A recent spate of lawsuits has accused mortgage lenders of impropriety or outright fraud at virtually every level of the mortgage process. Moreover, as lenders increasingly find themselves on the losing end, these lawsuits will have important implications for the future of mortgage lending.

Bank of America is currently in the process of resolving all of the disputes surrounding Countrywide Financial, which it acquired during the height of the housing boom. In 2009, it was sued by the state of Massachusetts for originating risky loans without verifying borrowers’ ability to repay the loans. BofA ultimately settled the case in May 2010, and agreed to “$18 million in loan modifications for Massachusetts homeowners, $3 billion in loan modifications for homeowners across the country, and a $4.1 million payment to the Commonwealth.”

However, the Attorneys General from the states of Nevada and Arizona have already filed suit alleging that BofA has failed to live up this agreement, as it “told consumers they would not be foreclosed on while requests for loan modifications were under way, not acting on the modifications within a specific time, making false promises to consumers and potentially selling their homes while they were waiting for decisions.”

Last week, Bank of America finally settled its case with Freddie Mac and Fannie Mae, in which it agreed to repurchase a substantial portion of Countryide mortgage securities, and subsequently write down $2-5 Billion of it. Meanwhile, All State Insurance, which also lost money on investments in mortgage securities, and MBIA, which lost money insuring such securities, have also filed lawsuits. Both allege that BofA deviated from its underwriting standards when it originated such loans. Such claims are supported by an internal Countrywide audit, which found that “approximately 40% of the Bank’s reduced documentation loans . . . could potentially have income overstated by more than 10% and a significant percent of those loans would have income overstated by 50% or more.”

Meanwhile, the State Supreme Court of Massachusetts “affirmed a lower court judge’s ruling invalidating two mortgage foreclosure sales because U.S. Bancorp and Wells Fargo did not prove that they owned the mortgages at the time of foreclosure.” While there was no doubt – as in thousands of other cases – that the borrowers were in default, the lenders failed to convincingly establish proof of ownership at the time of foreclosure. These cases were closely watched by foreclosure defense attorneys around the country, and it is likely that additional cases will now be brought forward.

The upshot is that lenders are finally being held accountable for lax origination/documentation practices that were begun during the housing boom. As if it wasn’t already clear, their operations will continue to be the subject of rigorous scrutiny, and it’s possible that more lawsuits will be brought forward.

If the statistics are to be believed: “strategic default” – the act of voluntarily walking away from one’s mortgage – is now becoming quite fashionable. According to the latest estimates, more than 30% of foreclosures are strategic defaults, compared to 20% in 2009. However, the calculus of “strategic default” is changing, such that you need to think twice before jettisoning your mortgage.

The debate surrounding strategic default was ignited by Brent White, a Law Professor at the University of Arizona, who suggested that breaking one’s mortgage contract was a choice like any other, and that some borrowers were acting against their best interests by continuing to pay their mortgages. White urged such borrowers to mail their keys back to their respective lender, and continue living – rent-free – in their homes until they were forcefully evicted through foreclosure.

According to White and other proponents of walking away, the only down-side of such a decision is a negative hit to your credit score. To be sure, you can expect that foreclosure will cause your FICO score to decline by 100 – 400 points, which will make securing any kind of loan in the immediate future quite difficult, to say the least. Thanks to a 2007 law enacted by Congress, you are not responsible for paying tax on a canceled mortgage, which otherwise would be treated as forgiven debt and taxed accordingly.

However, this is not the whole story. There are 11 states that have so-called non-recourse laws, which prevent lenders from laying claim to borrower assets if the proceeds from foreclosure are insufficient to repay the mortgage: Alaska, Arizona, California, Iowa, Minnesota, Montana, North Carolina, North Dakota, Oregon, Washington, and Wisconsin. That means that there are 39 states which the lender can effectively go after you for the difference, by garnishing your wages, freezing your liquid assets, or obtaining a lien on other hard assets. In addition, the lender has up to 7 years to seek such restitution, which means that you can only really escape the lender through bankruptcy.

Finally, there is the matter of securing a new place to live. Even ignoring your beaten-down credit score, the stain of credit default will prevent you from obtaining a mortgage for 5-7 years, thanks to a recent rule imposed by Fannie Mae and Freddie Mac. Buying and Bailing – in which you attempt to secure a new mortgage on a new home, before dumping your existing one – is now quite difficult, again thanks to increase vigilance by Fannie and Freddie, as well as a more stringent guidelines for mortgage lending. The only realistic alternative, then, is to rent….that is if you can find a landlord who is amenable to your financial situation.

