EXPERT WITNESS: A 'moving' experience: The real-estate market in the Great Recession

By Dr. John F. Sase With Gerard J. Senick "If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that grow up around them will deprive the people of all property until their children wake up homeless on the continent their Fathers conquered." -Thomas Jefferson, Third President of the United States The present economic milieu has been labeled the Global Financial Crisis of the late 2000s. More commonly, it is called "The Great Recession." Reflecting upon this second label, economists and pundits alike have compared our current fiasco to the Great Depression of the 1930s. However, this time may not end as severely because of some older federal regulations that have remained in place since the 1930s and some newer legislation that addresses specific issues within the housing/mortgage market. Let us not forget that mortgage-backed hedge funds triggered our recent calamity in 2008. With this fact in mind as well as the difficulties that many of us are having in affording our current homes or buying or selling new ones, we will explore two recently enacted laws, the Protecting Tenants at Foreclosure Act of 2009 and the Dodd-Frank Reform Act of 2010. Three years ago, Congress passed the Helping Families Save Their Homes Act of 2009 that includes Title VII, the section that we know commonly as the Protecting Tenants at Foreclosure Act (PTFA). President Obama signed the Act into law on 20 May 2009. In addition to the new language of the PTFA, this Act amended Section 8 of the United States Housing Act of 1937 that regulates Section 8 Housing. The two portions of the bill established new Federal protection for tenants living in residential units at the time that the properties go into foreclosure. The new law, which provides stronger safeguards for tenants, preempts current state statutes, except in cases where state laws provide even stronger defenses for tenants. Originally, the shield offered by the Protecting Tenants at Foreclosure Act was set to expire on 31 December 2012. However, the Dodd-Frank Wall Street Reform and Consumer Protections Act (Dodd-Frank) that passed into law on 21 July 2010 not only addressed the wide range of issues implied by its name but extended the life of the PTFA until 31 December 2014. Dodd-Frank also clarified the former Act to the effect that any lease or tenancy created prior to change of title resulting from foreclosure will be protected under the PTFA. Furthermore, Dodd-Frank provided partial clarification to earlier language that pinned PTFA protection to the "notice-of-foreclosure" date by specifying that the date represents the time at which the complete title is transferred. Generally, safeguards under the PTFA are limited to residential one- to four-family mortgage loans. However, some commercial loans also are covered in cases where a loan is made to an individual or entity to purchase or improve one- to four-family residential properties. More specifically, such commercial-purpose loans must meet the definition of a "Federally Related Mortgage Loan." Qualifying points of this definition include the facts that a loan must be made by a lender that is regulated, insured, guaranteed, or supplemented by the Federal Government; that the loan is made in conjunction by or with a Federal agency; that the loan is intended to be sold to Fannie Mae, Ginnie Mae, or Freddie Mac; that the creditor is a large investor ($1,000,000 of real-estate loans per year) under the definition of Dodd-Frank; that reverse mortgages must have been made by one of the aforementioned institutions; and that the loan is an installment contract for a one- to four-family residence. Primary Residences So, why should we care about these regulations and, more specifically, who should be concerned with them? In answering this compound question, let us consider that the American Housing Survey of 2007 reports that one-third of all housing units are rental properties (http://www.census.gov/prod/2008pubs/h150-07.pdf). Though only 30% of units in the suburbs are rentals, this figure climbs to 53% in central cities. Economists attribute the current wave of foreclosures to the bulk of Adjustable Rate Mortgages for properties that have gone underwater due to low down-payments and falling market prices. These mortgages have, or will, reset at higher interest rates, causing monthly payments to escalate. In respect to these negative-equity properties that are facing increasing monthly payments, homebuyers have the economic disincentive that may encourage them to walk away from these residential units. Given the number of foreclosures that have occurred since 2008 along with the expectation of more to come, a large segment of the population has a growing concern about this situation. In addition to tenants, other directly concerned parties include financial institutions engaged in foreclosures, owners of properties that have fallen or may fall into foreclosure, purchasers/investors