Part II of this article discusses the rational decision of a negative equity homeowner to strategically default on his purchase-assist mortgage, and thus force the lender to buy his property, with no personal liability for the lender’s losses when the retention of the property is a mismanagement of his assets. For Part I, click here.
The negative equity condition: prelude to a cramdown
A balance sheet mathematically determines a property owner’s net worth by subtracting his liabilities from the current fair market value (FMV) of his assets. When the homeowner’s net worth is positive, he is solvent. Adversely, when a homeowner’s net worth is negative, pulled down by the diminished FMV of his most substantial asset, he is insolvent; a prime candidate for bankruptcy protection.
The massive decline in California property values during this Great Recession has turned roughly 2,500,000 California homeowners who purchased or refinanced after 2001 into negative equity owners — they owe more on their mortgage than their property is worth. They survive financially due only to their cash flow from employment or a business they own. Thus, a disconnect has developed between the use of the home – as the family’s shelter and the family’s largest financial asset – due solely to the cyclical reversal of fortune for homeowners who bought or refinanced after 2001.
This debauched California homeownership situation provides perceptive real estate agents with the opportunity to engage homeowners in a candid discussion about the options available to reverse course and head towards solvency – a financial baptism comparable to cleaning up the homeowner’s balance sheet in bankruptcy without the disruption of filing a petition.
But bankruptcy courts at the moment cannot correct the negative equity loan-to-value (LTV) ratios and keep homeowners in possession, a maneuver they can perform for real estate investors and businesses. Eventually, the federal government must act to reinstate the authority bankruptcy judges held until 2005 to reduce the mortgage debt of negative equity homeowner’s to the current FMV of their home (or less, preferably 94%), called a cramdown.
A cramdown of a loan to 94% of the current value of the underwater property suddenly makes the homeowner solvent, and more importantly, keeps the family in possession – the key to the nation’s century old housing policy. Thus, the owner is restored with the ability to build up a net equity in his property through loan amortization and inflation, instantly giving him a financial incentive to continue paying on his mortgage and improve the property.
However, a cramdown is not in the best interest of a lender’s bottom line. A loan reduction forces a lender to report its losses and for some will lead to insolvency. Interestingly, lenders won’t voluntarily bite the cramdown bullet to correct the social injustice of immobile homeownership unless they are forced to do so by a higher authority – the judicial arm of the government.
Congress, bowing to the “no-to-everything” constituency, failed on two occasions in 2009 to reinstate bankruptcy judges’ pre-2006 ability to reduce the long-term economic damage negative equities inflict on homeowners and their families. [For more information regarding the failed cramdown measures, see the December 2009 first tuesday article, The House rejects “cramdown” measure: more foreclosures on the way.]
Until that insightful day comes, and come it must once public opinion in California reaches the critical boiling point due to frustration, lenders will just continue to shout about borrowers’ morals and the benevolence of lenders, not reality. They will continue to buoy the mythic deprivation of future loans homeowners might suffer due to credit ratings as a strategy to collect payments on devalued mortgages from insolvent owners of upside-down properties (even with a 30% loan reduction).
Lenders presently are doing nothing real in California to assist desperate homeowners. Our government is not yet legislating to directly reallocate the nation’s wealth between lenders and homeowners, and is doing nothing more than talk to indirectly keep lenders’ feet to the fire. While these curative measures to be implemented by lenders and government are out of the negative equity homeowner’s means of direct control, pro-active options are available which real estate agents can bring to the homeowner’s attention.
Legal options for a negative equity homeowner
The most logical choice for a negative equity owner with an LTV exceeding 125% is to strategically default. Default is logical: no temporary or permanent loan modification relief is available to them – even if they are granted a 30% loan reduction they will not become solvent. Default gets lenders’ attention since it will eventually force them to acknowledge their losses when their LTV ratios for a mortgage exceeds 94% of the property’s value.
To default is especially relevant in California. Mortgage lenders know California is a nonrecourse state. Lenders who make mortgage loans in California 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 homebuyers. Likewise, on recourse loans, such as refinances or equity loans, lenders also know they 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 judicial foreclosure).
The promise to pay a mortgage lender 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. When the 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 a prudent financial strategy as no personal liability exists to allow the lender to collect any part of their purchase-assist loan. [California Code of Civil Procedure §580b]
Most importantly, an agent must understand that default is the legal act a homeowner takes to exercise the put option they hold under the provisions in all trust deeds. On default, the lender is forced by contract (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.]
