The case for principal reductions

These days, it's hard to find a more emotionally charged issue than the idea of a principal reduction for underwater borrowers. The problem is that arguments such as "Not fair!" "No taxpayer-funded bailouts" and "You made your bed -- now lie in it!" do nothing to address the larger, macroeconomic issue of foreclosures or short sales that might be unnecessary if lenders wrote down the principal to current market value.

What's to be gained by forcing people to refuse jobs in other locations because they can't sell their (underwater) homes -- especially when a lender will still have to write down the principal owed with a short sale or a foreclosure? It just seems nonsensical to me to do so if the borrower has the financial means to continue making payments on a reduced mortgage.

But rather than listen to me, listen to real estate columnist and "Real Estate Professor" George W. Mantor, who provides an excellent overview of the subject and the benefits of principal reductions. From the article:

...as continuing price declines push more and more homeowners deeper and deeper underwater, we are going to see a second wave of defaults. And, this one is not only going to swamp the market, it’s going to take the future with it when it recedes.

The employment numbers don’t mean anything. They don’t count failed business owners and other self-employed, and there are a lot of them, who are not entitled to unemployment insurance. There are those who have simply given up looking for work or those who have “graduated” and have maxed out their benefits.

Without substantial job creation, more homeowners will lose their grasp on their finances as unemployment insurance, savings, and retirement accounts are depleted.

Then there is the thorny issue of deferred interest loans made between 2005 and 2007, the peak of the market, that will adjust upwards in the months to come. Property values in some cases have fallen by as much as half, making the possibility of a refinance remote and increasing the likelihood that the borrower will exercise a strategic default...

The only way to avoid more and deeper pain across all sectors of the economy is principal reduction to market value. What is a short sale but a principal reduction for the new owner? How does that solve anything while getting us to the same place?

Obviously, the banks will resist and not just so they can collect on the default swaps. Principal reduction would require bringing the borrower and the true holder of the note, the investor, to the same table. The last thing the banks want is for borrowers and investors to come face to face.

The investors would realize that half of their money was skimmed off the top and that the value of the security is only a fraction of what they were led to believe.

As investors, they understand the difference between a 75% loss of value and a 100% wipe-out. Sooner or later, these assets have to be corrected on someone’s balance sheet. Not only would they more readily agree to mark to market rather than lose everything, but in most cases, these are the only people who could legally agree to a permanent loan modification or a short sale.

The upside for them is that the revenue stream is restored. Once the pools are in default, they get nothing, even though there may be performing loans within the pool.

Foreclosing and reselling in most markets is done at a price that represents the true market…what a willing buyer will pay tempered by what a willing lender will appraise the collateral for, often, some tentacle of the foreclosing lender. In this scenario, the financial intermediary also gets any proceeds from the foreclosure, not the investor.

These are extraordinary times and they call for extraordinary approaches. Here are 10 reasons why reducing loan balances and restoring lost equity is the best approach now.

1. What we are doing to address the problem isn’t working.

It isn’t going to work and, in fact, the longer we pretend that there will be significant loan modifications, the worse things are going to get.

2. Everyone who is upside down should get relief.

By “re-equifying” those households, we free up consumer spending, stimulate lending, and start putting people back to work—everyone wins.

3. It will cost less.

By keeping people in their homes, we reduce the costs of social services that are breaking the budgets in every community.

4. We were all gamed by the system.

Some worse than others. Here is just one little trick that even the smartest know-it-all usually wouldn’t catch in their loan documents. It is in the disclosure of Yield Spread Premiums. Most of us are used to seeing four percent written as either 4% or .4. But financial intermediaries express it this way, .04. The way we might express four tenths of a percent. On a $500,000 loan, it’s the difference between $2,000 and $20,000.

5. It will happen anyway.

The equity is gone; the loss is real. Foreclosure is the most expensive, least desirable way to bring the property back to its true market value

6. We all win if we do and we all lose if we don’t.

I’m sure that a handful of people who haven’t felt some real pain may be taking some perverse pleasure in watching their neighbors pack up and leave, but when you hear the stories of some of the homeowners who have stayed in vacant neighborhoods, the actual cost to those who remain is probably greater.

