Obama to Pay Homeowners to Sell at a Loss?

March 9, 2010

by David Moenning

With the help of 20/20 hindsight, it is easy to see that the housing bubble was at the epicenter of the financial crisis that nearly toppled the U.S. banking system a year ago. Mortgages became too easy to get because of the insatiable demand for Wall Street debt products that provided buyers higher-than market rate yields coupled with the perceived safety of the American homeowner.

Due to the fact that interest rates had hit generational lows during the 2006-07 period, investors around the globe began to look in every nook and cranny for bond-type products that paid yields higher than prevailing rates. And there is one thing that is for sure in this world; if there is a demand, Wall Street will find a way to satisfy it.

But when the demand for mortgages began to exceed the available supply, mortgage companies developed the “no doc” mortgages in order to try and increase the number of loans available to be packaged up by the Street. In the old days, home buyers were required to prove they had a job and verify that the income they stated on the mortgage application was legitimate. But, with Wall Street pounding the table for more mortgages, these tiny details apparently became unimportant.

With interest rates at generational lows and little-to-no documentation required to get a mortgage, suddenly everyone could live the American dream of home ownership. And for the record, the very same politicians that are now pounding the table for someone to “pay” for the mess that was created were completely onboard the home ownership train. As politicians tend to do, some even took credit for this wonderful development in our great country.

It was at this point that things got out of hand. With no oversight, no regulation to speak of, and the demand for mortgages continuing to rise (Wall Street is also very good at marketing its products/innovations), the mortgage brokerage business exploded. Pizza deliverymen were suddenly making six-figures selling mortgages. The only problem was they didn’t know what they were selling and a great many home buyers clearly didn’t understand what they were using as a mortgage.

The ensuing boom in “liar loans” created some unintended consequences – higher home prices. With no income required and teaser rates at next-to-nothing, almost anyone could afford to get a piece of the American Dream. And with home prices increasing the wealth of Americans everywhere, there just didn’t seem to be any problem.

But, when the bubble burst and the easy money went away (in a heartbeat), the support for rising home prices also disappeared. And just like that, the prices of homes across the country went into a freefall.

Two years later, it has become painfully apparent that the bubble-induced prices seen in the really hot real estate markets (think Sunbelt) are not coming back anytime soon. As such, homeowners who paid too much for a property they really couldn’t afford to begin with have been walking away from their homes in droves. And since there are SO many people walking away at the same time, prices have been unable to stabilize, which, of course, serves to continue the downward spiral.

The decline in housing has put something on the order of 25% of Americans under-water on their mortgages. And given that these people owe more on their home than it is presently worth, they have limited options. Although the government would love for them to refinance at lower rates, which the government will subsidize, the fact that they are upside down on the mortgage means they can’t refinance without coming up with a boatload of cash.

Thus, the administration’s $75 billion mortgage modification program has largely been a bust. In short, the problem is somebody has to make up the difference between what is owned on the existing mortgage and what the property is worth. And not even the government can handle a burden that large on a countrywide basis.

So, the Obama administration has come up with a new plan – let the big, bad banks eat the losses. According to the New York Times, the latest program will allow homeowners to sell their home for less than they owe on the mortgage. The program forces the bank to accept the deal and the government will even give the seller a little cash to help them along the process.

The administration’s fear is that millions of Americans will decide to throw up their hands and simply walk away from their homes this year. With no way out, many homeowners see foreclosure as the only alternative. However, given the vast number of adjustable rate mortgages due to reset again this year, the last thing the economy, and anyone running for reelection, needs is for foreclosures to start to increase again.

Starting on April 5, the new program could encourage hundreds of thousands of people who are behind in their mortgage payments to sell their homes at a loss via a “short sale.” The program will compel lenders to accept the sale and forgive the difference between the sale price and the amount owed on the mortgage.

The Times reports that under the new program, the bank servicing the mortgage will get $1,000 for their trouble. (Another $1,000 can go toward a second loan, if there is one.) And then, the government would give $1,500 to the distressed homeowners as “relocation assistance.” So, in effect, homeowners will have an incentive to sell that condo they bought for $100,000 to the next bidder offering $48K.

The thinking is that such incentives would actually create legitimate transactions, which would help establish price stability in the market. Given that the bank has to eat the difference between the loan value and the sales price, the administration assumes the sales prices will be “real.”

Since foreclosed properties tend to be ransacked and drag down prices in an area, fewer foreclosures is also expected to be a good thing for prices. In addition, the owners of mortgages might actually receive more money from the “short sale” than they would under a foreclosure situation – and then there is the added benefit that no new property would be put the books to deal with.

For the homeowner, there is the benefit of getting out from under a untenable situation with a little cash in their pocket as well as the fact that a short sale does not damage their credit rating the way a foreclosure would. And since the property has been sold, there is no chance of the homeowner being sued by the lender down the road.

Sounds like a win-win situation, right? Well not quite. Somebody somewhere has to eat the difference between what the homeowner owes and can get from the sale. But given the administration’s view that the banks should pay to clean up the mess that was made, their view is that it is fine for the banking industry to eat the losses. Never mind the fact that most banks servicing mortgages had absolutely nothing to do with the alphabet soup of derivative securities that really caused the problem. But this little detail isn’t a concern at the present time.

So, will the White House’s new plan finally put an end to the decline in housing prices? We’re not terribly confident this plan will work on a broad scale, but we will give them a little credit for trying.

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Obama to Pay Homeowners to Sell at a Loss?