As mentioned in the previous article 23% of America’s are upside down on their mortgage. It’s no secret the re-default rates for loan modifications are 50% after six months. The challenge even with Obama’s Homeowners Affordability Refinance Program (HARP) and other loan modifications is that it does not address the issue of negative equity. Even if you could refinance at little or no cost, you’re still paying for an asset that really isn’t an asset.
No matter which way you slice the apple, it’s still rotten. If you amortize your payments over 40 years versus 30 years you’re still paying to own a house at a loss.
If property prices were to recover at a healthy 5% per year, it’d take 6 years compounded annually to make up a 25% drop in home values. This still does not cover your selling costs if you wish to sell.
Even a loan modification drops the interest rate, monthly payments decrease but you’re still paying to own a home at a loss.
The situation gets tougher if you’re getting a loan modification from an interest only loan to a principal and interest loan. In many cases your payment actually goes up because of the amortization.
Lewie Raniere, a person credited with terming “securitizations” has a solution.
The idea: an investor buys a mortgage 40-50 cents of face value from a bank and then works with the borrower to to get them on a payment plan they can afford. In some cases principal is lowered by as much as 20% (also known as a mortgage cram down), and the investor may even pay the person’s credit card bills so they can get the homeowner back on track. The homeowner works with a financial consultant one-on-one to come up with a budget and payment that will work. They even build in a 10% “cushion” to decrease the likelihood of default.
To-date, this is the only viable long-term plan that addresses negative equity and will likely prevent future defaults.
The biggest indicators of whether the borrower will re-default are 1) Do they have income and 2) Have they lived there longer than two years. To no surprise, income is still the primary determinant whether someone can pay the bills. And the second factor, surprisingly makes lots of sense because overtime people get attached to their homes and are more willing to make sacrifices.
For example, my wife just had a conversation with her co-worker. Her colleague’s family bought a couple years ago and they’re considering letting the mortgage go. The numbers just don’t make sense. They have less commitment to the home and look at it more from a cash flow perspective. They think, “We’re paying $3000/month for carry costs (interest, taxes and insurance) when we can rent an equivalent home for $1500, save money, and not deal with maintenance.”
Negative equity will play a big causal role in foreclosures for at least the next couple years. We won’t get out of the woods until this is addressed by either 1) a market increase in value or 2) lenders lowering principal.
I don’t like predictions, but if I had to place my bet I’d say negative equity will likely get address in the way of market price recovery. The idea of mortgage cram downs to lenders is still unfathomable, not to mention the moral hazard it might present for people seeking a free lunch.
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Hey here is a interesting article that looks at the benefits, or lack thereof, for a homeowner to consider keeping their underwater mortgages. It also talks about possible legislation that could motivate both banks and homeowners to work together to not default on their loan. http://www.nytimes.com/2010/01/24/business/economy/24view.html?scp=1&sq=Underwater,%20but%20Will%20They%20Leave%20the%20Pool?%20&st=cse
Steve,
Thanks for the comment. I like the solution presented:
“The bank would be required to reduce the mortgage by the average price reduction of homes in the neighborhood. In return, it would get 50 percent of the average gain in neighborhood prices — if there is one — when the house is eventually sold.”
While it makes sense in theory, I wonder how to practically execute it. How and when will the banks realize 50% of the upside? The average person stays in their home for 11 years, so it may take a while for banks to realize and monitor this.
Another issue, across the board so many areas have dropped over 20%. If this were the criterion to get modifications, I would think we’d have a free lunch mentality for people who aren’t necessarily struggling. Just a thought.
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