7. Borrowers and investors both gain.

Securitized loans put the investor and the borrower in same boat. Both were defrauded by the financial intermediaries and neither has received any remedy for their losses.

Trillions for financial intermediaries and nothing for the parties that were scammed. Instead of giving the money to the financial intermediaries that perpetrated this Ponzi scheme, it should have gone to the investors who were willing to accept the reduction in value of the pool. Instead, we give the money to the financial intermediaries who conceal the values of the assets. It’s a game.

8. We can afford to do it; we cannot afford not to.

Since the start of the meltdown, the Fed has amassed a whopping $9 trillion in loans to foreigners, but they will not say and, apparently there is no record of, where the money went. That’s $30,000 for every man, woman and child in America. That’s our money and right now, we need it.

At the moment, Congress is pushing for an audit of the fed, something that hasn’t been done in over ninety years. You would think everyone who is working for the taxpayer would want the taxpayer to know where their money is going, but this is shaping up to be one heck of a fight.

9. Some players in the mortgage arena are starting to get it.

Wilbur Ross owns American Home Mortgage Servicing, Inc. the third largest mortgage servicer in the country and he recently became one of the leading advocates for principal reduction. His reason, loans with significant principle reduction that give the owner equity in the property stay current.

In an interview with HousingWire he said, “The price of housing needs to be cleaned out. The Obama administration could right-size every underwater home and reduce principal to fit the current market value of the home. If they are going to deal with it they have to deal with it in a severe way.”

This was demonstrated in a study by investment firm Ellington Management which showed that every month, 8% of homeowners whose mortgages were 160% of the value of the home became delinquent while only one percent of those with loans that were 60% of value become delinquent.

10. It would jump start the economy.

Uncertainty isn’t good for the economy. Not knowing how far values will fall, not knowing when job losses will abate, and seeing no light at the end of the tunnel are paralyzing. Not just to consumers, but also to small business owners who are the hiring engines we need to pull us out of this recession. They need to know that consumers can and will spend before they start rehiring.

By restoring the lost equity in homes, we immediately stabilize real estate prices by establishing a “floor” and the true market value of property.

By stopping foreclosures, communities start to see their tax basis improve. They can start to rehire laid off workers such as teachers and emergency responders.

As distasteful as this may be to some people, it’s time to admit that there are no other solutions. The value is gone, never was really there, a few people got rich, a lot of people got poor, and now we have to fix it.

Has the time for mass-produced fuel cells finally arrived?

Back around the year 2000, I wrote an article for a local building industry group magazine about fuel cells and the impact on housing, cars and overall economy. But due to ongoing issues with using hydrogen to power these cells, over the last decade the industry has struggled to gain traction. Now, however, a Silicon Valley start-up called Bloom Energy has invented a relatively simple fuel cell that can run on not just hydrogen, but a host of other renewable energy sources.

Firstly, 60 Minutes aired a segment about Bloom Energy (I sure hope they give their PR people a nice raise!) on Sunday night:


Watch CBS News Videos Online

Next, a story in the L.A. Times covers the company and its technology:

After nine years of research shrouded in secrecy, a Silicon Valley tech firm Wednesday took the wraps off a fuel cell that it says can generate energy by combining air and a wide range of fuels without going through the process of combustion.

The firm, Bloom Energy, said the solid oxide fuel cell -- resembling a Polaroid snapshot both in dimension and thickness -- could be a game-changer in the clean technology industry because it can be powered by either fossil fuel or renewable sources in an electro-chemical process that is both cleaner and more reliable than current options.

In the company's plans, thousands of fuel cells would be crammed into a box about the size of a refrigerator called the Bloom Energy Server, each capable of producing 100 kilowatts of electricity, or enough to power 100 average-size homes or a small office building, Bloom said...

Still, given the high cost ($700,000+), it will be awhile until prices come down far enough to power individual homes. However, power companies could install a unit at a substation to power a specific neighborhood rather than build expensive power plants in remote locations that can be expensive to transmit (just look at your power bill).

Last year, EBay Inc. set up a 500-kilowatt system powered by biogas outside its San Jose headquarters, taking 15% of the campus' energy needs off the electrical utility grid. The fuel cells, which EBay dubbed "skinny batteries," were officially introduced at the company's site Wednesday with Gov. Arnold Schwarzenegger and former U.S. Secretary of State Colin Powell on hand.

