This article responds to the recent town hall discussion on real estate held by Assemblyman Ted Lieu in Riverside, California on July 30, 2009.

Frustrated homeowners and real estate professionals packed Riverside City Hall on July 30, 2009 to discuss California’s foreclosure crisis with state Assemblyman Ted Lieu (D-El Segundo). Lieu is responsible for the 2009 law which imposes a 90-day delay on foreclosure proceedings. The delay only applies to foreclosure by lenders who fail to put forth the effort to start a dialogue about loan modification with homeowners. [See first tuesday September 2009 Legislative Watch]

In Lieu’s words, “foreclosure is a lose, lose, lose scenario.” A foreclosure sale costs the lender money to conduct, but fails to make up for the lender’s loss on the loan. Foreclosure causes the homeowner to lose his house. Also, the neighborhood suffers a loss in the form of blight associated with distressed vacant properties. All these things happen in any recession and are corrective in nature.

But part of what Lieu said, or at least implied, about loss is dead wrong. Indeed, foreclosure can be an actual money loss for some homeowners and communities, and foreclosure costs must be paid. However, foreclosure for lenders is not a losing scenario at all; rather, foreclosing on a delinquent loan is in the lender’s best interest—unless they can arrange the rare, profitable modification with a quasi-solvent homeowner. The risk of loss on a loan is factored into the interest rate as a premium charge.

Politicians seem compelled to say lenders lose money by foreclosing. This false perception is fueled by general ignorance of the gears driving the secondary mortgage market. Even the Federal Reserve, in its paper “Reducing Foreclosures,” agrees no evidence exists to suggest lenders are acting against their own self-interest when they reject modifications in favor of foreclosures.

Contrary to Mr. Lieu’s assertion, lenders continue to win when toothless state legislation and resolutions do nothing but forestall the lender’s eventual use of their legal remedy. Legislated foreclosure delays hoodwink homeowners (and voters) into thinking they are being helped. Worse, they stall California’s real estate recovery by prolonging the time needed to clear out property which must be foreclosed and resold, presently some 650,000 homes. Future jobs, construction, and the stabilization of real estate prices depend on the vital correction prompt foreclosures enable.

Ownership of all these failing mortgages was long ago transferred to bond money pools. Mortgages were bundled up and sold by loan servicers into Wall Street’s pooling arrangements, called the secondary money market. These bundled mortgages continue to be sold to the world’s individual investors. The pools are structured as tranches (tiered among a pool of investors with rights to the interest paid based on priority and subordination). Subordinated tranches cause some bond investors in a pool to lose while those with priority lose nothing, effectively barring a future rise in meaningful modifications without Congressional action.

tranche-graphic1

So, as homeowners default, servicing lenders have limited authority to modify a loan in a no-loss game called extend and pretend. Homeowners are ‘allowed’ to cure their default by paying amounts that pale in comparison to their once-steep monthly mortgage payment. But the new monthly amount is so low it produces negative amortization—the principal debt increases every month—but no loss for anyone. Whether or not the modification staves off foreclosure, the servicing lender loses nothing while gaining all the fees and the homeowner keeps his over-encumbered home.

Without the necessary cramdown of the principal to the value of the home, the homeowner’s finances will not be consistent with reality now or in the future. This is wrong-headed. Excessive debt freezes the forward motion of recovery for years.

Further, the California state legislature can do just north of nothing to force lenders to modify loans. Their attempts to do so will continue to bear no fruit. At the time of the town hall meeting, the foreclosure moratorium law (ABX 2 7) had already been in effect for more than a month. Mr. Lieu admitted only a tiny fraction of lenders have chosen modifications, further evidence lenders would rather sit on their haunches and wait 90 days to foreclose — unless they made the small visual adjustments for online contact by defaulting homeowners.

The moratorium “solution” is not one at all, and misses the point by a long mile. The kernel of truth in all of this is that the lenders lack a competitive reason to make meaningful loan modifications—judicial cramdowns. The foreclosing lender typically no longer owns the liability of loss. It is owned by others, including those with Wall Street retirement accounts and taxpayers whose money (and deficit) funded the Troubled Asset Recovery Program (TARP) investments. Through TARP, insolvent lenders were given huge reserves (which they promptly deposited in interest-bearing accounts with the Federal Reserve).

