How Homedebtors Could Avoid Foreclosure

There was a recent article posted on MSN about mortgage companies working with FB’s to save their homes from foreclosure. This particular article is most likely part of a public relations campaign from the lending industry to show they are working on the problem. They are bracing themselves for the inevitable congressional hearings which will happen next year. There is nothing quite like an election year crisis to bring out congressional grandstanding by our leading politicians. But I digress… the MSN article got me thinking about what really could be done about the foreclosure problem.

I have written in several posts about the serious foreclosure problem looming as several trillion dollars of mortgages reset to higher payments over the next 5 years. There is no way to effectively restructure payments when a borrower cannot even afford to pay the interest on the debt. Lenders cannot lower interest rates to near zero because then they will lose money on the loan. Any borrower who thinks the lender is actually going to forgive the debt and allow them to keep their home is really living in a fantasy world (I would wager many FBs believe this). Lenders will not take a loss on a property loan and allow borrowers to keep the home: it’s as simple as that.

Loan Reset Calendar

As much as it pains me to write this, there is a short to medium term solution to the foreclosure problem: convert part of the mortgage to a zero coupon bond. For those of you not steeped in finance, a zero coupon bond is a bond which does not make periodic interest payments. Think of it a zero amortization loan. You don’t pay either the interest or the principal, and both accumulate for the life of the loan. The loan would be due upon the sale of the house.

Here is how it would work for our typical homedebtor: Assume our financial genius utilized 100% financing and took out a $500,000 interest-only mortgage with a 2% teaser rate that is due to adjust to 6%. Let’s further assume his real income (not what he reported on his liar loan) could support a $1,500 payment on a $250,000 conventional 30-year mortgage at 6%. The bank could convert $250,000 to a conventional mortgage, and convert the other $250,000 to a zero coupon bond at 6% due on sale. The homedebtor can now make their payment, and they get to keep their house. But here is the catch: when they sell their house, they will owe the bank a lot of money. If they sell the house in 20 years, they will owe $800,000 on the zero coupon bond note. In other words, all the equity gain on the value of the home will go to the bank.




This would solve a multitude of problems: First, it would provide a mechanism whereby people who were victims of predatory lending could keep their homes. This would make the homedebtor happy, and it would get government regulators out of the bank’s business. Second, it would make the banks more money in the long run because they are still making their interest profit even if they don’t see it until the homedebtor sells the home (many may not be aware of it, but lenders book income on the increase in principal on a negative amortization loan). Third, since foreclosures would be the primary mechanism facilitating the crash, it would keep home prices from crashing by reducing the number of foreclosures.

Sounds like a panacea, doesn’t it? There are some problems.Its a Wonderful Life

The first problem will become apparent when people start selling their houses. People are greedy. They won’t want to give the bank all their equity when they sell. They will conveniently forget the debt relief and avoiding foreclosure and all the problems they had earlier. All they will see is that they sold the house for a lot more than they paid for it, and they did not make any money. And what happens when the appreciation does not match the term of the note? Do they do a short-sale 20 years down the line? This will cause a huge uproar and more calls for congressional intervention. In other words, for everyone involved the day of reckoning is merely delayed, not avoided.

Second, it does nothing for the affordability problem. If prices do not crash, a great many people really will be priced out forever. To solve this problem, banks will make zero coupon bonds available to everyone, and eventually everyone will have them. Think about where we will be then: we will be a society of homedebtors who have collectively agreed to give all our equity to the bank for the pride of ownership. Starts to sound a bit like Pottersville from It’s a Wonderful Life. Is that the way we all want to live?

Sub Prime Move Up Chain

Third, The zero coupon bond solution would effectively eliminate the move-up market because you won’t have any equity to take with you from house to house. Unless you save money or get a big raise so you can afford a larger payment, you can’t buy a more expensive home. This would result in a dramatic flattening of prices. In other words, the low end would be supported at inflated levels while the high end would stagnate or decline.

Fourth, Based on the problems above, it will be difficult to find a new equilibrium in prices. How would people figure out how much anything is worth? How would all price ranges be supported equally? Small changes in the interest rate on the zero coupon bond can make the difference between hundreds of thousands of dollars at the time of sale, particularly on a long-term hold. Does anyone think this will turn out in favor of the borrower? I suspect we would see a lot of short-sales as the banks graciously agree to take all the gains and forgive the rest of the debt. This takes us back to our first problem with angry, greedy sellers.

