The Real Alternative To Walking Away Is A “Back Door Cram Down”

Posted on May 18, 2008
In Basics, Laws | 2 Comments

It has been a few months since my last article.  My foreclosure and bankruptcy business has exploded beyond even my wildest predictions.  I also didn’t have a lot to add to the now chorus of housing bust news.  But my wife Nickie managed to get me to take a week’s vacation to Maui which is now in its last few hours.  One of the things I promised myself I would do this week was write a blog article so here it is.

A lot has been written by me and others about How To Walk Away From Your Home.  My blog has become more of a self-help guide to walking away in California.  I get at least 25 calls and emails a week from people who want to get out from their underwater homes, but are scared they will be liable for the unpaid mortgage debt.  As I previously explained, California homeowners who used 80/20 loans to purchase their homes and have not refinanced the second mortgage, can walk away without paying anything.

But I also get many folks who have refinanced that second mortgage, or who want to keep their homes, but can’t pay for the adjusted payment on their mortgage, or don’t want to pay on a house that worth substantially less than they owe on it.  They have tried to get the bank to work with them, but are frustrated because the bank won’t talk unless they are two payments behind and the only thing the bank will do is freeze their payments or add their arrears to their loan balance.  Banks will not reduce the principal amount on loans to fair market value to save a borrower from foreclosure.  They just won’t do it.

Once again it’s the 80/20 loan to the rescue.  This beautiful piece of financial engineering genius  (you really need to click on that link, it’s hilarious!) has found yet another way to help distressed home owners.  And not just in California, this trick works all over the United States. 

The trick is called a “Chapter 13 Lien Strip” but I like to call it the “Back Door Cram Down.” You may have read about the proposed mortgage “Cram Down” legislation that would allow Chapter 13 judges to reduce or “Cram Down” mortgages balances to fair market value in a Chapter 13 case.   This legislation has zero chance of passing until a new election and Congress are seated next January.

Instead, we are “Cramming Down” second mortgages using the old Bankruptcy code section 1322 which states:

“Contents of plan

(b) The plan may– 

(2) modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor’s principal residence, or of holders of unsecured claims, or leave unaffected the rights of holders of any class of claims.”

What’s not obvious about this code section is a loan is not “secured” by your personal residence if there is no value or equity in your home that would go to the lender if the home was sold.  That means the loan can be converted to unsecured or the lien “stripped” from the house by “modifying the rights of holders of secured claims.”  This turns it into unsecured debt, like credit card debt, which can be discharged!!!!  This is why I call it a “Back Door” cram down because we are cramming down the second mortgage to unsecured status.

Here is an example. You bought your home in 2006 for $500k with 100% financing using an 80/20 loan.  So your first mortgage is 80% or $400k and your second mortgage is 20% or $100k.  The market is down more than 20% from its peak and your house is now only worth $375k.  This means if the house was sold, the first mortgage would take all $375k and the second mortgage would get nothing.  In this case the second mortgage is “wholly unsecured” and the second clause of section 1322(b) does not apply, so we can modify the rights of the second mortgage holder and turn it into unsecured debt.

What happens to the now unsecured stripped off second mortgage?  It gets paid in your Chapter 13 plan but only after your other secured debts are paid.  Secured debts are the first mortgage, your property taxes, and your car payments.  And because a Chapter 13 plan lasts only 3-5 years (usually 5) a whole lot of that unsecured debt does not get paid.  At the end of 5 years, most unsecured debts (not student loans, back income taxes, or family support payments) are discharged so you don’t have to repay them.

So at the end of 5 years, you are left with just your just mortgage payment on your house.  Your cars and your back property taxes are paid off, your student loans and back income taxes are paid down, but your second mortgage and your credit card debt is gone!  Beautiful isn’t it?  God bless the 80/20!  It just keeps on giving.

You can read more about Chapter 13 plans here so I’m not go into great detail on them other than to say they are like debt consolidation inside of a bankruptcy, they last 3 to 5 years (usually 5) and you also can included student loans and back income taxes.

So what is the downside?  First off, you will have gone “Bankrupt.”  Your creditors will report that for 7 years and it will appear as a public record for 10 years on your credit report.  Creditors do not really distinguish between a Chapter 7 or a Chapter 13 bankruptcy so your credit will take a beating.  But I like to point out to people that if they do nothing, their credit will likely take a beating anyway, so it’s not really any worse.

The other major downside is you must make every plan payment for 3 to 5 years.  If you fail, everything goes back to the way it was.  You owe all that debt, and the second lien is no longer stripped off.  So I always tell my clients to make a budget that will work for 5 years, not just one that looks good to the Bankruptcy Court.

Enough for now, I’ve got to pack my bags and head to the airport.

