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The foreclosure crisis is the number one economic issue facing America today. While some may argue that job creation should be our top priority and others may believe that stimulating the economy should be job one, the simple fact is that there can be no meaningful economic recovery so long as the housing market remains dead in the water. Unless and until we deal with the foreclosure crisis, there can be no improvement in the housing market and no sustainable economic recovery.
Since the 1950's, the housing industry has been America's single most important engine for economic growth. Historically the housing industry has directly or indirectly accounted for one-fifth of all American jobs and 17% to 18% of GDP. Today, however, the housing market is on life support. Since the peak in 2006, home prices have fallen 27%, wiping out $9.0 trillion in wealth as millions of homes have been lost to foreclosure. Today, with many of these foreclosed homes languishing on the market, the supply of unsold homes in America has ballooned to 3.4 million, representing more than eight months of supply. With plummeting prices and an enormous glut of unsold homes clogging the market, builders are simply not building. New home sales in 2010 fell to the lowest level in 47 years. This means that no one is buying the concrete, lumber, glass and steel that go into building our homes. Nor are we buying the sinks and stoves, the pools and patio furniture, or the toilets and TVs that fill our homes. Moreover, we are not hiring the carpenters, electricians, masons and plumbers needed to build our homes or the brokers, bankers, lawyers and accountants needed to sell our homes.
While it may be tempting to view the foreclosure crisis on a micro level, seeing it as a problem only for those few irresponsible homeowners that foolishly got in over their heads, this is simply not the case. The reality is that the foreclosure crisis is a societal problem that keenly affects all of us. The homeowner facing foreclosure has already lost the equity in their house and, in reality, has little left to lose. The rest of us, however, stand to lose substantially more if an additional ten million foreclosed homes are dumped on an already saturated housing market. Not only would this surely quash the nascent economic recovery now in place, it would destroy trillions of dollars in market value on top of the losses already sustained.
While we can argue about the root causes of this crisis, there can be no argument about its potential impact. If another ten million homes are lost to foreclosure the effect on the overall economy will be catastrophic. Robert Schiller (of the Case / Schiller Index) recently estimated that housing prices could fall as much as another 25%. If this were to happen, Americans would lose another $6.0 trillion of asset value. Consequently, we cannot let our collective desire to assign blame or punish irresponsible behavior stop us from taking the necessary steps to put the U.S. housing market back on the road to recovery. Our experience at Scudder Bay has shown us that there are bad actors on all sides of this issue, from unscrupulous homeowners that borrowed against their house and never made a single payment to shady loan originators that put unsophisticated homeowners into mortgages they knew they could never afford to those notorious robo-signers that routinely filed false affidavits in the name of expediency. Nevertheless, we must now focus our efforts on resolving this crisis and putting the country back on the path to economic recovery rather than continuing to seek retribution for past wrongs.
The statistics surrounding this crisis are staggering. Since 2007, over 3.2 million Americans have lost their homes to foreclosure, causing housing prices to fall 27%. However, this is just the tip of the iceberg. An additional 2.2 million homeowners are currently in foreclosure. A further 4.7 million borrowers are at least 90 days delinquent on their mortgage and it is only a matter of time before foreclosure proceedings are initiated against these homeowners. This means that we are only one-third of the way through the foreclosure process and that there is still significant pain ahead. Moreover, if housing prices stagnate or fall further we could see many more defaults as more than one-quarter of all homeowners in America, about 15.7 million people, have no equity in their homes. As a result, if we do nothing, as many as 12.5 million more homes could be lost to foreclosure. It is impossible to overestimate the impact this would have on the economy as a whole.
We all remember from Economics 101 that prices are a function of supply and demand. Due to the insidious nature of foreclosures, however, when a home is lost to foreclosure it affects both sides of the equation. Not only does the foreclosed home come on the market, adding to supply, but, based on current lending practices, the foreclosed-upon homeowner is effectively barred from the housing market for up to seven years, thereby reducing the pool of potential buyers and hence reducing demand. With increased supply and reduced demand, housing prices have nowhere to go but down. If we add ten million homes to the supply side of the equation and remove ten million potential buyers from the demand side of the equation, housing prices would remain under extreme pressure for many years.
