May 11, 2010 UPDATE since original post:   60 Minutes with Morley Safer did a piece on Strategic Defaults on May 9, 2010 that you may want to check out.

Following on the heels of my post the other day on the Option ARM perfect storm that’s brewing in the San Francisco Bay Area, the LA Times recently ran a piece on the growing phenomenon of“strategic defaults”, by which is meant the intentional defaulting on a mortgage loan by a borrower despite an ability and the wherewithal to make the payments. In other words, just walking away.

Why would someone do this? Simple: The debt far exceeds the value of the collateral by such a margin that continuing to make the payments can no longer be justified by sound economics or abstract moralizing, guilt, sense of duty or any other non-economic reasoning. In other words, the numbers just don’t crunch any more.

The Wall Street Journal Economic Insight Blog also recently ran a piece on the subject in June, called “When is it cheaper to walk away?” The answer, according to the writers of that piece is 10%. When the balance of the loan is more than 10 greater than the value of the property, economically, it makes more sense to just walk away rather than keep making the payments.

The WSJ articles was, in turn, based on a very thorough paper prepared jointly by the University of Chicago School of Business and Northwestern’s Kellogg School (under the auspices of the Financial Trust Index). The paper, called WHEN HOMEOWNERS WALK AWAY: NEW RESEARCH REVEALS MORE THAN 25 PERCENT OF MORTGAGE LOAN DEFAULTS ARE STRATEGIC” concludes about 25 percent of foreclosures are “strategic,” meaning intentional and driven by larger economic considerations than merely the borrowers’ ability to make the payments, and that…

Homeowners start to default at an increasing pace, and walk away massively after decreases of 15 percent and more. In fact, 17 percent of households would default, even if they can afford to pay their mortgage, when the equity shortfall reaches 50 percent of the value of the house.

As for “strategic bankruptcy,” this is just the next step after the “strategic default.” (I wrote about this last year in an only-partially tongue-in-cheek “Top 10” list for why bankruptcy is the “ultimate mortgage modification tool.” I won’t repeat myself here.)

What does all this mean? Well, for one thing, it means that what we’ve known all along is now starting to attract the attention of economists and journalists.

As for what it might mean for an individual or family? Probably not much frankly. It seems to be giving an academic gloss to what people tend to know at a gut level anyhow: That we’re not out of the woods yet, there are lots more foreclosures and bankruptcies to come, and the housing market probably has a few more bumps in the road awaiting it before things smooth out.

As to whether this data or these reports can help you or anyone you know as you wrestle with difficult decisions: whether to default, whether to file bankruptcy, what other options you have, it probably can’t. Everyone’s situation is unique. Just like everyone else’s as the old saying goes. But before you decide that you’re going to “strategically default,” or file a “strategic bankruptcy,” you should consult bankruptcy counsel. There are lots of moving parts, and the amount of your home loan and the value of your house are just two pieces or a much larger puzzle.

The San Francisco Chronicle is reporting that a recent study estimates that more than $30 billion in so-called “option ARM” resets in the Bay Area are due to hit the foreclosure stats next year.  (If the above link has expired, I have uploaded a reprint here.)  If you are one of the borrowers who fit into this difficult spot, you probably already know it. For those who don’t, here’s a brief primer.

An “Option ARM” is an adjustable rate mortgage that includes a feature which allows the borrower to decide whether he is going to pay just the interest or interest and principal.  There may be other flavors, variations or exotic trim packages, but that’s the basic idea: Borrower gets to choose the payment that they will make in any particular month. The problem with most of them is that they usually include a negative amortization (or “neg am”) risk, meaning that, if the borrower elects to make the minimum payments, the amount of the outstanding principal actually increases over time. So with housing prices declining and loan balances increasing, you have the perfect storm for a home loan disaster.  Whether it’s a whole new home loan disaster or just a continuation of the one we’re already in, well, I’m not sure that we need to slice it that thin.  In  short, more bad news coming.

The Chronicle article, written by Chronicle staffer Caroline Said, lays the problem out nicely, and does a good job of showing what’s on the horizon.  It’s not pretty.

