And I’m not what I appear to be
What have I done to deserve such a fate
I realize I have left it too late
And so its true pride comes before a fall
I’m telling you so that you wont lose all
I’m a loser and I lost someone who’s near to me
I’m a loser and I’m not what I appear to be
I’m a Loser — The Beatles
Selling for Less
During the bubble price rally, sellers and realtors, the agents of sellers, had everything going their way. It was easy to price and sell a house. A realtor would look at recent comparable sales, and set an asking price 5% to 10% higher and wait for multiple bids on the property — some of which would come in over asking. The quality of the property did not matter, and the techniques used to market and sell the property did not matter either. As far as buyers and sellers were concerned house prices always went up, so the sellers were thought to be giving away free money; obviously, the product was in high demand. As the financial mania ran its course, buyers became scarcer; all the ones who could buy did buy. The buyer pool was seriously depleted leaving prices at artificially high levels. When the abundance of sellers became greater than the number of available buyers, prices began to fall.
Residential real estate markets generally move very slowly and trend in a single direction for long periods of time. Once these markets reach an inflection point, the direction of price movement changes, and the balance of negotiating power shifts from an advantage to one side to an advantage for the other. However, most market participants do not recognize this change for some time. Sellers continue to price and attempt to sell using tactics that worked during the rally, and they find they are unable to sell their properties. It often takes two years or more before sellers accept the reality of the new market and adjust their attitudes and behaviors to the new dynamics of a buyer’s market.
In a buyer’s market, buyers have the upper hand, and sellers need to adjust their pricing tactics to reflect this fact. During a rally, many buyers must compete with each other for the property of a few sellers. In a price decline, many sellers must compete with each other for the money of a few available buyers. It is common for sellers to ask their realtor to find a buyer who will appreciate the “unique qualities” of their property. Every seller thinks their property is the finest in the neighborhood and certainly commands a premium 5% to 10% more than their neighbors. These fantasies are reinforced by the behavior of buyers during the rally. At the risk of losing the listing, the realtor must find a diplomatic way to convince a would-be seller their property is average at best and needs to be priced accordingly. It is a difficult challenge for an experienced realtor to persuade an owner their castle is a cottage. Failure to educate the sellers to the reality of the market wastes the seller’s time and the realtor’s resources. Experienced realtors who thrive in bear markets earn their commissions.
Sellers in declining markets must compete on price. Only the best properties can command prices equal to recent comps. In a buyer’s market, there are no premiums: getting the price of recent comps reflects a premium because prices are declining. Properties with negatives must price 10% or more below recent comps to attract the attention of buyers. There are many books and articles written about staging a property and various little things a seller should do to sell their home. Most of these writings pander to the ego and false hopes of sellers who refuse to compete on price. No amount of sales and marketing is going to convince a buyer to overpay in a buyer’s market. Price is the ultimate amenity.
Paying off the Mortgage Note
Once a price decline gets underway many buyers who were late to the price rally find they are in a property worth less than they paid for it. As prices continue to fall, many find themselves “underwater” owing more on their mortgage note than their property is worth. When these late buyers want to become sellers, they cannot sell and pay off the mortgage note balance with the proceeds from the sale. Then they have a real problem. It is a problem with only 4 solutions:
- The borrower can keep making the mortgage payments until prices go back up. This is the “hold and hope” strategy. If the borrower uses exotic financing — which most buyers did in the later stages of the Great Housing Bubble — it may be difficult to continue making mortgage payments because these payments are likely to increase substantially. If the property is not owner occupied, the borrower may try to rent it out to cover expenses; however, this is generally not feasible. Buyers who purchased during the mania paid too much money relative to prevailing rents and available income. If this were not the case, it would not have been a financial mania. Since the payments are too high, renting the property does not cover the expenses. Renting out the property lessens the pain, but it does not make it go away. Also, since housing market corrections often last 5 years or more, it may be a very long time before prices recover to peak bubble levels. Keeping the property is a “death by a thousand cuts,” or perhaps a death by a thousand payments.
- The borrower can write a check at the closing to pay off the portion of the mortgage not covered by the proceeds from the sale. Many people do not have the amount necessary in savings, as few thought such a loss was even possible, and even fewer are willing to go through with the sale knowing they will have to pay for the loss. The unpalatability of this option usually forces the borrower to keep the property and try to endure the pain, or let it go up for auction at a foreclosure.
- The borrower can try to convince the lender to agree to a short sale. A short sale is a closing where the lender accepts less than the full mortgage amount at the closing.
- The borrower can simply stop making payments and allow the property to go to public auction in foreclosure. Both short sales and foreclosures have strongly negative impacts on credit scores and the availability of credit in the future.
