Foreclosure, Short Sale Real Estate

The lending community will plainly tell you that foreclosures are on the rise -- in part because of rising interest levels -- but don't worry. According to the party line, there's no need for alarm because the overwhelming majority of owners will not be foreclosed.

The alleged logic here is in the numbers: 40 percent of all homes are mortgage-free. Of the rest, 50 percent of the loan originations made during the first half of 2005 were fixed-rate loans according to figures from the Mortgage Bankers Association.

In total then, 40 percent of all homes have no mortgages and 30 percent (half of 60 percent) have fixed-rate loans, so we can see that 70 percent of all property owners need not worry directly about rate changes. As to the 30 percent of all owners with adjustable-rate and interest-only loans, they may want to watch interest levels with care.

To put this in perspective, imagine that a subdivision with 500 homes was built in 2005. We might expect that 200 hundred are mortgage-free, 150 have fixed-rate financing and 150 are financed with adjustable or interest-only mortgages.

It can be said that to this point the national experience with ARMs has been good, however what's happened in the past with ARMs is irrelevant. Why? Because interest rates largely fell during the period between 1990 and 2003. Since 2003, however, rates have trended upward -- not much by historic standards, but enough to bother people who bought on the extreme cusp of affordability.

In addition, in many cases we're not talking about established ARM programs. Too often we're discussing what I call "toxic" financing, meaning "nontraditional" loans such as option ARMS where borrowers can make low, low payments for the first few years of the loan, payments not sufficient to even cover interest costs.

Lastly, as toxic loans age, their initial "start" periods with low monthly costs begin to end. The good old days of low-ball costs are replaced with the far-higher monthly payments needed to amortize the loan.

We usually see that about 1 percent of all loans are in the "process" of foreclosure. That is, the owners may have received foreclosure papers but in many cases they can bring their loans current, refinance or sell the property before there is an actual foreclosure. In fairness, of course, it should be pointed out that not all troubled loans are adjustables.

However, the coming number of loan foreclosures may be far higher -- and they may be far higher precisely because toxic loans are now used so widely. USA Today reports that as many as 1 million of the 7.7 adjustable loan products issued in the past two years may be foreclosed -- that's a foreclosure rate 13 times higher than normal. (See: "Some homeowners struggle to keep up with adjustable rates," April 3, 2006)

The official line is that if the number of foreclosures goes up that's not really worrisome because even a bigger number of distressed properties would still represent just a small fraction of all homes. Such logic avoids the reality of the marketplace.

Buyers don't care how homes are financed. It makes no difference to them whether an owner finances with a fixed-rate loan, an adjustable product or if the property is mortgage free. What counts is price and terms, and owners facing foreclosure are not likely to hold out for either premium prices or stiff terms.

Consider what happens in a new subdivision with 1,000 condo units where the builder begins offering a few at a $50,000 discount to clear out inventory. Can anyone in the subdivision sell units for more? Have not the value of all units fallen -- including those owned free and clear of any mortgage debt? Do not low-ball prices show up when comparables are checked?

Most owners in the subdivision will continue to meet their monthly mortgage payments and not sell, thus the fact that large numbers of homes have been devalued will not show up in foreclosure statistics. While this may please lenders and regulators, owners -- especially those who had hoped to sell or refinance -- may not be too thrilled.

To believe that an increasing number of foreclosures will not have a marketplace impact is neither logical nor believable. Just ask the people in the subdivisions and condo projects where developers have recently cut prices on just a few units.

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