To wit, the following frightening statistics:

  • Bay Area Mortgages written between 2004 and 2008 that have the Option ARM feature:  This varies by county, but the high is in Solano County, at 28.12%, and the low is in the San Francisco/Marin/Alameda/Contra Costa and San Mateo cluster at 19.52.  One fifth AT LEAST.
  • The percent of these loans that are either already in default or foreclosure, again varying by county, is a low of 27.23%, and a high of 36.91%
  • The average loan value across the 9-county range is $584,000, so we’re not talking studio condos. This is a problem that is going to hit the higher priced neighborhoods.
  • Total outstanding loan balance: $30.9 billion.
  • Borrowers who make the minimum payments? 94%  Eeek.  That is a scary number. And to my mind, it suggests that most of these properties are seriously under water and that the minimum-payment syndrome is a rent-paying strategy designed to buy time and make room for an unlikely “hail Mary option” to miraculously show up on the doorstep.
  • And the two most jarring stats: Average loan-to-value ratio at time of loan inception: 79%. Average now? 126%
  • 9-County figure of Option ARM borrowers who are delinquent now? 39.3%.

So what does all this mean? It’s pointless to try reading tea leaves with information like this, but it seems pretty clear that the Bay Area has a long way to go before our housing market is completely out of the woods. It’s very hard to believe that all of these loans are going to cure without some very painful side effects, like bankruptcies, foreclosures and other “rip cord” type solutions, hitting a higher income bracket than ever before. People who borrow a half-million dollars aren’t used to the word “bankruptcy” being in their day-to-day lexicon.

And what if you’re a homeowner who falls into this picture? Well, that’s beyond the scope of this little blog. But the question that presents itself is the same one that has been presenting to many, many other folks in the last couple of years: How underwater are you, and how long do you want to keep dumping good money after bad? To me, in most instances, the problem isn’t much more complicated than that.  The hard question isn’t what to do, it’s more a matter of when to do it and whether there are planning steps that can or should be considered.

There is no on-size-fits-all solution to this problem, and your strategy is going to have to depend on a very careful and detailed analysis of your total financial picture.

Do you need to see a lawyer? Maybe, but I wouldn’t start there. I’d start with an accountant and an appraiser to get the best picture of your exposure. The legal decisions after that are easy. In fact, the legal decision will probably be obvious once the true facts are known. What do you have? What do you owe? What do you want to do about it and are there any timing issues that need to be considered?

My clients get tired of hearing me say it, but if the mantra for real estate values is location, location, location, then the mantra for bankruptcy petition and schedule preparation is disclose, disclose, disclose. This isn’t Chicken Little screaming about the sky falling; it’s real and it can have real consequences.

The 8th Circuit Court of Appeals recently decided the case of In re Barrows. In that case, the debtors borrowed money from their 401(k) just before their bankruptcy petition was filed, and deposited the funds into their bank account. They didn’t tell their lawyer about it.  On their bankruptcy schedules, they disclosed–under penalty of perjury–that their combined bank balance was $325 on the day of filing. The trustee requested bank statements, and those statements revealed the additional funds. When their lawyer sought to amend the exemption schedules to include the additional funds apparently mistakenly omitted, the Court denied the amendment and the debtor’s appealed.  They lost the case and, therefore, their $13,000.

The Court of Appeal reasoned that, because the debtors signed their schedule under penalty of perjury, such omissions can’t be cured by simple amendments.  The Court upheld the lower court decision, and the debtor’s lost the $13,000.

The most painful–and truly absurd–irony of this tale, however, is that, because the money was borrowed from the debtor’s 401(k) retirement account, and would have been exempt if either a) They had waited until after filing to borrow the money, or b) Correctly disclosed the bank balance and source of the funds. The important issue for the Court of Appeal wasn’t whether the funds would have been reachable by the creditors or the trustee, but the debtor’s “bad faith” in failing to be truthful in the schedules. In other words, the doctrine of “no harm, no foul” doesn’t apply. This kind of stuff drives me nuts because it is so easily avoidable.