Nonrecourse laws provide an exit strategy
No moral obligation ever existed to pay on any loan, upside-down or otherwise. No lender in California can enforce any mythically proclaimed moral obligation. However, the legal obligation requiring an individual to pay their debts is the general rule. Yet some 75 years ago, nonrecourse, anti-deficiency laws were established in California to equalize the lender-debtor relationship when real estate is taken by the lender as security for repayment. Anti-deficiency rules bar a mortgage lender from obtaining a personal money judgment against a homebuyer on a purchase-assist home loan.
The social purpose for California anti-deficiency laws is to motivate lenders to make only reasonable and prudent loans when they tie their risk of loss on a loan solely to the value of the real estate. If a nonrecourse mortgage turns out to be imprudently made, it is foreseeable by any lender that homeowners will default and the lender will then be forced to take the property by foreclosure.
If the homeowner concludes that his continued ownership of his largest asset (his home) is a mismanagement of his financial affairs now that it has a hugely negative equity, he must then consider ridding himself of the property – just as any investor or businessman would do with any non-performing asset. Instead of supporting an inverted asset, the homeowner rids himself of the underwater property by merely exercising his put option – defaulting – and preparing to move in about 12 months – the time it now takes lenders to hold a trustee’s sale after the initial default. Like a snake sloughing off its dead skin which is of no further beneficial use, the homeowner is freed to pay substantially less for his family’s shelter, either by paying fair rent for a comparable property or purchasing a similar replacement home – both options producing a monthly expenditure substantially less than the homeowner’s boom-time mortgage payment.
With replacement shelter found, the family finances are restructured to produce a dramatic increase in their discretionary spending. These newly available funds can then be spent elsewhere, such as:
- family savings for future education;
- emergency medical needs;
- investments which provide a return;
- increasing consumption to raise the family’s standard of living; and
- acquisition of durable consumer goods, boosting both the job market and the economic health of our sales-tax dependent state.
For every month a negative equity homeowner keeps a bad asset on his books (read: balance sheet) and makes monthly payments, he is losing money. The loss is the difference between his monthly mortgage payment and the fair rental amount all homeowners implicitly pay for the occupancy of their residence (or the comparable amount of a mortgage payment, property taxes, insurance and maintenance on a newly acquired replacement home at recession adjusted prices). This difference frequently reaches two to three thousand dollars each month. If the owner chooses to retain the black-hole asset, pulling down his net worth and contributing nothing to his long-term wealth, the balance sheet starkly presents the tangible dollar amount of the sacrifice he has knowingly burdened himself with by not walking away and freeing up income for more socially and economically beneficial expenditures.
When agents make negative equity homeowners more aware of the equivalent amount of rent a tenant would pay for the occupancy of the homeowner’s residence, as well as the amount of the monthly payment they would be making on a mortgage equal to 94% of their property’s current FMV, more will walk away. They can rent the identical property next door, so to speak, for a fraction of the cost of owning the property they now occupy, the “same-house, same-tract” analysis. This is especially true in California where during the 2000s a larger percentage of the nation’s homeownership population overextended themselves to acquire or refinance housing that has since gone negative.
Editor’s note – The fair rental value of low-tier valued property has now become nearly equal to the monthly mortgage payment, property upkeep, taxes and insurance for a home purchased in the present recessionary market – whether acquired from real estate owned (REO) inventory or a seller with a real equity in the property.
Satisfy immediate credit needs first
As part of a strategic decision to walk away, the homeowner must first arrange for any financing the family may need during the next two years. This includes a car purchase or other large dollar item which will need to be financed, including new credit cards if they intend to receive the best available interest rates on the financing. By making tactical credit decisions before strategically defaulting, the homeowner’s logistical needs for credit will be satisfied. In this manner, his family won’t be left wanting during the next two years when his credit score will make loans more difficult and costly to obtain.
After defaulting on the mortgage, the homeowner must keep all other loans and lines of credit current to rehabilitate their credit score which will be dinged by the default, a period of around two years. When applying for financing in the future, the employed homeowner can fortify a credit report containing derogatory information on the foreclosure with a Derogatory Credit Explanation Letter. With this technique, the homeowner describes how the real estate crisis and bad timing for purchasing and financing a home caused the blemish, and that no other issues of credit do or will exist. [See first tuesday Form 217-1]
The Derogatory Credit Explanation Letter provides a personalized explanation for derogatory items listed on the credit report, such as the strategic default on a mortgage secured by an underwater property. The explanations establish the historical context and set out the external factors which correlated to create the negative conditions under which the property was purchased. This context reveals the derogatory foreclosure item was the result of the financial crisis suffered universally – not solely a judgment error on the part of the individual applicant. [See first tuesday Form 217-1 §4]
This candid response to the credit report is considered favorably by lenders when determining a consumer’s creditworthiness (the individual’s propensity to repay loans) and often makes the difference between approval or denial of a loan.
