model”. That model is used to see if it is better for the Mortgage Backed Security holders to modify a loan rather than to foreclose. The last two years we have seen one of the greatest devaluation of assets ever. Because of all these factors I believe it is important for any loan Modification Program to work we have to include a principle reduction. Around 25% of all mortgages are underwater and I believe that if we use the Net Present Value Model we can justify principal reduction on all existing underwater Mortgages. It is also the only way to stop Strategic foreclosures. Most MBS holders will go along with the principal reduction if we make some changes to Mark-to-Market regulations and if we provide tax incentives. Wells Fargo is already offering the program in a limited way. Green Tree has recently offered a 40% principal reduction.
Time is of the essence for a bold new approach to foreclosure mitigation. What is needed is a plan that can be implemented quickly and broadly, lowering the monthly mortgage payment so that homeowners can afford the payments and stay in their house. The plan we are proposing is simple.
• Years 1-5 rate of 2-3% with interest only option for owner occupied properties.
Year 6 rate of 3%, Year 7rate of 4% rate and Years 8-30 rate of 5%
There should be an option for a 40 year amortization program.
• Non-owner occupied can participate at a 1% higher interest rate.
An appraisal will establish the property’s present value. That will establish the new “Interest Bearing Principal Balance”. The difference between the loan balance which include loan amount plus arrearages at the time of loan modification is divided equally and 50% are principle forgiveness and the other 50% become noninterest bearing “Deferred Principal Balance” due on sale of the property or in 30 years at loan maturity.
Let us say we have a 500,000.00 dollar loan with 20,000.00 in arrears and appraised value of 300,000.00. In this scenario 110,000.00 of the loan is forgiven. The bank has 110,000.00 Deferred Principle Balance and 300,000.00 Interest Bearing Principle Balance. It is a win-win situation for everybody.
We should make this loan modification simple. The individual homeowner should be given more power to decide what program is best for him. Bank personnel and other consumer counseling groups can assist him in his decision.
We should have no income, asset, housing value or payment history qualification requirements. All residential 1 to 4 unit properties with a loan payment start date of January 1, 2002 and after are eligible, other than VA and FHA loans.
The benefits of this program are:
• A simple, standardized program that can be implemented quickly
• Estimated 60 to 80 percent foreclosure mitigation on current foreclosures
• Estimated 80 to 90 percent foreclosure mitigation on future foreclosures that will occur with adjustable rate mortgages when interest rates increase
• No new federal agency to monitor and/or implement the program
• Low or no cost to the US Treasury
• Economic stimulus due to the lowering of mortgage payments for millions of homeowners
• Lower losses to holders of mortgage backed securities, potentially stabilizing the secondary mortgage market.
In most places today it makes economic sense for people to walk out from their mortgage, rent for a while and they are happy to hear that three years later they can buy again.
We need to have a plan that modifies all mortgages without restrictions. Modify without any questions asked.
We should have principle reduction for all under water mortgages and 2% to 3% interest rates for all conforming loans with 3.50% to 4% interest on jumbo loans and non owner properties. If we do this we will stop foreclosures and at the same time we will also have a great new economic stimulus package.
The economy after 9/11 was mostly driven by the Real Estate and the refinance boom that according to some estimates placed over 150 Billion dollars per year in the hands of consumers. I do not know much money a drop of interest rates to 2% to 3% will put in the hands of the consumers in the next 4-5 years but what we know is that it will cut their monthly mortgage payment by more than half and all that money will provide a much faster stimulus to the economy than the 787 Billion economic stimulus package.
“In a recent study, Fernando Ferreira and Joseph Gyourko of the University of Pennsylvania, together with Joseph Tracy of the Federal Reserve Bank of New York, found that people who owe more on their mortgages than their homes are worth are about a third less mobile. David Altig, research director at the Federal Reserve Bank of Atlanta estimates that if the job market were working normally—that is, if openings were getting filled as they usually do—the U.S. should have about five million more gainfully employed people than it does. That would correspond to an unemployment rate of 6.8%, instead of 9.5%. Employers say getting people to move for work has been especially difficult this time. Often, that is a function of the mortgage and credit problems many potential employees face.” Our proposal will eliminate this concern because people will be able to rent their home if they have to relocate and have no financial hardship since rent will cover their mortgage.
I believe we need both the President’s Economic Stimulus package and a comprehensive Loan Modification Package along with principal reduction. If we do that, we will have a direct impact on consumer confidence and with the extra money placed in the hands of the consumer we will turn this economy around to reach new higher levels of production and economic prosperity for all. We are all in the same sinking boat and we need bold decisions to prevent us from following the deflationary environment that exists in Japan for the last 20 plus years or worst to repeat the problems of the 30s.
John Frangoulis, FHA Loan Consultant
Realtech Financial Services, Inc.
President CAMP East Bay
1399 Ygnacio Valley Road, #201
Walnut Creek, CA 94598
Office: (925) 472-8785
Fax: (925) 937-3281
Cell: (925) 998-8114
Email: John@rfn.net