Upside Down and Out of Luck

This week, the Obama administration released the details of how its expanded refinance and mortgage modification programs will work. I’ve combed through the details. And the view I shared with you two weeks ago in my Money and Markets column remains the same: There’s some good, some bad — and one glaring flaw …

We’re still not attacking the “upside down” problem head on!

What do I mean by that? Let me explain …

Falling Sales and Falling Prices Are Leaving More and More Homeowners Upside Down …

During the bubble days, when home prices were soaring, lenders and borrowers went hog wild. The monthly turnover of the U.S. housing stock surged, while home prices soared. One hundred percent financing was widely offered, either as single loans or “80-20″ combinations of first and second mortgages.

Now that the housing bubble has popped, “For Sale” signs are sprouting up like weeds, and prices are plummeting.

This resulted in ever-increasing numbers of homes changing hands at ever-increasing values, funded by larger and larger mortgages at higher and higher loan-to-value ratios.

And now, it’s all coming unglued …

• New home sales plunged to an annual rate of 309,000 in January. That was down more than 10 percent from December and the lowest level in recorded U.S. history (which goes back to 1963).

• Sales of existing, single-family homes have dropped to the lowest level in eleven and a half years, with no end to the declines in sight.

• The median price of a new home is down to $201,100 — the lowest since December 2003. Existing home prices have fallen to a median of $170,300 — the lowest in almost six years.

• The S&P/Case-Shiller Index shows prices in the 20 top metropolitan areas plunging 18.6 percent from a year earlier, the biggest drop on record. Individual markets are even worse: Phoenix is down 34 percent; Las Vegas, down 33 percent; San Francisco, down 31.2 percent.

• And it’s not just the bubble markets that are losing value now, either. A recent National Association of Realtors report showed a whopping 134 of 153 U.S. metropolitan areas experienced year-over-year price declines in the fourth quarter of 2008. That’s 88 percent of the U.S., up from 79 percent the prior quarter and the highest on record!

Result: An ever-increasing share of U.S. borrowers are now “upside down” or “underwater” on their homes. In other words, they owe more than their homes are worth — in some cases much more.

We’re talking about 8.3 million households … with another 10.5 million getting close to the negative equity edge — meaning they’ll be upside down if prices fall an additional 5 percent or less.

That’s 19.8 percent of ALL U.S. homes with mortgages that are now underwater, according to the research firm FirstAmerican CoreLogic. And if you include those homes that are near negative equity, you get a whopping 25 percent of mortgaged U.S. homes. One in four!

As you might expect, the numbers are much worse in some states, too:

• Some 59 percent of Nevada borrowers are either already underwater or close to it …

• 48 percent of Michigan homeowners with mortgages are suffering the same fate …

• As are 37 percent in Arizona, 35 percent in Florida, and 34 percent in California!

Obama and his team still aren’t attacking this problem head on. And the latest plan is going to exclude a sizable chunk of homeowners.

Yet once again, the Obama plan does not attack this problem head on. The Fannie-Freddie refinance part of the program only allows people to refinance if they are in the 80 percent to 105 percent loan-to-value “bucket.” Given the magnitude of the price declines I spelled out earlier, that’s going to exclude a sizable chunk of homeowners.

The modification portion of the program will also follow what’s known as a “waterfall” structure. It spells out the steps a servicer has to go through, one by one, to get the borrower’s monthly payments down to 31% of their income.

The first step? Lower the interest rate to as little as 2 percent.

If that doesn’t work, you move on to the second step: Extend the amortization or term of the loan to as long as 40 years.

Third? Forbear principal. That means you would no longer have to pay interest on a portion of the loan principal, but it wouldn’t be eliminated. You would still have to pay it back as a balloon payment when you sell the home or refinance.

At no point in the process is the cramming down of principal stressed. The program doesn’t PREVENT a servicer from doing it. But they’ve been extremely reluctant to do so to date.

One study in California found that less than 1 percent of the 88,830 loan modifications implemented in the first three quarters of 2008 included principal reductions. That compared to 47 percent where interest rates were cut. Throw in the fact the latest Obama program emphasizes steps other than principal reductions and I seriously doubt lenders will make widespread cuts.

And therein lies the problem …

All This Will Lead to More “Jingle Mail”

When borrowers are upside down, a sense of futility and hopelessness can set in: They wonder why the heck they’re making monthly mortgage payments when their house is continuing to depreciate!

Desperate homeowners will take advantage of Obama’s plan. But if anything knocks their finances for a loop, they’ll pop their keys in an envelope and send them off to their lender.

Here’s another thing: Higher loan-to-value ratio mortgages have ALWAYS had higher default rates than lower LTV ones. Why? When borrowers have none of their money at risk — skin in the game, if you will — they have no vested interest in sticking with the property. They’re giving up nothing by walking away.

Sure, they’ll take the lower payments they’re going to be offered as part of the Obama modification plan. Sure, they’ll stick around for a while. But if anything … anything … throws their financial situation off balance, a high percentage of them will resort to “jingle mail” — meaning, they’ll pop their keys in an envelope and send it off to their lender.

By the way, that option could be extremely attractive right now because rental property has flooded the market, and landlords are perfectly willing to cut deals. The nationwide rental vacancy rate was 10.1 percent in the fourth quarter of 2008, up from 9.6 percent a year earlier and just shy of the 2004 high of 10.4 percent. That level was the highest in the 49 years the Census Bureau has been tracking the data.

Figures from the National Multi-Housing Council’s confirm the rental market is extremely soft. The NMHC’s Market Tightness Index came in at a paltry 11 in the January survey, down from 24 a quarter earlier and the lowest in seven years.

So I’ll repeat what I said back on February 20:

“Unless and until you give borrowers an incentive to stick around … to ride out the tough times … by reducing their principal balances to levels that actually reflect some semblance of reality, you’re going to see many of these loan modifications fail.”

And that means many of the foreclosures the latest plans aim to prevent will just be postponed.

Until next time,

Mike

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