Fixing the Foreclosure Crisis by zhangyun


									                                Fixing the Foreclosure Crisis
                                             March 4, 2011

        The foreclosure crisis is the number one economic issue facing America today. While
some may argue that job creation should be our top priority and others may believe that
stimulating the economy should job one, the simple fact is that there can be no meaningful
economic recovery so long as the housing market remains dead in the water. Unless and until we
deal with the foreclosure crisis there can be no improvement in the housing market and no
sustainable economic recovery.
        Since the 1950’s, the housing industry has been America’s single most important engine
for economic growth. Historically the housing industry has directly or indirectly accounted for
roughly one-fifth of all American jobs and 17% to 18% of GDP. Today, however, the housing
market is on life support. Since the peak in 2006, home prices have fallen 27%, wiping out $9.0
trillion in wealth as millions of homes have been lost to foreclosure. Today, with many of these
foreclosed homes languishing on the market, the supply of unsold homes in America has
ballooned to 3.4 million, representing more than eight months of supply. With plummeting
prices and an enormous glut of unsold homes clogging the market, builders are simply not
building. New home sales in December fell to a seasonally adjusted rate of just 284,000 the
lowest level in 47 years. This means that no one is buying the concrete, lumber, glass and steel
that go into building our homes. Nor are we buying the sinks and stoves, the pools and patio
furniture, or the toilets and TVs that go into filling our homes. Moreover, we are not hiring the
carpenters, electricians, masons and plumbers needed to build our homes or the brokers, bankers,
lawyers and accountants needed to sell our homes.
        While it may be tempting to view the foreclosure crisis on a micro level, seeing it as a
problem only for those few irresponsible homeowners that foolishly got in over their heads, this
is simply not the case. The reality is that the foreclosure crisis is a societal problem that keenly
affects all of us. The homeowner facing foreclosure has already lost the equity in their home
and, in reality, has little left to lose. The rest of us, however, stand to lose substantially more if
an additional ten million foreclosed homes are dumped on an already saturated housing market.
Not only would this surely quash the nascent economic recovery now in place, it would destroy
trillions of dollars in market value on top of the losses already sustained.

       While we can argue about the root causes of this crisis, there can be no argument about
its potential impact. If another ten million homes are lost to foreclosure the effect on the overall
economy will be catastrophic. Robert Schiller (of the Case / Schiller Index) recently estimated
that housing prices could fall as much as another 25%. If this were to happen Americans would
lose another $6.0 trillion of asset value. Consequently, we cannot let our collective desire to
assign blame or punish irresponsible behavior stop us from taking the necessary steps to put the
U.S. housing market back on the road to recovery. Our experience at Scudder Bay has shown us
that there are bad actors on all sides of this issue, from unscrupulous homeowners that borrowed
against their house and never made a single payment to shady loan originators that put
unsophisticated homeowners into mortgages they knew they could never afford to those
notorious robo-signers that routinely filed false affidavits in the name of expediency.
Nevertheless, we must now focus our efforts on resolving this crisis and putting the country back
on the path to economic recovery rather than continue to seek retribution for past wrongs.
       The statistics surrounding this crisis are staggering. Since 2007, over 3.2 million
Americans have lost their homes to foreclosure, causing housing prices to fall 27%. However,
this is just the tip of the iceberg. An additional 2.2 million homeowners are currently in
foreclosure. A further 4.7 million borrowers are at least 90 days delinquent on their mortgage
and it is only a matter of time before foreclosure proceedings are initiated against these
homeowners. This means that we are potentially not even one-third of the way through the
foreclosure process. Moreover, if housing prices stagnate or fall further we could see many more
defaults as more than one-quarter of all homeowners in America, about 15.7 million people, have
no equity in their homes. As a result, if we do nothing, as many as 12.5 million more homes
could potentially be lost to foreclosure. It is impossible to overestimate the impact this would
have on the economy as a whole.
       We all remember from Economics 101 that prices are a function of supply and demand.
Due to the insidious nature of foreclosures, however, when a home is lost to foreclosure it affects
both sides of the equation. Not only does the foreclosed home come on the market, adding to
supply, but, based on current lending practices, the foreclosed-upon homeowner is effectively
barred from the housing market for up to seven years thereby reducing the pool of potential
buyers and hence reducing demand. With increased supply and reduced demand, housing prices