of foreclosed properties, and attorneys who represent any of the above. Lest any of our readers get too upset with this foreboding reality, let us review the main points of the Protecting Tenants at Foreclosure Act and consider some of the economic ramifications entailed within it. Most of the issues of interest are addressed in Sections 702 and 703 of the Act. However, the big enchilada of the Act rests with Section 702 (a)(2)(A). The language explains that the entity that initiates the foreclosure-usually a bank that is holding the mortgage-or the person to whom it sells the repossessed property must occupy the unit as a "Primary Residence." This residency requirement constitutes the primary condition necessary for a lease to be voided and a notice to quit to be served. Without entering into the debate about corporate personhood under the Fourteenth Amendment, it would appear quite difficult for a bank to occupy a residential housing unit as its primary residence. Therefore, the practical matter requires that the property be sold after foreclosure to a purchaser who will occupy the residential unit. Before purchasers can hope to occupy properties themselves, a number of legal and economic hurdles must be jumped. The process of foreclosure is not an instantaneous one. On the contrary, the actual timeline for foreclosures has lengthened in recent years due to both an overburdened court system and to the glut of repossessed homes lingering on the market. Let us walk briefly along this timeline. In order for the foreclosure process to commence, the homebuyer must fall a few months behind in his/her monthly payments and the lender must respond with Acceleration Procedures. In recent years, though, we have seen that banks do not want to take back the homes and more frequently will seek alternative remedies. The rush to foreclosure has been due largely to the interests of mortgage servicers. When a property goes into foreclosure, servicers charge additional fees to the holder of the mortgage note. Therefore, these servicers have an economic motivation to allow homes to move into foreclosure and to keep them in a state of limbo for as long as possible. If and when the home is finally resold, the new mortgage becomes fresh meat for the servicing industry. Sometimes, delays in the foreclosure process can be attributed to servicers dragging their heels in order to extend the period. They do so in an attempt to maximize the service fees collected. Let us assume that a residential property in foreclosure goes to Sheriff's Sale, an auction in which the property is sold to the highest bidder. In many states, the lender may need to "advertise" for a month or more in advance before this sale can occur. When the sale finally takes place, the lender most likely will submit the highest bid and take possession of the Sheriff's Deed. At this point, the redemption clock starts ticking and the homebuyer may have half a year or more to redeem the property at the stated redemption price. The length of this time factor creates an economic deterrent for the bidders at the sale. A winning bid ties up working capital unproductively throughout the redemption period, a time during which the homebuyer actually may redeem the property. Often, the redemption price is low enough to allow the homebuyer to sell the property at a going market price and to submit the redemption payment concurrently. Furthermore, if a deal is on the table toward the end of the redemption period, then lenders often are willing to extend this period for a couple of weeks or more until the sale closes. Why? The banks do not want to take possession of more properties that will bloat their balance sheets. In a case in which the homebuyer does not redeem the property, it reverts to the bank. If the occupying tenant still has a valid lease at the conclusion of the foreclosure proceedings, the bank still may not terminate tenancy due to the "primary-residence" requirement. However, the tenant must continue to make rent payments and to comply with other conditions of the lease. The mortgage-holder now attempts to sell the property at market value to get it off of the books. A repossessed property often is bundled together with a hundred others and assigned to an independent real-estate broker who must make a "clean sale" of 80% of the properties in order to fulfill the assignment contract. The other 20% of houses may be left vacant and unmarketed. The broker then can "cherry pick" these properties. This is done by having an associate of the broker acquire these properties at a later date when the prices have fallen significantly. One beneficial economic factor on the side of the tenant is that an occupied and maintained house generally commands a higher market value than a property that is uninhabited. However, at the point that the bank conveys the title to the new buyer, the "successor of interest" must provide the tenant with a 90-day notice to vacate. Since the purchaser must wait three months to occupy the