Archive for September, 2009

The Trade-Down Option

While the mortgage crisis has abated a bit, housing values are still significantly down from their peak.  The average sold price has gone from $322,000 to 273,000 since 2007.  This leaves a lot of people with underwater mortgages.  For recent buyers, this has created a wave of foreclosures.  In any economy, a certain number of people will be unable to make the mortgage due to job loss, medical problems, or just simple over extension from the beginning.  Most times, this is an extremely stressful situation, but not a tragedy, because the buyer put 20% down, and real estate prices have tended to go up.  Therefore, the person who got into trouble would simply sell the house for more than the balance on the mortgage, pay off the mortgage, and find a new, smaller house to buy or rent.

Unfortunately in our current economy, several factors make this impossible for many people.  First, in the past half decade or so, lenders were making a lot of loans with zero or reduced down payments, and amortization schedules that built up little or no equity.  This dramatically increased the pool of dollars chasing housing assets, driving up prices, and bringing buyers more likely to default into the housing market.  This meant more people who couldn’t afford their mortgages, and more of those buyers could not sell their house for more than the balance of the loan.

As a result of this situation, the number of defaults has increased dramatically.  This caused lending standards to tighten up again, reversing the price increase caused by the looser standards.  The price decline further exacerbated the problem of low equity, as no or low equity became negative equity.

This creates quite a problem for the person who is not necessarily in dire financial straits, but needs to move for a job or for other reasons.  Many people are now effectively locked in their current home unless they are willing to default and rent somewhere else.

Let’s take a typical example.  Jones buys a $300,000 house in 2007.  In 2009, he loses his job, and he’d like to move to another city where jobs are more available.  His house is now worth $240,000.  Unfortunately, he only put 5% down, and got an interest only loan, so he would have to pay $45,000 plus a real estate commission of $14,000.  Being unemployed with little savings, he doesn’t have a spare $59,000 kicking around.  Therefore, he stays and tries to find another job, perhaps eventually defaulting.  Alternately, he might decide to live in the house, not paying the mortgage while waiting for foreclosure to save his money.   The lack of a mortgage payment and the cost of the foreclosure, of course, will cost the bank up to 50% of the value of the house.  Either way, the default ruins Jones’ credit, may keep his life on hold, and costs the bank a six figure sum.

One solution is to allow Jones to do a short sale.  This costs the bank $59,000, which is better than $150,000, but still a lot of money.  The bank will not want to do this unless it thinks Jones is very likely to default if they don’t agree to the short sale.  The bank also doesn’t want to create a prescient for other borrowers that might be able to keep making payments.

Jones might not even be in serious danger of default.  He might be able to get a lesser job that will pay the mortgage, but he would really rather move where he could get a new one.

Ultimately this all leads to the conclusion that the bank should let him move.  The bank has already lost its security for the loan — It can recover some of the lost money, but not all, and so the loan is only partially secured by real property.  The bank doesn’t want to just let Jones sell the house and write them an IOU for the balance, because Jones has a lot less incentive to make the monthly payment on that loan than he does on the existing one.  Furthermore, with current lending rules, Jones would probably have to come up with a 20% down payment on the new house, which he almost certainly does not have.

So why not have the bank let him move to a new house with the old mortgage?  The bank would require that he sell his existing house first, and then would allow him to buy a new house with the proceeds from the sale.  Any money left over would pay down the balance on the existing loan.

This way, the bank keeps its security — the remaining unsecured balance is constant or down, and Jones gets to move.  Furthermore, with the new job, Jones is much more likely to continue to make payments on the existing loan.

If Jones was overextended, he would move into a smaller house, trading down in house, but with the lower loan balance, getting a lower payment in the process.  The bank might require this if Jones did not meet current income guidelines in the new house.  The lower payment would make Jones much more likely ultimately repay the loan.

The bank might even ask that he move into one of the foreclosed bank-owned properties that are littering their balance sheets.  This solves two big problems for the bank simultaneously.

With the huge advantages to banks and Jones, why aren’t we seeing this as an option?


09 2009