In short, I would like to clarify my position regarding strategic default: you should only do so if you live in one of the 11 states listed above and if you are sure about your ability to secure a new place to live following foreclosure. You are also advised to speak to an attorney in order to fully understand your liability. Of course, if all things considered, it’s in your best interest to strategically default, then by all means, go right ahead.

Previously a fringe issue, strategic default is expected to take center stage of the foreclosure “epidemic” that continues to sweep the country. This is due to two primary factors:

The first is that more than 20 million mortgages will soon be underwater (the mortgage exceeds the current market price of the home); that’s 25% of the total. More worrisome is that 5 million of these will be underwater by more than 25%, which is a “critical” threshold as determined by analysts. Of course, there is a certain arbitrariness to this threshold, but the idea behind it is that at a certain point, the idea of owing more than your home is worth takes on a real significance as parity in the near-term becomes less of a hope and more of a dream.

Even assuming that starting today, home prices will start appreciating by 5% per year, that means it will be five whole years (10 for a borrower that made a 25% down-payment) before a borrower that is 25% underwater can get back to the starting point of the mortgage. When you consider that underwater borrowers are predominantly located in markets that also experienced the largest bubbles (i.e. Nevada, Florida, Arizona), even assuming 3% a year looks generous at that point. When you further consider that some of those borrowers are more than 50% underwater, the idea of waiting 20 years before they can get back to even can seem sisyphean. Purely in terms of the numbers, then, there is already a critical mass of borrowers for whom strategic default will be attractive.

The second factor driving strategic default is increasing attention by the (mainstream) media, which appears largely indifferent – sometimes cautiously supportive – of strategic default. At the beginning of the credit crisis, when default was seen as “legitimate” (there was no way many of those borrowers could make good on their mortgages under current circumstances), nobody made much attention to strategic default. Those that noticed it thought of it as “baffling” (in the words of Wachovia), and a handful of columnists ventured to call it irresponsible.

Since the release of the University of Arizona Professor Brent White’s paper on the subject, strategic foreclosure has gradually gained mainstream acceptance. Professor White examined the issue from the legal perspective, noting that contracts are frequently broken when one of the parties determines that it’s in his best interest (i.e. the benefits outweigh the costs) to do so. Public opinion, meanwhile, has focused more on the comparison with Wall Street, which behaved irresponsibly during the years leading up to the credit crisis, only to avoid collapse by being out by the government. To hold borrowers up to a higher standard, goes the argument, seems unfair.

As I have argued in previous posts on the subject, for many people, it would indeed seem that the financial benefits outweigh the costs. In states where non-recourse loans are mandated, lenders are entitled to the home and nothing else in the event of foreclosure. In the majority of states, recourse loans are the norm, which means that a lender can technically sue for the difference in the event that a foreclosure sale turns up less than the value of the loan- though few lenders actually bother doing so. In addition, there are no tax consequences for the majority of defaulters, thanks to the Mortgage Forgiveness Debt Relief Act of 2007, which “applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately).” The only costs then are those associated with moving, and the inability to borrow for the next few years due to a flattened credit score. For many defaulters, these costs pale in comparison to the immediate savings from renting a comparable property rather than making mortgage payments.

The main argument against foreclosure continues to be a moral one. But even this is somewhat flimsy, when you consider that the possibility of default is an inherent feature of mortgages (that’s why borrowers have to pay interest!). This is especially the case with non-recourse loans, where a study recently determined that borrowers unwittingly pay lenders an extra $800, when compared to recourse loans. In these states, then, strategic defaulters can perhaps rest assured that one way or another, they paid for the right to default.

You’re mortgage is underwater. What do you do?

A few years ago, this would have been a fringe question for a fringe audience. Nowadays, though, 25% of all residential mortgages are underwater. In states like Nevada and Florida – two of the epicenters of the housing bubble and subsequent bust – more than half of borrowers owe more on their mortgages than their homes are worth. In other words, for a growing portion of homeowners, this question is of foremost importance.

For argument’s sake, let’s assume that you have already discussed a loan modification with your lender, and you have been either rejected or presented with an inadequate offer. As a result, you have made the decision to part with your home. [Admittedly, this is a weighty decision]. Should you sell your home at a loss, or simply walk away from your mortgage and allow your lender to deal with the fallout?

The first option is known as a “short-sale,” since the proceeds from the sale of your home wouldn’t be enough to cover the balance of your underwater mortgage. Accordingly, a short sale (or its first cousin, the deed in lieu of foreclosure) first requires the approval of the lender, because it is tantamount to writing off part of the mortgage as a loss. Still, many lenders are amenable to this possibility, because it is often less complicated – and hence, less expensive – than outright foreclosure. You will also need to confer with any junior-lien lenders as well as the mortgage insurance company, if applicable. After receiving an offer on your home, this must then be submitted to the lender (via its loss mitigation department) for final approval.