In the price declines of the early 90s, most people opted to keep making their payments and stay in their homes. Downpayment requirements were high, and the use of exotic loan programs was less common in the rally which preceded, so many homeowners had equity and were able to make their payments. They accepted debt servitude as part of the price of home ownership. When faced with the four options presented to them, most chose to stay in their homes and keep making payments. As the slowdown in the housing market helped facilitate a recession in the early 90s, a recession compounded in California with defense industry layoffs, many people lost their jobs and as a result, lost their ability to make high mortgage payments. This created a problem with foreclosures that pushed prices lower. The decline in prices in the early 90s, though extreme in certain fringe markets, was not so deep to cause many people to voluntarily walk away from their mortgages. Most buyers during this period were required to put 20% down. This represented years of savings and sacrifice for many, so they were not willing to lose it. Since the total peak to trough correction was a bit less than 20% statewide in California and even less in other states, many homeowners still had some equity in their homes. The combination of high equity requirements and a relatively shallow correction made staying in the home the best choice for many. This kept foreclosures to high but manageable levels. The Great Housing Bubble was characterized by low or non-existent equity requirements, and a very steep initial drop in house prices. These conditions made foreclosures, both voluntary and involuntary, a tremendous problem.
Much of the purchase money in the bubble rally was debt. As 100% financing became common, the average combined loan-to-value on purchase money mortgages climbed to more than 90%. With so many people with so little in the transaction, it did not take much of a price decline to cause people to give up. By late 2007 prices had already fallen 10% or more in many markets, and there was no sign this would change any time soon. It was becoming obvious that those with little at risk were well underwater and they were going to be that way for the foreseeable future. This inevitably lead to one of the unique phenomenons of the Great Housing Bubble — Predatory Borrowing. Many simply stopped making payments they could afford because the value of their property had declined significantly. Nowhere in the terms of the mortgage did it state the payments would be made if, and only if, resale values increased, but many borrowers acted as if it did. When borrowers quit making payments they were capable of making simply because they were not going to make money on the deal, their behavior was predatory to the lender who ultimately had to absorb the loss. These borrowers often had so little of their own money invested in the form of a downpayment they felt little actual damage from just walking away from the property and mailing the lender the keys. Many borrowers simply stopped making payments, did not respond to letters or phone calls from the lender, and moved out. Short sales and foreclosures were not the end of the nightmare for sellers. It is the last contact they had with the property, but in many circumstances the debt — and debt collectors — followed them until the debt was repaid or discharged in bankruptcy.
A short sale is a property closing where the proceeds from the closing do not satisfy the outstanding debt on the property. The lender must agree to accept less money at the closing table for the closing to occur. From a credit perspective, there is little or no difference between a short sale and a foreclosure. Both a short sale and a foreclosure will show a series of missed payments and a secured credit line (or multiple credit lines) with a permanent delinquency and discharge for what is generally a very large sum of money. Both will have a strong, negative impact on the borrower’s FICO credit score that will persist for many years.
Because of the potential for fraud and the bureaucratic tangle of various parties involved, it is very difficult to get a short sale approved. If a lender is going to lose money, they are going to want to be sure the borrower is not selling the property to a friend or relative or engaging in some other kind of fraudulent conveyance. Also, the lender will want to be sure the borrower cannot pay back the money. This will require additional financial information like updated W-2s, 1040 tax returns, and a statement of assets certified by an accountant. In most cases, the borrower will have to stop making payments as evidence of their inability to do so in the future. Further, the property will also need to be listed for some period of time at a sales price which would result in sufficient funds to pay off the loan. Once it is demonstrated to the lender that the borrower has stopped making payments, cannot reasonably make future payments, and the property cannot be sold for a breakeven amount, then the lender may grant a short sale request. None of this happens quickly. If a buyer is found who is willing to purchase the property, the process of approving a short sale is so long and cumbersome, most buyers will move on to one of several other available properties on the market.
In the end, a short sale is only in the best interest of the borrower if they believe the bank will try to collect on the shortfall from the property sale. If a borrower is in a position where they will have to pay back any losses, a short sale may result in a smaller loss than a foreclosure and subsequent auction. If the borrower is not in a position where the lender either can or will go after the deficiency, there is little incentive for the borrower to even attempt a short sale. In these instances, the borrowers generally let the property go into foreclosure.
