Foreclosure: What happens when people can’t pay their mortgages

How much does a lender lose when a homeowner stops paying a mortgage? Approximately half the value of the mortgage, assuming there was no fraud. This essay will sketch out how the foreclosure process works in the normal case and in the less common case of fraud. The argument presented below is a simplification of the actual process that I believe captures the important aspects; if you have any questions or find any errors please contact me here.

The typical story (at least in the popular media, see here or just google for foreclosure) of a homeowner who cannot pay his mortgage goes something like this: an otherwise model citizen (let us call him Mr. Smith) goes to the bank to borrow money to buy a house. Mr. Smith does not carefully examine the paperwork that he signs when he gets the mortgage. Perhaps someone at the closing told Mr. Smith what a mortgage lender once told me when I was examining mortgage documents, about the “Golden Rule”: he who has the gold makes the rule. In other words, sign the papers now or cancel the mortgage and come back on another day. (When one reads a bit more about Mr. Smith it might occur that he has just bought several new cars and taken an exotic vacation, or that he was “persuaded” by his banker to exaggerate his income in order to qualify for a mortgage on a much more expensive house than he might have otherwise been able to afford; in many cases, the blame for the poor choice of mortgage can be apportioned across a number of actors.)

In any event, Mr. Smith finds that after a year or two of low, affordable payments, his payments are now much higher. Mr. Smith apparently agreed to an option ARM (such as this one) that allowed him to make small payments but now demands a payment that he is unable to make. Mr. Smith has very little equity in his house (perhaps he took out a 95% mortgage or even more, and his first few payments were interest-only). After Mr. Smith misses each payment the bank sends him a letter, and after three or four missed payments the bank gets a court to declare that Mr. Smith is in default and the bank now has the right to evict Mr. Smith and sell the house. Mr. Smith may try to sell his house, but finds that the amount that he would net from a sale is somewhat less than he would owe the bank; part of this gap may be due to an inflated price paid by Mr. Smith, part due to a drop in prices since Mr. Smith purchased his home).

(Years ago, a local banker might have visited Mr. Smith and tried to work out a program to help him; today, Mr. Smith’s loan might have been sold several times and he may be paying a servicing agent in another state with whom he had no previous relation. Again, a personal anecdote; once I had a mortgage that was resold once or twice; the eventual owner of my loan called up to offer to refinance my loan at a lower rate. But after a few questions is turned out that this lender did not make the kind of loan that I had. I eventually refinanced with another lender, but if I had been having financial difficulties it may have been impossible for that lender, who had bought my loan, to renegotiate the conditions of my loan.)

One possibility (before the bank forecloses) is for Mr. Smith to arrange a “short-sale”, in which he sells the house to a buyer for less than he owes the bank. The bank must establish that Mr. Smith has made a good faith effort to sell his home and that he actually is in a difficult financial position not as a result of his own excessive behavior. A short-sale is difficult if Mr. Smith has multiple mortgages against the house, because the holder of the subordinate claim (the “second” or junior mortgage) will not receive anything until the first mortgage is paid off. If both mortgages were from the same lender, then there is no conflict. But if multiple lenders are involved it is hard to solve this problem.

The advantage (for the bank) of a short-sale is that the home is likely to remain in good condition and the bank will likely recover something like 70% or more of the mortgage. However, if a short-sale is not possible, the bank must take ownership of the property (foreclosure) and sell it.

Once the bank owns the house it must pay the relevant expenses (taxes, condo fees, lawn care fees and so forth), but it may take some time for the bank to remove Mr. Smith from the house. If Mr. Smith does not leave voluntarily, the bank can offer him (through an intermediary) “cash for keys” (see a Wall St. Journal article here) a modest payment (perhaps $1000 or so) in return for voluntarily leaving the property in good condition. The property often must be cleaned up (and sometimes be repaired or have certain fixtures replaced) in order to be sold. There will be additional time to market the property and complete the transaction.

Depending upon the local market conditions and the nature of the home the bank should receive around 50 to 60% of the mortgage around a year after the first missed payment.

As noted above, the case of fraud can further reduce the return for the bank. In a typical fraud case the property will be flipped several times between buyers, often with the cooperation of an appraiser, a bank loan officer or an underwriter. Mr. Jones may buy a house for $100,000, sell it to Ms. Johnson for $200,000, who in turn sells it again to Mr. Jones for $300,000 (without much in the way of involvement of outside parties).

Mr. Jones will then go to the bank finance this purchase and borrow $250,000 which would appear to be a conservative loan against a $300,000 house. The money will be divided between Jones, Johnson and their confederates. No payment on the mortgage is ever made. The bank forecloses and winds up with a $100,000 home (if even that price was a fair value) that must be sold and will not be sufficient to cover the 250,000 mortgage, so the bank’s return could be as low as 10% or 20% of the mortgage amount.

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