There are things that can be done to avoid this outcome. However, we first need to change the way we approach the problem. The Government's "one size fits all" approach to the problem is not only wrongheaded, it is ineffective. That said, it is not necessary to overcomplicate the matter. The truth is that two sizes will fit all. Specifically, in coming up with a workable plan for resolving today's foreclosure crisis we must distinguish between those homeowners that can actually afford to stay in their homes and those that cannot. While this may seem obvious, it is a distinction that seems to have been lost upon policymakers in Washington.
If a homeowner has the financial wherewithal to remain in their home (if their loan were modified to reflect today's lower value of their home) we must do everything possible to keep these people in their homes and to keep these homes off the market. Conversely, if a homeowner does not have the financial wherewithal to remain in their home (even if their mortgage were to be modified), then we must do everything possible to transition these homeowners to more appropriate housing. Only in this way can these homeowners get back on their feet financially and can we work through the glut of non-performing loans.
So what is "everything possible?" First, the solution does not require an additional dime of taxpayer money beyond what has already been committed. Nor does it require new and complicated Federal programs. Rather it requires only common sense and a little arm twisting in order to get the various Federal agencies to do their job and work in concert to resolve the current crisis.
I formed Scudder Bay Capital, LLC two years ago with my wife (a consummate do-gooder) to help resolve the mortgage crisis in New England. We wanted to be part of the solution. Our strategy was simple. We would buy non-performing loans and then work closely with homeowners in a socially responsible manner to either help them stay in their home (when possible) or to transition to more appropriate housing and get back on their feet financially when it is not possible for them to stay in their home. The first order of business would be to determine which homeowners could afford to make their mortgage payments if their loan were modified or refinanced to reflect the current value of their homes and which homeowners could not afford the payments even if the loan were modified or refinanced to reflect the current value of their homes.
When we first started the business we thought that once gained the trust of the homeowner and made the determination as to whether they could afford to stay in their home, the process would be simple one. For those homeowners that could afford to stay in their homes, our plan was to either modify the loan or allow the homeowner to refinance the loan at a significant discount to the unpaid principal balance and arrearages. By reducing the principal balance and forgiving the arrearages we hoped could restore a modicum equity in the home thereby putting the homeowner back on his feet financially and giving them an incentive to remain current on their mortgage.
For those homeowners that could not afford to stay in their home, our plan was to provide financial assistance to allow these homeowners to transition to more affordable housing (often a rental property) and to forgive the deficiency balance and past due payments so that they could get back on their feet financially and move on with their lives. In addition, we would provide cash assistance, relocation services and credit counseling services to ensure a smooth transition. Once the family was relocated, we would sell the home on the open market to a more qualified buyer that could afford the payments. In this way, not only could we help the homeowner start over, we could turn a non-productive asset into a productive asset.
So what went wrong? With regard to the first group of homeowners, those that could afford to stay in their homes, we ran into two problems - it is impossible to refinance these loans and prohibitively expensive to modify them.
While the Federal government has made much of the moral imperative financial institutions have to modify loans, the fact is that the Federal government penalizes any institution that actually agrees to reduce a borrower's principal amount or even lower their interest rate. It used to be the case that when a financial institution purchased a mortgage on the secondary market and modified the loan, the homeowner was taxed on the debt that was forgiven while the financial institution was taxed on the difference between the purchase price of the loan and the new modified face amount. In response to the housing crisis, the tax on homeowners was removed, but the tax on the financial institution remains. Since almost all non-performing loans have been sold at a discount on the secondary market, this tax on "phantom income" serves as a very real deterrent to modification particularly as almost half of all mortgages modified since 2005 have re-defaulted within a year of modification. It is asking much of these institutions to pay an upfront tax on a 30 year stream of future payments when these payments so often cease within a year of the modification. It only stands to reason that if this tax is eliminated, the number of modifications will increase and the number of foreclosures will decrease. Moreover, this change to the tax code would be revenue neutral over time as the tax would still be due when the lender actually receives the payments.
With modification no longer a viable option we tried to find banks willing to provide refinancing for our homeowners by agreeing to write off a significant portion of the unpaid principal balance and all of the arrearage so that property was no longer under water. Refinancing, however, for this segment of the population is an urban legend, a myth, it does not exist. As a result of missed mortgage payments, the FICO scores for these borrowers are mired in the netherworld below 600 where no bank will dare to venture. Consequently, the very banks which caused this problem by lending to anyone with a pulse have now found religion and are unwilling to extend credit to anyone but the most pristine borrowers. As my Dad always said, banks only lend money to people that don't need it.
