The term "cramdown" used to be a dirty word in real estate, an expression meaning that a court would change loan terms — and not in a way that lenders liked.
Now the word does not seem quite so repulsive. Lenders have caught the cramdown spirit, or at least a whiff of it, and the result impacts foreclosed homes and their pricing.
Lenders have begun to see that the huge number of distressed properties they now hold or control will not be quickly sold off. In many cases it's better to accept a principal reduction than to hang onto empty houses with their maintenance, tax and insurance costs.
"In limited cases lenders will now accept a principal write-off," said RealtyTrac spokesman Jim Saccacio. "Could we see more mortgage write-downs? The likely answer is yes if only because a voluntary cramdown sometimes represents less loss and hassle for lenders."
In basic terms a cramdown can be seen debt made smaller as a result of a court order. An interest-rate reduction is also regarded by many as another form of cramdown.
There have been proposals which would allow federal bankruptcy judges to reduce mortgage debts, something not now permitted. As the Mortgage Bankers Association explains, allowing principal write-offs "would throw into question the value of the collateral that backs every mortgage made in this country — the home."
If cramdowns were allowed, then says the MBA "mortgage rates would increase in cost by 150 basis points (1.5 percent). In addition, lenders will be forced to require higher down payments and charge higher costs at closing. All these increased costs would be necessary to account for the new risks that lenders will face when judges decide to change how much borrowers owe on their mortgages." (Parenthesis mine).
It sounds like a pretty good argument except for two problems:
While it's true that bankruptcy courts cannot modify the mortgage for a prime residence, they can change the terms for the loan on a vacation home, yacht or private plane. If a $1,000 loan secured by a prime residence is debt, why should it be treated differently than $1,000 in debt secured by a vacation home? Just how are they different?
The second issue is this: A lot of lenders are saying yes to cramdowns.
The Real World
While associations and lobbyists vehemently oppose cramdowns, a small-but-growing slice of the marketplace now accepts them — not gleefully and not with open arms, but with a sense of resignation.
The most obvious examples are short sales.
With short sales the borrower offers to sell a property for less than the loan amount — under the condition that the lender allows will release its lien at closing. For instance, it may be that a home was purchased for $300,000 and has a $275,000 mortgage. Today the property is worth $240,000. If the borrower simply defaults and the lender must foreclose, the lender may hold the property for months and in the end may not even get today's lower market value. Rather than face a potentially bigger loss with foreclosure, the lender goes along with the short sale.
The National Association of Realtors said in October that distressed homes foreclosures and short sales typically sold at "deep discounts." NAR estimates that 17 percent of all October existing home sales were foreclosures while 11 percent were short sales.
As to the term "deep discount," we asked NAR about that expression during the summer. According to association spokesman Walt Molony, a deep discount at the time was defined as "about 20 percent" off market value — less in some markets, more in others.
So what's the difference between a short-sale, a foreclosure discount and a cramdown?
Nothing at all in dollars and cents.
Before the foreclosure meltdown began for real in 2007 short sales were as rare as unicorn teeth. Today they are entirely common, but often with a twist, the lender agrees to take less at closing but reserves the right to go after the borrower with a deficiency judgment.
The catch is that there are a number of states where deficiency judgments are not allowed or are not practical. For instance, in California a lender cannot seek a deficiency judgment when a borrower defaults on a purchase money mortgage — the value of the home is the lender's only recourse. If the property is refinanced then the lender may be able to get a deficiency judgment because the loan is no longer a "purchase money" mortgage.
To make matters worse for lenders, it used to be that borrowers could not dodge mortgage debt without a huge tax bill — the unpaid mortgage debt was considered "imputed" and taxable income by the IRS.
Tax policies created a strong reason to pay off mortgage debts but that's no longer the case. Under the Mortgage Forgiveness Debt Relief Act of 2007 many borrowers will not face taxes on up to $2 million (or $1 million if married and filing separately). For specifics, speak with a tax professional.
Deficiency judgments — a way to offset cramdowns — are themselves increasingly under fire.
"A deficiency judgment after foreclosure seems to be one of the greatest injustices that occur to homeowners after they have gone through the arduous foreclosure process," says Rep. Edolphus Towns (D-NY) "Not only are they behind by thousands of dollars on their mortgage payments and facing public auction of their houses, the ordeal may continue indefinitely."
Towns has introduced H.R. 3566, legislation that would limit deficiency judgments to one year and ban them completely in the case of low-income borrowers.
Cramdowns By Another Name
Given the fierce lender opposition to cramdowns it's surprising to find thousands of loans with recorded principal write-downs.
Under the government's Making Home Affordable program there's actually a formal option called a "Principal Reduction Alternative" or PRA. The October numbers tell us that to date more than 47,000 principal modifications have been started and that the typical write-off is $65,200.
In September when Ocwen Financial Corp acquired Litton Loan Servicing from Goldman Sachs, it needed approval for the deal from the state of New York. The arrangement went through — but only because Goldman agreed to write off 25 percent of the principal balance for certain delinquent loans. The deal is expected to involve 143 residential mortgages and will cost Goldman $52 million.
It would be a far bigger deal if Fannie Mae and Freddie Mac began to offer principal write-downs, a practice which regulator Edward DeMarco says is prohibited. Not everyone agrees and now 17 members of Congress have asked DeMarco in a letter for proof that Fannie Mae and Freddie Mac cannot take principal reductions.
The Remaining Taboo
Even though the door to principal reductions has opened a touch, there's one place where lenders are implacably opposed: deals which allow current owners to secretly cut their mortgage debt.
Imagine a short sale where a property is purchased at discount — and then re-sold to the current owners. The result is that the owners get to keep their home but reduce their mortgage debt.
Such an arrangement is not an arms-length transaction. Instead it could well be regarded as mortgage fraud, a felony and nothing to fool with. To prevent such transactions, most lenders have strict affidavit requirements for short sales, including most recently Freddie Mac.
Lenders now write-down interest levels with some frequency, in part because historically-low mortgage rates make such refinancing attractive. By refinancing good borrowers at a lower rate lenders create a mortgage with less risk — and a new asset that can be re-sold at a profit in the secondary market.
But principal write-downs are something new. Relative to the overall size of the mortgage marketplace voluntary lender cramdowns remain fairly exotic, rare events — but events that do happen.
Peter G. Miller is syndicated in newspapers nationwide and operates the consumer real estate site, OurBroker.com.