When House Values Drop Below Bank Loans=Bankruptcy!

Elaine Meinel Supkis

One of my readers thought I made a mistake today when I talked about repossessions of housing and how declining housing values leads to an increase in bankruptcies. Namely, people can't sell their homes below the cost of the mortgage. I should have explained that these situations are what we call 'bankruptcy'.

As a person who has bought and sold more than one property over the years, I assumed everyone knows the ins and outs of this field. So time for a review of what it means to buy and sell in a rising asset market versus a declining asset market!

I used to buy undeveloped land or run down properties and then bring up their value by either building something or fixing an entire community and then cashing in on the rise in value of these properties. It not only is lots of hard work and investing savings and taking out 'risky' loans that are short-term but easy to pay off if one then sells the properties. I have paid up to 9.45% loans that I used for up to 3 years and I considered it to be a bargain for me since I made a 400% profit on that particular sale.

As the years went by, I built up equity and part of this was to always keep the debts and construction loans below 35% of the value of my main property, usually my home. So, a house that is valued at $300,000 would be tapped for up to $105,000. This was plenty to run various schemes! I chose to do this because housing prices can then tank totally for 20 years and I still would have more value in my house than the debts outstanding on it.

In other words, I protected the asset itself by NOT tapping its total value! I have known many, many people who have done the reverse: running up more and more loans against their properties and then, when forced to sell by margin calls that have to be honored or other mishaps including divorce, they end up unable to sell their homes for more than the loans outstanding.

Usually, this is happenstance: being forced to sell during an asset downturn, they get caught in the gears and ground to death. Namely, they go bankrupt. One never knows when they might be forced to sell. I had to sell once during a downturn and got hosed for $100,000! That's plenty of money. But I didn't go bankrupt because my overhead was minor so I still had a good profit considering all things.

Thus my 35% rule! That property lost 15% of its value. 80% of America's housing has loans up to 90% and over on their homes. This is shocking. The entire nation can't afford to see housing drop in value. Of course, 80% of those people who are up to their eyeballs in debt will simply stay home and bite the bullet and wait this out. But the unfortunate 20% who are being forced to sell will go bankrupt. This is because, if they have to sell their homes and it comes to closing, the banks holding the mortgages on the property will all be there, eyes red with fury. And they will all have to be paid off before the deed is handed over to the buyer.

These are always, even in good times, tense meetings. Once, I was buying a bankrupt property from a consortium of banks. They sold it to me for taxes due plus fees but when we got to closing, they inserted a clause forcing me to pay the previous mortgages! I yelled like I was on fire. I stormed all over the place. It got very nasty. The banker's employees pulled the 'I don't know what you are talking about' faces and I ripped up the contract and forced them to hand back the deposit.

Once, when closing on a slum property, the slumlord selling to me tried to cheat me by slipping some of his own obligations onto me. My lawyer put a gun on the table and said, 'I suppose we should be clear what this is, a hold up.' I laughed. The seller paid his obligations and even he laughed. Mr. Lake and I got along just fine afterwards.

At closing, everything must be paid off. Period. This includes water fees, taxes, liens of any sort and there are a million sorts of liens, etc. And number one is back taxes, the goverment is always first in line, then the primary mortgage holder and then all the other mortgages and then personal loans and construction fees, etc all the way down to the ex-spouse or child support. After all these matters are cleared up, then the signing of the new loans and documents commence.

If there is ANY negatives here, even ONE PENNY, it all stops! Then there are negotiations. I have actually done this. 'OK, I'll cover that, just give me the deed,' is a nice ending but this is only for 'hot' properties, not duds. Alas, in a declining market, 99% of the properties in this condition if not 100% are 'duds': no one wants to pay anything extra for them! This is why down markets are dangerous: they amplify the loss of money and everyone with money is looking for bargains and each day, the prices drop so they have great incentive to NOT close but to refuse to finalize the deal. This means the deal falls through.

IF the seller can wait it out, they sit and home and cry but hope for better times. IF they need to sell for any reason, they are doomed. One of my neighbors who played the markets got caught in the big .com bust. As margins were called in he tried everything possible to keep up including running up a giant debt on his house.

Then time ran out and so did his money. At this point, he stripped his woods of trees and sold the doors of the mansion and other fixtures and then the police came and forced him out of his huge mansion sitting on the mountain next to my farm. He went bankrupt. The banks took possession of his home and sold it for a loss but at least they got something. He got nothing.

This is why the bankruptcy rate is rising along with the foreclosure rate. They are very much connected. You can't walk away from the obligation of paying off a bank loan EVEN IF THEY TAKE THE HOUSE. At this point, the person who run up the debts has to flee to the courts for protection. In the old days, these people would be put in prison. But we have liberal (not any more, arg) bankruptcy laws so people can discharge these differentials by simply saying they are broke.

The present mess was caused by a host of lenders lusting for higher interest rates loaning trillions of dollars to a host of people who couldn't afford to pay these loans and both parties hoped the rising value of real estate assets would cover their collective asses.

Well, it isn't and it can't.

From Market Watch:

Wall Street brokers Goldman Sachs and Bear Stearns said Thursday that persistent weakness in the subprime mortgage market weighed on second-quarter earnings.

Shares of both firms fell on the results, as Wall Street was a bit surprised by the weakness in the mortgage business, as analysts had expected the banks to largely dodge problems with the subprime sector.

However, without addressing any company specifically, Goldman CFO David Viniar said in a conference call with reporters Thursday that the subprime sector's woes are not over.

Vinair said to expect "more pain" in the sector before the problem is purged.
Bear shares fell 1.8% and Goldman shares slipped almost 3%.

