Loan Modifications Can Make Economic Sense

Years ago, before the recent market downturn, loan payment problems between lenders and borrowers were often referred to as “loan workouts” or simply as “workouts.”  These were situations where the lender and borrower worked toward a realistic resolution of the borrower’s inability to pay their monthly loan obligations as they became due.  In more recent months and years, these types of negotiations have become known sometimes as “loan modifications” or “short sales.”  A “loan modification” is part of a workout process where a lender agrees to restructure the loan, with possibly a reduction or deferral in interest payments, and possibly even a reduction in the principal balance due.  However, many lenders seem to resist principal reductions, and they seem much more interested in deferral or reduction of interest.

This makes economic sense for the lender.  If the lender were to foreclose at a low property value, then the lender may give up a hundred thousand dollars or more in lost principal that it would never recover.  However, if that same lender reduced the loan’s interest payment by a thousand dollars a month, then over a period of three years, that lender would only lose $36,000 because it would receive $36,000 less in interest payments than if the loan hadn’t been modified.  If the market improves so that the property is worth the amount of the loan, then the lender is in a very positive position.  Any reduced interest rate could be adjusted back to where it was before, and then the borrower could repay the loan at the higher interest rate.  If the buyer can’t make the payments, then the lender can foreclose.  If in three years the property is worth at least $36,000 more than it is today, then the lender is ahead. This is because the lender would receive either more at the foreclosure sale, or if the lender bought the property at the foreclosure sale, then the lender could turn around and sell the property for more than it could if it foreclosed today.   If in three or five years the property is worth $100,000 more than it is today, then the lender is far, far ahead because it will recover much more when it forecloses in a few years.  If a lender can defer interest payments instead of reducing the interest, then the lender is also ahead if the market improves and the borrower elects to keep the property.  So the current lender reduction in interest rates may be an indication that lenders are hoping that the real estate market will improve so that lenders can foreclose, if need be, in the future with smaller losses.

Honesty Is Still the Best Policy

Some years ago, a Northern California newspaper recently ran a story about a police officer who had been charged with felony mortgage fraud.  According to the article, the officer took out two loans on two different residential homes at approximately the same time.  That’s certainly not a crime.  But the officer has been charged with applying for each loan as an “owner-occupied” loan. What’s more, the officer was apparently charged with substantially overstating his income on his loan applications.  The police officer denied any wrongdoing.

If true, these charges would amount to lender fraud.  Lenders want to know the economic status of the borrowers they deal with.  That’s the reason lenders require Borrowers to fill out loan applications.  A good credit score isn’t enough.  The lender wants a true snapshot of the borrower’s financial condition.  The lender wants assurance that the Borrower has the financial resources to repay the loan – with interest.  And the lender wants further assurance that the Borrower will be motivated to repay the loan.

Borrowers who use a loan to buy their principal residence may be more motivated to repay a loan than borrowers who are purchasing investment property.  If a borrower runs into financial trouble, that borrower may be more likely to default on an investment loan than on a loan on the home where they live.  Thus, an “owner-occupied” loan may have less risk than a loan on an investment property.  The simple reality is that a borrower’s home is often the last, and possibly most important, asset that most borrowers will ever have.  Lenders can gain some assurance from knowing that a borrower is accepting a loan for a home where they plan to live.

Borrowers receiving an “owner-occupied” loan can often can get a loan on better terms than they could on a loan for purchasing investment property.  There can be a substantial economic incentive for borrowers to claim that they intend to live in the property when they actually don’t intend to.  If borrowers falsely represent they intend to live in the home they are buying, then the borrowers commit a fraud on the lender when they make such a representation.

The officer in the story referred to above apparently overstated his income by a significant amount.  This can be a problem because a lender relies on income information in determining whether or not a borrower can repay the loan.  Without sufficient income, the borrower may not qualify for the loan  There can be a significant incentive for borrowers to overstate their income in order to qualify for a loan.  Again, such a practice constitutes lender fraud.

In the story above, the officer reportedly refinanced both loans within a few months of receiving initial loans.  He reportedly pulled cash out of the properties through refinance loans, and he then allegedly defaulted on the loans.  The defaults probably spurred the investigation that resulted in his being charged with felony lender fraud. If loans are fully paid as agreed, then lenders may not have any incentive to confirm whether or not any misrepresentations were made on the loan application.  But once loans go into default, and especially if a lender will suffer a loss, then a lender has an economic incentive to carefully review the borrower’s application to determine whether or not all of the representations were truthful.

What a terrible risk to take.  When borrowers take out loans on investment property in a hot real estate market, misrepresentations on a loan application can seem to be a minor thing.  But when the lender loans hundreds of thousands of dollars on those representations, and if the market turns downward so that there’s a foreclosure, then a borrower who is less than honest can end up facing criminal charges.  Nobody expects this when they fill out a loan application – but it’s a real possibility.  The end result?  Honesty truly is the best policy – even when it’s more expensive.

Security First Rule Can Be a Protection

With the 2006 downturn in the market, lots of homeowners found their home was worth less than they owed on it.  Sometimes these owners ran into financial trouble due to illness, divorce, or loss of employment.  When this happened, those owners often couldn’t make their monthly mortgage payments.

When the market was good, these homeowners had several options.  Because of rapid and significant market appreciation, owners often had substantial equity when trouble arose in their home after holding it for a short period of time.  If they couldn’t make their payments, such owners could sometimes refinance their home and borrow against their equity, which would provide them with cash for living expenses and mortgage payments.  If they couldn’t qualify for a refinance loan, then they could sell their property and cash out their equity.

When the market went down, all that changed. Because of the economic downturn, many owners found themselves “upside down” in their properties, with their home being “under water.”  The terms “upside down” and “underwater” are commonly used to refer to properties where the mortgage debt is more than the property value.

California has a “Security First” rule.  In most cases this means that a lender can’t ignore a mortgage and sue directly on a loan.  When a property is “underwater,” then if a borrower has assets other than real estate, a lender might prefer to ignore the mortgage and sue directly on the promissory note.  When borrowers take out a mortgage loan, they sign a promissory note whereby they agree to make monthly payments.  If there is little or no equity in a property, the lender might prefer to just ignore the mortgage and sue the borrower on promissory note.  But California law usually won’t allow this, because of the “Security First” rule.  California requires a lender to foreclose on a mortgage before looking to a borrower’s other assets.  This rule can help protect a borrower’s other assets by requiring a lender to first foreclose a mortgage on real property before looking to a borrower’s other assets.