Bloom Chief Executive K.R. Sridhar, a former NASA scientist, described the technology behind the fuel cell in a statement as potentially having "the same kind of impact on energy that the mobile phone had on communications."

Fuel cell technology has been in development for decades, with hydrogen as the usual fuel source. But Bloom's flat ceramic squares are more versatile, the company said.

Is it time for principal reductions?

Amidst the news that approximately 25% of homeowners with mortgages are now underwater (meaning they owe more than their mortgage balance), will we start seeing more cries for lenders to offer principal reductions to (a) make these existing mortgages more affordable; and (b) provide an incentive to keep borrowers in their homes? Given the high recidivism rate among borrowers with loan modifications -- which is often like putting a Band-Aid on an amputated limb and then praying it holds -- perhaps it's time to look at other options. From a CNNMoney.com story:

Nearly 25% of all mortgage borrowers were underwater, meaning they owe more on their loans than their homes are worth.

First American CoreLogic, the research firm that monitors housing equity, reported Tuesday that 11.3 million homeowners -- or 24% of all homes with mortgages -- were underwater as of the end of 2009. That's up from 23% and 10.7 million borrowers three month earlier...

For many homeowners, being underwater, also know as negative equity, has few consequences. If they're not planning to sell and can afford their monthly bills, they can wait out the downturn.

For others, however, plunging underwater can spell disaster. If they become unemployed or have a financial emergency, they have no equity to tap. Or, if they need to downsize or sell their home to relocate for a job, they can't...

Traditionally, being underwater was one of two main factors in determining a borrower's likelihood of foreclosure. The other is having sufficient income to pay bills. But, there's an increasingly important exception: strategic default. As equity gets more and more negative, some homeowners are choosing to quit paying and give the keys to the bank.

As long as negative equity remains a big problem, it will be difficult to stem the tide of foreclosures that continue to plague many local real estate markets around the nation.

New home sales fall to all-time low

One of the biggest concerns regarding efforts by the federal government to boost homebuying activity was that by borrowing demand from the future, when those training wheels were removed we could see a double-dip. So is that what's happening with the new home market? From a CNNMoney.com story:

Sales of new homes plunged to a record low in January, government figures showed Wednesday, as the weak economy and a glut of foreclosed homes continue to weigh on the market.

The seasonally adjusted annual rate of new home sales plummeted 11.2% to 309,000 last month, compared with a revised rate of 348,000 in December, the Census Bureau said. That's a decline 6.1% from January 2009...

The drop surprised many industry analysts. A consensus of economists surveyed by Briefing.com had expected January sales to rise to an annual rate of 354,000.

"Some people were expecting a surge in demand because of the tax credit," said Patrick Newport, an economist at IHS Global Insight. "But that surge isn't materializing."

Congress extended a popular tax credit last year that allows first-time buyers to deduct up to $8,000 from their income taxes and some repeat buyers to get a $6,500 break. Buyers now have until April to apply for the credit, which helped boost new home sales from depressed levels last year.

New home sales fell in all U.S. regions except the Mid-west, where sales edged up 2.1%. The Northeast was the hardest-hit last month, with sales plunging more than 35%...

At the current sales rate, it would take 9.1 months to sell through that inventory. That's up from December, when there were 8.1 months of inventory on the market. Prior to December, inventory levels had been steadily declining since May 2009.

Adam York, an economist at Wells Fargo, said the inventory of new homes for sale appears to be leveling off near 235,000 units.

"This is well below the level that persisted for most of the 1990s," he said, "suggesting builders have moved most of their excess inventory and will be in a better position when sales do eventually recover."...

Some economists expect new home sales to improve as the number of foreclosed properties on the market decreases and buyers take advantage of the tax credit.

"The supply of foreclosed homes has tightened," said Celia Chen, a senior director at Moody's Economy.com. "I think by early spring, home sales will pick up because buyers will want to take advantage of the tax credit."

IHS Global Insight's Newport said he also expects sales to pop this spring. However, he may reduce his full year forecast for new home sales in light of Wednesday's report.

