The Mortgage Calculator has blogged extensively on the topic of loan modifications, and many of the posts have harped on banks for failing to make the program a success. A couple of recent exposes in the mainstream media, lend additional credence to this notion. It turns out that despite the cash subsidies offered by the government, loan modifications are still less profitable for banks, on average, than the alternatives.

The first alternative is to take no action. Research has showed that a large portion of borrowers (between 1/5 and 1/3 according to two estimates) are able to catch up on their loan payments without help from the lender. Meanwhile, “A second set are those who are likely to fall behind on their payments again even after receiving a modified loan and are likely to lose their homes one way or another. Lenders don’t want to help these borrowers because waiting to foreclose can be costly.”

Another option is to allow the home to slide into foreclosure. Conventional wisdom suggests that foreclosure is never profitable for the bank. What this notion ignores, however, is that the majority of mortgages are packaged and bought by investors, leaving the bank only to service the loans. In such cases, the hit caused by foreclosure is born entirely by the investors, rather than by the originator. As a result, “Even when borrowers stop paying, mortgage companies that service the loans collect fees out of the proceeds when homes are ultimately sold in foreclosure. So the longer borrowers remain delinquent, the greater the opportunities for these mortgage companies to extract revenue — fees for insurance, appraisals, title searches and legal services.”

Then, there are the fees that lenders charge for late payments. “Servicers charge substantial penalty fees when loans are in delinquency or default — a source of revenue that goes away if a homeowner gets back on track.” That delinquent mortgages are extremely profitable is reinforced by the data: “From June 2008 to June 2009, the number of American mortgages that were 90 days or more delinquent soared from 1.8 million to nearly 3 million, according to the realty research company First American Core Logic. During that period, the number of loans that resulted in the bank taking ownership of the home declined to 245,000, from 333,000.”

Despite the federal government’s claim that the loan modification program has been and will continue to be a success, the fact remains that “The latest available figures show that the number of households at risk of foreclosure is 700% higher than the number of loan modifications, and the gap has been increasing steadily.” Until the program is tweaked, such that banks are compelled to increase loan modification volume – through greater incentives and/or stricter punishments – borrowers receiving loan modifications will remain the exception, rather than the rule.

On July 30, a new set of mortgage guidelines, mostly administrative in nature – will go into effect, under the auspices of the Federal Reserve Bank. I use the term administrative to describe the new regulations because they refer principally to the provision of mortgage information, rather than the provision of mortgages, themselves. [On a side note, this could be the last piece of mortgage regulation passed by the Fed, if the Treasury Department is able to convince Congress to legislate the creation of a Consumer Protections Agency. See related post.] In short, banks will be required to deliver a greater quantity of information to (potential) mortgagers, in a timely and upright manner.

“Among other key changes, the new Federal Reserve regulations require lenders to provide you with initial disclosures of your estimated mortgage costs within three business days of your loan application. If you don’t get them, you can pull the plug.” Until this updated truth-in-lending disclosure (which must also include an APR calculation) has been prepared and sent out, lenders are prohibited from “collecting any fees — except a reasonable charge for checking your credit.” That means no up-front application fee, no appraisal fee, etc., until you have been officially notified of the total lending costs associated with the mortgage.

There are also several considerations that affect the timing of the mortgage process. First of all, lenders will be required to wait seven days after preparing the truth-in-lending disclosure before they can close the loan. If the APR changes by more than .125% from start to finish, you must be notified and given a fresh seven days to think it over. At least three days before closing, meanwhile, you must received the final truth-in-lending disclosure, which among other items, includes the real estate appraisal. Given that the appraisal now has the potential to make or break a deal (see Monday’s post: “Uproar over New Appraisal Rules could Spur Change“), this rule could have significant consequences.

Overall, the rule changes should increase transparency in the mortgage process, by serving to make borrowers aware of junk fees, and giving them enough time to potentiall having them removed. From a timing standpoint, “Closing dates will be more closely tied to lenders’ and settlement agents’ accurate estimates and their ability to deliver disclosures and appraisals by the required dates. If appraisers are backlogged and can’t produce valuation reports quickly, settlements will have to be delayed.” According to one source, “There is an active and aggressive segment of the legal profession that specializes in going after banks and mortgage companies for truth-in-lending violations,” which could force lenders into compliance.

