With all the talk of good news on the recession front there remains the little matter of reality. The real estate market cannot possibly return to normal until we clear out local inventories of unsold houses, meaning in many markets homes which have been foreclosed.
But now a new idea has begun to emerge: Reduce foreclosure numbers before they're created by subsidizing owners, buyers and investors. How? By tapping into the mortgage insurance system.
One of the major reasons for the current financial meltdown has been the effort to avoid mortgage insurance. This is about as good an example of delusional financial thinking as one can find.
Lenders have traditionally wanted buyers to purchase with 20 percent down. Few buyers have such cash so instead they opt for a strong co-signer, a mortgage insurance plan that promises to pay back part of the loan in the event of default. With FHA, VA and private mortgage insurance the consumer can buy real estate with little down and even nothing down under the VA plan.
With mortgage insurance we solve the problem of missing downpayment money but such insurance is not free. The cost of mortgage insurance varies but it can mean fees at closing, monthly premium charges or both.
Somehow the notion arose during the past few years that we don't really need mortgage insurance. The way around mortgage insurance costs was to finance with piggyback loans — one mortgage equal to 75 percent to 80 percent of the purchase price an a second loan for some or all of the balance. Now the lender has a first lien which can easily be sold to investors and a second lien which can often be sold as well. As to piggyback borrowers, no mortgage insurance payments for them.
Piggyback loans seem fairly shrewd — at least as long as property values continue to rise. In a market with upward prices, if a borrower got in trouble the home could be readily sold to pay off the loans and foreclosure would be avoided.
Alas, in the past few years three problems arose: First, most local markets have seen home values fall. Second, many piggyback loans included financing where the initial payments were so low that even interest costs were not covered. The unpaid interest was added to the loan balance, meaning that mortgage debt was growing at the very time home values were falling. Third, if you don't pay for mortgage insurance you don't have coverage when things go wrong.
How Mortgage Insurance Works
In situations where there's mortgage insurance if a borrower defaults the lender has big protection: The mortgage insurance policy typically provides coverage for 20 to 25 percent of the original loan amount plus a variety of foreclosure costs.
So far, so good, the lender is happy to have mortgage insurance coverage. But now we have to consider the fate of the mortgage insurance companies. Like all insurance firms they want to hold down claims.
As it happens the mortgage insurance system to date has worked as exactly as intended. However, paying claims also means that the mortgage insurance companies have had big losses. Those claims are offset with reserves but the point remains that a loss is a loss.
Mortgage insurance companies are a prudent bunch but they have no protection against general economic trends, in particular rising unemployment rates. Now faced with growing claims, mortgage insurance companies have begun to publicize a foreclosure option which can potentially keep large numbers of homes off the auction block — and potentially help buyers and investors.
If a home is foreclosed and a mortgage insurance company faces a whopping claim from the loan owner. But what if the foreclosure can be prevented?
With a claim advance the mortgage insurance company steps in and tries to prevent a foreclosure. This can be done by bringing the loan current or by paying the lender to lower the interest rate — a buy-down.
What about the borrower? Typically the mortgage insurance company places a lien against the property, but does not charge interest. The idea is that if the property is sold years in the future the mortgage insurance firm will have a claim against sale value of the property and hopefully re-coup its advance.
The mortgage insurance company is not helping the borrower out of any charitable impulse. If the home can be saved then the insurer avoids foreclosure and a huge claim by the lender. If the home is foreclosed, then the "claim advance" is a credit against anything owed to the lender — it's money that would have been spent anyway.
Buyers & Investors
To promote claim advances the mortgage insurance industry is now telling the world about "second look" programs and asking consumers to contact mortgage insurance companies when foreclosure looms. This is a good idea, but be prepared with paperwork to show the owner's financial situation just as if asked for a mortgage modification.
While there's obvious connection between lenders, borrowers and mortgage insurance companies, one has to ask if there's also a connection that involves buyers and investors.
Imagine that Smith has lost his job and is going to be foreclosed. There's no possibility that he can repay his loan. The mortgage insurance company steps in, checks out Smith's financials, shudders, and says no to a claim advance because the property is going to be lost anyway.
Now let's take the same situation and say that buyer Wilson is willing to buy the Smith property at market value. Alas, market value is less than the mortgage balance, and since Wilson wants a short sale, the transaction depends on the willingness of the lender to take a loss.
But imagine if an mortgage insurance company stepped in and said to the lender, we'll give you an amount equal to 10 percent of the original loan value if you'll accept the short sale. Now the interests of buyers, investors, owners, lenders and mortgage insurance companies are aligned. Wilson is getting the property at today's market value, Smith is able to move on, the lender has cut its losses and the MI company is not facing a bigger claim.
Why would a lender with mortgage insurance coverage agree to such an arrangement? Even with mortgage insurance coverage, price declines in many markets are so steep that even mortgage insurance policies cannot prevent substantial lender losses. In such cases a short sale with mortgage insurance help may be a far better option for the loan owner than an outright foreclosure.
"If you look at the claim advance program what you really see is a willingness to deal with losses," says James J. Saccacio, chief executive officer at RealtyTrac.com, the leading online marketplace for foreclosure listings. "The mortgage insurance companies see that they're going to have losses and are trying to hold down costs while lenders want to prevent foreclosures and even larger expenses. We've reached the point where mortgage owners face either marginal losses today or massive losses tomorrow — and for many of these loan owners tomorrow is not far off. The result is that in many local markets it would not be surprising to see mortgage owners increasingly accept short sales with mortgage insurance help."
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.
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