The Downward Spiral of Home Values
By Michael W. Smith
Home market values have dropped significantly in most markets. In many cases, home values have dropped below the mortgage encumbering the property. When homeowners in this situation go into default, they often contact a real estate agent who suggests selling the property as a short sale. Short sales are homes listed at a sales price which is lower than the mortgage encumbering the property. Short sales pose many challenges; long processing times, lack of pricing guidance, poor procedural guidance and procedural uniformity among many banks. To handle these challenges agents have adopted techniques which are indirectly contributing to the downward pressure on home values. Unfortunately, if these techniques are not used, short sales would be nearly impossible for agents to handle. Individuals who understand these techniques and bank procedures are in a unique position to view the market from a much broader prospective. These individuals can provide much needed insight into the planning for a market recovery.
In the early stages of the housing downturn, many banks thought short sale listings should generate higher sales prices and resisted granting approvals. Agents responded with a technique that provides evidence to the bank supporting the reasons the bank should accept the offered price. Real estate agents who employed this technique asked home sellers to sign a release granting the agent full control over the properties listing price. This control is freely granted since sellers are informed that they will be unable to receive any proceeds from the homes sale. The agent prices the property at or slightly above other listings in the area. From this start price, the agent systematically reduces the price of the home until a buyer comes forward with an offer. The listing agent maintains a history of all price changes and a corresponding log to track buyer activity. These logs are used as evidence to convince the bank that the offer received is the highest and best offer. The unfortunate side effect of continuous price lowering worked to undermine buyer confidence; buyers became convinced that home values were in a freefall state with no bottom in sight.
As time progressed and the market continued to deteriorate the number of short sales and foreclosures increased dramatically, overwhelming banks. The time needed to process short sales increased often requiring 8 weeks or more. With increased processing times and the uncertainty that the short sale will be approved, most agents working with buyers began to avoid showing short sales. Agents who list short sales realized a new technique was needed and worked to develop what is now called the pre-approved short sale. Unfortunately, banks are unable to pre-approve short sales but are able to provide a counter offer on contracts that have been declined. The counter offer indicates the price the bank is willing to accept. Listing agents quickly learned to submit any offer (no matter how low) just to get the banks counter offer. To attract buyers, short sale listing agents began to price properties artificially low. Artificially low pricing has skewed buyer’s expectations. Buyers pursue short sales, which are priced much lower and are often far superior to listings that have been priced realistically. Competition has developed between agents to have the lowest price listing to attract buyers. Buyers who choose to enter a contract at the artificially low prices are obligated to wait until the bank responds; a response that is often a decline. Once the contract is declined, the listing agent places the property back on the market and advertises the property as a pre-approved short sale. Buyers agents are happy to show pre-approved short sales knowing that their concerns about the short sale approval and the long processing time have been remedied. While both the listing and buyers agents are happy with this technique the consequences to the market have been dire. Homeowners with large amounts of equity who wish to sell their homes, price match listings that have been priced artificially low by agents seeking bank pre-approval even though these short sales would not likely be approved. When one of these homes sells, the lower price reduces the market value of the entire community forcing agents to further lower their short sale listings. Another side effect that’s not hard to see is banks are forced to process short sale offers that have little or no chance of being approved. This further increases processing time and labor costs incurred by the banks.
Still more problems exist in the way banks determine market value of properties. Banks use broker price opinions called BPO’s (a condensed appraisal) ordered from real estate agents, brokers, and appraisers (BPO providers). These BPO’s aide banks in their pricing decisions for both short sale approvals and foreclosure properties. Banks, in an effort to be competitive, prices foreclosure listings just below the homes currently listed to ensure a quick sale. To accomplish this, BPO providers are given guidelines for performing BPO’s. These guidelines direct BPO providers to give more consideration to active short sale and foreclosure listings which are known to be the lowest priced listings; the very same listings that agents have priced artificially low. The banks assumption is that properties are listed at fair market value, however due to the techniques real estate agents are using to market short sale properties, these properties are priced well below market. The bank unknowingly uses faulty information to determine foreclosure pricing and whether or not to accept a short sale offer.
As the market continues to erode banks have become more desperate to unload properties and have begun selling properties and accepting short sales not based on their value but based on the amount owed. In many cases, properties are being sold at the loan payoff, which is far less than the value of the property. This practice has caused a rapid decline in home values.
The following measures must be enacted immediately to curb our economic downturn:
Increase the number of buyers who are willing and able to purchase homes.
Solutions:
- Increase FHA’s loan to value ratio to allow for 100% financing. Risks to overcome include collaboration between homebuyers and sellers to increase the price of the home to cover costs associated with the homes purchase referred to as closing costs. During the housing boom sellers often offered to pay all buyer costs with proceeds a seller would receive from an increased price. Sellers can also agree to increase the real estate commission paid to a real estate agent so that the agent can rebate the buyer for his/her closing costs. These arrangements can lead to rapidly escalating home values and the risks can be managed by eliminating seller concessions and rebates. No rebates or concessions may be given by any party involved in the transaction that would be used to defray the buyers out of pocket cost to include those made after closing.