have nowhere to go but down. If we add five or ten million homes to the supply side of the
equation and remove five or ten million potential buyers from the demand side of the equation,
housing prices would remain under extreme pressure for many years.
        There are things that can be done to avoid this outcome. We first need to change the way
we approach the problem, however. The Government’s “one size fits all” approach to the
problem is not only wrongheaded, it is ineffective. That said, it is not necessary to over
complicate the matter. The truth is that two sizes will fit all. By that I mean that in order to
come up with a workable plan for resolving today’s foreclosure crisis we must distinguish
between those homeowners that can actually afford to stay in their homes and those that cannot.
While this may seem obvious, it is a distinction that seems to have been lost upon policymakers
in Washington.
        If a homeowner has the financial wherewithal to remain in their home (if their loan were
modified to reflect today’s lower value of their home) we must do everything possible to keep
these people in their homes and to keep these homes off the market. Conversely, if a homeowner
does not have the financial wherewithal to remain in their home (even if their mortgage were to
be modified) we must do everything possible to transition these homeowners to more appropriate
housing. Only in this way can these homeowners get back on their feet financially and can we
work through the glut of non-performing loans.
        So what is “everything possible?” First, the solution does not require an additional dime
of taxpayer money beyond what has already been committed. Nor does it require new and
complicated Federal programs. Rather it requires only common sense and a little arm twisting in
order to get the various Federal agencies to do their jobs and work in concert to resolve the
current crisis.
        I formed Scudder Bay Capital, LLC two years ago with my wife (a consummate do-
gooder) to help resolve the mortgage crisis in New England. We wanted to be part of the
solution. Our strategy was simple. We would buy non-performing loans and then work closely
with homeowners in a socially responsible manner to either help them stay in their home (when
possible) or to transition to more appropriate housing and get back on their feet financially when
it was not possible for them to stay in their home. The first order of business would be to
determine which homeowners could afford to make their mortgage payments if their loan were

modified or refinanced to reflect the current value of their homes and which homeowners could
       When we first started the business we thought that once we gained the trust of the
homeowner and made the determination as to whether they could afford to stay in their home,
the process would be a simple one. For those homeowners that could afford to stay in their
homes, our plan was to either modify their loan or allow them to refinance at a significant
discount to the unpaid principal balance and arrearages on their existing loan. By reducing the
principal balance and forgiving the arrearages we hoped to create at least 5% equity value in
their home in order to help the homeowner get back on their feet financially and provide them
with an incentive to remain current on their mortgage.
       For those homeowners that could not afford to stay in their home, our plan was to provide
financial assistance to allow these homeowners to transition to more affordable housing (often a
rental property) and to forgive the deficiency balance and waive all past due payments so that
they could get out from under their crushing debt load and move on with their lives. In addition
we would provide cash assistance, relocation services and credit counseling services to ensure a
smooth transition. Once the family was relocated we would sell the home on the open market to
a more qualified buyer that could afford the payments. In this way, not only could we help the
homeowner start over, we could turn a non-productive asset into a productive asset.
       So what went wrong? With regard to the first group of homeowners, those that could
afford to stay in their homes, we ran into two problems – one, it is impossible to refinance these
loans and two, prohibitively expensive to modify them. With regard, to the second group of
homeowners, those that could not afford to stay in their home, the Federal government and the
state Attorneys General have essentially told them that they don’t need to make their mortgage
payments in order to remain in their homes.
       While the Federal government has made much of the moral imperative that financial
institutions have to modify loans, the fact is that the Federal government penalizes any institution
that actually agrees to reduce a borrower’s principal amount or even lower their interest rate. It
used to be the case that when a financial institution purchased a mortgage on the secondary
market and modified the loan, the homeowner was taxed on the debt that was forgiven while the
financial institution was taxed on the difference between the purchase price of the loan and the

new modified face amount. As a result, mortgages were rarely, if ever, modified. In response to
the housing crisis, the tax on homeowners was eliminated, but the tax on the financial institution
was left untouched. Since almost all non-performing loans have been sold at a discount on the
secondary market, this tax on “phantom income” serves as a very real deterrent to modification
particularly as almost half of all mortgages modified since 2005 have re-defaulted within a year
of modification. It is asking much of these institutions to pay an upfront tax on a 30 year stream
of future payments when these payments so often cease within a year of the modification. It only
stands to reason that if this tax is eliminated, the number of modifications will increase and the
number of foreclosures will decrease. Moreover, this change to the tax code would be revenue
neutral over time as the tax would still be due when the lender actually receives the payments.
           With modification no longer a viable option we tried to find banks willing to provide
refinancing for our homeowners. We thought that if we agreed to write off a significant portion
of the unpaid principal balance and all of the arrearages so that property was no longer under
water we could find banks willing to write a new loan. Refinancing, however, for this segment
of the population is an urban legend, a myth, it does not exist. As a result of missed mortgage
payments, the FICO scores for these borrowers are mired in the netherworld below 600 where no
bank will dare venture. Consequently, the very banks which caused this problem by lending to
anyone with a pulse have now found religion and are unwilling to extend credit to anyone but the
most pristine borrowers. As my Dad always said, banks only lend money to people that don’t
need it.
           In response to this problem, the Federal Housing Administration rolled out its “Short Re-
fi” program. The program was designed to help borrowers with damaged credit scores by
providing government guarantees. The program is only available to deserving homeowners that
are current on their mortgage payments but underwater on their mortgage. If the lender is
willing to write of at least 10% of the principal balance (but as much as necessary to restore
equity in the home), FHA would insure the new loan. From our perspective, this program was
just what the doctor ordered. It requires banks to write down loans in order to restore equity for
the homeowner in return for a getting a government insured loan. Moreover, it is only available
to deserving homeowners that have continued to make their mortgage payments despite being