Finally, I think this is only a short to medium term solution to the foreclosure problem. For as much as we are addicted to credit in this country, there is a point where people will say “enough is enough.” When a house fails to have any investment value, people will not be so excited about home ownership. People can blather on about pride of ownership all they want, but people want to make money on selling their houses. Inflated valuations are only supported by greed. If home ownership becomes less desirable, prices will end up falling back to their rental equivalent value because the demand will not be there. In the long run, we would end up with prices where they should be anyway, it would just be a much more prolonged and painful journey. Does anyone want to experience what the Japanese went through?Japanese Bubble

When faced with the prospect of more than a million foreclosures, some Wall Street genius (I am being facetious) is going to come up with a solution very similar to what I just presented. To be honest, zero coupon bond structures and other exotic financing terms are quite common in complex real estate deals like the ones I see on a daily basis in my line of work. Exotic loan terms are the exclusive purview of sophisticated investors who understand what they are doing. They are not intended for consumption by the general public. Given the profusion of interest-only, and negative amortization loans in the market today, is it any surprise we have such a big mess now?


It’s a Wonderful Life

25 thoughts on “How Homedebtors Could Avoid Foreclosure

  1. lee in irvine

    Meet Casey Serin — he is a 24 year old immigrant from Uzbekistan who came to America with big dreams. His dreams ultimately lead him to quit his is $50,000 a year job and become a real estate flipper. This Donald Trump wannabe bought eight homes within eight months using liar loans. (Hey everyone … FREE MONEY)

    Here’s a quote from the story:

    “I have a lot of critics that say because of me, the market is overpriced,” he said. “Because of me, the renters are priced out. It’s interesting. I’ve been put in a position where I’m blamed for macroeconomic problems. I’m kind of like a mascot for what’s really going on.”

    Warning; this story that was aired on Nightline last week is likely going to piss a lot of us “bitter renters” off. Read at your own peril. LOL

  2. IrvineRenter

    Casey I-am-facing-foreclosure Serin: He will be the poster child of all that went wrong in the great residential real estate bubble. I guess infamy is better than anonymity for some.

    I read recently he may be signing a book deal. Nothing like rewarding his behavior…

  3. Donut

    I doubt anybody will want zero coupon bonds of generic housing. Housing doesn’t age well, particularly in the hands of people that really can’t afford it.

    If you look at the MSN article, I think you see what the real extent of modification the loan service industry is willing to do. Ana Rodriguez and family in the article are a prime example. In the end, due to job loss, the lender simply delayed one or months taking any action, if they even did that, Ana & hubby then made all the past due payments including penalties. Then to top it off, bank gladly refinanced them into a bigger loan with a bigger payment that hubby’s new job would support.

    In the case of a borrower using a neg-AM loan, the banks aren’t going to budge beyond what they did for Ana. Nor are they going to continue to allow anyone to use the teaser or Neg-AM portion unless they really have the equity and can be refianced into a new 30 year ARM generating all those nice fat commissions and charges.

  4. No_Such_Reality

    If you do 15 year strip, you can get the principle repaid and have a end value owed value equal to the bigging balance for a prime borrower.

    However, that requires a $3600/month payment for a $650K house, which will put the income around $150,000/yr.

    I’d guess that payment schedule is roughly twice the teaser rate stuff that has been driving the market. Stuff like Quicken’s $450 per $150K borrowed.

    A 30 year zero just repaying the principle ($1800 for a $650K) results in an end value that requires 4.6% annual appreciation to be able to clear the loan. (Assuming 6.5% interest). I think that’ll be too much risk for the market.

    You might be able to swign a thirty with a principle and partial interest payment to keep the terminal value down, however, you quickly climb back to the $2800/month or more payment range.

  5. No_Such_Reality

    I need an edit feature. Let me rewrite that first sentence.

    If you do 15 year strip, you can get the principle repaid and have a end owed value equal to the beginning balance for a prime borrower.

  6. SoCalwatcher

    Go read Casey’s newest entry. Good for some laughs at how stupid he is.

    How about this nugget of wisdom:

    Hey man, you should know better than criticize my investment into education. How much did you invest into your medical eduation to become an anesthesiology resident?

    You have to spend money to make money. You will either spend it on education and save on mistakes. Or you will go cheap on the education and make more mistakes in the field. I kind of did both. Sometimes even great education is no replacement for learning through mistakes.

