A new twist in the foreclosure drama--a consumer gets a mortgage to buy a second home by promising to rent out his first home and using the rental payments to pay the second mortgage. Then, once he buys the second home, he does a walk-away foreclosure on the first home rather than renting it out. The new loan thus is obtained before the foreclosure damages his credit score. From the WSJ story:
Next month, Michelle Augustine plans to walk away from her four-bedroom house in a Sacramento, Calif., subdivision and let the property fall into foreclosure. But before doing so, she hopes to lock in the purchase of another home nearby.
"I can find the same exact house as what I live in right now for half the price," says Ms. Augustine, 44 years old, who runs a child-care service out of her home. She says she soon will be unable to afford her monthly payments, which will jump to $4,000 from $3,300 in August, and she doesn't want to continue to own a home that is now worth $200,000 less than what she paid for it two years ago.
In markets hit hardest by falling home prices and rising foreclosures, lenders and brokers are discovering a new phenomenon: the "buy and bail," in which borrowers with good credit buy a new home -- often at a much lower price -- then bail out of the "upside down" mortgage on their first home.
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That loophole currently works like this: Homeowners provide a rental agreement showing that they will rent out their first home, and underwriters allow rental income to cover as much as 75% of the mortgage payments on the first home when determining whether the borrower can make payments on two homes. This allows homeowners to secure a second mortgage that they might not otherwise afford.
The strategy is especially attractive in states with antideficiency laws for purchase-money mortgages, such as California and Arizona. One Nevada real estate broker who specializes in "buy and bail" plans says he is receiving one to two dozen inquiries per week about buy and bail plans.
Fannie Mae is proposing new guidelines to try to restrict the practice.
Perhaps I'm demonstrating my ignorance, but is this not the sort of thing that the market could catch on to on its own? If anyone has an incentive to be aware of these practices, it's the lender for the second mortgage... and if the buyer breaks her promise to rent out her first home, there must be some kind of recourse for the second lender.
...though I suppose the person who really gets screwed is the lender of the first mortgage.
How quickly (if at all) could announcements in a major national newspaper that you intend to default on your mortgage result in adjustments to your credit score?
You fully intended to pay off the first loan when you applied for it.
You fully intend to pay off the second loan when you apply for it.
The dishonest part is deciding to no longer honor your original commitment, but this is breach of contract, not fraud. Some argue that from a society-wide perspective, efficient breach is better than forcing parties to continue to perform a painful contract.
I'm just wondering, I don't do mortgage law.
Look at it this way: if you inherited a large sum of money, paid off the mortgage on house number 1, and kicked out the renters, would that be fraud? I would say no.
She would be especially bold, however, to try this with both loans being secured by the same lender.
Rental income partially offsets the enormous first mortgage payments. The homeowners is basically just saying "yeah, it's a drain, but adding your mortgage won't bankrupt me because I can cover it with the rental money and be no worse off."
If the borrower later divests themselves of the rental property, they lose the rental income but also the mortgage payments. This will not negate the original assertion since the net effect on the borrower's income will be an extremely positive one. This is beneficial to the 2nd lender. Intending to do this isn't fraud at all. Quite the opposite.
Unless the mortgage contract specifically promises that the lender shall receive the rental income from the first property and that no other money shall suffice, it isn't material that the borrower rearranges his affairs and pays from a different source. Even if the contract did say that, a court isn't going to grant specific performance, damages would be in money and since the borrower is already paying them the money (from a different source), it isn't even a material breach that is being alleged. Despite my disorganized thoughts, I'm basically trying to say that the second mortgage company has no case.
The first one may have a case by virtue of the enormous unsecured debt that they get left with after the foreclosure, but the various asset protection laws and mortgage laws at the state level probably protect the homeowner. There is definitely no fraud here either since the homeowner doubtless intended to pay the mortgage at the time he got the original loan. He just got screwed by his failure to anticipate market conditions.
What the hell are you talking about? Those of us in modest homes on 30 year fixed mortgages, who make our payments and are in no real danger of foreclosure, are the ones who are about to get screwed by falling home prices and a taxpayer-funded bailout. I hope that nice lady managed to draw out any equity she had in her home, because I hate to think about her losing her nice cars, big screen or any of the other essentials of modern life.
Jerks.
But, the lender was protected at the front end. When the lender priced the loan in the beginning, the lender knew that California was a non-recourse state. Thus, the lender should have priced loans higher in California than a non-non-recourse state. That is, the risk of loss in foreclosure was higher in California, therefore, the interest rate should have been higher in California.
So, the mortgage lender was able to protect itself by insuring against non-payment. The borrowerer is able to get out of a bad contract and pay the price required by contract and law. The losses are distributed appropriately.
