My girlfriend and I have been in the market to purchase our first home for some time now. As prices have been rapidly declining in South Florida, we were able to see a lot of different things and develop some insights. Let me share my story with you …
There is a two story condo in Delray Beach, FL, which caught our attention back in November 2008. The homeowner, “Johnny Real Estate Speculator,” overpaid for this condo and six others between 2005 and 2006. He used his equity in one property to borrow for the next. However, Johnny decided to cut his losses approximately a year ago when he and the other seven tenants in his building got assessed $25,000 each (due to some landscaping issues). The developer obviously bankrupted his company and left the country as soon as he finished selling the condos. Smart sleaze-ball.
I hired a specialist to come in and perform what is called a “Liquidation Value Appraisal.” This appraisal takes into account many of the recent comparable sales and foreclosures/REO (Real Estate Owned) properties in the area. This type of appraisal estimates a price for which a bank will be able to liquidate the property if they had to sell within a week. When calculating my bid, this was a much more accurate appraisal value than the bank’s appraisal because the bank still takes into account a rising home price appreciation (HPA) multiple and many other factors that aren’t very relevant in today’s market. In order to calculate my bid, I first learned the rental values of similar units in the area. The rental payment should be 5-8% higher than the sum of all monthly expenses to own the property (mortgage + taxes + insurance + HOA fees). If you cannot rent your place for a small profit, prices are still too high.
The appraisal for the condo came in just above $300,000. Unfortunately, Johnny paid $850,000 for it in 2006 (he is currently living there for “free” while attempting to complete a short sale). A “short sale” occurs when a borrower/homeowner finds a buyer for a property that offers to pay a price less than the amount owed on the borrower’s current mortgage. The bank must approve a short payoff amount, hence creating a loss for whoever is the true lender. In most cases, the loss feeds through to the pension funds, hedge funds, and insurance companies (i.e., investors) who purchased the mortgage-backed securities which provided funding to the homeowner. The bank to which the borrower pays his mortgage each month (Bank of America, in this instance) is known as the “servicer.” The servicer collects mortgage payments from homeowners and passes them through to a trust. This trust then disburses the payments to the security holders, according to the seniority of the tranches of the securitized bonds.
Why is this story relevant to today’s markets? Let’s start with the facts of my case. The homeowner stopped paying his mortgage in August 2008. To this day, Bank of America continues to forward payments to the trust. Bank of America continues to receive their servicing fee (NYSE:IO) as long as they continue to forward payments to the trust. This IO is currently calculated from of a $680,000 loan balance (assuming Johnny put down 20% when he purchased in 2006 — highly unlikely, but I am being generous. Most likely he put down less than 10% creating an even larger balance). Every payment the servicer does not actually receive (but forwards to the trust) is recuperated first upon liquidation of the property. Hence, the servicer can continue to receive their IO as long as they want or until they feel the loan will hit a 100% loss severity. Once this happens, they can no longer recuperate their fees. This was not what was agreed upon when investors purchased the mortgage backed securities. All prospectuses and pooling & servicing agreements state the servicers must act with fiduciary responsibility to maximize the value of the trusts for the investors. They are, in fact, doing just the opposite.
It should not surprise you that I submitted my bid back in December and still have not heard back anything from the bank. Every time Johnny calls to see what’s happening, the bank responds, “We will have an analyst assigned to it within the next 2 weeks.” It reminds me of the sign at my local gas station that says “Free Beer Tomorrow.” When the hell is tomorrow? Every day I go back and ask the attendant if there is free beer today and he says, “No, read sign! TOMORROW!” If the bond investor knew I submitted a bid for the property back in December and they had a chance to get some of their principal back more than 6 months ago, I guarantee they would be infuriated. As most investors must mark their securities to market, the bonds backing this loan were written down long ago. The investor most likely could have taken a gain if the property was liquidated in a timely fashion. Now, with every month that passes, the losses increase and eventually the investor receives nothing back.
Johnny is not being pushy because he is living nicely and not paying a penny. Bank of America is in no rush to sell the place because they still maintain their servicing fee. I am out the $400 I paid for the appraisal and am still looking for another place to buy. All Johnny’s neighbor’s in the building have an increased monthly HOA fee as they must pitch in to make up Johnny’s share in an effort to upkeep the property. The bond investors are left holding the big bag of shit.
Johnny knows his credit is going to be out of whack for at minimum the next 10 years. His work is done by finding a buyer to enter into a short sale agreement. The bank is off his back and his loan is in limbo. The bank still profits off the loan at the bond investor’s expense. My hope to close this deal is vanishing.
America’s problems are only getting worse. Obviously foreclosure sales have been down massively in the past four months because the government imposed a moratorium on foreclosures and the servicers don’t know what to do with their second lien positions. It is one of my jobs at work to read through over 250 remittance reports on the 25th of each month. These are detailed reports on the performance of mortgage-backed securities, specifically the performance of the underlying collateral. While liquidations have slowed slightly, the delinquency buckets are still getting larger as are the foreclosures, REOs, and bankruptcies. This warns us that if the banks are not able to negotiate loan modifications for all these borrowers, liquidations will eventually occur and further deteriorate home prices in our country. The prices of ABS bonds in the market have rallied recently. I do believe we hit bottom in these markets back in March. The assumptions in everyone’s models have not changed, but now buyers are purchasing with 10-15% yields instead of 20-25%.
It is my guess that you are going to start seeing some serious law suits popping up with mortgage bond investors as the plaintiffs and the banks (servicers) as the defendants. Although there is no question of guilt on the servicers end, until recently it seemed the government would rather erode contract law in this country than side with mortgage investors. Last week, Senate Chairman Chris Dodd and House Chairman Barney Frank finally addressed this issue [click here to download Dodd and Frank’s letter]. They noted homeowners that qualify to be placed in Hope for Homeowners are not getting the loan modifications they need because the banks (servicers) are holding the second liens on their books at inflated values. It is a shame that it has taken this long to bring things to light, but it is also encouraging that the truth is coming out. What follows in the coming months will have a great effect on the future of housing and banking in America. My guess is that the government will have a mean bark but no bite. I hope they prove me wrong.
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