One of the matters I have been helping some clients with are issues relating to their residential loan workouts. There is a lot to be said about the topic, so I just want to give some very general comments in this first post about the current incentive structures in place for homeowners in Arizona. In short, much of what has occurred in the last two years encourages homeowners to walk away from their home loans – which is unfortunate for the Arizona market as a whole as it creates a continuing downward push on home values.
In Arizona, property values are down an average of 35% since last November – and by as much as 50% from the peak of values (See John Wake's blog for some stats on this). Once we finally hit a bottom in the market (hopefully before the end of 2009), most experts don’t expect any sort of bounce in values. More likely we will bump along the bottom for a few years with flat or minimal appreciation before beginning to slowly start recovering value. And even then, annual appreciation won’t be anything like the last four years. It is more likely to be between three and five percent appreciation for quite awhile.
The result of such devaluation is that many Arizona property owners who purchased at or near the height of valuations in 2006 and 2007 are way underwater on their loans and are looking at potentially between 10 and 15 years before the value of their home is again equal to or greater than the value of their loan. For instance, let’s assume a borrower purchases a house in Arizona for $300,000 in 2007 putting down only 3% (not an unusual thing) and using just a standard 30-year fixed term loan with 5.5% interest (we’ll leave aside interest-only, option ARMS, negative amortization loans, etc. for now). If their house devalued to now being worth $150,000, here is a chart showing when their house will again be worth what their loan is worth:
(Note: I generously assumed for the next two years 1% annual appreciation and 5% annual appreciation thereafter.)
As you can see, it is about month 150 from their purchase date in 2007 that they are no longer underwater (so 11+ years from today). And note that many homes were purchased with some of the variable features I described above that would extend out this time period.
So a borrower is essentially locked into a situation where if they want to move or sell their home for any reason in the next 11 years, they will still have to go to their bank to ask for short sale approval or some other loan workout because they are underwater, and thus will still take a hit on their credit.
Looking at this scenario, it is easy to see the current incentive for individuals in Arizona to walk away from their homes now. Beyond taking a major hit on their credit report (still a pretty severe penalty), little else in the way of penalties remain in many circumstances. Generally a foreclosure will stay on an individual’s credit report for seven years. The other potential penalties to walking away are that a lender may, in some cases, be able to collect for any shortfall (or “deficiency”) amount on the loan and the borrower may be taxed on any loan amount forgiven. However, Arizona’s anti-deficiency statutes and the Mortgage Forgiveness Debt Relief Act passed late last year in many cases can make the latter two penalties go away – leaving a homeowner in Arizona only with bad credit to repair. (Note here for readers that you should talk to an attorney before making decisions about your home loan – as each situation differs and there can be some pretty nasty consequences if you don’t make sure you qualify for exemption from certain penalties).
Weighing the option of being stuck in their home for the next 10+ years versus having bad credit for the next seven years, many homeowners are deciding that the best option is to walk away from the home now. Coupled with the feeling that they are paying a large monthly payment for a home that is worth only half of what they paid, they have lost their job, are being transferred out of state or only bought the property as a short-term investment, it isn’t hard to see why Arizonans are walking away from their homes in significant numbers. This harms entire neighborhoods as one or two foreclosures quickly causes home values in an area to be further devalued and creates a domino effect of people throwing in the towel and going into foreclosure.
To stop this, lenders and Congress need to get to the root of the problem – principal amounts that are far greater than home values. To date, very few, if any, lenders are writing down principal on their notes. One reasons for this is if a lender writes down its loans, it has to devalue those loans in its loan portfolio and the resulting write-down may jeopardize the solvency of the lender. So lenders are delaying taking action for as long as possible. Another reason is that many of the loans have been bundled and securitized and the “lender” is in fact only acting as a loan servicer and has little power under the securitization documents to modify the loan (even changing interest rates, much less writing down principal). We have already seen several of the investors in these securitized mortgages suing servicers for modifying loans without their consent. So the lender may not even have the authority to complete a loan modification.
So as I see the situation today, at least in Arizona, we have a stalemate with borrowers seeing more and more incentive to walk away from their homes as they drop in value, and lenders unable to really get to the root of the problem and write down principal to an amount where borrowers would think twice about walking away in order to salvage their credit. In the meantime, lenders are offering various loan modifications - which is just postponing foreclosure to a later date.
There are some people who are starting to make the point about principal write-downs on loans, but the discussions in the media and on Capitol Hill still seem to be about lowering interest rates and deferring principal. I think that over the next six months, the discussion will turn more toward principal write-downs as foreclosures continue. One of the voices on TV who has been bringing this topic up in most of her discussions about the ongoing loan modification efforts is Diana Olick at CNBC. You can follow her blogging here, where she writes about many of issues relating to residential loans. Her main critique of all of the legislative efforts so far is that they don’t write down principal.
The end of the housing boom and bust saga is yet to come and I will be highlighting various issues surrounding loan modifications, short sales and foreclosures on this blog often, as it is truly at the root of what ails our economy. Hopefully we can get out of this downward spiral in home values in Arizona soon.
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