    -Casey Serin

  7. irvine_grad

    This is bad news to me because, given their recent stupidity, I’m not entirely convinced the banks WON’T do this.

  8. gepetoh

    I don’t think zero-coupons would fly, especially in this market. Bondholders would require higher rate of return for the risk, and a 6% annual ror is not going to get debtholders to jump into invest in an instrument with such a high default rate risk. This plan would either force the homeowners to keep their homes for 15-20 years, or they will short-sell and debtholders are stuck with the shortfall. Chances of the 2nd occurence is too great for the borrowers in this market.

    Taking IR’s example, that $500K house would have to be worth about $1.25M in 20 years for the borrower to exit with no loss or profit. That’s after having paid interest and principal on $250K of it. That would amount to a $2500 monthly payment for 20 years just to leave it with nothing owed. There is slim chance that a typical borrower will be able to endure that, which means debtholder’s risk of default is substantial. They can invest in U.S. Treasury for 5%, they’re not going to settle for a 1% risk premium on this kind of a bond. It will likely be 2-3% premium, which means a higher risk of default, since borrower’s home values would have to increase much more substantially. Required ROR will be too great for the risk for this to be viable.

  9. OCOwner

    The zero payment loan, which I will coin the term “never ending neg” will never happen. Think about it, all it does is transfer the risk of owning a home to the lender instead of the owner. If the lender is going to assume all the risk then there are 3 huge problems:
    1) Unlimited appreciation will happen immediately. Why would you bargain for the price of a house when the bank’s making the payments.
    2) No one would ever rent. Why when you can live for free in the lenders house.
    3) What incentinve is there to maintain the property? Why would you upgrade or remodel a home when the money invested will go to the bank?
    If this program is ever developed, I’ll be the first to sign up.

  10. IrvineRenter


    I agree, the zero coupon bond would not be an investment vehicle of choice. However, the lenders are faced with a substantial loss in a foreclosure. Even if they hold these bonds in their own portfolio, they probably aren’t any worse off than they would be in a foreclosure. At least with their potential loss rolled into a zero coupon bond, they have some chance at recovery.


    I am only suggesting the banks refinance the portion of the loan the homedebtor cannot handle. They would still be getting payments on the conventional loan. The zero coupon loan becomes a piggyback.

    Maybe we will get the “never ending neg” in the next bubble. We came amazing close this time around…

  11. gepetoh

    “I agree, the zero coupon bond would not be an investment vehicle of choice. However, the lenders are faced with a substantial loss in a foreclosure. Even if they hold these bonds in their own portfolio, they probably aren’t any worse off than they would be in a foreclosure. At least with their potential loss rolled into a zero coupon bond, they have some chance at recovery.”

    It makes sense that the lender might be inclined to do this, but I don’t think they would find investors to hold the bonds. And the lenders would never hold these zero-coupon debts themselves, since they would have no cash flows on these. Lenders’ margins and debt/equity ratios don’t allow them to “invest” in such illiquid instruments. They need the coupon payments to reinvest, otherwise they’re dead.


    Actually, the risk doesn’t transfer to the lender, it stays the same. It just defers it about 20 years – or when the borrower must move out for some reason and they have to pay up. Come to think of it, because of the time horizon, it probably increases the risk for the borrower.

  12. IrvineRenter


    “And the lenders would never hold these zero-coupon debts themselves, since they would have no cash flows on these. Lenders’ margins and debt/equity ratios don’t allow them to “invest” in such illiquid instruments. They need the coupon payments to reinvest, otherwise they’re dead.”

    In theory, the banks would be showing income on these instruments because the deferred interest is income according to GAAP. I remember being astonished that Countrywide and others were reporting the increase in principal on a negative amortization loan as income. IMO, zero coupon bonds would look great on a lender’s balance sheet — as long as you didn’t look too closely 🙂

  13. gepetoh

    By the way, I just calculated the monthly payments for a 100-yr loan, and it only came out slightly less than a 30-yr? I figured if I wanted to buy a house I get grow old in, in a nice neighborhood (Irvine), I would have to spend about $800K. Monthly payment for a 30-yr was $6,100, and for 100-yr was $5,300. 13% less payments for a 233% longer term? Man, that is depressing.

