The New York Times came out with a thunderous editorial a few days ago, an official opinion piece from the nation’s newspaper of record regarding the matter of foreclosures. Basically, the paper said we have too many foreclosures and the Obama Administration’s $75 billion federal effort to bail out homeowners is not providing sufficient relief.
What to do? Reducing monthly payments is not enough, said the paper, it’s also necessary to reduce principal balances for those who are upside-down on their mortgages.
According to the Times “for 15.4 million ‘underwater’ borrowers — those who owe more on their mortgages than their homes are worth — a lack of home equity puts them at risk of default, even if their monthly payments have been reduced. They have no cushion to fall back on in the event of a setback, like job loss or illness.
“This page,” continued the editorial, “has long argued that a robust anti-foreclosure plan should directly address the plight of underwater homeowners by reducing the loans’ principal balance. That would restore some equity to borrowers — and give them a further incentive to hold on to their homes — in addition to lowering monthly payments. The mortgage industry has resisted this approach, and the Obama plan does not emphasize it.” (See: Foreclosures: No End in Sight, June 1, 2009)
The Times editorial raises two issues, one objectively incorrect and the other discomforting. First, for most borrowers the issue of being underwater or above water is simply irrelevant. It has little to do with foreclosures. Second, if loan balances are to be reduced when home values decline then you have to wonder why loan balances should not be increased when home values rise.
We usually think of the value of a home in terms of market price. When home values are rising market values are discussed like badges of honor, but if you sell a home for $500,000 the odds of getting a $500,000 check at closing are just about zero. There are marketing costs, transfer taxes, brokerage fees and settlement costs. If you have $460,000 or $465,000 after closing you’re doing well.
Most homes, however, are financed. That means the check from closing will be further reduced by whatever remains on the loan balance. If you sell for $500,000 and owe $350,000 to the lender, then you have $150,000 in gross equity. Less $35,000 or $40,000 paid out for various costs and services at closing and the net result is maybe $110,000 to $115,000. A very nice check indeed, but a long way from $500,000.
Of course, if you have a $475,000 mortgage balance then selling is not such a pleasant experience — you’ll need to bring cash to closing to make up the shortfall from the sale.
During the past few years much of the lending industry has marketed loans with little or nothing down. The National Association of Realtors reports that the typical down payment for a first-time buyer was just 4 percent in 2008 — and 23 percent of all buyers purchased with nothing down.
For many recent buyers being financially underwater is the norm rather than the exception. If you buy with nothing down or close to it then the property typically cannot be re-sold for years without a loss because common marketing expenses are larger than the down payment.
Today millions of homebuyers are underwater because local real estate values have fallen and because they had no marketplace equity in the first place. For most underwater owners the issue may be psychologically bruising but it’s not a financial worry.
“Truth is people don’t lose their homes because they’re underwater, they lose their homes because they can’t make their monthly payments,” says James J. Saccacio, chief executive officer of RealtyTrac.com, the nation’s largest source for foreclosure listings and data. “People who have lost their jobs, gotten divorced, encountered huge medical bills or faced the death of a spouse are the individuals most likely to be foreclosed. Alternatively, if home values fall but monthly payments continue then the lender has no grounds to foreclose.”
According to the most recent survey by S&P/Case-Shiller, home values nationwide dropped 19.1 percent during the past year. There are huge numbers of homeowners with traditional loans and perfectly-good payment histories who are now underwater but not facing foreclosure. Why should lenders reduce the principal balance of such mortgages?
No less important, would not the Time’s proposal actually increase mortgage delinquencies? For instance, imagine two neighbors — each with a $300,000 mortgage. One runs into financial difficulties and his loan balance is reduced by $50,000. In such a situation why would the neighbor not default on his loan? Miss a few payments and you too can save thousands on your loan.
The Wrong Equation
According to the Times, lower principal balances will result in lower monthly payments. In the case of fixed-rate loans lower balances will produce smaller monthly costs.
The problem is that a large percentage of the most troublesome loans — those option ARMs and interest-only mortgages — are not fixed-rate financing. Lowering the principal balance for toxic loans will not necessarily result in smaller monthly housing expenses.
Suppose Smith has a $500,000 ARM with a 4.5 percent introductory rate. The start rate lasts for three years. For whatever reason, the lender after three years is forced to reduce the principal balance to $450,000. Now, however, the interest rate is 6 percent and the loan has 27 years remaining. Even though the principal balance is $50,000 less, the monthly payment for principal and interest goes from $2,533.43 to $2,807.93 because the interest rate is higher and the remaining loan term is shorter.
One of the most basic principles of common law is that you cannot change rules retroactively. Even if there was a legislative magic wand which could somehow reduce mortgage balances, either it would not apply to existing loans or if they was an effort to make it apply retroactively lenders would fight it in court for years. In either scenario there would be no help for current borrowers for a very long time, if at all.
Guaranteed Home Values
Imagine for a moment that the Times’ plan is somehow put into action. If borrowers could be protected from negative equity it would then make sense to buy as much house as possible and to get the biggest mortgage you could find. Why not? If home prices go up you win because your equity has increased. And if prices go down, who cares — your loan balance will also decline so you won’t have a loss because your loan would effectively be an insurance policy that would protect you if home prices fell.
Such a system would depend on the availability of financing, but few if any loans would be available. Why would any lender originate mortgages in an environment where they lose if home prices decline — but get nothing extra if prices go up? The housing market would shut down.
Where Relief Is Justified
It may be that the Times would like to see lenders have more responsibility for the mortgage meltdown, a notion which could easily get traction in Washington. The basic idea would be to change the mortgage lending system so that it could never again cause a financial implosion that threatens the entire economy.
How could this be done? You don’t have to look much further than the FHA insurance plan to see how the mortgage lending system could be modified. For instance, prepayment penalties are banned under the FHA program. Negative amortization is prohibited. Fully-documented loans are always required. All properties must have a physical appraisal. Buyers must have at least a 3.5 percent down payment.
In fact, if the government really wants to change the lending system it could simply set the rates for FHA mortgages. That would force private-sector lenders to compete by offering equal or lower rates.
Can’t happen? Until 1983 FHA mortgages rates were set by HUD. There’s no reason why a tried and tested system could not be revived, this time with daily rate updates published on the Internet for all to see.
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.