Bailouts and Short Sales: Where Will it End?
Friday, November 21, 2008 | Ethan Roberts
A very strange thing happened this past week. I received a call from a former customer asking for a consultation on setting up a "short sale" with her lender. A short sale is one in which the proceeds of a real estate sale fall short of the balance owed on the property, and due to financial hardship of the borrower, the lender agrees to allow a home to be sold for less than what is owed on the mortgage. But what was unusual was instead of her being in default on her mortgage payments, she was actually paid up and current on them, but still wanted the bank to allow her to short sale the home!
However, as the months went by, they began to realize that this ALF was not going to be the profitable enterprise they had envisioned. They had secured one full-time resident and a few others from time to time, but only for respite (temporary) care. While they weren't losing money, they were really only breaking even, given their income versus the money needed to pay the mortgage and other expenses.
The problem was the surrounding neighborhood. While the street on which the home was located was not too bad, the neighborhood was located in an area of town that was substantially blighted. When the relatives of an applicant would come to preview the home, they would have safety concerns about the area, and therefore would not want to put their loved one in this facility. This was unfortunate because the care being provided was actually very good, and despite the unseemliness of the neighborhood, they had never experienced any crime or trouble before.
So when the woman and her partner contacted me, their intent was to sell this home and find another property for their A.L.F. in a better part of town. The thinking was that since prices had come down, they could find a home in a better location for the same amount they had paid for this home.
In fact, they had already secured a buyer for the home. The problem was the buyer only qualified for a loan on a sales price some $15,000 less than the amount needed to pay off the mortgage. So they wanted to know if I could assist them by working with the lender to allow a short sale.
This was a totally new situation for me, and I was somewhat appalled by the idea. I explained to them that short sales are designed to help people who are unable to make their mortgage payments, and at risk of foreclosure. I added that it was doubtful that any lender would allow them a short sale unless they were behind by several months on their payments. I also cautioned them that by purposely falling behind on their payments, or simply by doing a short sale on the home, they could seriously impair their credit scores for a long time. If their intent was to buy another investment property, it could be years before they would be able to do so.
They replied that they had explained to the lender that although they are now current on their loan, they could soon be losing their one full-time resident, and that would put them at risk for a future default. What shocked me is that the lender actually told them to fill out the short sale paperwork, and send it in for consideration! This is one listing I am going to pass on taking. Enough is enough.
I am relating this story because it is the perfect example of the financial madness that has recently gripped America, and is creating an escalation of both economic and moral destruction in our once great country. Wait, check that. America is still a great country, but too many of its people have now fallen into an amalgam of irresponsible behavior, dependency, and boorish entitlement, in a never ending quest for immediate gratification.
This idea was reinforced this week with the new homeowner's bailout program, as proposed by the Federal Deposit Insurance Corporation (FDIC). It seems that every other day now someone else becomes the purveyor of a new bailout plan. I can't keep up with them all, and I'm dizzy just thinking about it. In fact, Sheila Bair, the chairwoman of the FDIC, seems to be fighting with Henry Paulson and the Treasury Department over who has the best plan.
Several aspects of the FDIC bailout trouble me. First, I don't like that it kicks in after the borrower is only 60 days past due. Can't you just foresee thousands of people whose credit is already bad, purposely going into 60-day default, just to be able to renegotiate their loans? Additionally, in an effort to create an affordable payment for the struggling homeowner, Bair proposes the following:
1) An interest rate reduction
2) Extending the 30-year loan into a 40-year loan
3) Forbearance of principal if necessary (ie. permanent deference unless the home is sold or refinanced)
And this is where the argument becomes sticky. On the one hand, Bair's proposals should help people to remain in their homes, which will slow the tide of foreclosures, and help to stabilize communities and home values. On the other hand, these ideas stick in my throat like an unseen bone in a fish fillet. Let's take a loan balance of $150,000, and see what happens to the monthly principal and interest payment when we modify it by interest rate or term:
Assume the homeowner currently has a 7%, variable rate mortgage. Their current monthly P&I payment is $997.95, with $122.95 of that going to principal. If the loan is modified to 6% fixed rate for 30 years, the new payment will become $899.33, with the principal portion starting at $149.33 (principal usually increases about two dollars per month, while the interest drops by the same amount). Change the term now to 40 years and the monthly payment drops to $825.32, but the starting principal drops to only $75.32 per month (see table).
Int rate 30 years Principal 40 years Principal
| 7% | 997.95 | 122.95 | NA | NA |
| 6% | 899.33 | 149.33 | 825.32 | 75.32 |
With a 6%, 30-year mortgage, after 10 years, the owner will have paid off $24,472.06. But change that to a 40-year mortgage, and the principal paid after 10 years is only $12,343.46. That is an incredibly small amount of principal to pay down over such a long time frame.
Also, did you know that when you sell a home, between realtor commissions and closing costs you will pay at least 8% of the sales price? On $150,000 that is $12,000, almost the same amount of principal that was paid down on a 40-year loan over 10 years. The homeowner with the 40-year mortgage better hope for substantial price appreciation over the next 10 years!
In fairness to the FDIC, I certainly prefer their idea of reducing mortgage payments to no more than 31% of the borrower's income, as opposed to the 38% figure that was proposed by the Treasury Department's bailout plan. The 31% maximum is much more sensible if we are concerned about attenuating the future rate of loan defaults. Another interesting proposal is to reduce the interest rate down to 3%, rather than reducing the principal amount. I wonder if the lenders would agree to that.
The final idea of the FDIC is to have the government guarantee up to 50% of the loan value in the case of a re-default. That means once again, Tommy and Tammy Taxpayer will have to come to the rescue. Let's face it, if you can't make a 40-year mortgage payment with a 3% interest rate, you have no business owning a home!
However, missing from all of these bailout proposals is a plan for providing these high-risk homeowners financial education, to help them learn how to budget, save money, minimize debt, and avoid getting behind on their payments. This education piece is vital, yet nobody is proposing it! Without it, we are merely treating the symptoms, but not the root cause of the foreclosure problems. In fact, if we don't start doing a better job of educating our teenagers and young adults on financial matters and ethics, we will continue to see more of the same.
This has been a difficult period for all of us, as we watch the government handing out bailout money like candy on Halloween night. Uncle Sam tells us the bailouts are essential, and will eventually restore stability to the stock market and to home prices. But like children who see another child getting more "loot", our eyes grow big and we want to know, "where's ours?"
Not that the world was ever a fair place, but this is just crazy. We have bailouts for irresponsible banks and insurance companies, and people who bought homes they could not afford. Meanwhile, responsible, hard working folks who pay their mortgages on time, are forced to pay for it all so that our economy won't collapse. Wait, this news just in: Congress is now holding hearings to consider bailing out the auto industry!
What's next, a bailout for Jimmy's Lemonade stand when business is bad after a rainy day?
Jimmy is all smiles, knowing Uncle Sam has his back...
We have morphed into a society of enablers for irresponsible and incompetent behavior, and it is frightening to imagine what effect this will have upon our economy in the long term.
Where is the bailout for the hard working taxpayer? Looks more like the shakeout!
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Ethan Roberts
Chief Investment Officer
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