Here are a few additional things to keep in mind: Minimizing the transaction costs of the sale (by hiring an expensive real estate agent, for example) will go a long way towards convincing the lender that the deal is worthwhile. Next, while a short-sale is less painful than a foreclosure, there will still be some inevitable damage to your credit. In addition, you might be expected to pay taxes on the portion of your mortgage that was forgiven by the bank. Finally, be advised that short sales typically take longer to complete than normal sales, as lenders will often spend a long time deliberating over whether to approve the deal.

If your house has depreciated too much in value, and/or your lender is not willing to approve a short-sale, then a strategic default might be your last option. So-called as to distinguish it from a “conventional” foreclosure, a strategic default is a voluntary decision to stop making mortgage payments despite the capacity to do so. While choosing foreclosure might strike some as oxymoronic, it turns out that for many, it is actually a perfectly rational choice. Simply, the negative impact on one’s credit score and the possibility of a deficiency judgment, pales for some when weighed against the prospect of spending the rest of one’s lifetime paying off a mortgage that is well underwater.

That’s because while foreclosure technically remains on one’s credit report for 7-10 years, it can become functionally irrelevant in the eyes of lenders in half that time. In addition, deficiency judgments (in which the lender sues to collect the difference between the value of the property at the time of foreclosure and the amount owed under the mortgage) are illegal in many states, and rare in the rest. That being the case, the only remaining consideration is the moral one- deliberately breaking a contract that you have the ability to honor. While there are strong arguments to be made for both sides, I don’t think this is an appropriate forum to explore that dimension, however. Let your conscience be your guide.

According to a new report by Deutsche Bank, and investment firm, the number of borrowers with underwater mortgages – those who owe more on their mortgage than their homes are worth – is projected to skyrocket in the next few years. This proportion, “will nearly double to 48 percent in 2011 from 26 percent at the end of March, portending another blow to the housing market.”

Deutsche Bank didn’t offer much in the way of context/analysis for its figures, which is somewhat surprising since several indicators of the housing market have begun to tick up. Regardless, the projections are eye-opening, to say the least. Everyone already knows about the problems affecting the riskiest class of mortgages. With regard to subprime loans, “69 percent will be underwater in 2011, up from 50 percent in March, Deutsche said. Of option adjustable-rate mortgages — which cut payments by allowing principal balances to rise — 89 percent will be underwater in 2011, up from 77 percent.”

Those following the housing market probably would have also anticipated that some of the most distressed regional markets would see a rising percentage of underwater mortgages, many of which were no doubt funded using the risky mortgages cited above. For example, “Las Vegas and parts of Florida and California will see 90 percent or more of their loans underwater by 2011.”

Few, however, would have expected such dire predictions for prime loans, which “make up two-thirds of mortgages, and are typically less risky because of stringent requirements.” As a result of a projected 14% price decline up to  41% of prime conforming loans may be characterized by negative equity by 2011. “Forty-six percent of prime jumbo loans will be larger than their properties’ value, up from 29 percent, it said.”

Most troubling, perhaps, is the notion that such borrowers won’t receive a break from lenders, nor from the government. Currently, the practice of reducing one’s mortgage (known as a cram-down) as a result of personal bankruptcy, remains taboo as a result of industry pressure. “House Financial Services Committee chairman Barney Frank (D-Mass.) has already warned that if more loans aren’t worked out, he’ll renew the push to allow bankruptcy judges to order reductions in mortgage amounts.”

In fact, government legislation appears to be moving in the opposite direction. Arizona, for example, is contemplating changing its laws on deficiency judgements, which currently serve to prevent a lender that “forecloses on a home mortgage to recover the balance of what is owed the lender if the foreclosure sale doesn’t produce the full amount…The changes, which haven’t yet taken effect, impose new eligibility requirements to qualify for protection against a deficiency judgment. One is that the borrower must have lived in the property for six consecutive months.” If this takes effect, then borrowers that walk away from their underwater mortgages might see the balance stay with them forever. What’s next – a return to the days of debtor prisons?

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.

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.

The recent stabilization of the housing market now appears to be a mirage, brought on by stopgap measures. “Until recently, many banks have put off launching foreclosure action on the troubled properties, in part because they had signed up for the Obama administration’s home-stability plan, which required them to consider the alternative of modifying loans to make it easier for borrowers to make payment. Unfortunately, the federal push to promote loan modifications and the related moratoriums that some states have imposed on foreclosures are already fading, at which point the foreclosure crisis is likely to expand.

