Housing Recovery is Spelled R-E-O
Short sales are a hot topic right now—especially with a much-ballyhooed government program focused on short sales, the Home Affordable Foreclosure Alternatives program, about to come online. But in the end, the real key to resolving the problems that yet remain in housing is likely to come back to an old standby: REO property sales. Yes, really. But to understand why, you’ve got to first really understand the scope of the mortgage default problem we’ve now got. According to data from Lender Processing Services [stock LPS][/stock], a whopping 7.4m loans are now non-current, compared to just 4.1m on average between January and June of 2008. A recent JP Morgan Chase [stock JPM][/stock] investor presentation presents the problem more visually, per the data below: (You can literally almost see the pig in the python.) What the above chart should call attention to is the aging of loans in the default pipeline. Again using LPS data, for all loans more than 90 days in arrears, the average days delinquent is now at 272 days—up from 204 days in early 2008. For loans in foreclosure, the aging numbers are even more staggering: loans in this bucket average 410 days delinquent, up from 260 days delinquent in early 2008. Ponder those numbers for just a second. On average, severely delinquent borrowers have gone more than 9 months without making a mortgage payment—and yet foreclosure has not yet started for them. For those borrowers who are in the foreclosure process, it’s been an average of 13.6 months—more than one full year—since they last made any payment on their mortgage. So, can short sales ride in to save the day for these 7.4m troubled borrowers? What about for the many millions more who are current on their loans, but are underwater on property value and unable to sell? For some, short sales will be an important solution—but don’t kid yourself: the hype currently surrounding short sales and the HAFA program will prove to be short-lived, and REO expertise will be prove to be the key to recovery, as it has been in prior cycles. Let’s explore two primary reasons for this. Second liens. Laurie Goodman at Amherst Securities, one my favorite mortgage analysts of all time, recently published some analysis showing that $1.053trn in second mortgages remain outstanding—and $963bn of that is on the balance sheets of commercial banks, thrifts and credit unions (the rest is largely within securitized pools). In plain terms, extinguishing second liens will have material impact on the reported capital positions of some of our largest commercial banks, a Very Bad Thing™. Goodman’s team estimates that roughly 51% of first mortgages outstanding have a second lien associated with them in some form; for prime and Alt-A mortgage holders, those numbers reach closer to 60%. Second lien holders, when they exist, effectively determine whether a short sale can proceed—and there is zero incentive, whether through the Treasury’s HAFA program or otherwise, for a second lien holder to voluntarily vaporize their note. Unless, apparently, money can be passed under the table. As seen in a story first broken by Diana Olick at CNBC, we’re already hearing reports of short sale fraud involving second lien holders attempting to extort dollars from seller’s agents directly, outside of the HUD settlement statement. Government’s implicit endorsement of short sales via the HAFA program seems only more likely to increase this sort of pressure. Regulators now face a very unique conflict of interest, and it will be interesting to see how this is resolved: on one hand, violating RESPA helps grease the wheels of a short sale, something the administration wants to see happen; on the other hand, violating RESPA is a federal offense. All of which means that second liens aren’t just a little stumbling block to short sales; they’re a boulder the size of Texas. Meet HAFA, child of HAMP. The HAFA program, going into effect on April 5, is getting plenty of attention—and the program’s heart is in the right place. But most are forgetting that it’s an extension of HAMP, the government’s loan modification program that has seen tepid success at best thus far. A loan must first be HAMP-eligible in order for anyone (borrower, servicer, or investor) to qualify for the program’s various incentive payments for short sale or deed-in-lieu. Which means any of the guidelines applicable to the HAMP program—loan in default or default imminent, within UPB guidelines, owner-occupied, and originated prior to 2009—still apply. Out of the gate, this simple fact rules out HAFA incentives for the many millions of borrowers that are underwater on their mortgage, but still performing. Read that again, because I’m seeing plenty of overzealous real estate experts suggest that the HAFA program will drive real estate sales for underwater homeowners (so sign up for their paid course to learn how to make millions using short sales!). As for the 7.4m already troubled borrowers? 1.3m troubled homeowners have received offers for modifications under HAMP to date, according to the latest report card, with 1.1m agreeing to a trial – and of that, 168,000 have moved to permanent status since the program’s start in the middle of last year. (We don’t know how many have since re-defaulted, however.) One of the largest problems within the HAMP program, even among eligible borrowers, is obtaining the paperwork required from the borrower to process a loan modification. JPM, for example, recently reported that out of every 100 HAMP trials offered, 25 borrowers do not pay as agreed and another 29 do not submit required documents, omitting Social Security Numbers, signatures and the like on documents that are submitted. Keep in mind these omissions and failed document submissions remain despite 15,000 staff members at JPM alone dedicated to nothing but loss mitigation. These omissions are coming despite an outreach strategy for each borrower that includes 36 calls, 15 letters, and 2 door-knocks prior to JPM kicking any individual borrower out of the HAMP program. If that’s what we’re seeing in terms of an effort to keep people in their homes, I’m not sure we should expect better performance when it comes to short sales (which would have people leave their home). Further, HAMP is itself a limited program, which means HAFA will face the same limitations. And HAMP’s handlers in the government understand the limitations of the program; the most recent report card from the Treasury notes that out of an estimated 6m borrowers at 60+ days delinquent, HAMP eligibility currently extends to 1.8m. While officials repeatedly state that they expect more borrowers to become eligible over time, even if the program hits its goal—3-4m trial offers extended by 2012—it’s still only part of a solution, not the solution. (After all, as the LPS data clearly shows, we’ve already got more than double the 3-4m 2012 HAMP target in troubled borrowers right now, to say nothing of who else will enter the pipeline between now and then.) The point here isn’t that short sales won’t matter—they will. But expecting HAFA to kick short sales into high gear all of a sudden is probably a very misguided expectation. As is expecting short sales to come to replace REO volumes in distressed real estate transactions. Instead, the short sale process in general is likely to become more streamlined as a result of the HAFA program, and that will help servicers process more short sales than they may have in the past. Nonetheless, in the end, we aren’t going to simply short sale our way out of 7m or so housing units’ worth of foreclosure overhang. What gets us out of this mess is tens of thousands of committed real estate professionals that really and truly understand REO. I’m not alone in this conclusion, either. JPM's got my back on this, and told investors a few weeks back that it sees REO volumes returning in the back half of this year, after dipping sharply in Q4 2009 and Q1 2010 under the influence of various government modification programs. The company’s baseline projections (below) show REO volumes returning to Q2 2009 levels by the end of this year—with stressed scenarios putting REO volumes back at late 2008 levels by the fourth quarter of 2010. Thanks to effective intervention from the government, we won’t see REO volumes soar to peak levels anytime soon—but we will see elevated inflows at least through the mid-2012, out of necessity. And those inflows should be seen as the road to recovery by anyone watching real estate. JPM forecasts, for example, that by Q4 2012, 22-28% of home sales in the Los Angeles region of California will still be REO; in Phoenix, that number is projected to be 39-50%. These projections underscore a message I've shared privately with many industry colleagues recently: recovery in housing is spelled R-E-O. Anything else is wasting time until we get there. Paul Jackson is the publisher of HousingWire.com and HousingWire Magazine.