Don’t Make The California Refinance Mistake

Posted on January 27, 2008
In Credit Contraction, Subprime Lending, The Equity Dead | 2 Comments

Central to the mortgage bailout plan is the refinance of adjustable rate mortgages to fixed rate mortgages.  There is even a plan to nearly double the “conforming” loan limit to help jumbo mortgages refinance.  But before you jump in, make sure you are not making the California Refinance mistake. 

California homeowners have been making the “refinance mistake” as long as the bubble has been going on.   The big mistake homeowners make is turning a ”non-recourse” second loan into a “recourse” loan by refinancing it.  A non-recourse loan is a loan that the bank can only look to their secured interest. In other words, they can only foreclose, they cannot get a deficiency judgment and chase you into bankruptcy collecting it.  THIS IS HUGE!  You can walk away from a non-recouse loan.

So how is a second mortgage a non-recourse loan?  Simple, it was “purchase money” for your home.  A purchase money loan is one where the money went from the lender, to escrow, and then to the seller or to pay purchase closing costs.  In California purchase money loans made on your home (note: not second home or investment properties) are non-recourse.  It’s simple as that.

The mistake comes when you refinance your second purchase money mortgage.  Because it is no longer a “purchase money” loan  a refinance transforms it into a “recourse” loan.  That means the lender will chase you into bankruptcy collecting it.  Or worse, they will sell it to a debt scrounger, the worst form of debt collector.  Your life will be hell if it falls into their hands.

It used to be second mortgages were never purchase money.  Enter the housing bubble and creative Wall Street financing.  The result:  the 80/20 loan.  It was really a beautiful thing.   Buy a house with no money down, get two loans, a cheap interest rate first covering 80% of your loan, and a high rate second mortgage covering the 20% you were supposed to put down to have some skin in the game.  Wall Street sold the loans to different investors and bought insurance on the second to cover the higher risk of default.

But there was an unintended consequence Wall Street seems to have overlooked.  The Purchase Money Rule made these loans “non-recourse.”   This has come back to bite.  It turns out ETRADEhas a bunch of California Second Mortgages.  Guess what?  They are unsecured now because housing prices have fallen so much, and there is no recourse against the borrowers.  They can just walk away-AND THEY ARE.

A couple of tips:

1.   You can refinance your first mortgage or both mortgages into one mortgage and still be “non-recourse.”  This is because the One Action Ruleprevents lenders from looking beyond the mortgage in a non-judicial foreclosure.  Second mortgages do not benefit from this rule because they have not had their “one action.”

2.   If a seller took a second loan on your property, they cannot look beyond a foreclosure even on investment properties or second loans.  This is the “Vendor Rule.”

3.   Always keep economics in mind.  It’s better to let your home go and walk away without liability to the bank then to try to save your home with a refinance and become personally liable.

Cheers,

Ken 

Dumping Your House? You Can Stay Six Months For Free In California

Posted on January 6, 2008
In Subprime Lending, The Equity Dead, Laws | 3 Comments

“If life gives you lemons, make lemonade.”  

It  was a poster Ms. Kerney had in her 8th Grade English class at Oak Grove Middle School in Jamul, California.  It stared at me for a year in 1979 and was forever burned into my brain.  I think it’s the only thing I learned that year.  That was a year when Carter was in office, hostages were in Iran, inflation was double digit, and new wave music was forcing great social change in the halls of my school.  Should I cut my hair?  It kept me awake at night. What was keeping adults awake was a Real Estate bust caused by those double digit mortgage rates.

Fast forward almost 30 years to a bigger and different real estate bust.  I now teach my clients how to make lemonade from their underwater homes.  They know the bad news.  So I tell them the good news. 

If you are letting your house go in California, you can stay in you home for free for six months.  That is, it will take a lender about six months from the time you miss your first payment until they complete the foreclosure.  This is a function of the foreclosure rules.  It will take about 4 months to send you a “Notice of Default”, the first requirement in the process.  And it will take another two months to send you “Notice of Sale” and set the auction date.

During that period of time, a lender cannot move you out of your house.  They cannot sue you either.  This is known as the First Action Rule.  A secured lender must move against the secured property first, before they can take any action against a borrower for non-payments.  Lenders can and will however harass you every day.  They can call you at work, at home, and call your “references” to locate you. 

I shield my clients from this constant barrage of abuse by representing them in the foreclosure process.  This invokes the California Rosenthal Fair Debt Collection Practices Act which protects consumers from creditor harassment when they are represented by an attorney.  If a lender contacts you after you tell them you are represented by an attorney, that you refuse to pay, and not to call you ever again, then they must stop or they are liable for statutory damages of up to $1,000 per act.

Lenders can continue the foreclosure process by sending you a notice of default and notice of sale, but nothing else.  They can also report your credit accounts 180 days past due and “foreclosure” so your credit will get wrecked.  And junior lenders that lose their security interest can sue you after the foreclosure if you are personally liable for the debt (see my previous article on The California Rules).

More good news, you can negotiate cash in exchange for return of possession of your home to a lender after foreclosure.  They may do this rather than go through a costly unlawful detainer action.

