Irvine Housing Blog

Do loan owners feel invested in their communities?

Posted: 08 Apr 2011 03:30 AM PDT

A recent federal reserve report suggests a suggestion between equity and community belonging. Does that mean underwater borrowers are invested less?

Irvine Home Address ... 14 FREEDOM Pl Irvine, CA 92602
Resale Home Price ...... $779,900

Well I lived on the outskirts of town
In an eight room farmhouse, baby
When my brothers and friends were around
There was always somethin' doin'
Had me a couple of real nice girlfriends
Stopped by to see me every once in a while
When I think back about those days
All I can do is sit and smile

John Mellencamp -- Cherry Bomb

My strongest feelings of home still reside in my home town in central Wisconsin. It's not a place I can indulge my entitlements, so I find myself wandering the globe looking for a place I can have the closeness of community and the conveniences of modern society. Irvine is as close as I have come.

For many, if not most, a sense of community starts with buying a home. The ability of Americans to buy homes depends on their ability to obtain mortgages. The future of home lending is being debated in Washington now, and the future prices of homes could be greatly impacted by the outcome.

The Future of Mortgage Lending

Narayana Kocherlakota - President
Federal Reserve Bank of Minneapolis

Minnesota Emerging Markets Homeownership Initiative Workshop
Federal Reserve Bank of Minneapolis
Minneapolis, Minnesota
April 5, 2011

Introduction

... Let’s turn back the clock for a moment to the second half of 2006. At that time, firms and people around the world held a wide array of financial assets that were ultimately backed by U.S. residential land. (Think, for example, of mortgage-backed securities or any asset backed by mortgage-backed securities.) They viewed those assets as being largely free of risk. Investors may have understood that a fall in the value of U.S. land would impose large losses on them. However, they put low odds on such a decline taking place. Rather, they seemed to believe that U.S. land prices would continue to rise at a steady clip.

By the second half of 2007, that belief began to unravel in the face of incoming data. People were beginning to learn the hard way that U.S. land was a risky investment. Now the only question was how risky. The uncertainty about the answer to this question planted the seeds for a global financial panic.

What do I mean by the term “financial panic”? Financial panics are events that blur the line between liquidity and solvency. A firm is solvent if its revenues (in a discounted present value sense) exceed its expenditures. A firm is liquid if it is able to raise enough funds—either by borrowing or by selling assets—to pay its current costs. In a well-functioning financial market, solvent firms are typically liquid, because they are able to borrow against their future profits. In contrast, in a financial panic, lenders feel unable to assess the future profits and/or collateral of borrowers. Borrowing becomes highly constrained, and even highly solvent firms may become illiquid.

The dilemma for lenders during a panic is to determine who is solvent and who is not, that's why all the liquidity dries up. No lender wants to pour money down a black hole.

Lending is sometimes characterized as a confidence game: if lenders all believed firms were solvent, they would be solvent because even the unsustainable Ponzi ventures would be sustained by more borrowed money.

Lending is a confidence game with regard to solvent institutions. When lenders lose the ability to discern between those who are insolvent and those who are not, the stop all lending: a credit crunch.

The federal reserve and the US Government came up with a solution. By declaring insolvent institutions solvent by decree, government makes some firms too big to fail, and it makes the US taxpayer responsible for plugging a hole in our economy that threatens to bring down our banking system.

During the mid-2000s, many forms of collateral around the world were either implicitly or explicitly backed by U.S. residential land. As I’ve described, beginning in mid-2007, it started to become clear that this asset had more risk than financial markets had originally appreciated. It was not clear, though, how much more risk was involved. As a result, financial markets became increasingly uncertain about how to evaluate assets backed by U.S. land. That uncertainty translated into uncertainty about the ultimate solvency of institutions holding those assets—and the ultimate solvency of any of those institutions’ creditors.

Here is where the confidence game interpretation becomes dangerous. This banker is describing this situation as if land is really worth what people were paying in 2006, and if the confidence game had not been disrupted, prices would still be there. That isn't reality.

