Generally, when a family is defaults on their mortgage, they need to find a new place to live. But a non-profit financial institution, Boston Community Capital, is trying to change that. The lender, featured in an article by the New York Times today, purchases foreclosed homes at auction and sells or rents them back to their former occupants. It's an interesting idea to be sure. It also raises some questions.
First, here's a little more explanation from the Times on how the program worked for Jane Petion, who defaulted on a home with a $400,000 mortgage balance:
In December Ms. Petion signed a new mortgage on her house for $250,000, with monthly payments of less than half the previous level. She and her husband now have a mortgage they can afford in a neighborhood that benefits from the stability they provide. A nonprofit lender made the deal possible by buying the house from her original mortgage company and selling it to her for 25 percent more than its purchase price -- a gain to hedge against future defaults.
Ripe for Principal Reduction?
My first observation here is -- why didn't the bank consider principal reduction in this case? The bank sold the home at auction for $200,000. The former homeowner then bought the home again for $250,000 from the non-profit lender. Wouldn't the bank have been a lot better off if it had just re-written the principal balance to $250,000 instead of foreclosing? Its loss would have been $50,000 less. It also wouldn't have had to pay the significant costs associated with foreclosure. I'm a little bit confused why there needs to be a non-profit lender out there to do what seems rational for profit-driven banks to do.
Credit concerns might be one potential reason why banks might not be interested in doing what this non-profit lender will. The bank may be convinced that the borrower will just re-default. They may adhere to the old saying, "Fool me once, shame on you; fool me twice, shame on me." It may be a punitive tactic where banks don't want to allow a defaulted homeowner remaining in the home. They might not like the moral hazard involved.
And that raises a question: should Boston Community Capital be worried about the credit histories of these individuals? Presumably, after foreclosure, these borrowers have very poor credit scores. The article explains that they create the new mortgage at some premium over the auction price to hedge the credit risk involved.
I wonder what type of underwriting goes on at a non-profit with this mission. In fact, many of these borrowers may have relatively good credit histories other than the foreclosure. For some time, prime borrowers have been dominating the thousands of homeowners defaulting. Particularly when that's the case, it could be a very smart bet to sell these individuals their home back at a price they can afford.
But What About Strategic Defaults?
The biggest problem I see here is what to do about strategic defaults. These involve people who willingly allow their home to go into foreclosure, even though they can afford to continue paying. They know the home is now valued less than the mortgage, so they don't see the point in continuing to pay.
On paper, this would appear to sort of be the perfect type of borrower from the non-profit firm's perspective. The only reason they aren't paying their mortgage is because its price is too high -- not because they can't. After buying this person's home at auction, he would be a very safe bet to pay the reduced mortgage price. Yet, presumably, this non-profit is out to help the kind of homeowner who is legitimately struggling. This presents an interesting sort of tension where the safer the borrower, the less you would probably want to help them.
I'll be interested to see how this program ends up doing. Since so many of the struggling homeowners defaulting these days likely had a relatively clean credit profile up to now, it could actually go fairly well. I just hope the company isn't also lumping strategic defaults in with families who were trying hard to live up to their mortgage obligation, but fell victim to hard times or tricky mortgage brokers.