Nationwide, only 3% of underwater homeowners have strategically defaulted. But many more homeowners need to consider walking away to avoid sacrificing the accumulation of necessary retirement savings and foregoing an improved standard of living for a decade or two. [For a thorough analysis of the potential long-term financial benefit of a strategic default, see the December 2009 first tuesday article, Homeowners, abandoned by government and lenders alike, must wield their walkaway.]
Editor’s note – Additional tools are available to homeowners to help them determine whether it makes financial sense to strategically default and rent, such as the walk away calculator available from youwalkaway.com.
Slap on the wrist for walking
The ongoing homeownership incentives have been neutralized for a negative equity homeowner since, though he is the legal owner, he is not the “economic owner” of the property. Thus, it is rational to walk away from excess debt in order to free income for better expenditures or the accumulation of wealth. But what are the consequences of walking?
It is a common belief that after a homeowner suffers a major financial shock — such as bankruptcy, strategic default, short sale and foreclosure or a loan modification – it is impossible for him to access new credit during a “penance period” of seemingly unknowable duration. Mortgage lenders (and the media) are quick to note that these items will taint a credit report for up to ten years. The myth holds that this period of self-flagellation and public ridicule must be endured as punishment for the homeowner’s financial miscalculations before he can be given a fresh start – a lender-contrived theology.
However, this is pure fiction and unsupported by facts. 90% of individuals who file for bankruptcy, a financial baptism of sorts, have access to some type of significant of credit within just 18 months of their filing. 75% of individuals who file for bankruptcy even have access to unsecured lines of credit after 18 months – not a very long penance period for the atonement of a purportedly major financial “sin.” Furthermore, the delay is just about enough time for a negative equity homeowner who strategically defaulted to save up for the 20% down payment needed to purchase another home (as mortgage lenders in California now take 12 months from the first month’s delinquency to complete a trustee’s sale).
To completely dispel this credit myth, look no further than the conduct of the Federal Housing Administration (FHA) which presently insures around 40% of all home loans in California. FHA will insure a home loan up to $729,500 to an employed buyer with a 3.5% down payment who was declared bankrupt a mere two years earlier.
Lending: the business function of lenders
Lenders will naturally lend again to wiped-out homeowners, even though their creditworthiness has taken a 140-150 point ding for the strategic default. It is the very purpose of a lender’s business operations to lend. It is contrary to the best interests of lenders (and the economy of the United States) to lock out the millions of future borrowers (including well over a million future California borrowers) who have or will default, modify, sell on a short sale or lose their home, strategically or not.
As history has shown again and again, lenders have an uncanny and consistent ability to forget the past or disregard lending fundamentals in order to turn a quick buck. Lenders always act in the interests of their profit. And they have now learned that the supposed predictive power about the likelihood of default infused in a borrower’s credit score is erroneous. Lenders are again realizing a 20% down payment to establish equity in the property is a better indicator for risk avoidance than a high credit score. [For more information regarding a lender’s extension of credit after a default, see the May 2009 first tuesday article, Credit after the NOD: the lender’s motivation to re-lend.]
Rational decision to walk away
Negative equity is a lurking menace to our California society, our state’s tax revenues and a fast economic recovery. Retention of an underwater home poses more long-term damage to a family (and California’s economy) than losing a home to foreclosure or taking a temporary hit to their credit score. Like a cancer, it exists unobserved as it slowly, but persistently, erodes the family’s financial health. Credit always heals as it can be rebuilt relatively quickly after a singular disruptive event, a shock to credit such as a crisis-induced foreclosure. A family’s continuing support of a negative equity deliberately wrought on themselves by retaining a mismanaged asset, compounded by the equal and collateral damage of lost savings and a reduced standard of living, will produce at least a decade of sacrifice and struggle just to maintain the status quo of yesteryear.
With lenders and Congress deliberately refusing to provide legitimate solvency assistance to negative equity homeowners by a principal reduction on their purchase-assist loan down to 94% of the property value, only one rational choice exists for the underwater homeowner. He must get his short-term credit needs in order then default, exercising his contract rights under the put option in the trust deed and forcing the lender to buy the property for the amount of the loan since no personal liability is attached to a homeowner’s purchase-assist mortgage. The negative equity owner will reside (payment and rent free) until the foreclosure sale some 12 months hence, then vacate and hand the keys to the lender – in exchange for key money cash.
Of course, these curative steps can only be taken once the homeowner, with the counsel of an informed real estate agent, has a firm grasp on the dollar value of his assets, the total amount of his liabilities and the resulting net worth or insolvency derived by the simple math of the balance sheet. [See first tuesday Form 207-1]