The reason financial markets ware unsure how to value mortgage-backed securities is because the value of the house was grossly distorted by the financial products of the bubble. With the air abruptly removed from mortgage balances, prices were destined to fall.

As investors became more concerned about the quality of mortgage loans, the secondary market for private-label mortgage-backed securities nearly disappeared. As a result, about 90 percent of mortgages originated over the past two years were guaranteed by government-controlled entities such as Freddie Mac, Fannie Mae, the Federal Housing Authority, or the Veterans Administration. Investors are willing to purchase mortgages and mortgage-backed securities from these agencies mainly because they have faith that the federal government stands behind those instruments.

The only reason private investors are paying prices that permit 5% interest rates is due to the government backing. If investors had to price risk into the market, as they do with jumbo loans, interest rates would be significantly higher.

This heavy reliance on government guarantees is not a sound long-term strategy. Over time, our country needs a mortgage market that returns to greater reliance on private risk-taking and private risk assessment, along with the enhanced regulatory oversight that is already in place. And, in fact, discussions are currently taking place on suitable options for bringing more private capital back into the mortgage market.

Even more generally, I believe that as a country, we need to take this opportunity to rethink many aspects of our public policy programs in the context of housing finance. Home ownership has long been part of the American dream, in no little part because home owners have invested not just in their houses but in their communities. But, through the mortgage interest tax deduction and other programs, we are encouraging people to buy homes by taking on debt—and sometimes large amounts of debt. If we truly want to encourage home ownership, we should contemplate programs that provide incentives for individuals to save and become equity holders in their homes—and, by extension, in their communities....

Are loan owners equity holders in their communities?

The argument used by policymakers for a wide range of government home-ownership assistance programs is home ownership quiets social unrest. People don't riot in a community they feel a connection with.

At some level, there is truth to the idea that people with a feeling of ownership take better care of things. Does owning a home create a feeling civic pride?

Let's assume that it does. The effect may be small, but civic pride is emotionally satisfying, and it tends to get incumbents elected to office, so polities that promote civic pride are favored by government.

What is truly important for civic pride? Does the manner in which a house is occupied have a major impact on civic pride?

If fee-simple title holder with no mortgage encumbrance -- a true home owner -- feels civic pride as an extension of their ownership, it is likely that mortgage holders also feel this pride in home ownership and community even though their actual ownership claim to real estate (equity) may be very small. The feeling of ownership is only loosely tied to a claim to an asset of tangible value.

In the case of underwater home owners, their claim to real estate has no current liquidation value. For their own personal balance sheets, the property still has option value -- their position may have liquidation value again in the future if prices go back up and they have equity again. This option value is the dangling carrot of hope that keeps debtors on the hamster wheel to service the debt. When debtors lose this hope, they strategically default.

The lending line of support in Irvine has been holding median mortgage balances in a tight range since the credit crunch in late 2007. That level of lending is holding the median sales price about 20% below the peak. At that price level, peak buyers are right on the cusp of going underwater.

Once prices drop below the previous median loan peak, the cascade effect of strategic defaults pounds market prices back to the stone ages. This is the lending cartel's greatest fear. Based on the tendency to strategically default, I deduce that loan owners do not have a deep bond with the community at large -- or at least not a bond that prompts them to take one for the team.

What about renters?

As a renter, I often ask myself what my connection to the community really is. Like loan owners, I have no equity stake in Irvine real estate. And like a loan owner's option value, I have an intangible freedom value they do not enjoy.

I feel as part of the community as anyone. Being the writer of this blog for four years, I have woven myself into the local fabric. I recently moved to Woodbury, and I feel very comfortable and at-home here. As a renter, I can attest to the possibility of renters for community involvement and a feeling of belonging.

Home ownership does not define one's sense of community.

They waited until the equity was gone, then they foreclosed

When banks stopped processing all mortgage delinquencies as they happened in early 2008, they had to establish buckets of similar loans and determine what to do with them.