In response to this problem, the Federal Housing Administration rolled out its "Short Refi" program. The program was designed to help borrowers with damaged credit scores by providing government guarantees. The program is only available to deserving homeowners that are current on their mortgage payments but underwater on their mortgage. If the lender is willing to write of at least 10% of the principal balance (but as much as necessary to restore equity in the home), FHA would insure the new loan. From our perspective, this program was just what the doctor ordered. It requires banks to write down loans in order to restore equity for the homeowner in return for a getting a government insured loan. Moreover, it is only available to deserving homeowners that have continued to make payments despite being underwater on their loan, providing a strong incentive for homeowners that are underwater to remain current with their payments.
So how did the industry respond? Of the hundred plus banks we have contacted we have found exactly none that are participating in the program including those banks that received TARP funds. And Congress's response? Kill the program. The Republicans have recently proposed eliminating the FHA "Short Re-fi" program. Why? It is too expensive. You cannot make this stuff up.
What is most puzzling to us is that no bank wants to participate. We would have thought that they would be all over this program. After all, who wouldn't want government guaranteed paper paying 5%. You would think that they would be doing this every day of the week and twice on Sunday. There is a catch, however, or should we say, two catches. First there is no secondary market for these refinanced loans (which means that these banks would be forced to carry these loans on their balance sheets) and second, if the banks keep these loans on their balance sheets, they will be penalized by Federal bank regulators for making loans to individuals with poor credit scores (despite the fact that the loan is insured by U.S. Government). Again, you cannot make this stuff up!
Discouraged by the fact that no one was willing to participate in the program, we decided to start our own bank. The only trouble is that you can't start a new bank in America today. Federal bank regulators don't want to be bothered issuing charters to banks that might want to be part of the solution. Where is the fun in that? When we brought this de facto moratorium to the attention of our Congressman (a ranking member of the House Banking committee), he claimed to have no knowledge of this de facto moratorium. He did get back to us a week later, however, to let us know that we were wrong - there were two banks issued charters in the United States during 2010. Two whole banks? Well we stand corrected. It is good to see that our Government is hard at work trying to solve the problem.
Despite the fact that this program is slated for the scrap heap, it can and should be saved. All we need to do is create a secondary market for these loans and who better to do that than our friends at Fannie and Freddie. After all, don't they work for us now that they have been nationalized? This would create the ultimate public/private partnership. Private companies would take the hit on the old loans if the Government would insure the new loans. For all those fiscal conservatives about to rear up and roil against the Federal government taking on this additional risk - take a deep breath. These loans are already insured by the FHA. As a result, there is no incremental exposure. Who knows, maybe Fannie and Freddie could actually make money packaging and selling these loans like they did a long, long time ago in a galaxy far, far away. In any event, if we could create a market for these loans the program could be an enormous success keeping millions of hardworking and deserving families in their homes (an millions of homes off the market).
Even if we can't get Freddie and Fannie to create a secondary market for these loans, we ought to be able to get the bank regulators to stop penalizing banks that make these loans. It makes no sense to have the FHA encourage banks to make these loans if regulators are going to penalize banks for making these loans. Either this is something the government supports or it's not. And if it is something we support, regulators must treat these loans differently when assessing the soundness of a bank's portfolio.
These two simple fixes, changing the tax code to eliminate the penalty on financial institutions that actually modify loans and creating a secondary market for FHA "Short Re-fi" loans could prevent millions of homes from falling into foreclosure thereby keeping millions of families in their homes and millions of homes off the market. C'est tout.
So now that we have solved the problem for those homeowners that should stay in their homes, what do we do about the poor homeowners that cannot afford to stay in their homes? We get them out of course and as soon as possible - nicely, humanely - but out. While the government has made it prohibitively expensive to modify a loan and almost impossible refinance a mortgage, they have also managed to keep millions of non-performing homeowners in homes they cannot afford. The number one solution from Democrats seems to be to delay foreclosures for as long as possible. This has been done under the guise of "making sure the paperwork is correct," however, that is just a ruse. The simple fact is that these lawmakers are simply choosing to kick the can down the road. While the banks have acted like idiots and their paper work is a mess, virtually all of the homeowners being foreclosed upon are squatting in homes for which they have made no payment in years. That's right - years. Our average loan, when we buy it, is 30 months past due and if we are forced to foreclose it generally takes us more than a year from the time we purchased the loan. Just to be clear, we are not foreclosing upon Mother Theresa.