- Increase the availability of FHA loans by removing the net worth requirement to and the prohibition against real estate licensees who also hold a mortgage license from selling FHA loans. Many mortgage professionals are unable to offer FHA loans to their clients due to HUD restrictions which many mortgage professionals cannot meet. During the housing boom, many homebuyers were sold mortgage products with undesirable terms (subprime mortgages) because the mortgage professional was unable to offer the superior FHA product.
- Repeal the $7500 tax credit for first time home buyers in favor of a $7500 first time homebuyer grant. The grant must be repaid if the home is sold in less than 10 years. First time homebuyers lacking upfront funds to make a home purchase are not able to take advantage of a tax credit.
- Current homeowners must sell and close current property before closing on a property to be insured. This prevents homeowners from buying another property and defaulting on current property.
Curb the tide of foreclosures and short sales.
Solutions:
- Freeze all foreclosures for a period of 90 days. This will allow the market time to stabilize.
- Offer mortgage refinances up to 105% of the current mortgage balance. 100% to cover the mortgage balance with 5% additional available to be used to cover loan closing costs or may be used to pay down other debts to reduce debt to income ratios. To accomplish this, the U.S. Government must guarantee the mortgage loan or banks will not be unable to sell the mortgages in the secondary mortgage market. Much discussion has been made as of late regarding mortgages being written down and the U.S. Government using bailout funds to pay these write downs. What has been overlooked is that while homeowners who have defaulted would benefit, homeowners who are not in default who paid the high prices during the housing boom would be left paying the full mortgage on a home worth far less. Many of these homeowners may then decide to default so that they too can benefit from this plan. A second problem with the write down plan is that homeowners who have had their mortgages written down could then sell having a much lower cost basis further causing market deterioration. Offering Government guaranteed refinance mortgages is a far less costly option and helps to support market values. Some risks to this plan include banks giving refinances to borrowers who could default once again. Qualifying guidelines designed to manage and insure this risk can be established as follows:
- To insure the risk a mortgage insurance fund must be created.
- 1% of the amount financed must be paid to the fund by the bank being relieved of a defaulted mortgage.
- An annual mortgage insurance premium of .5% is paid by the homeowner for the life of the loan, collected monthly by the mortgage lender and deposited to the fund.
- FHA may not insure Adjustable Rate Mortgages. Adjustable rate mortgages (ARMs) helped to inflate home values during the housing boom. ARMs allow homebuyers to purchase a more expensive home than they otherwise would not be able to afford at the higher rates on fixed rate loans. Mortgage lenders offering subprime mortgages are primarily responsible for the housing market collapse we are now in. These subprime loans by mortgage lender design forced homeowners to refinance after a very short fixed rate term. The terms of these mortgages allowed for a very short fixed rate term most often 2 or 3 years after which the rate would adjust wildly even when the market interest rates remained the same. To understand how this was accomplished ARM loans are based on two underlying rates the banks profit margin (margin) and the banks cost of funds (index). The margin rate can be found in the mortgage note and is a rate that is fixed for the life of the loan. The index rate is quoted in many financial publications and is constantly changing with market conditions. Subprime mortgages work by giving borrowers an initial start rate which is generally slightly higher than market for the fixed period of two to three years. After the fixed period, the rate on the mortgage changes to a new rate and is calculated by adding the margin to the index. Unfortunately subprime lenders used an artificially high margin on these loans often and in some cases higher than the start rate on the mortgage. Let’s assume that you have a start rate of 6% and the index rate at the time the loan was closed was 2%. This means at the very minimum on the date the fixed rate period ends homeowners will see their rate increased to 8%. Since index rates did not remain constant this 2% increase was far less than the increases most homeowners experienced. To make matters worse most of these mortgages only required interest only payments for the fixed period adding still more increases to the payment. Many have implied that the credit rating and the fact that these mortgages were 100% financing are the primary reasons these borrowers defaulted. This is simply not true unfair and predatory lending practices must bare the majority of the blame. I propose the following regulation to correct this issue: At the time of rate lock the margin and index must equal the start rate on the mortgage.
- Investment and second homes are not eligible.
- Increase loan limits to allow more loans to be encompassed into the program.
- Consumer credit is not a factor to be considered.
- Applicants must show an ability to repay loan.
- Applicants must have stable employment or income.
- Maximum debt to income ratio of 45%.
As more Americans lose confidence in our financial markets we slip further and further into what could be our next depression. With banks posting massive financial losses, investment firms collapsing, unemployment rates rising, budget deficits climbing coupled with our national debt there is no end is in sight. Measures need to be taken to counter these problems immediately. Our leaders have worked hard to pass a bailout bill which should help to relieve and restore our credit markets. This bill is the first step toward correcting our nation’s economic woes. Steps taken now, without delay, can have a major impact on correcting the housing market which is the main underlying cause for our financial troubles.
Written by
Michael W. Smith
Broker / Owner
CENTURY 21 Solutions Realty
http://www.c21solutionsrealty.com
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