  14. OCOwner

    Irvine Renter

    I guess it’s a possibility, the lender would have to write off the portion owe’d, then add the note back as an discounted asset. If you were a 2nd mtg holder on one of these FB’s, instead of foreclosing and getting nothing, why not mod the note and cross your fingers?


    The lender is taking increased risk. Instead of an equity cushion, there is negative equity. Though many lenders do these (125’s), none will without collecting a payment. It will put the FB’s into a bigger hole that, chances are, they won’t be able to get out of.

  15. GrewUpInIrvine

    I’m not sure what the answer is, but I would like to pass along a recent encounter I had with a POS flipper recently at a local gym.

    As I was standing talking to a friend about the direction of the market, and the looming foreclosure market, real estate crash, etc., a person close by on an exercise bike interjected, “Hey, you guys are talking about people like me! I bought two condos with no money down, and because the market has cooled off, I can’t flip them for a profit.” He went on to say he had stopped paying on the mortgage and was just going to wait and let the bank foreclose… but that he sure hoped the state or feds would step in and bail him out…. all said to me with the biggest grin ever. I couldn’t believe the gaul. I can only hope he was making the whole thing up.

    I sure hope that he is ready for Karma (or whatever) to pay him back in spades… it’s cavalier atitudes like his that make me adverse to any bail out… and as coined by one of the topics in the forum, why I am so hostile to flippers…

  16. sunsetbeachguy

    Grew up in Irvine:

    You and he are lucky I wasn’t there.

    Sometimes God or Karma works in mysterious ways, other times more directly 😉

  17. gepetoh


    True there is negative equity, but that happened because the prices went down, not because of the zero-coupon. The zero-coupon doesn’t do anything to the equity portion. The assumption of that negative equity is still on the borrower, not the lender, they just have longer to own up to it. But I agree for that reason, the risk for lenders (as well as borrowers, investors) are increased because the time horizon has stretched.

  18. No_Such_Reality

    Even if they hold these bonds in their own portfolio, they probably aren’t any worse off than they would be in a foreclosure. At least with their potential loss rolled into a zero coupon bond, they have some chance at recovery.

    I think the overall capital market will have a problem with banks booking increased vapor assets.

    Essentially, banks will be stated balance sheets and income statements for the SEC. I think we saw how that went with Enron, not to mention their current mortgage customers.

    Given that a 30 year treasury zero is going for about 25 cents on the dollar, any consumer item zero is going to be substantially lower, maybe half that.

    Another thought occured to me and haven’t the banks already done this and it’s blown up and that style loan massively fell out of favor.

    Does anybody else remember the original balloon loans in the 80s? Isn’t that what this is essentially? Real low payments for 15 years, 30 years and then a giant payment to close out the loan? I think we saw the consumers massively mess that one up. I wonder how short the banks and wall-street’s memory is.

    Many american consumers are crack-junkies when it comes to credit.

  19. OC Owner


    “The zero-coupon doesn’t do anything to the equity portion. The assumption of that negative equity is still on the borrower, not the lender, they just have longer to own up to it.”
    The zero coupon does affect the equity portion of it. The implied payments are added to the back of the loan, lowering the equity position. This puts the banks on the same side as the home debtor, wishing prices increase.

  20. IrvineRenter

    Did any of you see this in the LA Times?

    The foreclosure fighters

    Jeff’s Moped,

    It is good to hear, that such a workout would be impossible. If the banks were still holding this paper, it might be, but I imagine you are correct that the bond documents would never allow it.

    I remember a few years ago being involved in researching a real estate deal in Fresno where the developer was caught up in a bond financing Ponzi scheme. The developer who I was helping was going to try to negotiate a buyout of the bonds and take over the project. He offered the bond holders $0.40 on the dollar, and he was rejected because the bond servicer had to follow the procedures in the documents that did not allow that kind of transaction. The bond holders had to foreclose on the property, which wasn’t improved, and they ended up getting about $0.15 on the dollar after foreclosure and auction. The lawyers all did well though.

  21. gepetoh

    That’s an interesting article. As mentioned at the end of the article, those programs will rarely help those who bought what they can’t afford. But that soft lien program is interesting… what investor would hold such a security? What would be the payoff of a low-interest bond on high-risk loans? What am I missing in the viability of that type of an instrument?

