Foreclosures: How to Survive a Market that is Up in ARMs

by: Diana Olick
Consumers Digest Magazine
December 2007 Issue

On a Sunday afternoon in late July, while most Americans were barbecuing in their back yards, nearly 1,200 bargain hunters filled an unassuming conference room at an even less assuming hotel in Sacramento, Calif. The draw: close to 200 foreclosed homes on the auction block.

Why are so many of these foreclosed homes on sale? The primary reason is adjustable-rate mortgages (ARMs), the now-infamous loans that have a low introductory rate but adjust (reset) to higher rates over a specific period of time.

The use of ARMs fueled the recent housing boom when housing prices showed annual double-digit percentage gains. But the availability of these loans also prompted many buyers to bite off more than they could chew financially.

Many borrowers either didn’t read the fine print or didn’t understand that they would have to pay higher rates when the loans reset. Now, as more borrowers find they cannot pay their monthly mortgage bills, ARMs are fueling a housing bust.

Dave Webb of Hudson & Marshall, the firm running the auction, says ARMs affect everyone, from buyers of low-end homes on up to those who have homes worth millions.

Ultimately, borrowers bought homes beyond their means. “Somebody who maybe should have been shopping for a two hundred thousand dollar home ended up buying a four hundred thousand dollar or five hundred thousand home because they had artificially low interest payments,” says Guy Cecala, publisher of Inside Mortgage Finance, a mortgage industry publication.

According to National Association of Realtors, many people spurred by ARMs bought homes based on skyrocketing price appreciation, especially in markets such as Las Vegas, Miami, San Diego and Washington, during the housing boom that lasted from March 2001 to April 2006. Many buyers were real estate investors (also called speculators) who never had any intention of living in the homes. But lenders also marketed ARMs to subprime borrowers (borrowers with poor credit) during the height of the housing boom in early 2004.

Borrowers who expected double-digit appreciation bet that when their ARM reset, they would be able to refinance because their home would have increased equity. Unfortunately, prices tumbled. According to S&P/CaseShiller, which surveys prices in the top 20 U.S. housing markets, annual home price appreciation actually fell 3.9 percent during the summer of 2007. Now, a rapidly rising number of borrowers are losing their homes.

The number of loans that went into foreclosure in the second quarter of this year was 287,612, a 57 percent increase from the second quarter of last year, according to Mortgage Bankers Association (MBA). This is just the tip of the iceberg. A California-based online foreclosure tracker, RealtyTrac, states that 925,986 foreclosure filings occurred for 573,397 properties nationwide in the first half of 2007, which is a more than 30 percent increase from the previous 6mo. period and more than 55 percent compared with the first 6 months of 2006. Some lenders make more than one filing per home because some states’ laws require filings for each stage of delinquency and foreclosure. (See “Foreclosure 101,” page 24.) And with half a trillion dollars worth of ARMs   resetting in the next year, according to financial information giant Moody’s, foreclosures are expected to increase.

It’s no surprise that auctioning off foreclosed properties has become a booming business across the country. Webb said his firm’s business has skyrocketed. “They’re just much more acceptable now,” Webb says, explaining that the sheer number of properties on the block has mitigated the stigma usually attached to repossessed homes.

Credit Crunch. No one wants foreclosure. A congressional committee report in April showed that foreclosure costs homeowners an average $7,200 in fees and expenses. It’s a major blow to a consumer’s credit rating that takes years to erase, as well as results in the loss of his/her home. Even lenders don’t want to foreclose. In a troubled housing market, expensive foreclosed homes could be on lenders’ books for months. Ultimately lenders don’t want a home; they want the interest they get from a mortgage.

So, many are now setting up programs to help borrowers avoid foreclosure and continue making payments.

One such lender is EMC Mortgage, the mortgage banking arm of Bear Steams. EMC says it can lose 40 percent of its loan value on a home when it has to foreclose. Of the $78 billion in loans it holds, 2.9 percent are in default, a percentage that is increasing.
In April, EMC launched a mortgage modification team (known as its “Mortgage Mod Squad”). EMC added 50 credit counselors to its call center and put more credit counselors in the field to contact borrowers in danger of default.