"Builders are putting up homes," he said. "But what these numbers are telling us is that those homes aren't selling."

New home interiors adapting to a changing market

For years we’ve been hearing about gradual changes in the interior preferences of homebuyers, but during the boom years many builders stuck with the tried and true rather than risk their production schedules – and profit margins – on risky changes. Of course with discounted short sales and foreclosures continuing to dominate most local housing markets, new homes not only have to be competitively priced, but offer updated design cues and interior amenities.

Perhaps the biggest change today is that, on average, new homes are getting smaller after nearly doubling during the previous generation. According to a 2009 survey by the NAHB, 58% of potential buyers reported a preference for smaller homes with high-quality materials, and between 2007 and 2009 the desired square footage shrank from 2426 to 2292 square feet.

Although many production builders are getting ahead of this trend by ditching the status-seeking sweeping staircases, grand foyers and attention-getting fireplaces, Marianne Cusato, designer of the famous “Katrina Cottages” of 300 to 1800 square feet now available at Lowe’s, has introduced a “New Economy Home” for a larger audience.

At a reasonable 1676 square feet, Cusato’s design offers a flexible downstairs suite that can morph from a family room or office into a rental unit or a downstairs master bedroom in conjunction with an owner’s needs (and even, as she suggests, allow a divorced couple to share the house if finances are tight). What’s missing from her plans, of course, are features which might look nice but add little to a home’s utility value, such as long hallways, giant master suites, media rooms and that now-dated scion of the early 2000s – the Roman tub.

One key demographic group with design as a primary component of a home buying decision is Generation Y. While a large portion of this group may currently be doubled up with roommates in apartments or have temporarily boomeranged to live back with their parents, when the economy rebounds they’ll want their first taste of freedom in both stylish rentals and for-sale homes.

Importantly, for this cohort less is more, meaning clean lines and contemporary styling accented with bold colors against neutral backgrounds. Since both the Generation X and Y value social opportunities, builders can do a lot by properly merchandising small spaces for casual entertaining with the use of game tables and flat screen TVs.

Although the kitchen still remains the activity hub for most parties, the best designs create interactive flow with an adjacent family room by substituting breakfast bars for walls. And with outdoor spaces such as patios, yard and balconies increasingly becoming part of the overall entertaining experience, they should not only interact well with traditional interior rooms but also be easy to furnish.

For Gen Y, Gen X and Baby Boomers combined, they’re also increasingly demanding home offices or dedicated workspaces in lofts and alcoves, yet desire homes which require little maintenance and offer flexibility for a multi-tasking lifestyle.

And, while numerous surveys have demonstrated that buyers don’t want to pay more for green features, they still want to see them at least offered as an option (and one way to show a builder’s green credibility is to always offer appliances with an Energy Star label).

In the end, today’s more sophisticated buyers seem to be bringing a list of opposites to the sales table: homes that are both social hubs and sanctuaries, homes that are green but don’t cost any more, and homes that are well-designed but exclude pricey upgrades and options they can’t recoup when they re-sell. But for those builders who step up to that plate and are willing to swing, future riches may indeed await.

Banks finally seeing short sales as cheaper than foreclosures

For a few months now I've been hearing rumblings that many of the non-foreclosure sales out there are actually short sales since lenders have, after needlessly losing more money than necessary to the (old-fashioned) foreclosure process, realized that short sales are faster, easier and prevent angry borrowers from trashing the place when they leave.

So what took them so long? Well, I can only speak from personal experience, but my very first job out of college was for a mortgage company that was associated with a (now-defunct) S&L, and rocket scientists they weren't. From an L.A. Times story:

In a short sale the lender lets a homeowner unload a house for less than what is owed on the mortgage. The transaction recognizes that the home isn't worth what the owner paid for it after more than two years of falling real estate values.

Such deals are appealing to struggling homeowners because they escape weighty house debts -- but they don't get away unscathed. Their credit scores will be damaged, perhaps less severely than in foreclosure, but still badly enough to limit for years their ability to borrow money. There may be tax consequences. And any money invested through down payments and renovations will be lost.

Lenders, which can withhold approval of a short sale if they don't like the price, have resisted such sales because they are difficult to execute, particularly when multiple creditors and other parties are involved. And short sales lock in losses that might be reduced if the sale is delayed until the market improves.

