Thursday, December 16, 2010

Napoleon Rises Again - Short Sales and the Foreclosure Waterloo

Okay, I am not a history buff and to be honest, I'm not sure we have a good historical analog to the economic issues that we are facing today.  The amount of leveraging we have seen in the last 10 years is unprecedented and the decrease in real property values, though not undocumented, even under speculation (see housing markets in the 1870s)causing everything to come together in a unique 21st century conundrum. That said, we do have a Waterloo of sorts for foreclosures due to rising costs, and the most famous "short" in history, has to be Mr. Napoleon.

So why would Napoleon rise again in this world of nonjudicial foreclosure?  Well, according to a recent post on higher loss severity rates, investors in Mortgage Backed Securities are seeing incredible declines in their investments.  The measure being used is "loss severity."

If you are unfamiliar with loss severity, don't worry, I had to look it up too.  In a rather dry technical explanation from Moody's, the following definition was given: The loss severity rate (LSR), or loss given default (LGD), is the amount of losses, including both missed interest and principal write-downs, incurred by a defaulted security, as a share of its principal balance. The recovery rate is one minus the loss severity rate.

If you still feel lost, again don't worry, that previous sentence wasn't written for Joe Six-pack, or even for someone that is well versed in investing.  It is specialized to the mortgage backed securities which have spawned thier own language, issues, and neophytes.  The simple explanation is that loss severity is the measure of how much of the investment will never be paid back.  The recovery rate is how much will actually be paid back.

A quick illustration:  You invested $100,000 into a mortgage backed security(MBS) and it has a loss severity of 45%, you will lose $45,000.  Your recovery rate will be $65,000.

Well, the story is that foreclosures are causing these MBS investments to loose more money.  Foreclosure has been estimated to cost upwards of $75,000 though I haven't seen how that number is calculated.  It would seem odd to me that such number includes only direct costs such as attorney's fees, court costs, and the such.  It also likely includes some diminution in value of the loan or collateral in which that number may be low.  Many people that have mortgages now, don't have that mortgage with the company that originated it.  Rather, it is owned by a trust, and that trust has a duty to its investors to make the trust assets perform or at least stop losing value.

In order to accomplish this task of stopping the tide lost value, the trustees are looking past the simple aspect of holding essentially REO property through foreclosure.  In Washington, the number of houses actually sold at Trustee's sale is between 7.5 and 12%.  There is a push to get homeowners to short sale the properties rather than go into foreclosure.

Short sale has benefits to both the homeowner and the holder of the note.  The homeowner gets to be done with the process.  Okay, that is not much of a benefit and to be honest with you,  beyond the benefits certainty and a possibility of avoiding a foreclosure on your credit score, there is little value to a homeowner  in a short sale.  However, the benefits to the note holder are numerous:  Instant cash flow, no cost in holding or marketing the property, no real estate excise taxes, limited losses during falling housing prices and freed up cash for alternative investments. 

The home owner that goes through a short sale has essentially handled the administrative aspects of selling the property for the bank for no compensation.  On top of it, during a falling housing market, the homeowner obtains a better price for the note holder because it did not have to wait until after the foreclosure sale to market the property.  And, I would say the kicker to all of this, is that a short sale limits the possibility of litigation, either from the note holder in a judicial foreclosure, or a restraint of sale action on the part of the homeowner, further limiting the note holder's exposure to mishandled origination and chain of title issues.

So, when the MBS trust that holds the note to your property comes to you and suggests that maybe it would approve a short sale for you, don't be like Napoleon and surrender.  Because, the bottom line is that short sale push is a self interested move on the part of the note holders and not a benevolent change in policy.  Remember, we're Americans, we don't give up.  Live Free or Die.

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