So if you are losing your house anyway, make some lemonade and stay six months for free while you save up some money to move or pay off credit card debt.   It’s only fair for what the lenders have done to everyone.

  

Congress Gives Mortgage Tax Relief For Xmas, But Investors, Second Homes & Cash-Out Refis Get Lumps Of Coal

Posted on December 31, 2007
In Legislation, The Equity Dead, Laws | 3 Comments

HR 3648 is a Xmas gift. Just passed by Congress it will fix part of the mortgage tax problem, retroactive to January 1, 2007.  But the part of the problem it does not fix will leave many California families and investors with the same nasty problem. 

Prior to this law, some homeowners and investors that had their homes foreclosed, or sold them short, were taxed on the amount of their mortgages that were not covered by sale proceeds, but where the debt had been cancelled by agreement with the lender or by operation of law (see my previous article on the California Rules.)  This situation was particularly harsh to people who just suffered the trauma of losing their homes and left them with a big tax bill but no cash to pay it. 

The old law, Internal Revenue Code section 108, offered some relief.  If the debt was discharged in bankruptcy or cancelled when the taxpayer was “insolvent” the cancellation of debt was ‘excluded” from gross income.  This however left former homeowners seeking bankruptcy protection or trying to prove their insolvency to the IRS-neither one a good option. 

The new law avoids those hassles by adding a new category of exemption ‘E’ to Section 108 as follows:

“‘(E)’ the indebtedness discharged is Qualified Principal Residence Indebtedness which is discharged before January 1, 2010.”

Sounds pretty good right?  It leaves out investors and second homes, but the intent was to help the average homeowner, not investors.  But then Congress added this little “Special Rule.”

“(2) QUALIFIED PRINCIPAL RESIDENCE INDEBTEDNESS- For purposes of this section, the term `qualified principal residence indebtedness’ means acquisition indebtedness (within the meaning of section 163(h)(3)(B), applied by substituting `$2,000,000 ($1,000,000′ for `$1,000,000 ($500,000′ in clause (ii) thereof) with respect to the principal residence of the taxpayer.”

What’s left out is Home Equity Indebtedness which is defined in section 163(h)(3)(C) as

“ any indebtedness (other than acquisition indebtedness) secured by a qualified residence to the extent the aggregate amount of such indebtedness does not exceed -
(I)   the fair market value of such qualified residence, reduced by
(II)   the amount of acquisition indebtedness with respect to such residence.”

Can this really be true?  Did Scrooge Congress really do that?  Did they intend to punish the average homeowner who took money out to buy a car, pay down credit card debt, or send their kid to college? Well, let’s parse the Special Rule together.

“For purposes of this section,”

Meaning for the exclusions to cancellation of debt income only.

“the term `qualified principal residence indebtedness’ means”

Here comes the definition (pay attention now)…

“acquisition indebtedness”

This is the debt you incurred buying your house (note: not taking cash-out or paying down credit card debt). However, it can be refinanced acquisition debt.

 “(within the meaning of section 163(h)(3)(B), applied by substituting `$2,000,000 ($1,000,000′ for `$1,000,000 ($500,000′ in clause (ii) thereof)”

This is the same definition that you use for your home mortgage interest deduction but increasing the principal amount to $2 million or $1 million when married filing separately (This is screwy.  Congress is upping the amount of cancelled debt you can exclude but you would not get a home mortgage interest deduction for much of it—go figure).

“with respect to the principal residence of the taxpayer.”

This is your main home and the place where you get your mail.  Not your vacation home or investment property.  This is the same one you have been taking principal residence interest deductions on, so it better match you old tax returns.  (Note a planning opportunity here.  You might change your principal residence to your vacation home or investment property prior to letting it go back to the bank. Talk to you tax advisor).

That’s it!!!  Nothing else in your Xmas stocking.

In California, the new law’s impact will be limited.  Most debt that is not getting paid at foreclosure sales is second mortgage debt.  When a foreclosed loan is a second loan and not a purchase money loan on your personal residence, the junior lender may obtain a deficiency judgment after the first forecloses so the second mortgage debt would not be “cancelled” in the first place (see my previous article on the California Rules) and no tax would apply.

Why Not Just Stop Paying Your Second Mortgage In California?

Posted on December 9, 2007
In Credit Contraction, Subprime Lending, The Equity Dead, Laws | 2 Comments

This question has been bouncing around in my head for the last six months.   The question stems from the problem most underwater California homeowners have:  they are personally liable for their second mortgages because they are not PURCHASE MONEY LOANS.  These homeowners want to let their homes go in foreclosure, but they will be liable to the second mortgage company for any deficiency after the foreclosure sale.

So how do you get out of it? It’s a question I get every day.

The Answer is: GET THE SECOND TO FORECLOSE.  If the second, and not the first mortgage foreclose, THE ONE ACTION RULE says they cannot sue you for any deficiency or shortfall after the foreclosure.  The first mortgage will be paid in full.