Only Congress can alter existing contract rights held by lenders. To think a state-mandated foreclosure moratorium would do anything but delay the inevitable by tampering with foreclosure remedies (which they can do) is an impotent travesty served up on a platter of deceit to hapless homeowners. If Lieu wants a better return on his four-year stint in Sacramento, he should introduce a resolution demanding Congress flex its muscle to alter contract rights. Congress can re–authorize federal bankruptcy judges to cram down loan amounts to property values and make home loans assumable and properties marketable by eliminating the due-on-sale clause enforcement, except as needed to protect against property waste and un-creditworthy buyers.

Congress needs to strip lenders of the ability Congress gave them in 1982 to exact profits by using their due-on clause to interfere with a buyer’s assumption of a loan. Homeowners need to once again be able to freely sell on terms of a loan assumption, or a carryback second if necessary, when the market permits them to sell. Only then will lenders feel the bite of competition snapping at their heels in the form of judges and carryback sellers. This judicial competition will force the entire loan industry to voluntarily cram down principal to the property’s value. Otherwise, nothing meaningful will happen to allow negative equity owners to sell for several years, probably eight to fifteen years forward.

To give an example of the sort of modifications lenders are willing to make, one homeowner at the town hall said she had agreed to what initially sounded like a loan modification. Her lender allowed her to make small payments each month based on a percentage of her income—31%. However, she later discovered those payments applied only toward a percentage of the interest accruing each month, her late fees had been added to the principal balance, and the loan’s principal had not been modified. When she asked for a reinstatement amount, the lender threatened her with foreclosure if she did not adhere to the terms of the pseudo-loan modification.

Such modification practices, referred to as extend and pretend are, by any definition, predatory loans, dolled up like Hollywood-style red light district street walkers. Further, and in an effort to stop the resetting of home prices to current cash values, lenders are fingering real estate brokers and agents as deceiving lenders with low-ball opinions of value on resales of real estate owned (REO) property. To keep loans on the books and performing, the lender extends the homeowner’s stay in the home and momentarily assuages their emotional needs pretending to have significantly modified the loan by a huge, temporary reduction in payments.

Homeowners are told they will be blessed in the end for making the ‘right’ decision to take moral (not legal) responsibility for their debt. In reality, the homeowner is literally paying a monthly fee to the lender just to keep foreclosure temporarily at bay. Not a red cent of these monthly payments applies to the principal. Worse yet, all prior delinquencies of interest and late charges are added to the loan.

Thus, the ultimatum lenders give homeowners is “modify or foreclose.” A few choose to modify. However, the more rational (read: legal) choice for homeowners is to exercise their put option held under provisions in their loan trust deeds and California antideficiency law. A default by the owner triggers the trust deed’s put option, i.e., forces the lender to buy the property by foreclosing (or voluntarily accepting a deed-in-lieu). But homeowners are beseeched by lenders, who are abetted by erstwhile politicians, to consider the moral risks of defaulting. “Homeowners,” they say, “must understand the detrimental effects lenders can inflict on their credit scores” —so do ‘good’ so the lender does ‘well.’

Congress must take two steps to deliver a real solution: one involves creating a disincentive for loan servicers and lenders to resist loan modifications. Allowing bankruptcy judges to simply order a cramdown to the property value will do the job, authority they always had until stripped away by Congress in 2005 in its final days of deregulation.

Second, Congress must reinstate California’s due-on sale right for a buyer to automatically assume a real estate loan, a right Congress took away from all California property owners in 1982. The right to automatically assume a loan is a catalyst which keeps the real estate market fluid. The freedom of an owner to convey is essential element of the American Dream as it gives homeowners the great mobility they need to sell and relocate, leaving regions of low employment potential to areas where job opportunities are more plentiful.

Assumable loans allow owners to sell and cash out their equity or carryback a trust deed note to facilitate the sale. Carrybacks, as seller financing, then become a source of competition for lenders in the market, competition which lenders abhor. Then the loan modification process will turn into a useful tool for both keeping homeowners in their homes and setting the stage for buyers to freely assume those modified loans when the homeowner eventually has the need to sell.

Editor’s note—A recently published study by economists at the Federal Reserve in Boston indicates that mortgage modifications are not an effective method of combating foreclosure. For more information, see first tuesday’s “Mortgage modifications not ideal for foreclosure prevention.”