Most of the attention surrounding the foreclosure crisis has focused on homeowners, but perhaps its time to turn the spotlight towards another demographic: “Renters…are overlooked by federal foreclosure prevention programs solely designed to help homeowners. ‘They’re facing many of the same issues as homeowners, but there is not attention on it…They are swept up in the mortgage crisis as well, but they are kind of the unseen victims of it.’ ”

That’s right- many of the properties implicated in the housing crisis are not primary residences, but rather rental properties. “According to the National Low Income Housing Coalition, more than 20 percent of U.S. properties facing foreclosure are rentals, and renters make up about 40 percent of all families facing eviction.” Their owners made the same misguided assumptions about their ability to afford the properties, and lenders were just as happy to provide them with mortgages. Now, many of these owners are finding it difficult to stay current on the mortgages, which has caused some of the properties to slip into foreclosure.

Other properties have been beset by equity stripping, whereby investors used proceeds from cash-out refinancing to pay themselves dividends rather than invest in improving the properties. “Saddled with oversize mortgages, cash-strapped buildings scrimp on basic maintenance. In December, New York Sen. Charles Schumer urged the SEC to investigate, calling the situation subprime crisis 2.0.”

Previously, renters lacked even basic rights when it came to foreclosure. As soon as the lender took over the mortgage, it could legally evict all tenants. On May 20, however, Congress passed the Protecting Tenants at Foreclosure Act. “Renters now must be given at least 90 days to leave. In some cases, renters will get to stay even longer. If the new owner is an investor, the renter can stay until the lease expires. But if the new owner is the lender or the home is sold to someone who wants it as their primary residence, the 90-day rule applies. During the foreclosure process — before a lender takes back the home — renters can stay as long as they have a lease and continue to pay their rent.”

On the surface, this law restores the rights of honest, rent-paying tenants, by giving them time to make new arrangements in the event of foreclosure. At the same time, it doesn’t do anything to solve the problem that rental properties facing foreclosure are caught in a sort of legal limbo, making them undesirable places to live from the standpoint of tenants. “Many banks instead do all they can to avoid taking over, including stalling the foreclosure process so they don’t become owners…Between the time the owner stops paying and the lender actually forecloses _ a process that can take up to a year _ buildings deteriorate rapidly,” said one expert.

Fortunately, many states (already) have their own laws that protect tenants. “Seventeen states require that tenants receive notice when they’ll be evicted due to foreclosure…Twelve states require tenants be named as parties to foreclosure proceedings, in order to terminate tenancies or give the new owner immediate possession rights. In New Jersey and the District of Columbia, a tenant’s lease can outlive a foreclosure, and tenants can continue to rent from the new owner of the property when a foreclosure is finalized _ often the bank.” If you’re a renter living in a home about to be foreclosed, then, you should first begin by familiarizing yourself with state and local laws. If that doesn’t yield fruit, try contacting the constituent services office of your local congressman.

It’s been nearly three months since the Home Valuation Code of Conduct formally take effect and changed the system for appraising residential homes. By almost all accounts, the results are not good, as evidenced by the higher costs, less flexibility, lower valuations, longer waits, and delayed/failed closings.

In a nutshell, “The new rule, which took effect May 1, forbids brokers from hiring their own appraisers and requires middlemen — called appraisal management companies — to choose them instead. The change was intended [to] reduce the possibility that brokers and lenders would pressure appraisers to raise house values to match sale prices, regardless of the true value. It affects all loans backed by Fannie Mae and Freddie Mac.”

While the Appraisal Management Companies have benefited by standing in the middle of the process and collecting fees, nearly all other parties are suffering. Homeowners have witnessed rising appraisal costs – in some cases 30% higher than before. In addition, the appraisal fee must now be paid upfront (instead of rolled into the mortgage), and can only be used in association with one mortgage application. “Previously, the broker owned [the appraisal]. That has changed. Now, it’s in the name of the actual lender.”

Appraisers, meanwhile, are equally frustrated, since the new system “effectively commoditized their services overnight, undermining the value of specialization, experience and reputation. Theirs is now one name on a long list that receives seemingly random assignments, often in regions they don’t focus on and for less money than they used to earn.”