When we first started Scudder Bay two years ago, we found most homeowners cooperative and receptive to our offer to help them with financial assistance and relocation services. Frankly, for those homeowner unable to make their mortgage payments, they knew they had two options - work out a deal with us or lose their home to foreclosure. By working cooperatively with us, homeowners often got tens of thousands of dollars in financial assistance from Scudder Bay. Moreover, we agreed to forgive any deficiency balance and all past due payments. This allowed our homeowners to get out from under a bad situation and move on with their lives. Today, as a result of all the attention politicians are placing on shoddy foreclosure practices, homeowners are emboldened. With the help of ambulance chasing lawyers, many homeowners are going to the mattresses, contesting every aspect of every foreclosure proceeding.
We currently have one homeowner that refinanced her property 11 times, the last time for $800,000. The house is now worth $500,000. Her annual income is $36,000 a year. Needless to say she falls into the category of homeowner that cannot afford to stay in her home. Since she claimed to have a handicapped child we offered her $35,000 to move. On the advice of counsel she refused. Her response was a lawsuit claiming that she never received her TIL (truth in lending statement) and that as a result her mortgage is unenforceable. "But we have ours TIL - and it signed by YOU!" we protested. "So, what, I never got my copy and try to prove that I did" was her response. And did we mention, the homeowner is a real estate broker?
The actions and rhetoric of misguided politicians trying to score political points by bashing the big bad banks have encouraged homeowners to file frivolous claims to try to avoid the inevitable. The only problem, however, is that the inevitable is inevitable and ultimately these homeowners that have not, cannot and will not make their mortgage will lose their home to foreclosure and when they do there will be no $35,000 in financial assistance to help them move and start over as this money will have been squandered on lawyers and frivolous lawsuits.
The costs of delaying tactics like the one described above are not insignificant. First, most economic models show that there will be no meaningful recovery in housing prices until the market has bottomed out and foreclosure rates return to normal pre-bubble levels (approximately 300,000-400,000 per year). Any steps taken to stall foreclosures will only extend this bottoming out point. Instead of bottoming out in 2011 as originally expected, the market may now not do so until 2013 or 2014. This will have a huge effect on all homeowners, depressing equity values and trapping people in their homes. Secondly, by delaying foreclosures now, there is a risk that when the dam finally breaks, a huge glut of foreclosed homes could come on the market all at one time. If this happens, prices could drop significantly making the "Great Recession" seem like a rehearsal dinner. Third, policies that keep non-performing homeowners in their homes create a moral hazard. At Scudder Bay, we have worked hard to get people re-performing on their loans so that we can keep them in their home. Given recent events, however, it is hard for us to tell homeowners with a straight face that they should make their mortgage payments when the Government is effectively encouraging homeowners to default on their mortgages and squat in their homes without paying anything. Lastly, these policies have spawned tens of thousands of frivolous lawsuits, tying up limited judicial resources at a time when state budgets are already stretched to the breaking point. Creating more legal hurdles to foreclosure for lenders simply wastes the resources of servicers, lenders, and investors, all of whom could be using that capital to provide financial assistance to homeowners in transitioning to more affordable housing.
If you take anything away from this article it should be this: First, not all is lost. Despite the magnitude of the problem there are low cost common sense solutions we can implement. Second, not all homeowners are the same. In some cases we should do everything possible to keep homeowners in their homes. In other cases we should do everything possible to hasten their departure. Third, time is not our friend. The longer we delay the day of reckoning, the greater the pain when the bill finally comes due. While the magnitude of the problem facing us cannot be overestimated, by limiting the rhetoric and implementing simple common sense solutions that require little in the way of Government resources, we can limit the number of foreclosures, ease the transition for millions of families that must inevitably lose their homes and hasten the recovery. Until homeowners get an honest assessment of their chances of remaining in their homes, however, and until policymakers acknowledge that one approach is not going to work for all homeowners, the housing market will not fully recover and will remain a drag on the US economy for many years to come.