BUT WHAT IF THE SECOND MORTGAGE DOES NOT FORECLOSE? This is GOOD because the FIRST ACTION rule will prevent the second mortgage from suing you until after they foreclose.  This means you get to stay in your house as long as you can make your first mortgage payment but you don’t have to make your second mortgage payment.   But note:  THE SECOND MORTGAGE WILL EVENTUALLY FORECLOSE when you pay down your first mortgage enough or the value of your home goes back up above the balance of the first mortgage.

Now let’s talk about all the BAD THINGS that could happen.

1.                  YOU ARE NOT ABLE TO MAKE THE FIRST MORTAGE PAYMENT.  This is a real disaster.  You will be in the same place as before except you will owe the second mortgage for all the unpaid interest and garbage fees they tacked on.  DON’T LET THIS HAPPEN.  If there is any chance you might not be able to make the first mortgage payments, this is not for you.

2.                  YOU WILL WRECK YOUR CREDIT for as long as you don’t pay your second mortgage, plus seven years.  This is worse than walking away now because your credit will only take a hit for the bad mortgage from the date of the foreclosure plus seven years.

3.                  YOU WILL NEVER HAVE ANY EQUITY IN YOUR HOUSE.  The second mortgage will increase by the amount of the interest rate plus all the penalties and garbage fees they tack on.  AND THEY WILL TACK ON A LOT!!

4.                  When the second eventually forecloses because the house has grown in value and/or you have paid the first mortgage down, YOU MAY HAVE INCOME FROM THE CANCELLATION OF DEBT that is greater than the amount that you would have if you let it go now because the second mortgage has grown by the interest you have not been paying.  This could be significant!  What’s worse, you will not control the timing of this taxable income.  It will happen when the second decides to foreclose so your ability to manage this problem is out of your hands.

5.                  YOU WILL LIVE IN FEAR OF FORECLOSURE.  This might be the worst thing.  You will always know the second could foreclose at any time.  You will have an idea when this will happen because it will be when the FMV of your home is in excess of the first mortgage by enough to make it worth foreclosing to the second mortgage lender.  Once they issue a notice of default and 90 days has passed, they can issue a notice of sale and foreclose in 21 days!!!,  So you will need to be prepared to move once your home’s value starts to go above the first mortgage balance.

6.                  You will be harassed by the second mortgage debt collectors.  This is a manageable problem.  Just send them letters telling them you refuse to pay it and that they are not to contact you anywhere.  Better yet, retain me to send them a letter. If they continue to contact you, you have a RFDCPA lawsuit against them.

So who should do this?  This strategy is best suited for people who are personally liable for their second mortgages and have enough equity to induce the second to foreclose.  How much is that?  I can’t say, but second mortgage lenders are watching their equity slip away every day so they may act to protect whatever equity they have and foreclose.  If they do, the homeowner can walk away without personal liability (but probably a tax bill). 

A twist on this strategy is to stop paying your property taxes and homeowners association dues too.   I DO NOT RECOMMEND THIS.  While these amounts are often paid in the foreclosure process, you remain personally liable for them.  That means you can be sued for non-payment.  The first mortgage can also pay them and foreclose for non-payment. 

The California Foreclosure Rules or “So What Happens If I Let My California House Go Back To The Bank?”

Posted on December 4, 2007
In Subprime Lending, The Equity Dead | 6 Comments

I get this question a lot.  The answer is, IT DEPENDS.   That’s a slippery lawyer’s response (someone called me that yesterday) but the outcome in your situation could be 

1.                  You still owe the bank a big slug of money;

2.                  You have a big income tax bill with no cash to pay it;

3.                  You owe the bank a big slug of money and you have a big tax bill ; or

4.                  You owe the bank nothing and you do not have a tax bill. 

Everyone wants to be the last case.  A lot of my clients show up to my office as the third case.  The good news is most people can be the last case, but only IF THEY PLAN CAREFULLY!!! 

This brings me to Jim Cramer.  I like Cramer because he brings raw institutional investor insights to the masses. He tells the brutal truth (as he sees it) and I respect that.  But I was screaming at the plasma screen when he cavalierly advised his fans to “walk away” from their houses.   I don’t fault his economics:  if your house is sucking all your money from you, why throw good money after bad on it?  But you can really hurt yourself financially if you do not “walk away” carefully. 

So I have set out below the Califronia rules that you need to take into account when you let your house go. They are really complicated and are too complicated for you to figure out on your own so GET PROFESSIONAL ADVICE BEFORE YOU DO SOMETHING STUPID.

THE CALIFORNIA FORECLOSURE RULES

1.                  THE PURCHASE MONEY RULE: 

In California, a lender who loaned you money to BUY your home, which you ORIGINALLY moved into as your primary residence, cannot do anything other than foreclose.  This means if the foreclosure sale does not pay all “purchase money” loans, those lenders cannot sue you for the unpaid balance.  Most importantly, this includes second mortgages used in many 80/20 100% financing deals.   If you REFINANCED any of these loans, or paid down purchase money HELOC and drew down on it again, this rule does not apply. 