This alleged failure to match the right appraisers with appropriate assignments is being blamed for low (some would say “inaccurate”) appraisals. Recent news reports have been full of anecdotal stories of both buyers and sellers that watched deals fall apart at the last minute because the appraisal came in well below the sale price. In some cases, “victims” were able to search out an amenable appraiser willing to certify the sale price, while in other situations, they were forced to go back to the drawing board.

According to an “online poll of industry professionals, about two-thirds of respondents said they had had at least one appraisal come in under the purchase price since the new rules took effect, with the average difference being more than $13,000. And 90 percent of respondents said they had lost at least one transaction.” The National Association of Realtors conducted a similar survey, and found that “37 percent experienced at least one lost sale as a result of the new Home Valuation Code of Conduct, with seven out of 10 reporting an increased use of out-of-area appraisers. Seventy percent of NAR appraiser members said consumers were paying higher fees, while 85 percent report a perceived reduction in appraisal quality.”

Of course the flip-side of the debate is that the new system is working according to plan (minus the higher fees), with low appraisals providing a necessary check on real estate prices, to keep them from rising too high too fast. One industry insider notes that “40 percent of the market consists of distressed properties going at fire sale prices.’The real reason for the appraisals coming in “low” has been that the market is still in turmoil,” he said. “Home sales have not yet rebounded. Home prices are still in many areas still falling.’ ”

This counter argument has not stopped people from challenging the rule change. Many appraisers have “signed a petition (www.hvccpetition.com) to try to repeal the rule — a cause taken up by U.S. Rep. Gary Miller, a Southern California Republican who is co-sponsoring legislation asking for an 18-month moratorium.” They argue that while seemingly good-intentioned, this rule will succeed only in stymieing the nascent recovery in the housing market, if allowed to stand. With such vehemence (not to mention lobbyists) on both sides of this issue, it will probably be a while before any further action is taken. In the mean time, the best you can do is solicit a fresh appraisal if you’re not satisfied with the first one.

Okay, perhaps in vogue is an overstatement. But the fact that these mortgages are still available in the wake of the housing bust is frankly amazing. At least one online lender is offering these loans, although this time it has taken steps to mitigating its exposure by requiring a large down payment. “Company officials said they’re aiming these loans at customers who have demonstrated an ability to save money, hence the 25 percent down payment requirement. And they say various features of the loan will allow borrowers to pay off their homes more quickly than if they took out a traditional mortgage.”

Before I get ahead of myself, let me first briefly explain what exactly is meant by the term balloon mortgage. In a nutshell, it’s a “mortgage which does not fully amortize over the term of the note, thus leaving a balance due at maturity.” While the borrower makes payments (interest and principal) in accordance with a normal 15 or 30 year amortization schedule, the loan must be paid off after a fixed duration, usually 5 or 7 years. This lump-sum payment of the remaining balance is known as a “balloon.”

Irrespective of the size of the downpayment, balloon mortgages are still considered risky by most experts. The reason being that the average borrower won’t be able to afford the balloon payment, and will be forced into refinancing. If interest rates have increased and/or the borrower’s credit has deteriorated in the interim period, then this could prove both difficult and expensive. For this reason, balloon mortgages have received special scrutiny from regulators. “Under the new Fed proposals…Buyers also would be presented with a one-page document, in question-and-answer format, warning about risky loan features such as negative amortization and balloon payments…”

The main advantage of the balloon mortgage (cynics would say ‘the main way that lenders entice borrowers’) is its initial interest rate, which can be significantly lower than prevailing fixed rates. Even adjustable rate mortgages, which are similar in many respects, carry higher rates than balloon mortgages. However, interest rate increases are usually capped for ARMs, whereas balloon mortgages must be refinanced at the market rate. There are also closing costs associated with this refinancing, whereas ARMs carry any additional costs unless the borrower elects to refinance. Factor in prepayment penalties and extra mortgage payments, and it becomes a mystery why anyone would still be foolish enough to gamble with a balloon mortgage.

