America's housing mess

07.20.09
By Randy Johnson

It is difficult to separate the facts concerning loan modifications from the puffery from the big lenders’ Public Relations Departments. They talk about the number of people hired to do loan modifications – thousands – to the number of offices set up just to handle them – dozens – and the number of loans modified – hundreds of thousands. Is it real?

They make it sound as if they are successful, but upon examination of the facts you may come to a different conclusion:

• Loan modifications are being done at a slow pace.
• The modifications that are being done are not helping distressed homeowners.
• The majority of loans that have been modified go back into default soon after a modification.
• Foreclosures are continuing at a high pace.

According to a report by the Office of the Comptroller of the Currency (OCC), in the first quarter of 2009 some 185,156 loan modifications were done. When you add up the number of loans that each lender says they are modifying, it would appear that they are each counting the same loans.

Nonetheless, the re-default rate continues to be high. Of those loans modified a year earlier – that is, in the first quarter of 2008 – 53 percent had re-defaulted within six months. The numbers were slightly worse for loans modified in the second quarter of 2008. This constitutes failure.

Another measure of failure: Over 20 percent of modified loans went into a re-default status within the first month. Many of whom may well have just walked away when the hoped for modification fell short of meeting their needs.

Foreclosures increased to 844,389 in this sample of loans studied in detail by the OCC investigators, in spite of a moratorium instituted by Fannie Mae and Freddie Mac for about half of the quarter.

Let’s summarize, with the understanding that we aren’t necessarily talking about the same loans and the same periods of time. Lenders modified only 22 percent of the loans that went into foreclosure, and over 50 percent of those modifications failed.

That leaves us with only about 10 percent of modifications that could be deemed successful. To make matters worse, of the loans that were “in distress” and headed to foreclosure, 90 percent didn’t get a modification or got an inadequate modification that failed to stop the foreclosure. The clear conclusion that one would draw from these data is that the voluntary loan modification process is failing miserably.

Let’s look at some more statistics. The current estimate is that one in five homes is under water. A staggering 20 percent of American homeowners owe more on their mortgages than their homes’ current market value. That amounts to about 14 million underwater homes.
 
Equity equals hope. People who have equity have hope. People who have no equity may still have hope of they believe that their home might recover in value some day. But many people, particularly those in the hardest hit markets, have virtually no hope that the value of their homes will recover in their lifetime. Unless they are given a reason, many of them will probably stop making their payments. When this happens, foreclosure and eviction soon follows.

Yet the most believable data indicate that the number of loans that are modified by reducing the amount owed is inconsequential. In the study portfolio, only 1.8 percent of loan modifications resulted in a reduction of the balance owed. That means that the borrowers are still saddled with a property that will not become “valuable” again for many years to come. Their incentive for making payments on their huge dinosaur loan is likely very low.

My belief, therefore, is that people will not stay in these homes until they get a reduction in the loan balance. Even Fed Chairman Ben Bernanke agrees with me. Here’s a quote from a speech he made:

“In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.”

If you think that’s good news, he made that speech in March 2008, more than a year ago.

We can conclude that if the goal was to reduce the loan balance to the current market value of the property, the loss to the lender would be 10 percent in many areas, 20 percent in the more hard-hit markets, and as much as 40 percent in the hardest-hit markets like California, Arizona, and the city of Las Vegas.

The alternative is that the lender boots the owners out and sells the home (eventually) to someone else. The losses in this scenario are even worse. It appears that when a home is sold at foreclosure, the lender/investor re-coups only about 50 percent of the value of the loan. With this in mind, you wonder why lenders aren’t more eager to reduce the loan balances.

Here’s the final piece of the jigsaw puzzle: Banks and other financial institutions in this country are required to follow Rule 157 of the Financial Accounting Standards Board. That rule says that banks and other lending institutions must value their assets at the best estimate of the fair market value. You have read about the write-downs in the news. Indeed, the last estimate I saw of total write-downs by banks and other institutions is $1.4 trillion. Those were the same loans we are talking about now.

Let’s assume that loans were written down as follows: subprime loans by 50 percent; Alt-A loans by 40 percent; and loans in declining markets by 30 percent. Let’s take a prime loan that was 80 percent when it was done – say, a $320,000 loan on a $400,000 purchase. The current value of the home is $280,000, but the lender has that loan on his books for $320,000 less 30 percent equals $224,000.

Why not re-write the borrower’s loan for $280,000? If they did, they would actually have to record a $56,000 profit because they received a $280,000 payoff on a loan that was on the books for $224,000. If they let it go though foreclosure, they would likely get something closer to $224,000.

On July 28, the CEOs of the biggest banks are going to Washington. Maybe the folks there will ask these same questions. I’d sure like to understand the answers, but with the secrecy surrounding this whole issue, there will likely be lots of style and no substance. And that’s too bad, because we aren’t going to get this economy back on track without a recovery in the housing market. The housing market won’t be fixed until we stem the tide of foreclosures, and we simply are not doing it so far. 

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