My stompin’ ground is San Diego. When the bubble burst here, the median price for a single family residence was within shoutin’ distance of $600,000. To give you some perspective on that number, my first ever listing was a 4 bedroom home in a blue collar area in October of 1969 — $18,100. It didn’t sell during the 90 day listing period, as it was um, a tad overpriced. Gimme a break, it was my first day on the job, and I was just 67 days past my 18th birthday.
Let’s say you and I are partners in a bank making real estate loans in San Diego. In January of 2005 we approved a couple’s application to refinance their well located 2,500 foot home with a view. Our own appraiser came in with a value of $675,000. The borrowers wanted 80% which was $540,000 — very doable considering their 770+ FICOs and impressive credit history. The interest rate was 6% fixed for 30 years — a payment of $3,237.57 monthly. Add taxes and insurance — just under $4,000!
Their home is now worth $450,000 — more than $100,000 above the current median price for the county. She’s had to resume full time work due to her husband’s job loss. He’s now workin’ two jobs at drastically reduced pay. They’re goin’ through their savings like a mower spits out grass on Saturday morning.
What do we, as the lender wanna do?
Our Board of Directors thinks either the government or the market will eventually save us. But then the White House floats a plan calling for principal reduction. Crap on a cracker.
Even if we reduce the loan balance by $90,000 (Almost 17%), the payment will only be reduced by $540 — hardly a real life solution when we consider the couple’s severely reduced income.
If we offered them a significant reduction in interest rate, say 4.5% with interest only payments for two years, then 5% the next three years, then 5% fixed for 30 years fully amortized — it would make the difference in going through foreclosure or not.
Their payment the first couple years falls to $2,025 sans taxes and insurance, a monthly savings of over $1,200. It then rises per the agreement. We now don’t have a problem loan, which means no huge loss for our books. Sure, we’ve taken a hit on return, but only temporarily.
So I pose the question: You’re the lender/investor. Would you rather take a minimum $90,000 hit in foreclosure — very likely more, much more — or take a smaller haircut monthly ’till the ship rights itself?
The rough numbers for us as lenders: Over five years of the new agreement we collect just under $130,000 in interest. Under the original note we’d have collected about $156,000 or so in interest — a cash loss in terms of yield of less than $30,000. Principal reduction is suspended for the five year period, which we don’t particularly like, but it beats the heck outa the alternative.
You’re the chairman of the board, and the investor leaves the decision to you. What do you do?
Tom Vanderwell says:
I’ll right, I’ll bite first….
If it’s as you say, then why are the majority of loan modifications (the numbers I’ve heard vary from 60 to 80% delinquent again within 9 months) going bad?
I’ll tell you – because even with the modified payment, there’s two things that doesn’t address:
1. The borrowers can’t even afford that payment. If their payment is down by 1200 per month but their income is down by $6,000 per month, they can’t make their payments.
2. The underwater issue – many borrowers are faced with the difficult reality of how long it’s going to take to turn things around from an equity standpoint and are making very tough decisions.
I’m not disputing your numbers, but there is more to the picture than just that……
Tom V
January 9, 2010 — 10:38 am
Jeff Brown says:
The country isn’t just Michigan and Ohio. 🙂 Wouldn’t you agree that this couple represents a huge piece of the pie? This program would be worthless for many, but a lifesaver for possibly more.
Think of the ARMs about to come ashore.
Now imagine a third of the problem loans quietly going back to the other side of the accounting ledger due to this approach.
That would make a huge difference. Make sense?
January 9, 2010 — 10:48 am
Jeff Brown says:
By the way, Tom, the so-called loan mods failing all over the nation are faux mods anyway. It’s exactly because of those lame, meaningless payment reductions that my plan would work. All the current mods are doing is buying time for the lender, while screwing the homeowner.
January 9, 2010 — 10:51 am
Tom Vanderwell says:
Jeff,
New Flash – I know that the world isn’t totally built around Ohio and Michigan. But I also know that the problem of either borrowers who can’t qualify even with a 2% interest rate or underwater borrowers who can’t see the light at the end of the tunnel are in NO way unique to Michigan and Ohio.