2.                  THE ONE ACTION RULE: 

In California, a mortgage lender can only take one action against you:  A non-judicial foreclosure, or a judicial foreclosure.  The result of a non-judicial foreclosure is just like the PURCHASE MONEY RULE, a lender can only sell the property and pay the loan.  If the sale does not pay the mortgage, the foreclosing lender cannot get the unpaid balance from you.  However, the lender can get the balance from you in a judicial foreclosure. The good news is judicial foreclosures are too uncertain and costly for lenders that they are almost non-existent.  BUT, (pay attention, this is important) if a junior lender’s security interest is wiped out by a senior mortgage foreclosure, the junior lender can obtain a deficiency judgment for their unpaid balance because they have not had their ONE ACTION against you yet (subject to the PURCHASE MONEY rule of course).  This situation is very common these days for that second mortgage you used to remodel the kitchen and bathroom, or bought that Escalade, or refined a previous second mortgage. 

3.                  THE CANCELLATION OF DEBT RULE: 

Both the IRS and California tax you for the amount of debt that is CANCELLED in any given tax year.  Debt is cancelled only when a lender has given up on its right to collect the debt or they are barred by law from collecting the debt (think PURCHASE MONEY & ONE ACTION rules).  HOWEVER, if the debt cancelled was a “Purchase Money” loan (see above) the debt cancelled is treated as a sale of your residence, subject to normal homeowner exclusions.  This is because the loan is deemed to be non-recourse and therefore nothing has been cancelled.

4.                  THE BANKRUPTCY & INSOLVENCY EXCEPTION. 

Both the IRS and California exclude cancelled debt from your income to the extent the debt was CANCELLED in bankruptcy and you were insolvent; BUT ONLY TO THE EXTENT OF YOUR INSOLVENCY!!!!   You are insolvent when your debts exceed your assets.  Assets include IRA and pensions.  GET A CPA TO HELP YOU HERE. YOU WILL NEED IT!  DON’T BE STUPID AND TRY TO FIGURE THIS OUT YOURSELF!

5.                  THE FIRST ACTION RULE. 

Not to be confused with the ONE ACTION RULE, this rule says a secured creditor must seek to recover the secured property before suing you for non-payment.  This means a second or third mortgage will have to wait until the first or senior mortgages foreclose before they can sue you for a deficiency. 

So, you think you know the rules?  Let’s try a few examples and see how you do.  Answers & explanations are below. 

Example 1:  Mike borrowed an $800k first and a $200k second loans to buy a beach condo he stays at on the weekends and rents out occasionally.  The first foreclosed (non-judicial) and paid off only $750k of the first loan.  The second was wiped out.  What happens? 

A.                 Mike walks away without any debt to the first or second loans because it was “purchase money” debt;

B.                 Mike has income from the cancellation of debt of $50k on the first and all of the second;

C.                 Mike owes the second the entire balance and has $50k cancellation of debt on the first mortgage;

D.                 A&B

E.                  B&C

F.                  Mike can’t surf so it does not matter. 

Example 2:  Mike got a $200k first loan to buy his house and later took a $400k second to add a go-cart track and skate board ramp.  The SECOND foreclosed (non-judicial) and just paid off the first loan.  The second was wiped out.  What happens? 

  1. Mike walks away without any liability to the first or second loans.
  2. Mike has income from the cancellation of debt on all of the second loan;
  3. Mike has no cancellation of debt income;
  4. A&B
  5. B&C
  6. Mike can’t surf so it does not matter.

Example 3:  Mike got an $800k first loan and $200k second to buy his home.  The second was a HELOC that he paid off then borrowed against to buy land in front of a great surf break.  The first foreclosed (non-judicial) and just paid off the $750k of the first loan.  The second was wiped out.  What happens? 

  1. Mike walks away without any debt to the first or second loans.
  2. Mike has income from the cancellation of debt of the second loan;
  3. Mike has no cancellation of debt income;
  4. A&B;
  5. B&C
  6. Mike can’t surf so it does not matter. 

Example 4:  Same example as three, expect that  his first mortgage was refinanced and, just prior to the foreclosure, Mike had (in addition to his house debts) $10,000 in cash and no other debts.  What happens?

  1. Mike is taxable on the entire $50k CANCELLATION of debt from the first loan because he is not insolvent.
  2. Mike is taxable on $10k of his CANCELLED debt;
  3. Mike has no CANCELLATION of debt income;
  4. Mike can’t surf so it does not matter.

Example 5:  Mike buys an investment property with a $500,000 first mortgage and a $200,000 second mortgage.  Mike gets in an argument with the second mortgage company because they say he cannot surf.  So Mike stops paying the second mortgage when the property is worth less than the balance of the first mortgage. What happens? 