John Vella, EMC president and CEO, said borrowers have a number of options. One is reinstatement, where EMC allows a borrower to repay missed mortgage payments either in one payment or as a repayment plan-an increase to a mortgage payment over a short period. Vella says these are geared toward borrowers who “just had a blip in their income.” Another option for those still working but facing a decrease in income would be what Vella calls a re-underwrite, which is when loan terms are changed. Financial experts say these forms of forbearance, where a lender allows you to pay less or nothing as long as you make it up in a reasonable amount of time, are worth pursuing if you find you’re facing a mortgage crunch.

Of course, you can also refinance.

By October, EMC reported that it was doing 15 percent more “workouts” (loan modifications or deferred-payment plans) a month-nearly 3,000 borrowers total since the beginning of the program. Although workouts cost EMC some in the price of the loans (EMC would not disclose how much the workouts cost), EMC avoids losing borrowers’ business altogether.

Vella says that the flexibility helps EMC save money in the long run.

We think if it and programs like EMC’s keep borrowers from foreclosure and in their homes, so much the better.

Old Scams, New Blood. With so many borrowers facing rising rates, borrowers are fast becoming the target of aggressive advertising and outright scamming. Some online brokers offer help to those who have “bad credit,” promising “low cost options.” The come-ons might show low interest rates, as low as 2.9 percent, but when you read the fine print, these offers require very high credit scores (above 700), fees and large down payments.

On Sept. 11, Federal Trade Commission (FTC) warned more than 200 mortgage advertisers and media outlets about deceptive ads. “Many mortgage advertisers are making potentially deceptive claims about incredibly low rates and payments without telling consumers the whole story-for example, that these low rates and payments apply for a short period only and can go up substantially after the loan’s introductory period,” writes Lydia Pams of FTC’s Bureau of Consumer Protection. FTC says some ads are in violation of the Truth in Lending Act.
Unfortunately, as more stories about distressed borrowers hit the media, more-serious scams are increasing. “These are old scams, not so much new ones,” says Allen Fishbein, who focuses on housing for Consumer Federation of America. “Foreclosure rescue scams are popping up all over the country.”

A popular scam involves a rescue “company” offering to pay off the borrower’s unpaid debt and future mortgage payments until the borrower can recover financially. In exchange, the borrower transfers the deed to the house and continues to live in the home. He/she pays the “company” a rental fee that’s less than the mortgage payment with the understanding that as soon as the borrower can again make full mortgage payments, the “company” will return the deed. Then the scam kicks in: The scam artist holds the deed to the house, and the borrower can be evicted at a moment’s notice. “Few homeowners ever find a way to get their home back,” Fishbein says.

Short Sales. A viable option that might seem like a scam on first glance but has actually been a saving grace for many borrowers in default is the short sale. In a short sale, an investor approaches the lender and offers to buy the mortgage debt of a borrower who is at risk of going into foreclosure, typically at a discount of 30 percent or more. During the housing boom, lenders were willing to push delinquent borrowers into foreclosure because the market allowed them to sell the property at a high enough price to cover incurred expenses, says Dave Alzadeh, an investor with 1-800-CashOffer, a company that helps match investors with borrowers.

Breaking even was incentive enough to endure the foreclosure process. But as prices continue to fall in this difficult housing market, lenders are more inclined to take the short sale. Jeremy Brandt, CEO of 1-800-CashOffer, says the number of short sales is rising.

Deanna Critelli never expected to sell her home through a short sale. Critelli, a dental assistant in St. Petersburg, Fla., and her husband, Joe, who works as a maintenance technician for the city, refinanced their home in February 2004.

They wanted to consolidate loans, pay off bills and take advantage of what appeared to be a lucrative mortgage market.

“We thought we were getting a fixed thirty-year mortgage and that we would be able to pull cash out to pay credit cards,” Critelli says. The Critellis worked with Ameriquest Mortgage. Their original monthly payment was $849.

“Then we get a nice little letter telling us that it’s going from eight hundred and fifty dollars to twelve hundred dollars, and in six months, it would go up again to sixteen hundred dollars,” Critelli adds. The loan had an adjustable rate, not a fixed rate.

After an investigation by the nation’s state attorneys general, alleging that Ameriquest used deceptive practices to sell its loans, the company entered into a settlement to pay $295 million in restitution to some 725,000 borrowers. The Critellis will receive $1,200.

“What am I going to do with it?” she asks. “Am I supposed to go to the bank and say, ‘Here’s my down payment. Can I have my house back?'”