There really isn’t an ARM problem coming. The problem is the “option arms” where people were paying a minimum payment that is less than an interest only payment and due to negative amortization are going to go from that minimum payment to a payment of a fully amortizing loan.
I calculated the interest rate yesterday for someone who is going to have their ARM adjust and it’s going to go from 5.875% down to 3.875% due to where interest rates are at. A fully amortizing principle and interest ARM is not currently a risk to the economy.
When you say, “Lame meaningless payment reductions” you and I are essentially saying the same thing:
The way the loans are being modified isn’t enough to make a difference. And in many cases, it’s not enough because it’s not possible to be enough. There is no way you can modify a loan for $500,000 so that someone making $60,000 a year can afford it.
And then there’s the whole moral hazard issue. If by giving them a 2% interest rate, they can keep their house, why does their neighbor have to keep paying 6% on their loan?
Loan modifications, in my opinion, are merely an attempt to kick the can down the road and instead of some very pain filled time for 1 to 2 years, we’re in for a lot longer angst filled times.
Tom
January 9, 2010 — 11:20 am
Thomas Johnson says:
What happens when the word gets out that an upside down homeowner can stop making payments and live rent free for a year or more? I am convinced that the shadow inventory is not getting NOD’s filed because then the lenders have to come clean on their balance sheets or it is also possible that the paper is now in Helicopter Ben’s vault having been taken as collateral to shore up some zombie bank.
To complicate the matter the loan is owned in pieces by multiple investors: Norwegian villagers, union pension funds, and the worst pieces are held by Goldman Sachs and Citi and these are “insured” by AIG who gets a free ATM debit card issued by Tim Geithner so they can pass taxpayer cash to Goldman and Citi for “earnings” which generate bonuses and campaign cash. The looting of America continues…
January 9, 2010 — 11:44 am
Jeff Brown says:
How many borrowers do you think my approach would help, if any? Enough to make a difference. This method wasn’t intended to be a panacea.
Moral hazard? Seems I remember a post I read somewhere endorsing principal reduction as a solution.
January 9, 2010 — 12:01 pm
Elizabeth Evans says:
What you suggest is what every commercial lender does with their loans when the real estate cycle tanks. Work-outs are standard operating procedure when the you-know-what hits the whirling blades.
The difference here is the borrower is a homeowner, not a seasoned investor. Repayment depends primarily on the borrower, not on the income produced by the collateral. There is no track record or even a solid I & E statement or balance sheet for the lender to evaluate. In addition, the homeowner may not take the long view and may not understand values will eventually recover. He or she may act on emotion and not choose a well reasoned course of action.
Having said that, your numbers are a powerful argument for loan work-outs in a lot of cases, especially in areas that will likely recover the fastest such as the more desirable California markets. Getting someone in the mortgage servicing sector (and the federal government) with a brain to recognize the benefits and to target a wotk-out program to the right borrowers is the biggest obstacle to making this work.
January 9, 2010 — 12:03 pm
Jeff Brown says:
All sadly true, Thomas. But again, let’s take the whole pie whose filling consists of solid regular folk, not frauds, not those gaming the system, just folks who’ll come out of the mess whole if shown the way.
Out of the pie, a fair sized minority are homeowners in the exact position I’ve outlined here. These folks hate their status quo. The investors aren’t exactly lovin’ it either. Strictly speaking from a business standpoint, the investors would much rather lose less than more.
At some point a decision will either be made, or forced upon everyone involved. This is merely a free market option for one piece of this bitter pie.
January 9, 2010 — 12:15 pm
Tom Vanderwell says:
Jeff,
Do you have any numbers to “back up” your fair sized minority claim? Just curious….
Tom
January 9, 2010 — 1:57 pm
Jeff Brown says:
Don’t have any numbers, cuz they don’t exist. The question remains on the table. Do you have numbers that say they’re not a sizable group? 🙂
Again, let’s look at this as lenders/investors. Which way would you opt for?
January 9, 2010 — 2:19 pm
Jeff Brown says:
Hey Elizabeth — All excellent points. As you pointed out, the numbers speak for themselves. It doesn’t seem like a close call, given these circumstances.
