The airwaves are brimming with stories about the financial loss incurred by investors and financial firms due to the mortgage market meltdown. What is often ignored is that foreclosures also have a debilitating effect on communities. Home values fall reducing the tax receipts of local governments; empty homes become an eye-sore for the entire neighborhood and invite vagrants. Investors and owners of foreclosed homes will have to endure the pain of their imprudent financial decisions. However, the impact of foreclosures on communities can be reduced by creative planning.
In the past, mortgages were held by local banks who could work with homeowners in trouble to delay foreclosure till the hard times passed. However, in the days of securitization, the owner of the mortgage is a business entity, a trust created to buy mortgages and issue securities. There are mortgage servicing organizations who handle the book-keeping aspects, but they do not have any skin in the game. They do not have enough financial incentive to help homeowners stay in their homes.
Root Cause Analysis
Many home owners who are in trouble took sub-prime Adjustable Rate Mortgages [ARM] with teaser rates which reset after two or three years. After the reset point, the rates would go up to 500 to 600 basis points above the LIBOR rate (typically the 12 month LIBOR). Even the initial teaser rates were in the 7-9% range, much higher than what most prime home-owners pay.
The thesis behind funding sub-prime borrowers was that when the ARM reset, the owner would have built a credit history, and a rise in home prices would allow them to qualify for lower rates. However home-owners who bought at the peak of the housing bubble are now upside down and owe more than what their homes are worth. As a result, they cannot refinance and are stuck with the very high rates which they cannot afford.
Current Remedial Actions
Current efforts to address the problem are focused on keeping the monthly payments affordable. They include suggestions to freeze the rates on the mortgages for a few years. These proposals make sense for homeowners who have some equity in their homes and can afford to make the payments at the current interest rates.
However, for a large group of borrowers, the payments are not affordable even at the current level. Many of them bought their homes after 2005 at the peak of the home price bubble. Homeowners stretched themselves to get into homes in the hope that they would be able to refinance to a lower rate in the future. Further, many of them put very little money down and, with home values falling, have very little equity in their homes. They do not have any incentive to continue to stay in their homes, when they can rent at much lower monthly payments compared to what they would pay with the 7-9% rate on their mortgages.
Wide-Scale Repossession: Not a viable alternative
It is evident that a large group of homeowners will not have any incentive to stay in their homes even with frozen interest rates. Traditionally mortgage note holders would foreclose on the home and try to recover as much principal as they could. However, the housing market is currently in a big depression, which is likely to worsen as economic growth slows and mortgage availability shrinks. As a result, banks may be forced to hold on to these properties for a much longer time. Not only will the note-holder not make any money on the principal amount, they will also have to pay for home maintenance, house taxes, and other costs associated with maintaining the home. Further, an increase in the number of foreclosure sales will worsen home prices, and start a downward spiral where liquid creditworthy homebuyers will wait on the sidelines.
Typically, foreclosures were bought by investors who would then use them as rental properties. However, given the difficulty in obtaining mortgage financing, the number of foreclosed homes, and the general air of despondency in the home market, investor interest is likely to be muted. As a result, the capital recovered in foreclosure sales might be significantly less. Given the magnitude of the problem, it might make sense for note-holders to reconsider their traditional approach of selling the home in a foreclosure sale.
Interest Rate Arbitrage: Sub-Prime versus Prime
A typical sub-prime buyer is paying between 7-9% in mortgage interest. This is significantly more than what real estate investment firms would pay for the same home (5-6%). The ability of the investor to borrow at a lower rate than the current homeowner means that an investor can rent out the home to the existing homeowner at a much lower monthly rent than what the homeowner is currently paying.
The ability of the investor to borrow at significantly lower rates than the homeowner opens the possibility for an entity to become a landlord for the next few years and rent out homes at a much lower monthly payment than what the homeowner was paying. This is the reverse of what typically used to happen in the past. In the lower and middle income communities where sub-prime loans dominate, it was typically more expensive to rent than own. This was a reflection of the fact that credit was not easily available and even people with stable jobs were forced to rent, since they did not have enough savings for the down-payment.
Efforts to encourage home-ownership led to the proliferation of low or no down-payment loans, which allowed perennial renters to become homeowners. This lead to a bubble in home prices which is now deflating.
Rental Management Corporation
Given the large number and concentration of sub-prime foreclosures, there is an opportunity for a sponsored business entity to manage the foreclosed homes as rentals. In this article I will refer to it as Rental Management Corporation [RMC]. Each region will have an RMC unit, where the region could be defined at the county or state level.