Critelli and her husband still live in their home, but they don’t own it. Eager to avoid the embarrassment of foreclosure, not to mention the financial ramifications, they sold their home in a short sale. They rent from the investor (who happens to be a neighbor), but unlike in a foreclosure rescue scam, they have a legal rental contract, which protects them from instant eviction.

The short sale is, of course, a last resort, one of a few homeowners have at their disposal. (See “Foreclosure Escape Hatch.”) Although short sales are perfectly legal, as with any home sale, it’s important to be represented by either legal counselor an adviser who is well versed in such deals and who has no financial interest in your particular deal.

There might be tax penalties if your house has depreciated significantly; so check with an accountant to see whether a short sale will benefit you.

Pulling the Trigger. Refinancing is the best option for a borrower who wants to avoid foreclosure. Moving from an ARM to a fixed-rate mortgage doesn’t affect your credit rating, and best of all, it provides a long-term solution that allows you to keep your home. But it, too, can have problems. Refinancing can be costly; closing costs of essentially repurchasing your home can run into the thousands of dollars. Also, fixed-rate mortgages typically carry higher interest rates. This means your monthly payments will be more than your original payments, although perhaps not as high as when your ARM resets.

Refinancing also has become less of an option for some because of the credit crunch that shook the mortgage market this year. As loan defaults rose, investors with mortgage-backed securities either revalued the securities or simply stopped buying them. This shift pushed mortgage lenders to tighten standards and lend to only the most credit-worthy customers. Several lenders went out of business because they could no longer finance the mortgages.

Banks have changed their guidelines, be it for a $100,000 loan or a $5 million loan, says Melissa Cohn, president of Manhattan Mortgage. A year ago, subprime borrowers could easily be approved for a mortgage because lending standards were so lax. Today, it’s not only 10 times harder for subprime borrowers, but it’s also even more difficult for those with good credit to secure a decent rate on a mortgage. Lenders now require higher credit scores, proof of assets and employment, and larger down payments.

One unexpected turn is that those with good credit are being targeted more than ever by mortgage brokers desperate for a good client. Brian and Jacqueline Zeranski have little debt. Both are employed, and they’d like to buy a larger home. After they applied for a mortgage, they were barraged with calls from dozens of lenders.

The calls were the result of what is called a trigger lead. When you apply for a mortgage loan, the credit bureaus know because a certain type of hit on your credit report tells them you’ve applied for a mortgage. Credit bureaus sell that information to mortgage brokers. Brian Zeranski says he worries about his personal information. “Any Tom, Dick or Harry can put up a sign and say, ‘I’m a mortgage company now,’ sign up with one of these credit bureaus and just start sucking in information,” he says.

Fortunately, the credit bureaus don’t provide enough information about you to enable your identity to be stolen; they get only your name, phone number and perhaps the amount and type of loan you want. But having that information can open up the possibility for trouble. If a secondary caller dangles an offer attractive enough to receive a bite, a borrower could then divulge sensitive information, such as his/her social security number.

“Now you have a large identity theft issue,” says Craig Strent of Apex Home Loans in Bethesda, Md. Strent advises consumers to ask for referrals of lenders from friends and family before applying for loans.

According to FTC, the practice of trigger leads is considered fair competition because minimal personal information is revealed. It’s the same type of information that marketers use every day to target you with junk mail or unsolicited phone calls. You can opt out of these offers by calling 888/5-OPTOUT (567-8688) or visiting optoutprescreen.com.

Political Help? Politicians have taken notice of the foreclosure situation and are beginning to act. Both the House Financial Services Committee and Senate Banking Committee are investigating mortgage lenders for aggressive and predatory lending during the height of the recent housing boom. In September, Sen. Christopher Dodd, D-Conn., said he would introduce legislation to stop predatory lending. At press time, that legislation was still pending. He also advocates a modernization of Federal Housing Authority (FHA), which backs loans under $417,000 with government insurance. Dodd and others want to increase the loan limit to allow government backing for larger loans.
Meanwhile, on Aug. 31, President Bush introduced FHA Secure, an initiative to help borrowers who have good credit scores but missed a few mortgage payments to refinance into FHA loans. Trouble is, this plan leaves out subprime borrowers who make up the bulk of those borrowers in trouble.

Others in Congress, most specifically Sen. Charles Schumer, D-N.Y., chairman of Congress’s Joint Economic Committee, are focusing on a government bailout. Schumer’s committee, which developed the April report on foreclosure costs, found that in addition to the expense incurred by the borrower, foreclosure costs a lender $50,000 in the cost of repossessing, renovating and reselling the home; local government $19,000 in legal fees; and neighbors $1,500 in property value due to having a foreclosed home in the neighborhood.