As for the second mortgage. That is a win/win situation, too. We have a borrower who really is a good credit risk and a lender who will get its money.
Who loses? Possibly current homeowners, because walkaways are encouraged. But they would have lost anyway, because the walkaways would have been foreclosed upon.
It's not that complicated. First lender makes a loan to a borrower. Borrower decides to stop making payments. Instead of loan payments, lender gets a house that isn't worth much.
Moreover, the brokers who are are encouraging these schemes are guilty of conspiracy.
Is the first house "upside-down"? Yes. The first bank made a bad investment, but they are the bank. They are supposed to know the market well enough to make wise investment decisions. They goofed.
The person in the story is just making the only logical decision. It makes no sense to rent out the first property.
The only answer is to fight a taxpayer-funded bailout. Unfortunately, the two parties are so beholden to the lenders or fearful of mass foreclosures that we will have an uphill fight. But it's a fight that we can, and should, win.
You would think the borrower's ability to repay the loan would be of central importance to determining the fair value of such an instrument, no?
Apparently the market doesn't care much.
Imagine the following transaction:
-- Ms. Augustine sells the house to lender #1 for the exact mortgage balance.
-- The proceeds from that sale pay off the current mortgage.
-- Five minutes later, bank #1 gives Ms. Augustine a mortgage for the exact same terms that bank #2 was going to give Ms. Augustine on her purchase of "the exact same house 2 blocks away."
-- Five minutes after that, bank #1 sells the house to Ms. Augustine for its market value, which she finances with the mortgage that bank #1 just gave her.
Compare that scenario with what Ms. Augustine is planning: (I'm going to use some real numbers to make things more concrete -- the article implies that the mortgage on the current house is $400,000 while the market value is $200,000.)
-- In my scenario, the bank starts with a $400,000 mortgage on a house worth $200,000, eats the $200,000 loss, and ends up holding a reasonable, not-upside-down mortgage on a $200,000 house. Ms. Augustine ends up slightly better off -- she has basically the same financial arrangement that she would have had by buying "the same house 2 blocks away at half the price," but she doesn't have to move.
-- In the planned foreclosure, Augustine walks away from the house. The house deteriorates, slowly if just from neglect, or very quickly if it is subject to vandalism. In the very best case, the bank acts very quickly (1 year) and sells the house for a substantial, but not ridiculous, discount to the $200,000. The auction house gets a substantial chunk of it. Best case, the bank's loss is $200,000+discount+sellingCosts. In the worst case, the bank loses virtually all of the $400,000 because vandals move in and signficantly damage the place, and because the selling costs eat up any residual value that the property has.
It seems to me that the bank owes a fiduciary responsibility to its stockholders and/or to the holders of the MBO (if this mortgage has been packaged into an MBO) to play "let's make a deal" with Ms. Augustine. We've tossed around "fraud" accusations against Ms. Augustine -- anybody want to try "breach of fiduciary obligations" against Ms. Augustine's bank?
Perhaps I'm demonstrating my ignorance, but is this not the sort of thing that the market could catch on to on its own?
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It took the market years to catch on problems of giving loans with no down payment required. And Fannie Mae is only saying it won't deal with these loans. If a lender wants to make such a loan with its own money then its not Fannie Mae's area, although I'd like to think that the FDIC might have something to say about the matter.
It's fraud if you show a rental agreement and claim you are going to rent the first house when in fact you are planning to let the first house be foreclosed.
Really?!? A "good credit risk"??? Um, sure... they are having a home foreclosed on, and that makes them a "good credit risk".
If the market falls again, they will simply do this again (if they can). That is decidedly NOT a "good credit risk".
Basically, this is a way to shift all market risk to lenders. This MUST lead to higher rates from lenders... or a tax-payer funded bailout. Neither of those is harmless to those of us who don't do this dishonest (at least) action.
Odds are good that this "rental agreement" was just done with a wink and a nod, because the underwriter needed to see one.
Imagine that Ms. Augustine goes through with her plan to buy the second house, and figures "what the heck" and instead of just mailing the keys in to the first lender right away, pounds a "for sale by owner" sign into the front yard. Imagine that a buyer comes by and offers the market value for the house. (Perhaps they are playing the same game planning to walk away from their mortgage on their house 2 blocks away.) Ms. Augustine contacts bank #1 and says "here's an offer for market value, you won't have to pay the huge expenses of foreclosing and selling, take it or leave it." And bank #1, fulfilling it's fiduciary responsibilities, takes the money and declares the mortgage "paid in full."
Just the fact that this scenario is reasonably possible would seem to me to be a completely adequate defense against the charge of fraud.
