How Did We Get Here? Past, Present and Future of Short Sales (Part 3)

Part 2 of this series discussed the shift in the profile of short sale sellers. Over time this profile evolved from those who could not afford the homes they purchased to those who actually could afford the homes they purchased but began to suffer financially due to the economic downturn associated with the housing market collapse.

This final entry will look at the current real estate market and economic conditions and attempt to explain the direction of short sales going forward.

Where are we today?
In 2011, will those directly involved in working through the millions of existing (and future) foreclosures decide to take the necessary decisive action that will resolve the housing market crisis?

Based on our experience through Q1 and Q2 of this year the answer appears to be no.

Existing information regarding the interpretation of information coming from the sources that track foreclosure activity, such as RealtyTrac, is incongruent at best. For example, let’s look at two news articles released on February 10th, 2011, both based on the RealtyTrac report on January foreclosure numbers. This article from Yahoo Finance leads with “Mortgage default notices slow sharply in January” while, on the same date, an article from leads with “US Home Foreclosures Rise in January, More Seen”. The actual report from RealtyTrac clearly states an increase of 1% in foreclosures from the previous month but a decline of 17% from the prior year — but most consumers will not see the RealtyTrac report, just the interpretive articles written about it.

Further emphasizing the difficulty of forecasting whether it is a good time to purchase a home or not, news delivered in February 2011 by The Wall Street Journal projected an end to the housing crash and suggested that it may be a good time to buy a house.

Whom should we believe? How do consumers decipher the direction of the housing market when media source analyses are in stark contrast?

For a number of reasons it does not appear likely that we will see an end to short sales for another 4 or more years. Our economy is not improving. Unemployment is still high at 9.1%; Political unrest continues to threaten the Middle East; European financial troubles are mounting; There is grave uncertainty in North Africa; Energy prices are on the rise; and we have a presidential election to look forward to next year. Not a day goes by that this culminating uncertainty is not felt by consumers and that impacts their spending habits as a consequence.

Housing is a very large part of the US gross domestic product. Economic recovery is largely dependent upon a recovery in housing. But people need income to buy houses and until hiring in the private sector improves and unemployment returns to nominal levels there isn’t a foundation for a recovery in housing. In addition to unemployment and the struggling economy, there are other concerns.

What about all of the properties that have already been foreclosed?
Often called “shadow inventory,” the number of homes in foreclosure or already foreclosed and taken back by the bank but not released again for sale (called an “REO” for “real estate owned” by the bank) is significant.

According to Standard & Poor’s analysis in January there is a total of 60 months worth of shadow inventory in the US market. The same report states that in the San Francisco Metropolitan Statistical Area (MSA) there are 42 months of shadow inventory and this number has increased quarterly since the fourth quarter of 2009.

It is also interesting to note from the chart below that the months of shadow inventory is not only increasing but also reaching levels not seen since the previous peak in January 2008.

The market concern is that the banks cannot hold this inventory forever, nor can it be allowed to grow unchecked. The Federal Reserve places requirements for cash reserves to offset the REO inventory that a bank holds. If the inventory increases, so do the cash reserve requirements, resulting in a decrease in liquid reserves to lend, which further restricts available credit.

This “overhang” of REO inventory represents what could become a flood of newly available houses in a market that cannot support increased inventory and could cause a further decline in values.

Conversations regarding the possibility of a double dip in the housing market have been on the increase over the first half of this year. While foreclosures continue to occur at high rates, the shadow inventory remains unaddressed. When it is finally addressed, the expectation is that it may cause another decline in housing prices.

In this report from May 5th, 2011, Clear Capital, a provider of data and solutions for real estate valuation and risk assessment for large financial services companies, is forecasting a national double dip. This chart shows the national REO saturation from 2008 to 2011. Note the turnaround in mid-2010 after 18 months of general improvement, and then a steady increase in saturation from July 2010 to May 2011.

Who holds the power?
The majority of short sales are homes that were purchased with two mortgages using little or no money down with interest-only payments for both the first and second loans. When a property has decreased in value to the point that its value is less than the first loan, the second has no ability to foreclose, as there is not enough equity to clear the first loan and leave the second with remaining proceeds. In these cases, if the first forecloses the second gets completely eliminated and, depending on the status of that loan, the borrower may be liable for the unpaid balance or some portion thereof – pending a negotiated settlement. As such the second does not hold much power in the foreclosure process.

In a short sale the situation is different. To successfully close a short sale all lien holders must approve the sale, accept less money than they are owed and provide a release of lien so that the property can be transferred to a new owner. When the value is less than the total payoff for the first loan that lender will only offer a token amount to the junior second loan (approx. $3,000 regardless of the balance of the loan). Now the second loan lender has power. The sale cannot occur without their approval and they generally will not approve such a small offer. Also important to understand and critical to the negotiation process is that merely releasing the lien on a second loan does not guarantee that the borrower will be released from future liability for the unpaid or deficient balance.

Obtaining a second loan approval that includes not only a release of the lien but also includes forgiveness of the unpaid balance will cost much more than $3000. This creates additional hardship for a borrower who is trying to resolve an already significant housing challenge.

Lenders and servicers (and the investors behind securitized mortgage packages) are unlikely to accept short sale payoffs until they begin to recognize that, regardless of the consequences associated with their credit or forgiveness of debt income tax, most borrowers will choose to walk away from the home rather than continue to pay on an investment that has no hope of returning any value for years and years to come.

Until that time, second mortgages will continue to be difficult to address in short sales.

My short sale is complete and I am done, right?
Not quite. Not only do borrowers have to deal with the unpaid debt on second loans that a lender will not forgive, they have to be concerned with income taxes. When money is borrowed and not paid back, taxing authorities consider that income and it is taxable at the borrower’s marginal rate.

When a lender forecloses or accepts less than what is owed in short sale on an owner occupied, 1 – 4 unit residential property, the canceled debt could create a taxable event. The federal legislation (with which California also aligns) that forgives paying income tax on debt that has been canceled is set to expire December 31st 2012.

If this legislation is not extended when the time comes it could increase borrowers’ woes, forcing them to resolve the situation before they are exposed to even greater personal liability – possibly even pushing them toward bankruptcy.

Looking ahead…
Homeowners making mortgage payments on properties that have fallen in value from 20% to as much as 50% are losing patience. Many homeowners who can afford to continue making mortgage payments (but have become unwilling to do so because values have fallen) will eventually choose to default. Called a strategic default, this will likely require a contribution to their lenders but this amount will almost certainly be less than the combined amount of 10 years or more of monthly payments. In consequence, this will allow the borrower to regroup and buy again in a market with significantly lower pricing.

If the strategic default becomes a standard practice lenders will have no choice but to find a way to accept them, further increasing the pressure on an already fragile housing market.

In the end, our economy will likely be depressed until the housing market improves. This will require a recovery in employment. Until then, short sales will remain a significant component in the housing market and will likely make up 25% to 50% or more of available inventory in many local sub markets.

Please check back with Pertria for continued assessment of the economy and the housing market.