underwater on their loan, providing a strong incentive for homeowners that are underwater to
remain current.
       So how did the industry respond? Of the hundred plus banks we have contacted we have
found exactly none that are participating in the program including those banks that received
TARP funds. And Congress’s response? The Republicans have recently proposed eliminating
the FHA “Short Re-fi” program. Why? It is too expensive. You cannot make this stuff up.
       What is most puzzling to us is that no bank wants to participate. We would have thought
that they would be all over this program. After all, who wouldn’t want government guaranteed
paper paying 5%. You would think that they would be doing this every day of the week and
twice on Sunday. There is a catch, however, or should we say, two catches. First there is no
secondary market for these refinanced loans (which means that these banks would be forced to
carry these loans on their balance sheets) and second, if the banks keep these loans on their
balance sheets, they will be penalized by Federal bank regulators for making loans to individuals
with poor credit scores (despite the fact that the loan is insured by U.S. Government). Again,
you cannot make this stuff up!
       Discouraged by the fact that no one was willing to participate in the program, we decided
to start our own bank. The only trouble is that you can’t start a new bank in America today.
Despite the fact that the FDIC is encouraging community bank proposals, federal bank regulators
don’t want to be bothered issuing new charters to de novo banks that want to be part of the
solution. Attorneys that handle de novo bank applicants were widely quoted in the trade press as
saying that anyone wanting to start a new bank would be better served by “taking the high-six-to-
low-seven figure amount you’re going to spend trying to get a new charter approved and using it
to fly first class to Las Vegas, walking into the Palazzo and telling the croupier to put all the
scratch on 14 Red.”
       When we brought this de facto moratorium to the attention of our Congressman (a
ranking member of the House Banking committee), he claimed to have no knowledge of this de
facto moratorium. His staff did get back to us a week later, however, to let us know that we were
wrong – there were in fact two new charters issued during 2010. In the entire United States! For
the entire year! One charter, however, was granted to NBH holdings as part of a bailout plan of
Bank Midwest so in reality there was only one new bank established in the entire country in all

of 2010. With the old banks shell shocked from the mortgage crisis and still trying to work
through their old problem loans, the only hope for homeowners looking to refinance lies with
new banks with unsullied balance sheets. Once again, the Government has proven how adept it
is at closing the barn door after the horse has already gotten out.
       Despite the fact that the FHA “Short Re-Fi” program is slated for the scrap heap, it can
and should be saved. All we need to do is create a secondary market for these loans and who
better to do that than our friends at Fannie and Freddie. After all, don’t they work for us now
that they have been nationalized? This would create the ultimate public/private partnership.
Private companies would take the hit on the old loans if the Government would insure the new
loans. For all those fiscal conservatives about to rear up and roil against the Federal government
taking on this additional risk - take a deep breath. These loans are already insured by the FHA.
As a result, there is no incremental exposure. Who knows, maybe Fannie and Freddie could
actually make money packaging and selling these loans like they did long, long ago in a galaxy
far, far away. In any event, if we could create a market for these loans the program could be an
enormous success, keeping millions of hardworking and deserving families in their homes (and
millions of homes off the market).
       Even if we can’t get Freddie and Fannie to create a secondary market for these loans, we
ought to be able to get the bank regulators to stop penalizing banks that make these loans. It
makes no sense to have the FHA encourage banks to make these loans if regulators are going to
penalize banks for making these loans. Either this is something the government supports or it’s
not. And if it is something we support, regulators must treat these loans differently when
assessing the soundness of a bank’s portfolio.
       These two simple fixes, changing the tax code to eliminate the penalty on financial
institutions that actually modify loans and creating a secondary market for FHA “Short Re-fi”
loans could prevent millions of homes from falling into foreclosure thereby keeping millions of
families in their homes and millions of homes off the market.
       So now that we have solved the problem for those homeowners that should stay in their
homes, what do we do about the poor homeowners that cannot afford to stay in their homes? We
get them out of course and as soon as possible – nicely, humanely – but out! While the
government has made it prohibitively expensive to modify a loan and almost impossible