But that resistance is softening. With more Americans losing jobs and missing mortgage payments, banks and investors increasingly are agreeing to short sales as a less costly alternative to foreclosure...

Short sales are still few compared with foreclosures, but policymakers are looking at such sales to shrink the number of bank-owned homes on the market.

Late last year, the Obama administration added incentives to get short sales done if a borrower is unable to qualify for a modified mortgage as part of the government's $75-billion effort to help troubled homeowners. Starting in April, the government will pay incentives to lenders and borrowers when a sale is completed.

Many economists view short sales as a way to address a problem that mortgage relief hasn't fixed: properties that are "under water," carrying more debt than the home is worth....

Short sales remain difficult. Uncertainty over home prices makes properties hard to value, lenders are understaffed and multiple loans on a home can trip up negotiations among creditors...

One factor motivating banks to go along with short sales is that foreclosures typically cost more. Foreclosed properties often sit vacant, susceptible to damage from neglect or vandals. A study by Amherst Securities Group found that prime loans took an average loss of 45% in a foreclosure as opposed to 35% in a short sale...

Then there's the problem of second mortgages, which have proved to be a thorny impediment to the housing recovery. The loans were widespread during the boom years as people tapped rising equity or financed a down payment.

Of the 1.2 million U.S. properties in foreclosure, about 34%, or 403,670, have a second loan, according to RealtyTrac. In California, with 280,023 properties in foreclosure, about 46%, or 128,800, have a second loan.

A muddled outlook for homebuilders in 2010

In contrast to the overall market, stocks of some homebuilding companies have continued to rally this year on the assumption that the strongest ones will take market share and emerge victorious when the market eventually rebounds. But since it's largely been government largesse propping up the housing market in the form of tax credits and low interest rates, once those training wheels are removed there is a real concern of a double dip. And of course there's also the matter of another wave of foreclosures, which are generally priced far below new homes. From a story in BusinessWeek:

While new home orders have increased in recent months and the pace of housing starts is expected to accelerate, the reality is that the housing market continues to be heavily reliant on government stimulus initiatives affecting everything from mortgage rates, sales of homes to first-time home buyers, and the pace of bank foreclosures... Macquarie Equities Research analyst Kenneth Zener says he expects distressed home sales to be kept near the 2009 pace—1.8 million—over the next three years, because of efforts by the government and banks. But he believes government programs, such as the Federal Home Affordable Modification Program (HAMP), have only delayed and not solved issues around negative equity, which require some principal forgiveness... While the economic recovery holds out hope for homebuilders, the wild card will be the rate of foreclosures. And that's likely to become more volatile as the government withdraws its massive liquidity on signs that the economy is finding its footing again.

February 2010 column for Builder & Developer magazine now online

My most recent column for Builder & Developer magazine is now online. For this particular column -- and in keeping with the magazine's theme highlighting exteriors -- I discussed the importance of architecture and quality exteriors in order to builders to compete against existing homes (and especially foreclosures).

An excerpt:

With steeply discounted foreclosures taking a huge bite out of the potential demand for new homes over the past couple of years, the nation’s home builders initially reacted with a combination of incentives and price cuts to stay competitive. Yet as the recession has worn on, the building industry has managed to find another trump card up its sleeve that will stay with us even as the economy rebounds: compelling architecture. Ranging from the practical and sustainable to the purely aesthetic, new home design is here to stay as a primary means for builders to stay competitive.

At the most recent Gold Nugget Awards in San Francisco, the one common element among the award-winning projects was not only offering attractive exteriors and an efficient use of space, but also incorporating designs into the scale and look of the surrounding area...

You can read that column here.

Why that bomb in the commercial markets keeps on ticking...

For months now we keep hearing about this impending train wreck in the commercial real estate market. According to a story at CNN.com, however, banks have already recognized about 50% of their potential losses, meaning this is a train wreck that's already in motion -- albeit quietly. From the story:

Banks have already recognized about $50 billion in losses, or about 60% of the estimated cumulative losses, according to real estate research firm Foresight Analytics.

