A New Wrinkle in Foreclosures

Foreclosures have been getting a lot of press lately and will get a lot more in the next few years as their number increases. We have already seen a dramatic increase in many areas. But there is a new class of foreclosure that deserves discussion, the early-term default. A little background first.

The mortgage industry is divided into two main groups. There are those who originate mortgages, i.e. they find the clients and get the loans funded. The others are the ones that actually are the ultimate source of the money, those who buy the loans, hold them, and receive the monthly payments. Almost universally, loan originators, including big banks whose names everyone knows, sell loans. In fact, they won’t fund a loan unless they are sure they can sell it.

These loan originators sell them to what is known as the “Secondary Market.” The biggest players in that market are Fannie Mae and Freddie Mac. Those companies are “government-sponsored” entities who buy only those loans that meet their stricter credit standards, package them into pools, and sell interests in those Mortgage Backed Securities to investors, perhaps your company’s pension plan. 

It is estimated that 85% of all loans originated today whether by mortgage broker, mortgage banker, or bank are sold in the Secondary Market, usually within a few days. The other loans, mostly Adjustable Rate Mortgages or short-term hybrid ARM’s like 5/1 ARM’s, are done by lenders who keep them in their portfolios

Every sector of that market has its corollary in the Secondary Market sector. High quality loans are sold into one group and the ones of lower quality but higher yield (the sub-prime loans), are sold to different buyers.

All agreements that the lenders have with their Secondary Market sources have strings on the quality of loans they buy. In particular, sources that buy loans expect to keep them on the books for five or ten years. In fact, they don’t start making money for a couple of years, especially if they paid a Yield Spread Premium to acquire the loan. If the loan is paid off earlier than specified in the agreement, the originator has to buy the loan back.  Then the originator usually has to sell that loan to someone else at a discount, taking a loss on the transaction that certainly exceeds the income it made in the first place.

Normally, this doesn’t happen all that often, but recently there have been a few high profile cases that deserve our attention. In recent news, H&R Block, which originates sub-prime loans through its Option One mortgage operations, recorded a provision of loss in the amount of $102 million. Zounds! This charge was related to the company having to buy back loans that had “early-payment defaults.”  That means that very early in the life of the loan, the borrowers failed to make payments. In some cases, perhaps they never made even one payment.

So why would a borrower even go through the process of getting a loan in the first place if he didn’t intend to make any payments?  I am going to make this up because I obviously don’t know the actual circumstances, but my guess is that it’s like this. It wasn’t like the borrowers “ran into trouble” after getting the loan. I suspect that most of these borrowers NEVER intended to make the payments.  Let’s look at some hypothetical numbers.

Let’s suppose that the market is declining in your area and you know that you are going to have a tough time selling your home. Let’s make the assumption that you could sell your home for $260,000.Subtracting the commission and closing costs of 7 percent, you’d net $241,800.  But let’s assume that you can get an appraiser to give you an appraised value of $300,000 based upon comparable sales data from when the market was higher.

Let’s further assume that your friendly mortgage broker understands all of this and is willing be your co-conspirator, to help you get a loan without disclosing your real intentions to the lender.  Remember that sub-prime lenders will do loans of at least 90% of the home’s value. In this case 90% of the appraised value is $270,000, about $40,000 more than you could net from selling it. Not only do you get all the equity in the home, you also get another $40,000 in cash from the lender. Not bad.

That’s what I call selling your home to your lender without him knowing about it.  Obviously, the lender finds this out after a few months when no payments arrive. It may be a few more months before the lender figures out what’s going on and initiates foreclosure.  It may take another six months to get the borrower evicted from the house. Effectively, the borrower has sold his home and still gets to live in it for a year without making payments.

If you assume that the $102 million write-off was 10 percent of the value of the loans that had to be repurchased, that means H&R Block bought back over $1 billion in loans. That makes tax preparation look like a lot more fun, doesn’t it? And it is also the reason why prudent lenders try very hard to ask a lot of pertinent questions when they underwrite YOUR loan.

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