  1. The second mortgage forecloses and Mike has CANCELLATION of debt income.
  2. The second mortgage sues Mike for non-payment;
  3. The first mortgage company sues Mike for default;
  4. Mike sues the second mortgage company for slander;
  5. None of the above. 

ANSWERS 

1.  C & F are correct.  The loans are “purchase money” but because Mike did not move into the condo and make it his home when he got the loan, the purchase money rule does not apply (WARNING Ask your attorney about the rare VENDOR RULE).  The second can sue for the balance because it has not yet taken its ONE ACTION and is thus not CANCELLED.  The first is $50k short and it cannot sue Mike for the balance because it took its ONE action so the debt is now CANCELLED and is taxable income.  F is always true. 

2.  D & F are correct.  The first loan was paid and thus there is neither deficiency nor cancellation of debt.  The second loan was not a “purchase money” because the loan (although put to great use) was not used to buy the house.  BUT, the second foreclosed so it used its ONE ACTION and cannot get a deficiency.   Because the second cannot get a deficiency, the debt is now cancelled and is now taxable income.  F is always true. 

3.  Only F is correct.  The first loan was used to buy the home and it foreclosed so both the ONE ACTION and PURCHASE MONEY rules apply to prevent the first from getting a deficiency for the $50k.  But $50k of the balance is CANCELLED, BUT it was non-recourse PURCAHSE MONEY debt so it is treated as a sale of his home for $800k, subject to the home sale exclusion rules.  The second was not a purchase money loan because the second set of loan proceeds were not used to buy the home.  The second did not take an action so it can still sue Mike for a deficiency. Because the second can still sue Mike, it is not CANCELLED and thus not taxable income.  F is always true. 

4.  C and D are correct.  Mike has CANCELLATION OF DEBT income because his first mortgage is not purchase money but the ONE ACTION RULE prevents the lender from recovering the $10,000 deficiency.  However, Mike has $760k in assets (house + cash) and $1 million in debt so his liabilities are in excess of his assets and thus his income is excluded.  Had mike just had an $800k first mortgage, he would have been taxable on $10,000 of the debt because without the forgiven debt, he would have $10k in net assets.  So the tax is excluded only TO THE EXTENT OF THE INSOLVENCY.  D is always true.  

5.  E is correct.  The second mortgage is in default and can bring a foreclosure action against Mike but it cannot sue Mike because the FIRST ACTION RULE says they must move to recover the secured property first.  They will not do this because the value of the property is worth less than the first mortgage.  The first mortgage is still current so it cannot take any action against Mike.  Truth is always a defense against slander so Mike cannot sue for slander.

SIPC Has Only $3.4 Billion–FSLIC Had $5.6

Posted on November 22, 2007
In Credit Contraction, Subprime Lending | Comment

I’ll admit it. I panicked.

The Monday before last, I woke up to the news that ETRADE was suffering a run on the bank.  It turns out they took their customers’ deposits and invested them in mortgages.  We all know what a disaster that is for ETRADE, and the rest of the world.

Up until that morning, I thought I had done a good job of saving and investing.  I maxed my 401k contributions every year; I didn’t buy more house than I need; I have not spent a dime of my home equity; and I have not made any too many speculative investments. 

But did I make one big mistake which would ruin me?  My entire life’s savings was tied up in ETRADE!!!!   My bank, brokerage and IRA accounts were all there.  My investments were well diversified yes, but I was still at the mercy of an ETRADE bankruptcy to which some Citi analyst just put at 15%.   I remember reading about people who lost everything in the great crash of ’29 not because they made bad investments, but because their broker went bankrupt.  I felt sick to my stomach.

So, before I went to work (or even got out of bed) I moved my ETRADE securities accounts to Fidelity where I had an existing account, and I moved my bank cash to TreasuryDirect.  It all took less than 30 minutes once I started.  Then called my brother and convinced him to move his as well.  I think he agreed just so he could go back to bed.

Once initiated, the move would take up to two weeks according to Fidelity’s website.  I was still worried so I posted my concern on the YAHOO ETRADE message board.  I was called names like Chicken Little (and a lot worse) by the ETRADE cheerleaders.  But they reminded me of the SIPC insurance that protects every ETRADE account:  $500,000 total account coverage and up to $100,000 in non-bank cash. 

These were within my limits so I should not be scared.  Plus, ETRADE purchased additional insurance protecting accounts up to $150 million per brokerage account, underwritten by London insurers (aggregate $600 million) as stated here.

I should have been pacified, but I wasn’t.

I couldn’t fall to sleep Monday night because I was worrying about an ETRADE bankruptcy, so at 2:00 AM I started researching SIPC insurance.  I found their December 31, 2006 annual report here.  What I read made me lose even more sleep.

THE SIPC HAS LESS THAN $3.5 BILLION TO PAY CLAIMS!!!