“A new set of economic theorizing holds that any bottom that might have been glimpsed was a false one – just a plateau before a bigger drop, when lenders try to clear their books of bad loans. If that’s the case, the economic hole starts to look a lot deeper, and the housing crunch becomes another part of a larger, vicious cycle.” In other words, if banks move to place a fresh supply of foreclosed properties on the market, it will cause all prices to suffer. This will put even more pressure on those whose mortgages are already underwater (1 in 5, according to one estimate), and perhaps compel banks to race even faster to liquidate mortgages in default.

According to RealtyTrac, April “was the worst month ever, with more than 340,000 properties in some state of foreclosure nationally…They are expecting June’s numbers (to be released next week) to ‘give April a run for its money’ as worst month ever.” This was discerned from a large uptick in delinquent mortgages, many of which can be expect to result in foreclosures. “In the first quarter, some 1.8 million homeowners nationwide fell behind on their loans by 60 to 90 days, a 15% increase from the prior quarter, according to Moody’s Economy.com. The research firm said that loan defaults rose sharply as well, to 844,000 in the first three months of this year.”

Who’s to blame for this? The government appears to be doing as much as it can. “Foreclosure counseling is an extremely effective service; HUD reports that 45 percent of those who participated in 2008 were able to hang onto their homes.” While estimates vary, hundreds of thousands of borrowers have probably benefited from the loan modification program.

The problem is the banks, which continue to prefer foreclosure over loan modification. According to a new Federal Reserve paper, “lenders rarely renegotiate. Fewer than 3 percent of the seriously delinquent borrowers in our sample received a concessionary modification in the year following the first serious delinquency.”  There are two main reasons for banks’ entrenched resistance: “The first is ‘self-cure risk,’ which refers to the situation in which a lender renegotiates with a delinquent borrower who does not need assistance…The second cost comes from borrowers who default again after receiving a loan modification. We refer to this group as ‘redefaulters,’ and our results show that a large fraction (between 30 and 45 percent) of borrowers who receive modifications, end up back in serious delinquency within six months.”

More on loan modification- and why it’s failing – tomorrow….

Barack Obama and the rest of the federal government continues to roll out new initiatives designed proximally to help mortgagers in need, and ultimately to stimulate the ailing economy. At this point, pretty much everyone is eligible for help, regardless of what stage of the process they are at.
 
For those that already have a mortgage and are facing foreclosure, the government has pledged money to incentivize banks to grant loan modifications for qualifying mortgagers. “To be eligible, a homeowner must have a monthly mortgage payment larger than 31 percent of their gross income. The monthly payments of those who qualify are lowered to the 31 percent limit. Lenders can do this by reducing interest rates to as low as 2 percent, by extending the term of the loan to 40 years or by deferring principal.” Borrowers are then placed in a temporary program whereby they must make their reduced payments successfully for three months, after which points they see their loans permanently modified.
 
On the one hand, the Treasury Department is trying to make it easy for eligible borrowers to receive modifications: “About 100,000 homeowners across the country so far have been extended loan modification offers. ‘We are encouraging servicers to staff up, establishing a hotline for homeowners, looking for new tools to expedite this process, working with communities to get the word out about resources available to homeowners,’ ” declared the department’s spokesperson.
 
At the same time, those who have applied tell stories of long waits, lots of uncertainty, and probable rejection. There are two related reasons for this discrepancy. First, there is a lack of lender impetus to facilitate loan modifications: “Housing counselors say that while 15 lenders — including major ones like Bank of America, CitiMortgage, Chase and Wells Fargo & Co. are participating, many have yet to fully train people to process the applications. As a result, housing counselors say they often receive mixed signals, with different lenders offering different interpretations of the guidelines.”
 
Second, the mortgageholders (i.e. investors) have the ultimate say in whether a mortgage can be modified. In situations where the value of the mortgage exceeds the value of the home, investors are more willing to agree to modification, because a foreclosure would result in lower remuneration. In relatively healthy markets, however, investors are more reluctant, especially since all of the incentives are directed towards the banks.

Ultimately, “One thing is clear: Homeowners who have a HUD-approved housing counselor championing their cause are more likely to get a modification than those who try it on their own. Housing counselors say they often understand the program’s guidelines better than the people answering phones for lenders, so they know how to pursue a case aggressively.”
 
Stay tuned for tomorrow’s post, where I will outline the homebuyer tax credits and the implications of the proposed Consumer Financial Protection Agency…