I take three lessons from this:

1.  Don’t expect post petition amendments to cure material omissions without the threat of some possible consequence.

2.  Truth matters.  A lot.  Innocence alone doesn’t vitiate inaccuracy.

3.  If you are untruthful in your schedules, you should expect to be caught.

Here in the Northern District of CaliforniaJudge Alan Jaroslovsky of the Santa Rosa Division wrote an Open Letter to Debtors and their Counsel in 1997 with regard to the casual assumption that inaccuracies can be easily cured with later amendments.  You can read the original order here.

But to quote the most important message from the 1997 Open Letter, Judge Jaroslovsky says:

Whatever your attitude is toward the schedules, you should know that as far as I am concerned they are the sacred text of any bankruptcy filing. There is no excuse for them not being 100% accurate and complete. Disclosure must be made to a fault. The filing of false schedules is a federal felony, and I do not hesitate to recommend prosecution of anyone who knowingly files a false schedule.

That’s worse than losing $13k.

There’s an old saying: Beware of Greeks bearing gifts.  It refers to the Trojan horse that the Greek army used to trick its way into Troy during the Trojan War.  It has come to refer to situations and people that hide fraud and trickery behind a friendly and perhaps even generous demeanor.

The hottest new business in California?  One guess….  Mortgage modification.  Everyone and their brother is now opening up “mortgage modification” companies.   They appear friendly and eager to “help you save your home,” but be careful.

For instance, one I recently heard about is American Home Mortgage Servicing Company.  This company is not licensed as a real estate broker by the California Department of Real Estate. (If you want to check whether the company that is pitching you to modify your mortgage is a licensed real estate broker, use the DRE license check tool here.) Therefore, it is not a licensed “mortgage broker” and is thus not legally licensed to modify mortgages.  It is not a law firm.  It is not a non-profit credit counselor.  In fact, a little research reveals that it is nothing but a debt collector.  An unlicensed debt collector phishing for people with financial difficulties, which it refer to as “customers.”  (For reasons unknown, California doesn’t require debt collectors to be licensed any more.  It does, however, require them to comply with the California Fair Debt Collection Practices Act.)

Do what I did.  Call their toll free number.  Once you get past the language preference, the first thing on the tape is:  “American Home Mortgage Servicing Company is a debt collector and may record and/or monitor calls.”  Then, follow the various links on their website as if you are looking to modify your mortgage. You will eventually wind up on a form that you need to fill out and return to them. Do not do this. This form is designed to solicit highly confidential financial information from you which will, in all likelihood, be used against you in the event that you default on your mortgage.

There is no need to provide this information at this stage of the conversation with anyone.  (I’m a bankruptcy attorney subject to very strict rules of confidentiality.  I usually have very good reasons to request this information from clients.  Yet I never solicit this level of detail from prospective clients until they are an actual client and I have a rational and business-related reason for collecting this information.)  How do I know this isn’t a bona fide form for dealing with a mortgage modification? Look at it.  It doesn’t even ask who your lender is.  How are they going to modify a loan or provide you with advice and an opinion on the criteria required to modify the loan if they don’t know who the lender is?  (Lenders’ criteria for modification are not uniform, and a loan that one lender may modify may not qualify under another lender’s program.)

Here’s the fact:  No one has authority to modify your mortgage except you and your mortgage lender.  Anyone who claims to be able to assist you in modifying your mortgage but doesn’t ask who holds that mortgage right out of the chute is probably up to something very different.  Fortunately, these people tell you: They are “debt collectors.”   I wouldn’t give them the name of my dog without a written disclosure of who they represent, what they are actually authorized to do and a written representation from them as to what exactly is going to be done with the information I provide them. I suspect that if you call them and make this demand as a precondition to your giving them any confidential financial information, they will hang up on you.

Who are these people?  Are they licensed? Are they supposed to be?  Who’s regulating these guys?

In short, no one. It’s the Wild Wild West.  The California Department of Real Estate is supposed be on it, but in practical reality, it looks more like substitute teacher day in 5th Grade, erasers flying, tongues wagging, the whole works.  And who can blame the CDRE?  They’re overwhelmed.  So it will fall on the consumer.  If you try to do this without counsel, make sure that the person you’re dealing with knows what she is doing and that you’re protected.