January 9, 2010 — 3:23 pm
Elizabeth Evans says:
Jeff:
What keeps commercial lenders solvent in difficult markets and why what you suggest is key to a broader solution to the residential market problem is the accounting. As you stated, loan modifications such as you suggest allows these loans to be classed as performing. Performing loans reduce capital requirements and keep lenders solvent. Solvent lenders survive and continue to lend, albeit slowly and with government assistance.
Maybe lenders should be required to recruit commercial work-out specialists to design and administer the residential work-out programs. These folks know how to perform the triage necessary to get through this crisis. They can sift through the portfolios and make three piles – modify, offer a short sale, and foreclose. Modifications can be handled quickly, and the short sales and foreclosures can be handled as the lenders’ balance sheets can accept them.
January 9, 2010 — 3:49 pm
Jeff Brown says:
Elizabeth — Though I think your suggestion has much merit, the residential lenders know these numbers too. Until they perceive there’s not an Uncle Sugar or a huge market rebound in their future, they won’t move.
Confession: The couple in the post are real, I know them. The offer they received, completely unsolicited was BETTER than I wrote. Under 3%! Lenders/investors know this is a far better solution for everyone involved, both for immediate financial impact and accounting on the institutional side.
Also, moving these loans to the other side of the ledger would be huge.
January 9, 2010 — 3:57 pm
Tom Vanderwell says:
Only have a couple of minutes, so this will have to be quick….
1. Commercial loans, the lender/servicer owns 100% of the loan (in the case of participated loans, maybe there’s 3 to 5 banks).
2. In residential mortgages, they have been sliced and diced so many times, you can’t tell who owns them. That makes a difference in terms of a couple of things:
1. How motivated lenders are to work with borrowers.
2. Whether they can even get an agreement or not due to the servicer arrangements.
Not arguing the numbers, but the mortgage securitization system has made it harder to accomplish.
Tom
P.S. I’ve got a past customer who was offered a 2% start rate on their modification. He’s still not sure he can make it work, even with that number.
January 9, 2010 — 4:06 pm
Jeff Brown says:
Tom — RE: your customer — Anyone who still can’t make it with 2% doesn’t fit the profile used here.
Unfortunately, the point you make so well about the securitization is all too true.
A big freakin’ thanks to all the regulators who were apparently busy with something more important.
January 9, 2010 — 4:10 pm
Tom Vanderwell says:
Yeah, my customer makes the point about those who can’t afford their house no matter what the interest rate.
The system was built in such a way that doing what you propose, while it makes sense, doesn’t work.
January 9, 2010 — 4:58 pm
Jeff Brown says:
I realize that’s the general thinking, but the fact is, my example is real, and there are more out there with their story. The system can indeed produce these results. Somebody’s gotta figure out how to make it the rule when it’s possible.
January 9, 2010 — 6:44 pm
Ron Seay says:
Hi Jeff,
Another great post and Great question! Acting like the bank I will extend and pretend delay and pray! I will do this a million times and work my hardest to not take that house and that immediate loss! I will reduce that rate to zero if I have to if I can avoid taking a loss! If I can survive another year on this thing then all the better!
Jeff (bawldguy) Brown I have another question for you as the banker to consider in this business cycle. How do you lend money if you dont know what’s your real financial situation?
Is this loan really good or is it a bad loan acting like a performing/good loan? If it is a bad loan then how do you grow your business? If you know you have a boat load of bad loans acting like they are good loans and they will eventually either really go bad or just marginally go bad what do you do with your capital? Do you hold on to it for dear life or do you lend it?
January 10, 2010 — 11:46 am
Rudy McCormick says:
Well it seems to me that if your home payment is more than 18 to 20% of your NET pay your probably going to get in trouble at some point with a divorce or job loss situation. People themselves should plan for these types of issues and if they had done that we would no doubt be in a much more realistic situation all the way around.
January 11, 2010 — 8:07 am
Ralph Bredahl says:
What ever happened to 10 to 20% down?
January 11, 2010 — 8:57 am