More precisely, this is what the SIPC had at 12/31/06:

Net assets (mostly treasuries)                           $1.4b

SEC line of credit                                             $1.0b

Bank consortium line of credit                           $1.0b

Total funds available to pay claims                     $3.4b

Now $3.4 b may sound like a lot of money to you, but when you put in into perspective it’s horribly inadequate.

My account transfers were complete by last Friday and I am sleeping again.  But it’s not the SIPC that gave me comfort.  It’s my own due diligence investigating my broker’s balance sheet.  I’m considering using multiple brokers to diversify my broker risk, just like I diversify my portfolio risk.

So what’s on your broker’s balance sheet?  Ask them!  Don’t let them give you the line of bull about all the SIPC insurance protection you have–because you don’t.  If the answers don’t satisfy you, find another broker, because your broker is not paying you anything extra to take on their balance sheet risk.

You can learn more about the SIPC here. 

COUNTRYWIDE CALIFORNIA AUG. REO +23%: ALMOST $1 BILLION

Posted on September 1, 2007
In Credit Contraction, Subprime Lending, The Equity Dead | 6 Comments

Countrywide California REO inventory continued its rapid growth in August and is just shy of $1 billion.  Last month Countrywide added 506 California properties (net of sales) to their website here.  That’s more than any month and up 315% since the subprime crisis began last Spring.

Here are the numbers as of September 1:

Countrywide California REO August 

An emerging trend is the drop in the median price of REO homes.  It’s down almost 12% since February to $335,000.  This is also substantially below the July California median resale price of $478,000 as reported by DataQuick.

So what is causing the rate the drop in median prices and why is it so much lower than the California median price?

My hypotheses (guesses) are as follows:

1.                  There is more trouble at the bottom of the property ladder than at the top (or rich people don’t get predatory, subprime loans).

2.                  Countrywide lends to the lower end of the market more than the higher end (I have no evidence of this). 

3.                  A corollary to #2 would be expensive homes carry a lower loan to value ratio than entry level homes and are thus less susceptible to foreclosures.

4.                  The median is dropping because houses are not selling and Countrywide is dropping their prices (again, I have no evidence of this).

5.                  The demand for entry level housing has dried up with subprime lending so those houses are accumulating while more expensive sell faster.

6.                  Is there some other reason?  Anyone have any ideas?  

Some additional comments about these numbers: 

The values are Countrywide’s listing price. I have no Idea how they arrive at those numbers although it may include an appraisal or broker price opinion or both. The size of the total portfolio is not as relevant to me, as the trend of it’s change. I include the average and the median not only because they are marginally interesting, but to act as a check on the data. As you can see, they are relatively constant month to month (but trending down). If they were not, I would consider an error in the data. As noted previously, I do not believe Countrywide owns many of these properties. I think instead they are owned by the big Wall Street trusts and Countrywide just owns the servicing rights. Cheers, 

Ken

HOUSE UNDERWATER? HOW TO LET IT GO

Posted on August 18, 2007
In Uncategorized | 1 Comment

     For the past month I have gotten about one email a day from homeowners who are underwater (or “Equity Dead” as I like to say).  This situation happens for a lot of reasons and Predatory Lending is one of the big ones.

     You are Underwater/Equity Dead if you cannot sell your home for the balance of the mortgage and sales costs combined.  If you conservatively figure 8% closing costs, simply take the price you can sell your house for and multiply by 92% (.092 on or calculator). If that amount is not greater than the balance of your mortgage(s) than you are Equity Dead, as there is no equity in your house. 

What to do?

        First, how deep are you under water?  If you are close to surface, have a fixed rate mortgage you can afford, and the rest of your finances are under control, you can probably ride out this down turn if you can stay put for at least five years.   If you are deeper under water (more than $10k) you should consider the following strategies to let your house go.

Short Sale

            This is the Realtor solution de jour and the least helpful.  First you find a buyer for your house at a value that is less than your mortgage but supported by an appraisal. Then you approach the bank and tell them if they do not take your offer you are going to let the property go back to the bank.  The bank gets its own appraisal and you fight it out.  You do not know if you have a deal until the end of the process. 

If you have a deal, you can negotiate with the bank on how they will report this on your credit score.  The amount of the loan that gets reduced is added to your sales proceeds of your house so you can end up with a taxable gain depending upon if you qualify for the exclusion.  You are really at the mercy of the bank here.  If you have a second mortgage everything gets a little more complicated.  The second may not want to give up too much and the first will want to get completely paid.  I’ve counseled my clients that it’s worth a try but not to get their hopes up.  The bottom line is that buyers can be choosy in this market and I counsel them to stay away from short sales.

Deed In Lieu Of Foreclosure   

This is exactly what it sounds like.  You tell the bank they can take your house back or they can foreclose on it.  The trick here is to come away without any liability.  Again, if you have a second mortgage, this is going to be tough because the second is going to want something and the first is going to want full satisfaction.  You have the same debt forgiveness income issues as at Short Sale.