    OCO, so if the implied payments are added to the equity of the loan, would that not be MORE risk to the homeowner? I don’t see where that transfers the risk to the lender, as you stated in your original post. In any case, it doesn’t “add” to equity, it just accrues interest. The “equity” stays the same. The bottom line is, however, that the homeowner is still on the hook for the original principal amount AND the accrued interest. This is the same as they would have owed under a normal plan, and as a result their risk does not change (other than for the implied longer holding period for the owner, as I mentioned before).

  22. RogerSmith8080

    Let it crash,
    Your right about the people who get bailed out by this will want their equity when they sell if issued a bond to cover the excess. Most of the people who bought in this environment are ignorant of finances and economics. It’s a broad stroke but appropriate in this case, it took a lot of stupid/reckless decisions to lead to this situation. I do not feel that the rest of society should be punished by a relatively small groups screw up.

    One worry some factor is Uncle Sam’s stake in this, your idea would appeal to him for this reason, it inflates home prices and Uncle Sam makes a fortune off of property tax. If prices return to historically normal levels it is going to have a devastating effect on California’s state revenues. Sacramento spends like drunken sailors and has NOT reduced spending in over a decade, the best they have been able to do is slow down the rate of the increase in spending. As homes begin to change hands at lower prices the new owners will pay less in taxes than the prior owner. This WILL reduce revenues from property taxes, Sacramento will not like this and will do whatever it can to prevent that loss.

  23. Donut

    Irvinerenter, it’s basically the same article as the MSN & AP articles from two weeks ago. It’s a PR campaign being trumpeted through all the local papers. In the end, it won’t make any difference. All their options basically boil down to two:

    1. They refinance you into a new loan buying you time.

    2. They give you a few months to get it together and pay the original loan agreement.

    With toxic ARMs people, no amount of finaggling is going to turn the tide for something that’s already 100% LTV or looking at a 100% increase in payment.

  24. lendingmaestro

    It’s not about the banks…

    remember that banks can only originate a small amount of mortgages with their own money–money generated from core deposits.

    the vast majority of mortgages are packaged and sold to fannie mae, freddie mac, and other investors on wall street. These companies then package these loans together and sell them as mortgage-backed securties, thus diversifying the risk.

    banks that originate loans base the interest rates and fees charged to the borrower on how much the investor is willing to pay them for that particular loan. Prices are hedged with the 10 year note as well. NO INVESTOR is going to purchase a loan that is hedged with a zero coupon bond. That is way to much risk since all wall street firms need assets that produce revenue streams.

    There has been nearly zero media coverage on mortgage-backed securities except for recently. The problem is that the investors have no contact with the actual borrowers, and a different institution services the loan.

    Now that I work for one of the largest mortgage banks in the US, I am amazed at how little mortgages were discussed/taught in college. The vast majority of college professors, students, financial advisors, and financial reporters have no idea how the mortgage industry works. It is a niche area of finance that is not typically covered in finance programs, and they only way you learn is to work in it. That is because Real Estate is not really an investment, and it’s definirely no taught across the board. How many financial planners have told their clients to buy rental properties!?!?

    I on the other hand talk to people everyday that are prime borrower’s on the verge of mental breakdown. People who got 5/1 4.75% interest only arms. This seemed like a good loan at the time except they are now at 90% CLTV from 80% CLTV 4 1/2 years ago. No negative amortization, just deflationary prices.

    The mortgage industry is in for a colossal breakdown, mark my words. I’ve already liquidated all my companies stock and eliminated it from my retirement accounts

    just be ready

  25. robert

    RE: The foreclosure fighters

    EMC buys their paper at such deep discounts that they can afford to take this approach.

    Despite all the rhetoric about lenders being more flexible in the face of this “foreclosure tsunami,” many (ie, W-F) are as tough as ever to deal with and some (ie, Chase) have newly-instituted obstacles to obtaining a workout once foreclosure action has been filed.

    What’s really funny about this is that for all the hand-wringing that takes place at the servicing conferences, much of the action taking place in the collections/loss mit departments basically guarantees that they’ll incur more losses than necessary.

    [BTW, I’m talking about borrowers who legitimately CAN pay their mortgages, but fell behind due to a temporary hardship.]

    Loss mit is basically treated like any other customer service function in the US… always underfunded, undermanned, and neglected.

    There was an earlier post, “… the attorneys did well,” in this environment, I imagine that’s true here, as well.

    I’ve been saying for years, “If the investors knew how they’re money was managed (in the mortgage industry), they’d pull out immediately.”

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