I have known exceptional cases when the sellers do pay off the differential because they don't want to go bankrupt. These are usually people who are relocating from a low-value area to a higher value area, say, a former auto executive who can't sell his mansion will bite the bullet if he is relocating into a new sector, say, New York City. But most are deadbeats with no assets and no really good future prospects. There are exceptions like that nasty con-man, Donald Trump. But he isn't normal.

The downwinds from all this are only just appearing on the shores of Hedge Fund Fantasy Island. The big guys know perfectly well, what is going on. They depend on the dogs in the media to bark up a storm about how great things are and the jackals in the government will issue fake reports like the latest one that papers over what is wrong by focusing on the candy-land-lollipop statistics. I insist on looking at the over-all numbers and always am focused on the intersection between interest rates, government money printing (ie: the M3 numbers the government is now hiding from us) and of course the IMF reserve numbers that absolutely totally stink for the USA.

From Market Watch:

Private-equity heavyweight Blackstone Group LP disclosed its retirement agreements with its two top executives in a regulatory filing Thursday, outlining favorable investment terms for both but not any monetary compensation.

Blackstone is expected to launch its much-hyped initial public offering in the week of June 25, a deal expected to value the company at more than $32 billion.

This $32 billion is a mushy mess of red ink. Namely, most of what Blackstone rests upon is a zillion small home owners and businesses in trouble. These are the guys paying high interest rates. Anyone with good credit doesn't have to go to the funds run by or for these hedge hoggers. People with good credit get good banks who don't resell the loan! Low interest loans don't tempt these vultures and three-headed hell hounds. They want people running up loans at 12% or more!

And this is the bad feedback loop we are now seeing. Right now, stocks are still soaring but this is on the back of an international trade system that is falling to pieces rapidly because it is based entirely on the older industrial centers offshoring everything to China and everyone then selling it all back to the USA who is increasingly in debt to an astonishing degree. And like all those homeowners who have run up debts well up to the limit of the value of their houses which are now losing value, when this turns downwards on every front, we will have a Great Great Depression.

And readers ask me what to do about this. What can I say? Having courage, simple survival skills (I cooked on a Victorian stove for years and had no electricity or running water unless it was raining and the refrigerator was turned on in October and off in April!)---we can all survive on astonishingly little. Though having a lot is a lot of fun.

The key thing is, one should never run up debts on a property that are more than 65% of its value. If one has to get a loan for 80% of the value of the house the first year, this is OK only if this is the first house and one is very young. At 65, this is crazy. And 65% of the value after owning a house for 10 years is precisely because there is always a housing bust around the corner. I have seen four so far in my own life! And got my gears ground down on the 1991 downturn! Ouch!

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Comments

[JSmith]

"One of my readers thought I made a mistake today..."

NO!! How dare they?! They better say they're sorry!

[Cato]

The "cockroach theory" is most certainly in force. We're beginning to read stories re Goldman Sachs and a Bear Stearns hedge fund chocking on mortgage, CDO and asset-backed paper. So you know there's trouble in paradise. When the light is switched on and one cockroach is seen skittering away, be assured there are others hiding in the shadows.

Bonds backing underwater commercial and residential mortgage deals are stuck everywhere imaginable. Even in places you can't imagine. They circled the globe and come back again and everybody you wants to be a player on "the street" must own more than they care to just like all the rest. Institutional players survive by by "talking it up" & "marking it up". That's how the game is played. Trouble is the market is like an old crank phonograph who's spring is shot.

Ever try to find a pure play investment in anything lately? If you have a 401K and just want to keep things simple by selecting mutual funds - for safety. Let's say you're determined that tea kettle makers are the single safest investment over the long haul. Fidelity or Alliance Funds might very well manage a tea kettle fund, but be prepared to discover in the fine print that 70% of the fund is held in mortgage backed securities.

Herein lies the big surprise for every prudent investor who thought he was diversified. And a lot of litigation.

[DeVaul]

Cato is right. I recently received retirement "benefits" from my job and I had to pick from an approved list of mutual funds to put the money in that the firm was paying for me as part of my benefits.

One word stuck out like a sore thumb: "financials". This is code speak for "mortgage backed securities that will soon be underwater". Almost every fund had a huge position in "financials". Even the safest fund, the supposedly all cash fund, was really nothing more than government bonds and prime rated "financials". Only about 5% was actually held in cash.

I picked the one fund that had the lowest exposure to "financials", which also happened to be the one with the highest exposure to energy, natural resources, utilities, agriculture, etc.

It is the only fund in the portfolio that went up in value in the last six months. I had put all my meager benefits into it. Everyone else in the firm was surprised that their "safe" funds had lost value.

Well, they were never safe. They had been loaded up with bad mortgages and defaulted properties under a single code word, and they had no idea what that word meant.

[Elaine Meinel Supkis]

Like 'Carry trade' or 'leverage'=these words are LIES. They are disguises like the bonnet the Wolf wore when it tried to fool Little Red Riding Hood.

[blues]

Good for you DeVaul! I almost never hear of any one missing a bullet because they made the smart play. They ALWAYS head straight for where the next bullet is destined. I think they must have some incredible psychic powers in reverse to accomplish these anti-miracles.

[John]

Most are here precisely to step in front of as many bullets as possible.

At least, from what I can tell...

[DeVaul]

A miracle is probably correct. It was just dumb luck, really. My distrust of the word "financials" was the main reason for choosing the fund that did well. I did not really know much about the other things that it invested in.

My luck may run out, though. The fund is increasing its exposure to "financials". Great!

The thing that really galls me is that my co-workers lost enough money through inattention to pay off all my personal debts AND the mortgage on my house with enough left over for me to travel around the world in first class style.

I struggle to pay off tiny debts while I watch my fellow Americans burn money in their front yard just for fun or because they do not care or just because they can. I find that very frustrating.