Here are the rules, at least regarding licensing:

First, in order to function as a “mortgage modification company” in California the company must first be licensed as a “real estate broker” by the California Department of Real Estate.  (California does not have a separate licensing category for “mortgage brokers” nor for “mortgage modifiers.”) Modifying a mortgage is essentially the functional equivalent of originating a mortgage, so the same licensing rules prevail.  (Here’s an interesting opportunity to get a fly-on-the-wall ear to brokers talking to each other about this topic.)

Next, in order to collect any fee in advance for “mortgage modification” services, the entity must be licensed by the DRE and must submit its contract for services for approval to the DRE.  So if someone tells you they’re a “mortgage modifier” and wants you to pay them for providing those services, first demand their DRE brokers’ license number and then check the DRE website to see if their contract has been approved yet by the DRE.  If it hasn’t, then tell them you’ll pay them if and when they get a result for you.

[Update:  Effective July 1, 2009, it is unlawful for a foreclosure consultant, as defined in Civil Code Section 2945.1 to engage in the foreclosure consultant business unless it has registered with the Attorney General’s Office at:  http://www.ag.ca.gov/register.php. All foreclosure consultants operating in California must post a $100,000 bond and register with Attorney General’s Office by July 1, 2009.  There is list of companies whose agreement has been approved. It’s very short. You can find it on this rather hard to find site called California Foreclosure Prevention Act.   There is also a list of companies that have not been approved by the Attorney General, although that strikes me as sort of foolish.  Given that scam artists work pretty hard to cut a low profile, its a bit like saying “raise your hand if you’re not here.”]

American Home Mortgage Servicing is not on that list.  American Home Mortgage Servicing is also not a licensed real estate broker in the State of California.  In fact, American Home Mortgage Servicing does not appear to be licensed to do anything more complicated than exist in the State of California.  And it’s a Delaware corporation so it’s not even domiciled here.  (Debt collectors no longer need to be licensed in California.)

(Here’s a link to the California Attorney General’s recent online posting about how to avoid being ripped off by foreclosure rescue scams.   And here’s another article/consumer warning by the DRE about scams offering to “cut your home payments in half.”)

There is a growing number of unscrupulous people out there right now looking to take advantage of people who are in financial extremis.  There are also tons of folks who, while maybe not slimeballs, are woefully unqualified to “modify” anything more complicated than a typo on a spelling test.

Current statistics suggest that only 5% of the people who attempt to modify their mortgages are actually succeeding right now, and of those? More than 50% re-default in the first 6 months!  I’m not going to blame all of that on slimeballs and idiots, but I can’t think of any argument that suggests that the presence of opportunistic and unscrupulous slimeballs and idiots posing as “mortgage modifiers” is helping matters.

But there are also a lot of good, qualified and experienced people who want to help, who charge a reasonable fee and who know what they’re doing.  (And I absolutely guarantee you that they don’t refer to themselves on their voicemail as “debt collectors.”) Some are mortgage brokers, some are attorneys, some are credit counselors.  None are debt collectors.   Look for non-profit credit counselors as a start.

I’m not suggesting that everyone who wants to investigate mortgage modification hire an attorney. But at least do a little homework and make sure the person or company you hire is qualified and licensed.  If they disclose that they are “debt collectors” run the other way.  Such people have nothing of value to offer you.

Now, I don’t mean to be overly flippant or anything, nor to be accused of promoting “irresponsible behavior” by advocating that people walk away from valid and legitimate debts, but I have to say that the single most effective “mortgage modification” tool for most borrowers these days is found the United States Bankruptcy Code.

So here–with a nod to Letterman for borrowed style points–counting backwards from 10 to 1, are the Top 10 Reasons why, more often than not, I advocate filing a bankruptcy petition instead of incurring the brain damage of trying to deal with banks.

