Wealth Skills

Making Homes Affordable: From Lose-Lose to Win-Win

Posted on 13 May 2009

Millions of Americans are contemplating leaving their homes, dusting off their hands, and walking away. They can and do make their mortgage payments, but in many cases, the mortgage balance exceeds the value of the home by nearly 20 percent. Homeowners in this situation may feel that they made a bad decision, the consequences staring them in the face every time they walk into their homes.

Their home, once the object of their desire and love, now serves as a perpetual reminder of the bad decision they made. It is no longer a place they want to come to, a place to relax and enjoy life. It is more than a burden. It is an infected wound.

What happened? These homeowners had good credit; they bought their homes near the peak of the real estate market with little or no money down. Their home values plummeted, but the mortgage balances didn’t.

Refinancing or selling a house with an underwater mortgage requires coming up with a large amount of cash. In either case, the owner would have to pay the difference between the current market value and the loan balance. To sell the home, the owner would have to bring cash to the closing table.  Look at one real life example I worked through with a client:

• Initial purchase price: $235,000 (also the current mortgage balance)
• Current market value of the home: $199,000 (18% drop in value)

Potential action	Conditions & Assumptions	Cash needed
Refinance the mortgage under the new “Make Home Affordable” government program	Loan balance must not exceed 105% of current home value	$26,050
Refinance the mortgage-traditional	Max. loan at 100% home value, plus closing costs of 1.5%	$38,985
Sell the home by listing with R/E agent	Assuming 6% commission paid at closing, sells at the current market value	$47,940
Sell the home by owner	Sells at current market value	$36,000

This homeowner is stuck. It would appear that abandoning the home is the only logical course of action, and the least expensive one. Though far from ideal, this option at least allows the homeowner to start over.

In reality, this homeowner would incur costs by leaving the home and defaulting on a mortgage. These indirect costs may be harder to quantify, but they add up. The homeowner may lose other assets in addition to their home. Defaulting on a mortgage results in a low credit score, which may prevent financing of significant purchases, such as a car, furniture, or another home. A bad credit score also significantly increases costs of borrowing (credit cards, leases, etc.) for several years to come. Car insurance and other insurance premiums may increase due to the low credit score, and other companies (such as utilities) may require higher security deposits. These costs are ongoing, and they grow quickly.

Lenders don’t want to refinance or originate loans at 125% of a property’s value. This would be unprecedented, and they have no obvious incentive to work with homeowners who currently make their mortgage payments.

The government designs “cautious” solutions partially because we, the taxpayers, say that we don’t want to bail out someone who made a bad decision. After all, these people were irresponsible, and politicians want to be re-elected! The government has not made an effort to use the resources on hand to maximize the positive impact, given the current situation. So, we now have the Making Home Affordable program, intended to keep the creditworthy homeowner at home. However, with a maximum refinance rate of 105%, the program is not available to those who need it most.

In many areas of the country, homeowners continue to see home values dropping with each new wave of foreclosures hitting the market. More Americans find themselves in a bind each month, carrying mortgage balances exceeding their home values. If that happens to you and me, will we look stupid?

It is easy to see that this is a lose-lose scenario, and that it creates a ripple effect on our economy that extends beyond home prices.  We are accustomed to this. “Let the stupid person pay for their mistake,” we say.  “Let the lender take losses.” “They all deserve it.” We could easily make the case that they earned what’s coming to them. And then, we’ll blame government for running up the national debt.

There’s another side to this picture, however. Owners of foreclosed homes lose their ability to borrow for a long time into the future. The lenders lose capital, so they have less to lend, making it harder for you and me, for businesses, and for local governments to finance operations or purchases. In a prolonged recession, foreign investors (i.e. China, one of the largest investors) are more likely to sell the Treasury Notes they own (or simply decline to buy them). The government issues bonds to raise money in any economy, but it’s issuing more of them right now. If foreign investors stop buying U.S. Treasury Notes, it will send our economy into a new “spin cycle.”

Here’s an alternative win-win scenario.

The Make Home Affordable program “excludes” the homeowner who has experienced the greatest loss, the homeowner for whom there is no conventional help available. I think we are overlooking solutions that offer the greatest economic value. These alternatives would make it possible for creditworthy homeowners who suffered significant losses to stay in their homes. Lifting the 105% qualifying rule would impact homeowners who need the most help, in the geographic regions that experienced the most significant losses. What if, under this program, the loan-to-value ratio was evaluated on a case-by-case basis, set at a minimum of 105%? Keeping these homeowners at home would have the maximum impact on stabilizing home prices, a benefit to all other homeowners in the area and the economy. Then, the challenge would be to devise a repayment schedule that would bring the mortgage balance back in line with home value within a few years. We may not even have to “forgive” the debt. Unconventional? Yes! But let’s face it: the conventional solutions aren’t working.

Implementing an unconventional strategy, such refinancing a mortgage above 105% of a home’s value for a borrower making scheduled payments, is easier said than done. Under present conditions, a homeowner who has mortgage above the value of their home has two choices: accept a heavy loss (assuming he/she has sufficient cash to absorb it), or abandon ship. A homeowner without sufficient cash has only one choice. This leads many creditworthy homeowners to default on their loans, leaving lenders to write off the losses. This may appear easier than working out an unconventional solution, and in the short-run, it requires fewer resources. Refinancing loans at lower rates will reduce lender cash flow over the life of the loan, but isn’t that better than losing the entire revenue stream and taking a capital loss? Once the homeowner leaves the home, lenders typically sell the properties at auction, where they command significantly less than the outstanding mortgage balances. Lenders would benefit from lower default rates.  We, the consumers, also would. It makes no sense, in times like these, to go for the easy solution. It’s not that easy any more.

What would happen if we viewed a bad decision as a “mistake?” What is a “mistake”? It is a decision that didn’t produce the result we expected and planned for. The source of a mistake is the assumption(s) we made. An assumption is an expectation about how things will work in the future. In the case of this homeowner, the assumption was that the home price would increase. If that had happened, all would be well, and things would have worked out. For that matter, if home prices had continued to appreciate, we would not be facing this kind of economic downturn, and I wouldn’t be writing this article. So “a mistake” is a decision based on an expected outcome that did not materialize. To say it another way, there are no bad decisions; there are only assumptions we made that did not turn into reality.

In this win-win scenario, homeowners benefit in a way that, over time, will empower them to recoup their losses.

The government now has an opportunity to create a program intended to design unconventional solutions for unprecedented problems. Lenders could retain their creditworthy clients and contain their losses. We could move forward, continually examining the assumptions we make, and inventing solutions that provide the greatest economic benefit.

In these exceptional times, I forgive myself for the mistakes I made, forgive others for bad decisions they made, and vote for win-win solutions.