16 September 2010

Improving The Negative Equity Situation

It is most unpleasant to see your home fall in value. But, this, by itself, doesn't necessarily lead to economic decision making in other areas that hurts the economy. But, negative equity can have that effect.

It is difficult for homeowners with negative equity to sell, it is difficult to move for employment or other reasons, it is hard to refinance, and it is demoralizing for many homeowners (especially those with substantial negative equity).

Is there are better alternative to the status quo to deal with these situations?

In a state with non-recourse home mortgage, like California, selling a home with negative equity means a serious blight to your credit record that make make it impossible for you to buy a home or car on credit or get credit cards at reasonable interest rates for seven years, and the seller must turn over the job of selling the house to the bank.

In a state with recourse home mortgages, like Colorado, the problems for upside down homeowners are worse. Due on sale clauses cause the entire mortgage to be due when a house is sold. So, a seller of an upside down house has not only taken a loss on the sale of the house, but has also turned the part of loan in excess of the value of the collateral, that was payable at a low interest rate, with interest that is tax deductible (in practice, if not in theory), with payments typically based on a thirty year amortization schedule, into a loan due in full immediately. The seller probably can't get a new loan to pay the old one off on an unsecured basis, and even if that is possible, the new loan will have a higher interest rate, with non-tax deductible interest, that is amortized over a shorter time period.

Lenders can make deals with upside down homeowners, of course, but the transaction costs for the lender and homeowner alike are often high relative to the difference between the sale price of the home and the outstanding amount of the loan, and the homeowners who are upside down tend to be some of the less sophisticated homeowners and are often in a poor position financially to retain professional assistance to negotiate a deal with the lender.

Suppose that your are current on your mortgage, and that you bought your house for $300,000 with $30,000 down and a $270,000 loan, and have paid off another $10,000 of principal, leaving you with a loan balance of $260,000, and suppose that the value of the house has fallen to $255,000, of which perhaps $240,000 would be left over as proceeds after the costs of sale. You have a remaining debt to the mortgage lender of $20,000. Suppose that you are living paycheck to paycheck, have no real equity in your cars, and have no real savings, but currently have good credit and are making all of your other debt payments on time.

Your payment on that $20,000 remaining balance while you owned the home was probably something on the order of $114 a month (at 5.5% interest over thirty years), which would be manageable. It might force you to rent or buy a new place that is a little less nice than your current one, but it would destroy you economically. But, there is simply no way that you could pay $20,000 in a lump sum upon the sale.

The bank would start to assess default interest rates, late payment fees, collections costs, make a negative credit report, and quite possibly, this might even trigger reductions in your credit limits and increases in your interest rates on your credit cards. The interest would not be tax deductible. A judgment against you would go of record, making it virtually impossible for you to buy a new home or car. You would become a subprime credit risk who couldn't get a $20,000 unsecured loan. The amount owned on the judgment and on your credit cards could continue to mount and sooner or later you would probably have to go bankrupt.

In contrast, if the value of your house had fallen to only $275,000, you could sell the house, pay off the bank in full, maintain good credit, reduce the amount you spend on housing, and use the savings to pay off debts and develop some savings.

As a homeowner, of course, you have no practical ability to influence how much homes in your neighborhood fall in value once you own it. You can do your best to keep it in good repair, but that only has an impact at the margins.

Since selling your house is so catastrophic is you do in a state with recourse mortgages for upside down homeowners, you probably wouldn't do that. If you needed to move, you would rent your house to someone (at a rent probably below the cost of the mortgage, insurance and property tax payments, as a result of falling housing values), and pay the difference out of pocket. This allows you to maintain something closer to the situation you had before you sold your house, but imposes lots of transaction costs (finding tenants, preparing a lease, collecting rent, confirming that the property is in good repair, preparing tax returns) and lots of long term risk that you wouldn't have faced in a sale if you could continue to pay the balance due to the mortgage lender on the same terms that you were paying before the sale.

Is this consequence of due on sale clauses really a good result? If not, how could the law, or customary contract terms in government funded or institutionally funded loans be changed to get a better result?

A big part of the problem is that negative equity didn't receive much attention in the drafting and negotiation process, because it was assumed that this was very unlikely to happen, or at least, very unlikely to happen in situations where the home owner isn't substantially at fault for failing to properly maintain the property (e.g. throwing a big party and trashing it in a way not covered by insurance). Not a lot of thought went into considering how the deal would play out, and what incentives would be present in a situation that is now extremely common.

Should an upside down seller of a house in a state with recourse mortgages who is not in default at the time of sale have a right to unilaterally continue to make payments on the unpaid portion of the loan with a ratable share of the old monthly principal and interest payment without having it considered to be a default or producing a negative credit report? This right would be considerably less of a detriment to banks than the non-recourse laws, would provide a benefit to many upside down homeowners who care about their credit, and might avoid the incentives in non-recouse mortgage states that contibuted to the housing bubble without going overboard to the extent of being punitive.

Even if this contradicts the express terms of the mortgage, what benefit of the bargain does the lender lose by agreeing to those terms? The bank is getting the same personal liability benefits that it would have received if the homeowner had not sold the home, and the likelihood that the personal liabiltity will produce a collected debt has probably been increased. The bank is getting an arms length fair market value for the collateral on the date of the sale. The bank is giving up the possibility that the collateral could increase in value in the future, but is also eliminating the risk that it will fall further in value. The homeowner, because the homeowner remains obligated on the balance, has an incentive to balance these possibilities equitably, so on balance the benefits and harms to the bank associated with a sale of the collateral to a third party are likely to be evenly balanced.

The bank's recovery should the home owner later go bankrupt, would be the same as it would be if the short selling home owner had declared bankruptcy and surrendered the house to a bank that sold the house for the same price. The existence of an actual sale also eliminates the risks associated with unrealistically low appraisals that has caused banks to fear a cramdown remedy in Chapter 13 bankruptcies.

Even if this does mean some kind of compromise of a bank's rights, is it small enough and does it provide enough benefits, that banks should be expected to suck it up?

Should tax laws continue to allow short selling home owners to deduct interest on the remaining balance in that situation? Since nobody buys a house intending to end up with a short sale, it is hard to see how this tax boon would create an incentive for abuse and it would increase the likelihood the loans are paid as agreed by maintaining a constant burden for the short selling home owner, making the economy more stable. It would do very little to change the homeownership incentives created by the mortgage interest deduction, but might increase that incentive slightly especically in low down payment loans where an upside down loan situation is likely.

The changes to private law and tax law proposed are small and technical, but they might greatly alleviate the collateral consequences for the economy of the problems created by upside down mortgage loan impairments to the alienation of property, a property right protected even at common law because it provided such great economic benefits to devise legal rights that preserved it.

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