(Lawyerly or, the obligatory “all things being equal” caveat:  This is true in many, but not all cases, and I’m assuming that the borrower has a fair and real choice between these two options.  Like with ANY legal remedy, it has to make sense for your particular circumstances, and, of course, the numbers have to crunch.   Bankruptcy is a technical and specialized area of law, so the decision should be made neither lightly, nor without expert guidance.  Things may also change over the coming months when–or more accurately, if–the lending industry gets its “mortgage modification” act together and actually raises their success ratio to something more respectable.  As it is now, in some areas, the default rate is as high (around 5%) as the “mortgage modification” success rate is low.  That’s a disgrace.

Anyhow, on with the Top 10 List.

10.    Bankruptcy doesn’t require you to bare your soul to some faceless, nameless banker only to have them tell you you’re not “qualified” for their mortgage modification program.  Of course, this is inane to start with:  If a borrower was “qualified” for the unaffordable, predatory loan that got them into the dilemma in the first place, how could they not be “qualified” for something more affordable now?   This is “bank logic” talking.  And it’s “bank logic” that caused this mess to begin with.  Arguing YOUR personal finance with a banker is like arguing about Halloween candy with an 8-year old. Generally, you can’t win this argument so why have it?  (For an absolutely classic example of this  absurd paradigm in action, check out this story on MSNBC.)

Recent reports suggest that only about 5% of attempted mortgage modifications are actually succeeding.  Success being defined as a negotiation that concludes with a new, supposedly more affordable mortgage. What about the other 95%?

First of all, the bank has probably squeezed another few months of interest payments out of the borrower as they strung them along leading you to believe that your “application” for a modification was being seriously considered.  And second, all the information you worked so hard to assemble for your banker will now to go into your “file,” to be used for who-knows-what-purpose.  Since I’m a lawyer, I’m paranoid by habit and profession.  I assume it goes into storage to be be puled out and used against you later when when the bank decides to sue you for a deficiency.

9. The lender doesn’t get a vote.  Generally, if you file a bankruptcy petition with a goal being to jettison a burdensome and onerous mortgage, barring something going seriously awry, you’re going to achieve that goal.  No matter what the bank has to say about it.  In the vast majority of cases, they don’t get to vote.

8. Bankruptcy is faster and will get you back on the road to financial recovery much faster than a bank sponsored “mortgage modification.”  Chapter 7 can be over and done with in as little as 3 to 4 months.  Chapter 13 can have you in an affordable payment plan even sooner.  In order to even qualify for a “mortgage modification” program right now, in most instances, you need to be at least 60 to 90 days delinquent before they’ll even talk to you.

Then, after you’ve prostrated yourself on the altar of some Loan Modification Committee of Third National Bank of Timbuktu trying to get a modification approved, or worse, had to deal with some newly minted “loss mitigation specialist,” you are likely to wait for another 3 to 6 months for any word.  Why?  Because they are up to their eyeballs in “loan modification requests” and they are noteager to make those painful modifications.  Banks are not modifying loans because they think it’s a good idea; they’re doing it because they have no choice.  But if they can suck a few more months of interest out of you then, in the bankers’ logic, they’re making lemonade out of lemons. It’s a get-what-we-can-while-we-can mentality.  If your financial statement leads them to believe that you’re a likely Chapter 7 candidate anyhow, it’s in their best interests to recover as much as they can before that happens.

7.     It’s (probably) cheaper.  This is a hard one to be sure of, but if you hire an attorney (or worse, one of these new “loan modification companies” that are popping up like weeds these days) to try to assist you with a mortgage modification application, and then pay him or her to run all that interference for you, your final bill is likely to be significant.  (And don’t shop for a mortgage banking/loan workout lawyer based on the low bidder.  You get what you pay for in the legal profession and there aren’t a whole lot of low cost lawyers who understand the law of mortgage and real estate finance.  (Mortgage, bankruptcy and insolvency law is not a first offense DUI or uncontested divorce where pretty much anyone with a bar card can get you through the process.  In banking law you get what you will get what pay for.)

