White Knight Holdings, LLC

We are all only too aware of the massive changes that are occurring in the real estate market nationwide, but it is worth thinking what the short, medium and long term effects will be, and positioning our businesses to adjust accordingly.  In the short term, we are already seeing the impact: more foreclosures, more short sales, more bankruptcies, fewer real estate agent home sales, declining house building starts, and tighter mortgage criteria.  All in all, a pretty bleak picture.

Does the medium term future look any better?  Not much, is the answer.  The dynamics of the market must change.  As people sell their homes as short sales or lose them to foreclosure, they are going to find it next to impossible to qualify for another loan in the near future; particularly with the stricter credit criteria in place.  That means that the majority of people are going to end up in the rental market, or looking to qualify for rent-to-own homes.  This will obviously increase the attractiveness of the rental market, perhaps overcoming most investors’ reluctance to become landlords.  Specifically, the rent-to-own segment is likely to grow substantially, as the supply side will increase at the same time as the demand side.  This is because the supply side is made up of the properties bought as short sales, preforeclosures or REOs, and investors unable to sell them for an acceptable profit will take advantage of the market demand for rent-to-owns.  Ironically, the same people who are losing their homes and unwittingly supplying them to investors, are the ones who will be renting them (albeit different ones).

So, does the picture change in the longer term?  Yes, it does.  The banks are in business to lend money.  It’s no good making the credit criteria so tight that very few people qualify for loans - the banks would be out of business.  So they will inevitably develop new products that will allow more people to buy houses again, although preferably, not by relaxing the criteria to the previous lax standards where anyone who could fog a mirror was approved.  I don’t pretend to know what the new products will look like, or how they will protect the banks’ investment; perhaps with additional insurance?  There is no doubt that lending to more people, with lower credit scores, will increase the risk of default, but equally, given that banks have to lend money, so they will work out a solution, given time.  How long?  As long as it takes for the current mortgage squeeze to hurt their profits - the only thing that motivates banks!

Unless you have been living in a cave, you will have been bombarded by the political statements of both parties for the last few months. Without getting into any partisan arguments, I wondered which party, and which candidate, is going to be better for the housing market in general, and foreclosures in particular?

Considering the three main candidates; Clinton, Obama, and McCain, none of them have really had a great deal to say on the matter. Of course, Clinton is fighting for her life, so her focus is mainly on survival to the next round, but in the past she did weigh in on the matter.

CLINTON: If I recall correctly, she proposed a 90-day cooling off period, and a 5-year freeze on the present adjustable mortgage interest rates. I fail to see how those suggestions are going to help anyone? If they can’t afford their payments now, how likely is it that they will be able to in 90 days? The chances are they will just be 90 days deeper in debt. And a freeze on interest rates would be likely to cause damage to the housing market, as rates for new loans would increase to offset the money that would be lost when the institutional investors moved away from the housing lenders to more lucrative markets.

OBAMA: Although he has also supported the idea of a moratorium, he has made proposals that go much further than that, and that may stand a better chance of helping to improve the situation. Obama has proposed a tax credit to be given to struggling homeowners covering 10% of the interest on their mortgages each year, and has also proposed offering $10 billion in bonds to help the middle-class to avoid foreclosures. Backed up with tougher penalties for fraudulent lenders and brokers, and the introduction of a standardized scoring system to reflect the would-be borrowers’ ability to meet their obligations, these proposals seem more practical and substantial.

McCAIN: From the few mentions he has made on the topic, (as he himself said, economics not being his strong point) it seems that he believes “tough love” will put things right. He started out by opposing any intervention in the housing market crisis, and was happy to let things work themselves out. He said he was: “committed to the principle that it is not the duty of government to bail out and reward those who act irresponsibly, whether they are big banks or small borrowers…” But, now that he needs to woo more support, he has changed his stance somewhat, and suggested a plan to support to homeowners who took out sub-prime mortgages after 2005 for homes that are their main residence. They would have to prove they were creditworthy when they took out the loan, and would then qualify to have their loan retired and replaced with a new 30-year fixed rate loan. This is another case of “too little, too late”.

In summary, it looks as Obama has the best ideas to offer in terms of relief, although even his suggestions would not be able to reverse the current situation. But truthfully, this major correction in the market was needed. Admittedly, it’s painful, but once it’s over, we can get back to a normal situation where houses sell for realistic values when compared to incomes, and loans are granted on the ability of the borrower to repay them from income, not by repeatedly refinancing, putting off the inevitable. The key is to provide as much assistance as we can to those people who are genuinely suffering and help them to get out of their unfortunate situation and start looking to the future again.

Well at first glance it would seem to be…but look at the bigger picture. The total number of home sales reported in April was 526,000, up 3.3% from the adjusted March 2008 figure, but that was a massive 42% lower than April 2007.

That slight increase is not enough to halt the downward trend and even the National Association of Home Builders (usually optimistic on home sales) confirmed that lower prices are still on the horizon. They also pointed out that about three out of four builders reported that they had to incentivize buyers by offering inducements such as free upgrades or the payment of the buyers’ closing costs. That is in line with our experience locally, where almost every sale, whether of a new house or a resale, includes between $5,000 and $10,000 as a buyer’s subsidy.