In yesterday’s post, I expounded upon a new trend in the foreclosure crisis – the “strategic default” – whereby underwater borrowers deliberately make a calculated decision to stop making payments on their mortgage. “Current lending practices have created an environment where a measure as extreme as abandoning a home actually makes sense to some people. Many buyers put little or no money down, so they don’t have much invested in them. That leaves them with little incentive to keep making payments when a home’s market value dips below the balance of the mortgage.” With today’s post, I intend to develop this thread further to explain how default (strategic or otherwise) affects one’s credit score.

It turns out that this impact is relatively modest, especially when you compare it to continuing to make payments on a mortgage that well exceeds the value of one’s home. Obviously, borrowers can expect to see their credit rating deteriorate overnight, by a significant margin – as much as 200 points. In addition, it will be nearly impossible for one to take out a new mortgage (or any other significant loans, for that matter) for at least a couple years. The exact duration depends on many factors, namely the borrower’s credit score at the time of default. Ironically, “The higher the score, the greater the damage.”

However, the credit scoring system is such that continuing to make mortgage payments in lieu of payments on other debt instruments (such as credit cards and auto loans) might actually be more detrimental in the long run. ” ‘While a mortgage default can savage a person’s credit record, trying to pay off a loan they can’t afford could be worse for borrowers if it leads to bankruptcy,’ ” said one source. “Credit scores are hurt much more by missing multiple payments – on credit cards, cars and so on – than by a single foreclosure.” In other words, it would take longer for your credit to heal (i.e. a longer wait before you could take out a new mortgage) if you declared bankruptcy, than if you defaulted on your mortgage, even though the Dollar amount of the latter is in most cases much larger than the former.

What about the alternatives? A short sale is now an increasingly attractive option for many borrowers, “thanks to the Mortgage Debt Relief Act of 2007. Previously, if a bank sold a foreclosed home for less than the mortgage balance and it forgave the difference, the borrower had to pay tax on that difference as if it were income. Now the IRS will ignore it.” Even though short sales don’t show up directly on one’s credit report, they are still incorporated into the credit score as a negative event.

The same goes goes for a deed in lieu of foreclosure, in which “the borrower turns over the deed to the property to avoid foreclosure and settle the debt.” While such can help one avoid the delinquent payments normally associated with foreclosure, the deed itself will still show up on the report. According to one source, the logic that one of these choices is better than the other is just plain wrong: ” ‘Someone out there is passing along a rumor that a short sale is better for your credit than a foreclosure or even a deed in lieu of foreclosure,’ he said. ‘All are equal in the eyes of FICO.’ ”

Even loan modification can negatively impact one’s credit. One would think that by preemptively contacting one’s lender (especially before the mortgage becomes delinquent) would receive favorable treatment in the eyes of credit scoring agencies. Unfortunately, their rubrics assume that modified loans are more likely to result in default: “We view an account that has been settled or renegotiated for less than the full amount as a negative because historically consumers on reduced payment plans represent a greater risk,” explained one expert. While loan modifications are generally less punitive than foreclosures, the credit hit can still be significant. It’s no wonder some borrowers are electing to simply walk away.

According to a recent headline-grabbing study, “26% of the record numbers of home mortgage defaults across the country are ‘strategic‘ — that is, calculated economic decisions to bail out of loans by owners who actually have the money to make the payments but can’t handle the negative equity they’re carrying caused by local property value declines.” In most of the coverage to-date surrounding the foreclosure crisis, this class of defaulters has been largely ignored.

The study found that there were a few variable which correlate closely with borrowers’ respective willingness to intentionally default. First, and most obviously, is the value of the mortgage compared to the current value of the home. Specifically, those whose mortgages are most “underwater” are also most willing to default: “Researchers found that almost no homeowners would default if their equity shortfall was less than 10% of their home’s value, but one-in-six homeowners would default if their equity shortfall reached 50% of their home’s value.”

In controlling for age, location, and education level, the study determined that “Well-educated borrowers, homeowners in the Northeast and West, and people under 35 or over 65 were less likely to have moral reservations about choosing to walk away from making mortgage payments.” One’s sense of morality evidently plays a strong role in this calculation, with those who regarded strategic default is immoral 2-3 times less likely to default than their amoral counterparts. This relationship, however, is also proportionate to the size of one’s negative equity position: “While four out of five homeowners said they believed it was morally wrong to intentionally default, as negative equity rises, more borrowers—including those who said strategic defaults were immoral—would consider walking away.”