“It makes good economic sense to make sure families and neighborhoods are protected,” Schumer said during a press conference in May.

Although some of their efforts will help rein in aggressive lending in the future, we think much of the political action is happening after the fact and does little to fix the damage already inflicted by a mortgage market that got too hot too fast with too little oversight.

Opportunity Knocks? But every dark cloud has a silver lining. The general misery created by the failing housing market has opened a door for some homebuyers. Back at the foreclosed homes auction in Sacramento, Jason Lyon of Davis, Calif., and his wife hope to buy their first home. “We’re looking at this possibly being a cheaper alternative to entering into a market that’s kind of a little out of our reach right now,” Lyon says.

The Sacramento-area homes at the auction range from $100,000 to well over $500,000. Some are in a sad state of disrepair, while others are move-in ready on quiet cul-de-sacs. It’s possible to find bargains.

“We have a lot of investors here [who say] they want to buy the property, fix it up and flip it as fast as they can to try and make money,” Webb says. “We also have investors who want to buy the properties and hold them for a while.”
Buying a foreclosed home before a bank auction is riskier than buying at auction because there still can be second liens on the home that you might not know about. Once a home has reached bank auction, it has been cleared of all liens.

Bidders at foreclosure auctions are not allowed inside the homes. However, check out the properties in person. If possible, research the local market and neighborhood. Many auction firms list all of their properties with addresses on their Web sites. Other sites, such as foreclosures.com and realtytrac.com, list foreclosed properties with pictures online, accessible to anyone for a small monthly fee, roughly $50. Some properties might be empty, while others might still have the original tenants or even squatters. Getting rid of a squatter could require help from law enforcement. Buyers might find other unsavory surprises once the purchase has been made, such as leaky plumbing, filth, or stolen fixtures and appliances.

Greg Walsh of Gold Link Real Estate in northern California, who works with banks to sell foreclosed homes before they go to auction, tells clients to investigate properties thoroughly and search permits and county code enforcement. “Buying a home sight-unseen is insanity in my mind,” Walsh says’. “If you don’t do a thorough inspection on the property, you’re just gambling. You might as well go to Reno.”

Saridy Schweiger, who works in real estate, is living in a previously foreclosed home that she purchased several years ago. “You can always get stuck with a house whose former owner comes back … to abuse the house because he/she is bitter and upset at the circumstances,” Schweiger says. However, Schweiger adds that her sale went very smoothly. “Do your homework,” she says. “Your due diligence is the most important thing.” Walsh also sells foreclosed homes that have never been occupied. Investors bought these homes for the sole purpose of flipping them for a profit, a strategy that went awry when the housing market collapsed. These homes might be more attractive to a buyer because they were just an investment vehicle, not a place where residents built emotional attachments.

In California, defaults on non owner-occupied homes account for 21 percent of all prime defaults. That’s nearly twice the national average. Arizona, Florida, Nevada and the other states that drove the housing boom show even higher percentages of investor defaults.

Experts expect foreclosure numbers to rise as more ARMs reset. That will mean more opportunities for buyers and lower prices overall because these properties join an already massive inventory of unsold homes.

Not Yet Home Free. So far, no one is willing to call a bottom to this housing downturn, even though the Federal Reserve’s Sept. 18 rate cut inspired enthusiasm among financial experts. And in any case, the Fed doesn’t set mortgage interest rates. That’s done by mortgage lenders and investors on Wall Street who buy mortgage-backed securities, and rising foreclosure numbers have them feeling jittery. “The way we’ll really be able to determine that the bottom is here is that, number one, you will see inventories flatten. Number two, we’ll start to see sales go up-notice I’m saying sales, not building permits,” says Tim Sullivan of Sullivan Group Real Estate Advisors.

For investors, there are certainly great deals to be had, and they could get better as the foreclosure epidemic worsens. For borrowers looking to get out of mortgages they can’t afford, there’s no way to sugar coat it; these are hard times. Lending standards are tighter, lenders are fewer and mortgage products are more expensive. The market has returned to its more responsible pre-boom days, but unfortunately, that comes at a high price.

Diana Olick is a real estate reporter for CNBC. She also publishes Realty Check, a real estate blog on CNBC.com.