Forgiveness and Redemption - A Housing Policy Proposal

By Michael Douville - Real Estate

In many markets across America, the decline in housing values has eliminated the equity in properties purchased through the years 2005-2007. Indeed, not only has the equity been eliminated, but the current value has decreased so much, many owners feel it is futile to struggle with mortgages on properties that may be worth 60% of their purchase price. In such an instance, the concept of honoring one's obligation becomes extremely stretched, and the incentive to remain in a property that is severely underwater becomes nonexistent.

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There are many examples of properties purchased for $400,000 that are now appraised for $240,000. The current owner may have a payment based on the higher acquisition price from 2006. In purchasing, most buyers used very little down payment and consequently may have a mortgage of approximately $380,000, leaving a $140,000 negative equity situation. In such instance, a business decision needs to made exempt of conflicting emotions.

The hard reality is that the prices paid by consumers were too high. The argument for those decisions is keyed on the fact that the market dictated the value and buyers accepted the price. However, the often-used standard for value is the price that a non-distressed seller is willing to sell at and an educated buyer is willing to pay. Does a mania, buying frenzy, or "irrational exuberance" qualify buyers as "educated?"

In my experience, as high as 40% of the homes were purchased by "get rich quick" speculators posing as owner-occupants. These transactions involved fraud and need to be investigated and prosecuted. The true owner-occupant is undoubtedly struggling and has found himself in a very bad financial situation. As a fiscal conservative, I have reached a conclusion I would not have believed I ever could… I believe a program for forgiveness and redemption is needed.

In the reality of the foreclosure process, the value of the property has typically dropped; as an example, in 2005, Building A sells in 1 hour with 6 bids for $400,000. The buyer is euphoric and obtains a loan for $380,000 using a minimum down payment of 5%. The payment is based on a 3-year adjustable rate loan at 4.5%: $1926.60 P&I. The loan can adjust no more than 2% in any given adjustment period. Only 2%, but that adjustment will raise the effective rate over 45% and increase the payment considerably to $2410.60 P&I; that's a 25% increase in their payment.

Next year, the process repeats, and will go to market with the same parameters of a 2% interest rate cap in either direction. However, another parameter has entered the equation, that being severe price deflation. Most buyers were aware of the rate fluctuations; however, not a one anticipated even a slight drop in value, let alone a severe drop. If a decision is made to accept the loss on the property and walk away, everyone loses.

The lender will foreclose and suffer an immediate loan loss. In the example I used, the property generally will be foreclosed upon using a judicial foreclosure. So, revenue stops and expenses begin. Law firms are retained to process the claims; appraisers, inspectors, repairman, and title companies are used. Real estate brokers will be retained to dispose of the property. The house will be marketed and asset managers will struggle to attain sales near the market value. Often the properties are stripped of appliances, fixtures, and cabinets, adding to the loss for the lender. A property foreclosed on at $240,000 may have a minimum additional expense of $20,000, $30,000, and often much greater. The lender removes the delinquent borrower from the property at a cost of over $160,000. The buyer loses; the lender loses, and the entire neighborhood loses value.

The new buyer will gain a discounted property probably bought at the bottom, and the new payment today would be around $228,000 at 5 7/& interest fixed for 30 years: $1349.60, which represents an astounding $1108.16 less than the adjustment for the foreclosed upon prior owner. The market has corrected the pricing imbalance.

How can these losses be mitigated? How can the borrower receive an incentive to remain in the property? I suggest a program of forgiveness and redemption.

The mechanics for such are already in place at most lenders: the short sale review. I propose the loan be split into two parts: a performing portion and a non-performing portion. The example used is a $380,000 loan; a new buyer would finance the purchase at current rates and at a $228,000 mortgage level. This would be the performing portion for the existing homeowner. There is a deficit of $152,000: the non-performing portion, this is totally lost through a foreclosure; it disappears.

If a set of requirements can be established without encouraging fraud or abuse, I would propose to encourage the owner to remain in the property by reducing the loan payment to the original pre-reset amount, in this case $1926.60, if the borrower has shown the ability to repay the loan and will remain current. The performing portion of $1349.60 is used as the monthly payment; the additional portion of $577.00 is used as a principal reduction interest free.

Furthermore, as an incentive, I would vest the current owner with 25-50% of the principal reduced, with the qualification that the payments need to be on time and as agreed, for a period of time, perhaps 5 years. Five years principal accumulation would result in equity of $577 x 12 = $6924 per year for 5 years, or $34,620. This results in far less losses for lenders, and more performing loans on the balance sheets of banks. The homeowner has the ability to earn equity and still maintain his family home while not destroying his credit rating.

The authority rests with the government and our officials. All of us taxpayers now own a stake in Fannie Mae (NYSE: FNM), Freddie Mac (NYSE: FRE), FHA, and VA, along with other financial firms; as the owner, the U.S. Government has the right and the ability to change the loans. Limiting the losses is good business. These loan losses always occur at the bottom of the market and force sales at the worst possible time.

These market corrections and recessions have a beginning and an end; I believe we are halfway through. The market should recover by 2010, and the nonperforming portion will represent a steadily declining percentage, where as a long-term investment, the entire portion may be recovered in the foreseeable future. As an additional incentive, a formula to allow the homeowner to participate in the future gains can be created if he has honored the new agreement; perhaps he could receive 50% of the future profit, and the balance could go to the U.S. Treasury. We have been handed a batch of lemons, so let's make lemonade!


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