One such bucket is composed of properties where the mortgage holder is delinquent, but they still have significant equity. Lenders have no urgency to foreclose on this group because as long as their is equity, they can foreclose whenever they want and still get paid in full. In fact, since they profit on all the fees and late charges, they have incentive to drag the process out until the loan balance is large enough to consume all equity.

That is what the lender did on today's featured property.

The property was purchased on 4/23/2004 for $900,000. The owner overpaid using a $595,000 first mortgage and a $305,000 down payment. Savvy cash buyer, right?

On 6/29/2004 she got a $100,000 HELOC, but it doesn't appear to have been used. On 12/27/2005 she obtained a $55,000 stand-alone second.

By late 2005, this property only had $650,000 in debt, and at the time, it was likely worth much more than that. In late 2007 or early 2008, she went delinquent on the first mortgage.

Foreclosure Record
Recording Date: 04/22/2010
Document Type: Notice of Sale

Foreclosure Record
Recording Date: 08/28/2008
Document Type: Notice of Sale

Foreclosure Record
Recording Date: 05/08/2008
Document Type: Notice of Default

Wells Fargo was the loan servicer, and they foreclosed on 12/7/2010 for $713,932 -- the outstanding balance on the first mortgage.

During the time this debtor was delinquent, the loan went from less than $600,000 to more than $700,000. The lender let them squat until their equity ran out, then they foreclosed.

There was no free lunch for this borrower.

Irvine House Address ... 14 FREEDOM Pl Irvine, CA 92602

Resale House Price ...... $779,900

House Purchase Price … $900,000
House Purchase Date .... 4/23/2004

Net Gain (Loss) .......... ($166,894)
Percent Change .......... -18.5%
Annual Appreciation … -2.0%

Cost of House Ownership
-------------------------------------------------
$779,900 .......... Asking Price
$155,980 .......... 20% Down Conventional
4.84% ............... Mortgage Interest Rate
$623,920 .......... 30-Year Mortgage
$158,557 .......... Income Requirement

$3,289 .......... Monthly Mortgage Payment

$676 .......... Property Tax (@1.04%)
$125 .......... Special Taxes and Levies (Mello Roos)
$162 .......... Homeowners Insurance (@ 0.25%)
$0 .......... Homeowners Association Fees
============================================
$4,252 .......... Monthly Cash Outlays

-$798 .......... Tax Savings (% of Interest and Property Tax)
-$772 .......... Equity Hidden in Payment (Amortization)
$289 .......... Lost Income to Down Payment (net of taxes)
$195 .......... Maintenance and Replacement Reserves
============================================
$3,166 .......... Monthly Cost of Ownership

Cash Acquisition Demands
------------------------------------------------------------------------------
$7,799 .......... Furnishing and Move In @1%
$7,799 .......... Closing Costs @1%
$6,239 ............ Interest Points @1% of Loan
$155,980 .......... Down Payment
============================================
$177,817 .......... Total Cash Costs
$48,500 ............ Emergency Cash Reserves
============================================
$226,317 .......... Total Savings Needed

Property Details for 14 FREEDOM Pl Irvine, CA 92602
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Beds: 5
Baths: 3
Sq. Ft.: 2550
$306/SF
Property Type: Residential, Single Family
Style: Two Level, Traditional
Year Built: 2000
Community: 0
County: Orange
MLS#: P772387
Source: SoCalMLS
Status: Active
On Redfin: 31 days
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Bank Repo! Fresh interior two tone paint and new carpet. Beautiful 5 br 3 ba pool home value priced for quick sale! Spacious living room, dining area, separate family room with granite fireplace and plantation shutters, open & bright kitchen with granite counters and center island, gorgeous distressed hardwood floors throughout, one bedroom and bath downstairs, master suite with granite tile floor master bath, dual sink vanity, separate tub and shower, tile roof. Super motivated seller. Submit!!!