After Foreclosure: A Housing Surplus

Of the 74.5 million homes in the United States approximately 45 million homeowners borrowed money to buy their homes.   Out of these 45 million, six million homeowners have already lost their homes to foreclosure and another ten million are underwater, which mean their homes are worth less than their mortgages.[1]     Potentially over 16 million homes could be bank owned and on the market as REO properties.

REO stands for “real estate owned” by a lender typically a bank, government agency, or government loan insurer, after a foreclosure.   Once a lender takes possession of the foreclosed property, the lender is responsible for insurance, taxes and maintenance of the property in order to preserve the asset.  These expenses add up if the property does not sell.  These expenses combined with the decreasing value of real estate highlight a conundrum for lenders: foreclose on distressed property or modify loans and preserve as much of the loan as possible.

As it stands now, real estate values have fallen around 30% since 2006. [2]   Admittedly the reduced value reflects just how over heated the real estate market became when securitizing residential mortgages generated more money than the loans themselves.  However, unloading more inventory will only add to the downward pressure on real estate values with a commensurate dampening effect on the overall economy.

The dampening effect works something like this:  Federal banking regulations[3]require lenders to maintain a certain amount of cash to cover a percentage of the difference between the amount of loan and the value of the asset securing the loan.   The longer a lender holds the property the more cash they have to hold to cover its loss on the loan.   And with its money tied up as collateral for its bad loans, lenders are unable lend to potential buyers.   With banks unable to make loans because of this reserve requirements and new stricter lending guidelines, sales of residential property are stalled.   The result is a vicious downward spiral.  Residential property values continue to slide and banks have their money tied up. 

Another effect of this downward spiral in property values is the strain on American communities.  Local governments lose income generated from property taxes and are unable to pay for public services.   Sprawling neighborhoods of foreclosed properties become waste lands of crime and deterioration without adequate police and fire protection.   Schools close down and the higher number of students per classroom in the remaining schools reduces the effectiveness our educational system.   Unemployment remains high because manufacturing, construction and service related industries follow the real estate development.

Within this grim landscape, it is as wonder that lenders have not figured out that entering into a new agreement with existing homeowners to stay in their homes by either reducing the interest rate, the amount owed or extending the time to pay holds more hope than foreclosing on distressed real estate.   Why not modify loans with people who want to stay in their homes rather than selling these homes after foreclosure for half of what lenders can expect from loan modifications? 

A lender’s decision to foreclose is in fact a modification albeit controlled by bank accounting rules called “troubled debt restructuring”.[4]     And even these rules countenance against wholesale foreclosures in favor of more workouts with current homeowners because the more lenders foreclose and sell their REO inventory, the lower the price of REO properties.

Modifying loans to reflect the 30% decline in real estate values is better than selling the properties after foreclosure with a return of 60% to 65% of the loan amount.[5]   Saving 30% to 35% on loans makes good sense and combined with the banks’ tacit acknowledgement that they are partially responsible for the housing bubble, may help communities move forward together.    

So, why are lenders stuck on foreclosure rather than modification?  

One concern is there will be a rush of homeowners, who are able to pay on their loans, to modify loans in order to lower interest rates and/or reduce the principle amount.   Considering the downward pressure on the real estate market, anyone who asks for a modification are most likely candidates for foreclosure in the future and dealing with it now may help stem a further decline.       

Another answer may lie in the fact that lenders do not understand the full extent of the financial crises.  Or they might understand the financial crisis and are waiting for the government to bail them out as they did during the Savings and Loan scandal in the 1980’s or as they did in 2008 with TARP.   Maybe lenders are unsure on the direction of the economy and are stalling by blaming tougher loan guidelines and high unemployment as their reason for not lending money.  

There are signs that lenders may want to reconsider blaming the borrowing public or government regulations.  Lenders are coming under increased government scrutiny for mortgage fraud[6]  and title companies are becoming leery of insuring title to REO properties because of the uncertainty of the chain of title problems recently highlighted in mortgage backed securities.   Another consideration is the talk of “right to rent” legislations which would allow homeowners to stay in their foreclosed homes and pay rent.  This legislation would only cover government backed mortgages held by Fannie Mae and Freddie Mac which make up half of the foreclosures.[7]  Consequently, Lenders will have a harder time selling their REO properties if the government is leasing their REO stock.

Hopefully, lenders will see their way to working with distressed homeowners rather than against them.

Unfortunately, the corporate face of banking does not bode well for individuals facing tough economic times.  Lenders, who were in a better position to prevent the housing bubble than the individual home buyers, are avoiding responsibility at all cost because they know the tax payer will eventually bail them out.   

[1] American’s equity in their homes near a record low, Christopher S. Rugaber, Associated Press June 10, 2011.

[2] S.&P./Case-Shiller index, tracks the value of residential real estate in 20 metropolitan regions across the United States.

[3] 12 U.S.C. 29, 84 and C.F.R. 34.82

[4] Accounting Standards Codified (ASC) 310—40.

[5] The Next Crisis in Residential Mortgages-New Data Emerges, by Dan Alpert of Westwood Capital, The Big Picture, June 20, 2011.

[6] Office of the Comptroller of the Currency, Press Release April 13, 2011.  See:  http://www.occ.treas.gov/news-issuances/news-releases/2011/nr-occ-2011-47.html

[7] Right to Rent: Will Obama Administration Finally Fix Housing? Dean Baker, Truthout   June 27, 2011.

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tagged Foreclosure, REO properties, bank owned properties, modification, troubled debt restructuring in Banks, Defense, Foreclosure, Modification