refinance a mortgage, they have also managed to keep millions of non-performing homeowners
in homes they cannot afford. The number one solution from Democrats seems to be to delay
foreclosures for as long as possible. This has been done under the guise of “making sure the
paperwork is correct,” however, that is just a ruse. The simple fact is that these lawmakers are
simply choosing to kick the can down the road. While the banks have acted like idiots and their
paper work is a mess, virtually all of the homeowners being foreclosed upon are squatting in
homes for which they have made no payment in years. That’s right – years. Our average loan,
when we buy it, is 30 months past due and if we are forced to foreclose it generally takes us
more than a year from the time we purchased the loan. Just to be clear, we are not foreclosing
upon Mother Theresa.
       When we first started Scudder Bay two years ago, we found most homeowners
cooperative and receptive to our offer to help them with financial assistance and relocation
services. Frankly, for those homeowners unable to make their mortgage payments, they knew
they had two options – work out a deal with us or lose their home to foreclosure. By working
cooperatively with us, homeowners often got tens-of-thousands of dollars in financial assistance
from Scudder Bay. Moreover, we agreed to forgive any deficiency balance and all past due
payments. This allowed our homeowners to get out from under a bad situation and move on with
their lives. Today, as a result of all the attention politicians are placing on shoddy foreclosure
practices, homeowners are emboldened. With the help of ambulance chasing lawyers, many
homeowners are going to the mattresses, contesting every aspect of every foreclosure process.
       We currently have one homeowner that refinanced her property 11 times, the last time for
$800,000. The house is now worth $500,000. Her annual income is $36,000 a year. Needless to
say she falls into the category of homeowner that cannot afford to stay in her home. Since she
claimed to have a handicapped child we offered her $35,000 to move. On the advice of counsel
she refused. Her response was a lawsuit claiming that she never received her TIL (truth in
lending statement) and that as a result her mortgage is unenforceable. “But we have our TIL –
and it signed by YOU!” we protested. “So what. I never got my copy and try to prove that I
did” was her response. And did we mention, the homeowner is a real estate broker.
       The actions and rhetoric of misguided politicians trying to score political points by
bashing the big bad banks have encouraged homeowners to file frivolous claims to try to avoid

“the inevitable.” The only problem, however, is that “the inevitable” is inevitable and ultimately
these homeowners that have not, cannot and will not make their mortgage will lose their home to
foreclosure and when they do there will be no $35,000 in financial assistance to help them move
and start over as this money will have been squandered on lawyers and frivolous lawsuits.
       The costs of delaying tactics like the one described above are not insignificant. First,
most economic models show that there will be no meaningful recovery in housing prices until
the market has bottomed out and foreclosure rates return to normal pre-bubble levels
(approximately 300,000-400,000 per year). Any steps taken to stall foreclosures will only extend
this bottoming out point. Instead of bottoming out in 2011 as originally expected, the market
may now not do so until 2013 or 2014. This will have a huge effect on all homeowners,
depressing equity values and trapping people in their homes. Secondly, by delaying foreclosures
now, there is a risk that when the dam finally breaks, a huge glut of foreclosed homes could
come on the market all at one time. If this happens, prices could drop significantly making the
“Great Recession” of 2008 seem like a rehearsal dinner. Third, policies that keep non-
performing homeowners in their homes create a moral hazard. At Scudder Bay we have worked
hard to get people re-performing on their loans so that we can keep them in their homes. Given
recent events, however, it is hard for us to tell homeowners with a straight face that they should
make their mortgage payments when the Government is effectively encouraging homeowners to
default on their mortgages and squat in their homes without paying anything. Lastly, these
policies have spawned tens of thousands of frivolous lawsuits, tying up limited judicial resources
at a time when state budgets are already stretched to the breaking point. Creating more legal
hurdles to foreclosure for lenders simply wastes the resources of servicers, lenders, and investors,
all of whom could be using that money to provide financial assistance to homeowners in
transitioning to more affordable housing.
       If you take anything away from this article it should be this: First, not all is lost. Despite
the magnitude of the problem there are low cost common sense solutions we can implement.
Second, not all homeowners are the same. In some cases we should do everything possible to
keep homeowners in their homes. In other cases we should do everything possible to hasten
their departure. Third, time is not our friend. The longer we delay the day of reckoning, the
greater the pain will be when the bill finally comes due. While the magnitude of the problem

facing us cannot be overestimated, by limiting the rhetoric and implementing simple common
sense solutions that require little in the way of Government resources, we can limit the number
of foreclosures, ease the transition for millions of families that must inevitably lose their homes
and hasten the recovery. Until homeowners get an honest assessment of their chances of
remaining in their homes, however, and until policymakers acknowledge that one approach is not
going to work for all homeowners, the housing market will not fully recover and will remain a
drag on the overall economy for many years to come.
Bryan S. Ganz, CEO Scudder Bay Capital LLC
Dan Koffman, General Counsel Scudder Bay Capital LLC


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