True, but this is missing the point.
It's a potential fraud against the mortgagor on the second house, not the first.
Assuming the individual in this case bought within her means on the second house, she's not going to default on her mortgage payments.
If she were to default, she might well face a potential fraud suit from the mortgage company.
But no mortgage company is going to look at a paying loan and say "no, I think we'll toss this loan and sue you for fraud because you misled us on the application." That's a losing proposition for them.
There's no fraud as against the first mortgage company, all they did was issue a regular mortgage on a house to someone who couldn't afford it in a non-recourse state.
It seems likely there is a violation of 18 USC 1014, but I don't think that law is typically enforced without a complaint from a mortgage company. A mortgage company isn't likely to complain against a buyer who's actually paying their debt.
What false statement? Is there an indication that the rental agreement presented to the second mortgage company was invalid?
California AD Laws
Notice the last few paragraphs. Basically, because the Bank gets soaked for $200,000, they can write it off and then send Mrs Augustine a 1099 which basically makes this "forgiveness of Debt" taxable income. (She owed 200,000 and the bank "gifted" her $200,000 in forgiveness.)
According to the article, the homeowner can avoid the Taxes if she is "insolvent at the time of the forgiven debt". But that may interfere with her ability to get the second loan and- besides, she may not be legally insolvent at that point!
So, the fidiciary duty of the bank is give money to the dishonest? Um, I fail to see how that will work out in the long term...
Sure, if you only look at the current case, that makes sense... but we should look a lot farther than that.
It would have been easy enough for the homeowner to rent out the first home for a few months, and then let it foreclose. It would then be impossible to say that they never intended to rent it out.
The only problem with this is that the renter gets screwed when they are evicted from a home they have only lived in a few months.
If you ask me, I think reasonable leases (1 year or less) that are made at arms length should be encumbrances on the property that bind subsequent owners to avoid this problem.
I think a case like this is often hard to prove. You have to prove that the person who turned in the rental agreement new that it was important (their broker did not tell them it was just a non-binding formality -- i.e. it is just more paperwork in that mountain of paper whose purpose the homeowner doesn't understand) and you have to prove, beyond a reasonable doubt, that they knew at the time they presented the rental agreement that they were not going to rent it out.
Depending on the evidence, it is not necessarily an impossible case to prove, but in many cases it will be pretty tough.
There is a really useful concept in economics called "sunk costs". Those people who appreciate it will find life far easier to navigate.
The company that found my last mortgage (17 years ago) is advertising no-doc jumbo mortgages today.
17 years ago, it wasn't doing that.
Once Ms. Augustine has the first foreclosure on her record (spoiling her credit for seven(?) years), she's much more likely to default on the second loan if, for example, two years later the second house is underwater due to a continued decline in the market — the incremental cost of the the second foreclosure is much smaller to her (just another couple years of spoiled credit) because of the overhang of the first foreclosure. Especially in a non-recourse state, the fear of spoiling one's credit for seven(?) years is a significant motivation to continue making payments even if the borrower is a little underwater and presumably lenders rely on this motivation when making a loan but the borrower's fraud in this case has masked her plan to eliminate most of this motivation to make payments to the second lender.
As for the ethics. If this borrower had not owned a home, there would be no issue. the borrower merely intends to break a contract with bad terms. Does this mean she is a higher credit risk than someone in exactly the same situation, except who does not own a home? Maybe, maybe not. I have not done the research.
Personally, I blame the whole housing bubble problem on the realators, the mortgage brokers, the lenders, the insurers, and the bankers who bought the loan packages.
If I left 50 $100 bills on 42nd and Broadway and came back the next day to find them missing, would you be sympathetic because we can expect everyone to do the right thing, or would you think my actions foolish? The lenders just left the money on the street. I have little sympathy.
But, I don't have much sympathy for the guy who took the money off the street, either.
If she has declared to a third party that she is "renting" the house out, doesn't that negate the "primary residence" clause?
Note: I could be talking out of my ass.
I inherently feel though that this is the "consumers" PMI (Private Mortgage Insurance), and cant feel too sorry for the corporations and lenders who screw the middle and lower class each day.
A recent federal law eliminated that tax.
A more likely candidate for fraud victim is the purchaser--and there almost certainly will be one--of the second lender's mortgage. It likely won't be given more information than that the mortgage is part of a large package of mortgages, all taken out by borrowers with good credit ratings. That is, the second lender will be concealing the highly pertinent fact that the borrower is a high risk of quickly turning into a bad credit risk.
And if you want to understand the subprime mortgage crisis, you could do worse than to think about this case--and the difficulty a whole bunch of commenters had figuring out the identity of the real victim.