And despite a steep drop in the price of apartments, office buildings and industrial properties nationwide over the past year, there have been recent indicators to suggest that the market may have finally hit bottom.

After 13 months of consecutive declines, overall commercial property values climbed 1%, according to the most recent monthly reading by Moody's/REAL Commercial Property Price Index...

Unfortunately, the consensus is that neither prices nor occupancy rates will improve anytime soon.

Estimates published last November by the Urban Land Institute and PricewaterhouseCoopers suggest that commercial real estate vacancies will continue to increase in 2010, while prices could tumble further during the year. Prices could fall as low as half their peak levels from 2007.

If that happens, that would only darken borrowers' hopes that banks will refinance their outstanding loans. And some $1.4 trillion is commercial real estate debt is expected to come due over the next three years.

Matt Anderson, partner at Foresight Analytics, said that can mean only one thing for banks: more losses...

Strategic defaulters beware: banks coming after those with deficiency judgments

Well this is interesting. Although we've been hearing over the last couple of years that lenders are too swamped with defaults to consider pursuing borrowers who can't re-pay the mortgages, that is now changing. In those states in which loans are recourse -- meaning they can come after you personally even after the mortgage lien has been released -- borrowers who walk away or complete a short sale are finding out that banks aren't happy until the entire amount borrowed has been paid.

And for those who think walking away through a strategic default is about the same as using a coupon in a store? Banks are combing through payment histories to make sure that if you walk away that it's because you can't pay any of your bills and not just your mortgage.

Of course in recourse states such as California, lenders can only take back the property used as collateral for the loan. But if you've refinanced or placed other debt on that property, watch out! From a CNN.com story:

Former homeowners may still be on the hook if there's a difference between what they owed on their mortgage and what the bank could sell it for at auction. And these "deficiency judgments" are ticking time bombs that can explode years after borrowers lose their homes.

It can even happen to people who got their bank to approve them selling their home for less than it is worth...

Whether banks can and will pursue deficiency judgments depends on many factors, including what state the borrower lives in and whether there's a second mortgage or other liens. But if borrowers ignore the possibility of deficiencies, it could haunt them...

In the case of foreclosure, lenders can pursue deficiencies in more than 30 states, including Florida, New York and Texas, according to the U.S. Foreclosure Network, an organization of mortgage law firms.

Some states, such as California, are "non-recourse" and don't allow deficiency judgments. But, even there, if the original loan was refinanced, some or all of it may be subject to claims...

Releasing title does not necessarily end the debt. It's complicated because of variations in state law, but, generally, a mortgage has two parts: a pledge of collateral, represented by the home, and a promise to pay off the loan.

Lenders may release property liens in order to facilitate short sales without releasing borrowers from their obligations to pay under the promissory notes. The secured debt can convert to an unsecured one after the sale..

Sometimes lenders go after borrowers walking away from their homes if they have other assets, according to Florida real estate attorney Larry Tolchinsky.

"Banks are pulling credit reports to see if it's a strategic default," he said. "If you're behind on all your other payments, you're okay. But if you're not, they'll come after you."

New realities for Baby Boomers

Question: what happens when you're a Baby Boomer, your home equity evaporates and the value of your retirement savings plunges?

Answer: You work longer!

Such are the findings from a survey conducted by pollster Harris Interactive retirement community builder Del Webb/Pulte. From a BigBuilderOnline.com story:

The study, which polled Boomers in two specific age groups--those turning 50 this year, and those turning 64--found that the average anticipated retirement age has been extended by about four years. Whereas a majority of 50-year-olds polled in 1996 said they planned to retire at 63, those turning 50 today said they expect to retire around age 67.

But what is retirement? The research also suggests that today's definition does not necessarily exclude professional pursuits. In the latest survey, 41% of 50-year-olds and 18% of 64-year-olds who are still working said they don't anticipate ever retiring. Boredom, self-satisfaction, and enjoyment were among the reasons cited for staying employed, but the No. 1 factor was financial stability.

Sobering as it may be, more Boomers are economically unstable now compared to a decade and a half ago. In 1996, roughly 11% of 50-year-olds reported they had not even begun saving for retirement; today that number is double. The study also found that nearly 40% of older Boomers who have already technically "retired" are continuing to work on some level...

Click here for entire story.