Other house sales reports, such as that by the Office of Federal Housing Enterprise Oversight, also said that “the prices of homes sold in the first quarter of 2008 posted a record decline” (3.1% from the first quarter of 2007). This was the largest decline reported since the agency began keeping records in 1991.

And just to add fuel to the fire, Peter Schiff, President of Euro Pacific Capital said “It’s not going to be the largest decline on record for long, prices are going to keep falling until we get to the equilibrium, which is much, much lower. This is only the beginning.”

With 17.77 million houses standing vacant in America (Census Bureau, 1st Quarter, 2008), the problem is not supply - it’s demand. People are not going to buy a house today if they think prices are still going lower and, the more the vacant stock increases, the larger the pool from which the buyers can choose, and therefore the greater the downward pressure on prices.

So, although any increase in home sales is to be welcomed, in reality this was just a blip in the figures. We are still going to see prices declining for the rest of this year, and probably much of 2009. The impact on the economy is going to be severe, as more people lose their homes, fewer people can afford to buy their own homes, and mortgage companies continue to apply more stringent lending criteria. Ultimately, prices will reach a level where people will start to buy again. Where is that level? Nobody knows. It is impossible to predict the bottom of this market, just as it is impossible to pick the bottoms in the stock market. But one thing is for sure, the bottom is still quite a way off.

The US Census Bureau today released the data for new house sales for April 2008. These figures are always interesting and today was no exception. One of the most interesting figures was the number of months it took to sell houses, after they were completed. That number has risen to over 8 months, compared to 3 to 4 months for most of 2006 and 2007.

The report also shows that the seasonally adjusted estimate of new houses for sale at the end of April was 456,000. This represents a supply of 10.6 months at the current sales rate. Again, the average for the 2006 years was been nearer 4 months, and for 2007 was about 6 months - showing the dramatic slowdown in the market.

The number of homes facing foreclosure was up 65 percent compared to April 2007 and that is contributing to a deepening slide in home values, according to a report published by the Irvine, California-based research company, RealtyTrac.

Foreclosure filings have increased from a year earlier in all but eight states, and now 1 in every 519 households in America  received a foreclosure filing in April.  The greatest impact is seen in Southern California (up 112% from last year), as well as the Las Vegas area, South Florida and parts of Arizona.  Some of the other states with high foreclosure rates are Colorado, Maryland, Georgia, Ohio, Michigan and Massachusetts.

RealtyTrac goes on to say that more than 1 million home foreclosures are forecast for 2008.

Of course, as more properties are foreclosed on, they add to the inventory of homes on the market and will  inevitably drag down home prices.  It looks as though we’re in for a long ride!

There is a lot of debate about the effect on homeowners of going into foreclosure, or agreeing a “short sale”, or loan forbearance with their lender.

The best sources for accurate information are an appropriately qualified lawyer or the IRS itself (www.irs.gov) but as a preliminary guide, the following extract from the IRS site gives this basic information.

The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief.

This provision applies to debt forgiven in 2007, 2008 or 2009. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion doesn’t apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

(Source: IRS Newsroom page)

The interpretation of this is that, as long as the loan that is forgiven was solely for the purpose of purchasing or enhancing the primary residence, the forgiven debt is not taxable in 2007. 2008 and 2009. If, on the other hand, the home was a vacation or investment property, or was refinanced to pay for a new car or college fees, the debt may well be taxable.

In practice, when a homeowner is facing foreclosure but has the opportunity to negotiate a short sale or other debt forgiveness, the question of whether the transaction will attract tax is probably irrelevant to them - the tax position is likely to be the same whether a short sale is effected or the property goes into foreclosure, but at least with the former route there is less damage to the homeowner’s credit score and it will recover more quickly.

The term “short sale” in real estate should not be confused with the same term applied to the stock market.  In the latter case, a short sale means selling something you don’t own, with the intention of buying it later at a lower price, and making a profit from the difference.  In real estate, in simple terms, a short sale is when the lender accepts a purchase price of less than is owed on a property.  For example, if the homeowner owes $350,000 on his mortgage, and the property is now valued at $310,000, the lender may accept an offer somewhere between, say, $220,000 and $290,000.   The remaining debt would then be “forgiven”.

Until the Mortgage Relief Act was passed in December 2007, the lender would then have had the option, in most states, of claiming a deficiency judgment against the homeowner for the difference between the amount owed and the selling price.  That is generally no longer the case, as long as certain criteria are met: the main ones being that the property must be the homeowner’s primary residence and the loan and any subsequent refinancing must be for the house purchase and improvements only.

There are a number of conditions that lenders will look for before accepting a short sale.  One is that the property must have lost value in the market and/or the financial circumstances of the seller have changed significantly for the worse.  Also, the homeowner must not receive any money whatsoever from the transaction.  And it is important that the homeowner can provide proof that they can no longer afford to make payments on the mortgage.  This means providing an income and expense statement, copies of pay stubs, W2s, bank statements and other financial documents.  Just as they had to prove they could afford the mortgage in the first place, now they have to prove they can’t!

It is also usually necessary to have had the house listed with a real estate agent, to demonstrate the current market value.  If an offer has been received, it is submitted with the rest of the documents needed for the lender to consider a short sale.

Although most lenders will consider short sales in cases of genuine hardship, there are a few who will not.  Hopefully, they will relax their rules in the future, to avoid causing further hardship and stress to people who find themselves in the unfortunate position of being “upside down” on their mortgage.