Foreclosure

            This is actually one of your best options.  Why?  Because it puts you in the driver’s seat.  You are in the house.  They want to get the house back with as little cost as possible.  It will take the bank 4-6 months after you stop paying them to sell your house in foreclosure and more time and legal fees to evict you.  If you go bankrupt just before the sale, you can add several months on top of that, and all without paying your mortgage or taxes.  Meanwhile, you have stopped watering the lawn and the trees are all dead. I always counsel my clients to pay their homeowners insurance as it protects them as much as the bank. 

For my clients in foreclosure I like to point out two things.  First, if you have a second mortgage, and the first forecloses you are still personally liable for the second mortgage unless it was “purchase money.”  That is, unless you used it to purchase the home.  I always tell my clients to assume it is not purchase money second because there are too many tricks to that exclusion like a refinance or an equity line of credit, etc.  So the trick here is to pay your first and make the second foreclose.  If the first does not get paid off in the purchase, they still have a lien and they will foreclosure again if the new owner does not pay YOUR mortgage.  That’s right, the new owner will take the house subject to your first mortgage and they will pay it or risk losing the house. 

If the house does foreclosure again, you are not liable because California has what is known as the “one action rule.”  That is, if you hold a defaulted mortgage on a home, you may either foreclose on the court house steps (most common) or you may foreclose by lawsuit, have the Sheriff sell the house and get a judgment for the deficiency.  The latter is very uncommon because it is costly and unlikely to result in any greater proceeds to the lender.  So in this scenario, you stop paying the second, have them foreclose, and walk away from the house without any liability to either lender.  You still have a potential tax liability as discussed above for the amount of mortgage that did not get paid by the foreclosure bid.

The second thing I tell my clients is not to be afraid of the bank.  The banks are in big trouble now.  Ask them to pay you least $2,000 to give them the keys and move out voluntarily.  If they refuse tell them you will go bankrupt and fight any eviction proceedings, and you will counter sue them for predatory lending and fraud.  This has worked well for many of my clients.  You need make sure you answer any lawsuit for eviction or the Sheriff will move you out.

Bankruptcy

            This is actually one of you best options because it buys you time, shakes off non-secured debt and stops all the nasty phone calls.  In bankruptcy, you can hand the house back to bank, walk away from the second or third mortgage without any liability, shake off all your other consumer debt, and keep your car. You can also add to the time you can stay in your house, for free, by months.  People think it is too hard to qualify for bankruptcy, but I have not had any trouble qualifying my clients.

Cheers,

Ken

COUNTRYWIDE CALIFORNIA REO’S UP 21% IN JULY

Posted on August 5, 2007
In Credit Contraction, Subprime Lending, The Equity Dead | 2 Comments

Countrywide REO inventory continues to stack up in California, but the monthly rate appears to be decreasing.  In July, Countrywide added 373 California properties (net of sales) to their website here.  That compares with just 174 last month and 374 in May.  What is causing the rate of decline is anyone’s guess, and I will make mine below.

Here are the numbers as of August 1:

Countrywide California REO

The inventory dollar value also crossed the eight hundred million dollar mark this month. The billion dollar mark could be this month if things don’t change.

So what is causing the rate of increase to slow?

Is it slowing foreclosures?  Not likely.

Here are the montly 5 and 25 year foreclosures for San Diego County as of June 30:

5 year san diego foreclosures 

25 year san diego foreclosures

As you can see, we have hit a new foreclosure high each month since February, so the supply side doesn’t seem to be the answer.

That leaves a couple of other possibilities:

1. Is Countrywide is unloading these faster than before?  Maybe.  I’ve seen some auctions advertised and heard a lot of homes have been sold that way.

2.   Are the Wall Street trusts that own these (Countrywide is just the service company for many of these-see note below) letting more of them go at the foreclosure auction rather than take them back?  I don’t think so.  I keep a pretty close eye on the San Diego foreclosure scene and it seems more properties are going back to the bank than to investors.

3.  Is Countrywide failing to put all of their properties up on their website?  Could be, but if they are I doubt it is for nafarious reasons.  I would guess they may be struggling with the increased volume of REO properties.

4.  Is there some other reason?  Anyone have any ideas? 

Some additional comments about these numbers:

  1. The values are Countrywide’s listing price. I have no Idea how they arrive at those numbers although it may include an appraisal or broker price opinion or both.
  2. The size of the total portfolio is not as relevant to me, as the trend of it’s change.
  3. I include the average and the median not only because they are marginally interesting, but to act as a check on the data. As you can see, they are relatively constant month to month. If they were not, I would consider an error in the data.
  4. As noted above, I do not believe Countrywide owns many of these properties. I think instead they are owned by the big Wall Street trusts and Countrywide just owns the servicing rights.

Cheers,

Ken

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