Foreclosure is the forced sale of a property owned by the borrower in order to satisfy the debt(s) secured by the property. Foreclosure laws are complex, and they vary from state to state. There are no federal laws governing foreclosures. The borrower is the legal owner of the property who has entered into a mortgage agreement with a lender to pay back all borrowed money, fees and interest due. The Mortgage is a security instrument that pledges the property as the security for the loan. This document provides the lender the ability to force the sale of property to satisfy the debt if the borrower fails to pay in accordance with the terms of the agreement. The lender does not own the property, they merely own a lien on the property which can be exercised to force a sale to satisfy the debt. At the time of a sale, all proceeds first go to settling this indebtedness before any residual “equity” goes to the seller. Foreclosures are always public auctions where the lender must notify the general public in advance, and the general public must be allowed to bid on the property. This public auction is necessary to prevent the lender from forcing the borrower to sell the property at a below market price to the lender who could then resell it for a profit on the open market.
Lenders do not want to own real estate. Lenders are in the business of loaning money and collecting fees and interest. At a foreclosure auction the lender will bid on the property up to the value of the loan. This ensures auction bids will be high enough to satisfy the outstanding loan amount. The lenders do not want to be the highest bidder. They would rather someone else bid over the loan amount and make them whole. If they end up being the highest bidder, then they must manage the property and ultimately arrange for its sale in the non-auction real estate market. There are costs and fees associated with this endeavor which eats in to the final disposition amount garnered from the final sale of the property. These fees generally increase the loss for the lender.
Recourse vs. Non-Recourse Loans
Loans used to purchase real estate assets can be either recourse loans or non-recourse loans. A recourse loan is one where the lender can sue the borrower for any amount owed in the terms of the loan contract. As with foreclosure laws, whether a loan is recourse or non-recourse varies from state to state. In California, all purchase money mortgages are non-recourse loans. In most states, including California, all refinances, home equity lines of credit or other loans not used to purchase the property will be recourse loans. This distinction becomes very important in a foreclosure or short sale. If a loan is non-recourse, the lender cannot collect from the borrower for deficiency under any circumstances. The sale and closing of the property is the end of the matter: the debt does not survive. If the loan is a recourse loan the lender may have the right under certain circumstances to go after the borrowers assets after a foreclosure. This depends on whether the foreclosure was judicial or non-judicial.
Judicial vs. Non-Judicial Foreclosure
Foreclosure proceedings in most states can be either judicial or non-judicial at the lenders discretion. The lender has the right to sue the borrower in a court of law for repayment of the debt on the property. This legal action is a judicial foreclosure. A judicial foreclosure is slower and costlier than a non-judicial foreclosure. The mortgage agreement has a provision where the borrower authorizes the lender to sell the property at a public auction if the borrower fails to pay the debt. A lender can exercise this right without a court order, and therefore it is considered a non-judicial foreclosure. It is faster and less expensive to perform a non-judicial foreclosure because no attorneys are involved and there is no waiting for a case to come up on a court’s schedule; however, there is a problem with non-judicial foreclosure, in most states the lender waives their rights to obtain money in a deficiency situation because no deficiency judgment is entered in the court record. When faced with deciding between a judicial or non-judicial foreclosure, the lender must weigh the cost and time of a judicial foreclosure against the probability of actually collecting any deficiency judgment. If a borrower is insolvent, which they often are if they are going through a foreclosure, they may not have enough money or other assets for the lender to collect on the deficiency judgment. In these circumstances, the lender will foreclose with a non-judicial procedure to minimize their losses. In these circumstances the borrower is not liable for repayment on the deficiency.
Prior to the Great Housing Bubble, if a mortgage debt was forgiven, the amount of forgiven debt was subject to taxation as ordinary income. Since people who lost their house under these circumstances were already financially ruined, this tax provision was seen as unduly burdensome to those it was levied against. The President signed into law the Mortgage Forgiveness Debt Relief Act of 2007 to relieve the federal income tax burden on debt forgiven in a short sale, foreclosure, dead in lieu of foreclosure, or a loan restructuring where the principal amount was reduced. This tax relief is only given to an owner’s principal residence and only for debt used to acquire the property. Speculative properties purchased as second or third homes are not covered, and debt incurred after the purchase through refinancing or opening new credit lines is not covered. This tax change made it easier for some borrowers to make the decision to go through a foreclosure because it removed one of the negative consequences of the decision.
Many would-be sellers failed to sell their homes at inflated bubble prices. This might not have be a financial burden depending on how they managed their mortgage debt. They may have regretted missing the windfall they could have received by selling at the peak, but they stayed comfortably in their homes and forgot about the excitement of the real estate bubble. The sellers who missed the peak sales prices and fell underwater on their mortgage, they faced more difficult choices. Many borrowers concluded a foreclosure was the best course of action because they owed more on their loan than their property was worth. Also, due to the exotic loan terms utilized by many borrowers, they were experiencing increasing loan payments and decreasing property values. With the prospect for recovery bleak, many decided to give up paying their mortgages and allowed the lender to foreclose. One can argue the morality of this decision, but financially, it was the best course of action given the conditions.