In bankruptcy, most attorneys charge a fixed fee for taking the client all the way through the process, and those fees are subject to the approval (and possible adjustment) by the Bankruptcy Court.  Filing fees are relatively cheap, at present, $299 for a Chapter 7 and $234 for a Chapter 13.

Paying an attorney to try to get a home loan modification approved is tantamount to handing over a blank check.  As much as I love my profession and trust in the utmost integrity of my fellow members of the bar, only a fool gives a lawyer a blank check.

6. You don’t have to talk to any bankers.  Nothing personal to any of my banker readers (as if) but dealing with bankers is only slightly less painful and irritating than a root canal.  Contrary to what you may have heard, bankers don’t care about you.  Their job is to lend money and maximize their company’s return on investment, or, in this economy, minimize loss.  Converting an asset that is returning 8.5% interest into one that only returns 6.5% is going backwards.  Bankers created this mess.  I don’t believe it’s realistic to believe that they’re going to be the ones to fix it.

5. When bankruptcy is over, it’s over, and it feels very good.  Mortgage modifications are forever.  Or until you default again.

There is no doubt but that, in addition to the day they graduated from college, the day they were married, and the day their first child was born, other Red Letter Days in the lives of people who have endured financial stresses severe enough to make them consider bankruptcy, include the day they got their discharge and emerged from bankruptcy.  It’s like the relief one might expect to feel when you stop banging your head against a brick wall.  In my experience, I’ve never heard anyone who relieved themselves of mountains of unmanageable debt say they wish they hadn’t filed.  What I hear is that they wish they hadn’t waited so long.

4. You can’t get scammed by a bankruptcy court that’s giving you relief from the guy who scammed you in the first place.  LoanSafe.org is reporting that “loan modification scams” are one of the hottest new consumer ripoff industries.  I suppose they take a lot of different forms, but be careful.  At least lawyers have to be licensed, bankruptcy fees are subject to the supervision of the court, and loan modification scam artists generally don’t hang around in Federal court rooms wearing black robes.

3. The Bankruptcy discharge is forever.  More than half of mortgage modifications are headed for another default.  What do I mean by this? Well, first of all, a little background, and if you don’t want the background, skip the next paragraph and race to the “payoff.”

One of the Federal government’s official keeper of mortgage statistics is the Office of Thrift Supervision, known–as with any self-respecting government bureaucracy–by its acronym OTS. (OTS is a wholly owned subsidiary of the US Department of Treasury for those keeping track.)   Every quarter, OTS releases its “Mortgage Metrics” report, which is a 25 to 30 page impenetrable tome of economic gobbledy gook.  If you don’t believe me, here’s Q1 2008 and here’s Q2 2008.

Now the payoff:  The Mortgage Metrics Q3 2008 report will, when it is released, report that 53% of all mortgages that are modified wind up back in default.  This is what is being reported by sources that have seen it, or at least talked to people who have seen it.  My source?  MortgageDaily.com.

2. Bankruptcy is less stressful.  Financial fear and worry is one of the worst sources of stress that we can suffer from.  It’s only exacerbated when the cause of that stress is also the very roof over our heads.

1.     When it’s over, you get a REAL fresh start.  Bankruptcy is a financial reboot.  A whole new day.  Yes, if you are successful in completing a loan workout with your lender, there will be relief. Probably substantial relief.  But you also don’t get to start a rebuild, or get rid of other debts and liabilities that may threaten to drag you down again later.  If your oppressive mortgage is your only financial woe, then you may get some real relief from a mortgage modification attempt.  But those sorts of problems are not usually so isolated.

Again, I don’t mean to sound flip, nor to minimize the impact of having to file bankruptcy.  But if you are able to do so, and if your mortgage is only one part of a larger scheme of financial woes, what better way to “modify a mortgage” than to get rid of it?  Of course, this means that you will also lose the property, but in most of the cases that I’m reviewing these days, that isn’t a priority anymore. When the loan is $750,000 and the house is worth $600,000, what’s left to save?  (Those are Northern California numbers; your examples may vary if you live in other parts of the country.)

Upshot:  Know your options before you dive into a process that may not do as much for you as you hope it will.