The process would be as follows:
1. Properties at the risk of being repossessed will be bundled together into a group which will be open to general bidding.
2. RMC will provide a guarantee of a minimum bid for the set of properties. This price should account for the following:
- Rental yield of the properties.
- Historic prices trend prior to the rapid increase since 2004.
- I expect, on average, the backstop bid price will be around 70% of the home’s original sale price. A 30% haircut means that the final 43% of home appreciation will be recognized as a principal loss.
- Note-holders will have to sign off on the minimum bid.
3. If another solvent entity comes up with a bid greater than the minimum bid, the role of RMC will end.
4. If no other entity can meet the minimum bid, RMC will take over the property at the minimum bid price.
5. Note-holders will transfer the ownership of the property to RMC at the bid price. The note-holders will recognize a principal loss; RMC will obtain financing to pay off the note holders.
6. RMC will manage and rent the properties out for the next few years, till the housing market stabilizes.
7. The original homeowner will get preference to rent the home from RMC at the prevailing market rent.
8. RMC will start selling the property once the housing market stabilizes in the area. Two years of non-negative home price changes can be the trigger used to start the sale process.
9. The current renter of the property will have a chance to bid on the property before it comes to the market. It is likely that the existing homeowner will continue to rent and then buy back the property.
Is there a Moral Hazard?
There is a question of the moral hazard when a government-sponsored rescue plan comes in to the picture.
In this case, the bail-out is NOT for the note-holders or the homeowners who made poor financial decisions. Note-holders will take a principal loss. Homeowners will lose the equity, if any, they have in their home.
Further, responsible homeowners who did not stretch themselves will benefit, since there will not be foreclosed properties blighting up the neighborhood. Unlike other proposals to reduce the principal amount, irresponsible homeowners will not be rewarded.
Why RMC instead of Private Investors?
Free-market dynamics will take too long and cause too much pain; the market can remain irrational for a long time. RMC will facilitate an orderly wind-down process which ensures that the community at large does not suffer.
- The foreclosure process is long and costly. There are fixed costs associated with foreclosure, which often eat up the principal recovered, especially for lower end housing. Note-holders are better served in a low cost transaction with similar principal recovery.
- The length of the foreclosure process will keep a lot of unsold inventory on the market depressing the overall sentiment towards the housing market. RMC can guarantee that the properties move off the market quickly.
- Distress sales will likely happen at fire-sale price, which will depress home-values and accelerate the downward negative spiral in asset prices.
- Private investors will cherry-pick only the most desirable properties leaving behind a big overhang of unsold foreclosed inventory.
- Foreclosures have a detrimental effect on neighborhoods.
- Families who are thrown out of the homes have a tough time in the future since their bad credit is damaged even further.
Caveats for RMC
- The price paid by RMC for homes it purchases should not be inflated to bail out note-holders.
- The properties selected by RMC should have clear potential to be cash-flow positive as rentals at the specified price.
- RMC should focus on regions with a high concentration of homes to get economies of scale and low rental maintenance costs.
- RMC should not compete with private investors but provide a back-stop.
- RMC should start selling properties after 2 years of non-negative home price change in the area. They will be required to sell all the properties within a 5 year period after the home prices stabilize.
What is the role of Government Agencies
- For an entity like the RMC to succeed, multiple stake holders have to come together and agree on some rules which preserve their interest, while working towards the greater good of U.S. citizens. Federal Agencies can define the ground rules which will govern the RMCs operating in different regions.
- Organizing Bundles of Properties: In order to move the properties off the market quickly, the properties will have to be organized in large region based bundles. Government agencies can facilitate this process and ensure that it happens at a quick pace.
- Organizing Auctions of Bundles: Once a minimum bid price is established, government agencies can facilitate the auction process and make sure that the entities bidding are financially solvent and have the capacity to hold on to the properties for a few years.
- Access to Financing: RMC will need financing to pay off the existing note-holders. The financing will have to be at competitive terms, to allow it to operate in a cash-flow positive manner.
Incentive for Note-Holders
- Note-holders will have the economic incentive to take the non-performing asset off the books. The capital recovered can be invested in more attractive opportunities.
- As a variation, note-holders can be given some equity stake in the RMC in return for a lower sale price. This will allow them to participate in any potential upside.
In the age of securitized mortgages, it is very hard for note-holders to work with individual homeowners in distress. Further, due to the large scale of the problem, traditional market processes will take too long and cause too much pain. An organization like the RMC can ensure an orderly wind-down of the excess, while ensuring the stability of American neighborhoods.