However, morality (in the case of strategic default at least) is apparently received from social cues. In other words, borrowers surrounded by default were themselves more likely to accept default as an amoral possibility. “The higher the number of foreclosures in a given ZIP Code, the higher owners’ willingness to walk away, the researchers found, suggesting what they call a ‘contagion effect that reduces the social stigma associated with default as defaults become more common.’ ”

This has some important implications for the recent federal legislation, which has aimed to prevent foreclosure by simply helping borrowers to modify their monthly payments, thereby making their mortgages more affordable. However, this legislation is built implicitly on the ideas that underwater borrowers will still repay their mortgages, and that affordability should be measured/enhanced on a monthly – rather than an aggregate – basis. If this report is to be believed, both of these assumptions are questionable. Perhaps this means that we will soon seen a corollary to this legislation passed, in which borrower equity (i.e. mortgage value) is also adjusted. Or maybe not.

Two of last weeks’ posts were entitled “Distressed Housing Attracts Speculators” and “How to Spot Mortgage Fraud.” While seemingly unrelated, these topics actually speak to two trends that are closely intertwined. The first trend is that the housing bust is increasingly starting to resemble the housing boom, from the standpoint of businesses that market themselves to homeowners. The second trend is a rise in mortgage fraud, again practiced primarily by mortgage service providers.

Essentially, many such companies have retooled (or closed and then re-opened under new names) and our now offering new services under the same pretenses. Specifically, many former subprime lenders are now in the business of modifying loans. This is especially repugnant considering that it’s partially because of these subprime lenders that unaffordable loans were issued in the first place, and now require modification if foreclosure is to be avoided.

A new investigative report by the New York Times (A must-read!) details exactly how one such company operated. “For fees reaching $3,495, with most of the money collected upfront, they promised to negotiate with lenders to lower payments on the now-delinquent mortgages they and their counterparts had sprinkled liberally across Southern California.” Backed by misleading national advertising campaign, the company was quickly flooded with calls by people desperate to avoid foreclosure.

Sales people quoted exaggerated success rates and in some cases encouraged borrowers to take money that would otherwise be used for mortgage payments and instead advance it to the loan modification company. According to one agent, “They basically told us, ‘Do whatever you need to do,’ ” he said. “ ‘It’s a sales floor. You’re here to sell.’ People would quote success rates and just pull them out of thin air. People would say 60 percent, 80 percent, 90 percent. To the average Joe in Kansas, that sounded great. But the reality is that 50 percent were immediately declined by the lender.” Customers were further sold on the pretense that their loan modification would be vetted and submitted by a licensed attorney, which was little more than a deliberate falsehood.

The company, FedMod, now faces a lawsuit by the Fair Trade Commission, which has also brought legal action against several similar companies. Still, given that thousands of people made payments to FedMod in good faith and now face foreclosure, it’s hard to argue that justice is being served. In the end, the most important lesson to take away from this debacle is never make an upfront payment for a loan modification. Never, ever, under any circumstances. Even if you are guaranteed a 100% success rat and that a licensed attorney will review your application. Never.

In fact, you can theoretically achieve a loan modification free or charge- either by speaking directly to your lender or with the help of an organization that is not-for-profit and/or government-approved. If you still feel compelled to enlist the services of a for-profit entity, at the very least you should hold off remitting payment until after your loan has been modified.

There seems to be an important exception to that notion that this is a buyers’ market when it comes to housing: distressed real estate. Properties that are delinquent and nearing foreclosures or are already in foreclosure are now attracting bubble-like interest.

According to a report by RealtyTrac, “1.5 million U.S. owners have been told they are in danger of losing their homes. The company Thursday said one in every 84 households got at least one foreclosure notice during the first six months of the year, a new record.” As a result, “The existing home market is still vastly oversupplied, and we continue to be inundated with an influx of distressed and foreclosed properties,” observes another analyst.

Unfortunately – at least from the standpoint of “genuine” buyers – many of these properties are being snatched up by speculators and institutional investors, who have finally found a corner of the real estate market that remains buoyant. “Vornado Realty Trust, one of the biggest real-estate investment trusts in the U.S.,” made headlines when it announced its intention to “raise $1 billion for a private-equity fund to invest in the wave of distressed properties expected to hit in the next few years.” According to marketing materials, the fund is aiming for a 20% annualized return on its investment, which is in indication of just how excited people are about the market for foreclosed properties. Distressed commercial real estate, meanwhile, is nearing $100 Billion and growing rapidly.

Other investors, meanwhile, are hoping to benefit indirectly from a new federal program “designed to stabilize and revitalize neighborhoods ravaged by foreclosures and abandonment.” Across the country, “Out-of-state speculators continue to swoop into these neighborhoods, plucking properties they might fix up and rent out. Then again, they might try to flip them or simply sit on them, perhaps fouling any attempt to stabilize these areas.” These properties are being snatched up for eye-poppingly low prices- under $10,000.

Real estate agents are also getting into the game. A just-announced arrangement “will give local RE/MAX agents…access to RealtyTrac’s database of properties that are in some state of foreclosure — including properties in default, homes scheduled for public foreclosure auction and bank-owned properties…Going forward, prospective homebuyers visiting remax.com also will be able to search RealtyTrac’s database.” While ostensibly affording both buyers and sellers of foreclosed homes more opportunities, a byproduct of this arrangement is that speculators will also have an easier time spotting such properties.

Investors have another advantage – beside deep pockets – over regular homeowners; they almost always pay cash. Until the credit crisis is fully resolved and banks once again trust each others’ credit, it seems speculators will have the upper hand.

“Once upon a time, choosing a mortgage was easy. Nearly all mortgages were of the 30-year, fixed-rate variety, required a 20-percent down payment and were devoid of tricky features like balloon payments, teaser rates and prepayment penalties….Fast forward to 2008, and the world of mortgage shopping had become a much more complicated place.” This glib history of mortgages provides the backdrop against in which one behavior economist defends the government’s efforts to overhaul the mortgage system.

Critics of mortgage reform argue that free markets and consumer choice will yield the best system for allocating mortgages. The problem with this notion, however, is that it hinges on a couple false assumptions. The first is that information is symmetrical; in other words, both lenders and borrowers have access to the same relevant information. The second assumption is that all borrowers/consumers are inherently rational, and hence have only themselves to blame if their choice backfires.

According to behavioral economists, these assumptions are not realistic: “What if consumers believe the following: ‘Creditors reveal all information about me and the loan products I am qualified to receive.Brokers work for me in finding me the best loan for my purposes, and lenders offer me the best loans for which I qualify. I must be qualified for the loan I have been offered, or the lender would not have validated the choice by offering me the loan. Because I am qualified for the loan that must mean that the lender thinks that I can repay the loan. Why else would they lend me the money? Moreover, the government tightly regulates home mortgages; they make the lender give me all these legal forms. Surely the government must regulate all aspects of this transaction.’ “While most borrowers aren’t naive enough to believe everything there, the vast majority must believe that the fact they were issued a certain mortgage inherently means they are qualified for that particular mortgage. Given the increasing number of defaults and mortgages, this is clearly not the case.

In steps the federal government, whose latest proposal is to increase transparency, simplicity, and fairness in the mortgage process. Specifically, consumers would be presented with a concise summary of risks/benefits, costs, and terms. Their ability to afford the mortgage would have to be thoroughly verified by the bank. And here’s the kicker: they would be encouraged to take out a plain-vanilla mortgage, rather than a more complicated alternative.

Critics of this proposal insist that the current rules (stipulated by the Truth in Lending Act) are adequate, and that a simple disclosure of risks should be enough to enable a consumer to take out a mortgage deemed risky by the government. Behavioral economists counter, “Even if meaningful disclosure rules can be created, sellers can undermine whatever before-the-fact or ex ante disclosure rule is established, in some contexts simply by ‘complying’ with it: ‘Here’s the disclosure form I’m supposed to give you, just sign here.’ ” In other words, it’s disingenuous to argue that most consumers read lengthy disclosure documents, which are often many pages long and written in legal jargon.

Under the new system, it would be much easier for borrowers to compare vanilla mortgages offered by different lenders, because the terms/conditions would presumably be identical. The paperwork burden would be lower, and hidden fees and prepayment penalties would be banned. Sounds pretty good to me! No wonder mortgage industry lobbyists are fighting it tooth-and-nail…