house as a primary residence, s/he may be faced with the predicament of selling the present home while gaining enough time to vacate in order to ride out the 90-day hiatus period. Due to the additional costs involved with this scenario, another economic deterrent to potential buyers is created by this condition. Furthermore, the primary-residency requirement may encourage fraudulent action on the part of buyers. Occasionally, a purchaser may establish "mock" residency in order to take possession of a property. The Three Bears on Wall Street Considering the real-estate market purely from a business perspective, the primary issue with real estate is management of inventory. By the simple law of supply and demand, having too many homes available on the market at any given time translates into an increase in supply that subsequently pushes home prices downward. Simultaneously, lenders may remain wary about initiating a mortgage for a residence whose market value is stagnating or, worse yet, falling. Unless the homebuyer contributes a significant margin and maintains it as a hedge against a potential drop in prices, the lender may be faced with the undesirable decision of making a "margin call" on the asset. If this call was on a share of stock, the reversion would be simple. However, in the case of real property, the margin call implies initiating another foreclosure. Therefore, banks have the economic incentive to maintain the status quo while the homebuyer goes underwater but continues to make monthly payments. The resulting bearish position on the part of lenders translates into a stagnant or falling demand for properties, one that pulls home prices downward. Therefore, such a round of events place banks and associated lenders in a quandary because these entities have substantial control over both supply and demand in the housing market. In an economy where the supply of housing is tight and the financeable demand is rising, banks indeed would find themselves in an enviable position. However, in the current market, the opposite holds true. As the three bears in the "Goldilocks" story might query, "Is market regulation too hot, is market regulation too cold, or is it just right?" Does a point of regulatory optimality even exist? Thus, the present situation places banks in another Donnybrook in respect to regulation. Without the Protecting Tenants at Foreclosure and the Dodd-Franks Acts, the markets may have corrected themselves. On the other hand, these Acts may have had, and continue to have, the ability to prevent a market free-fall in which the supply of foreclosed homes severely gluts the market while financeable demand plummets. An episode like this resembles the decline of the stock market from its nosebleed high in October 1929 to its abysmal low in July 1932. Interestingly, this period occurred during a time in which there was little market regulation. Prepare to Bounce All of us hope that the real-estate market already is near bottom. However, based upon multiple economic forecasts, the smart money tells us that the actual bounce will not occur until 2014. During the next year and a half, what will attorneys deal with in the real-estate market, both professionally and as investors? The Protecting Tenants at Foreclosure Act of 2009 and the Dodd-Frank Reform Act of 2010 appear to have slowed down the rate of market deterioration by keeping transitional rental demand under control. Although market deterioration is slowing, the downward ratcheting still exists in most parts of the country. Generally, normal sales are taking longer to transpire while short sales are taking a lot longer, if indeed they are occurring at all. In their book "Security Analysis" (McGraw-Hill, 1934), Columbia University professors Benjamin Graham and David Dodd explain that the prices of assets fall to their "Firm Foundation Value" following a speculative peak. We might say that Firm Foundation Value is the inherent value that an asset has in even the worst of times. This value marks the point at which the market will bounce before making a sustained long-term recovery. Like many of us, attorneys depend on the collateral value of the equity in their primary residences and investment properties to finance and sustain their professional practices. The Acts of 2009 and 2010 have helped to slow down the churn in the real-estate market. In turn, this has bought us time to make further stabilizing adjustments. As a result, there is no need to panic. However, investors and homeowners need to be aware of the need to maintain sufficient equity in order to ride out the remainder of the storm. Attorneys practicing real-estate law or encountering aspects related to real estate in other cases can expect this climate to continue for a while. Both plaintiff and defense clients depend upon real-estate equity in their own financial profiles. The conditions in the market will affect the judgment in cases as well as the ability to collect on these judgments. The Acts have given attorneys and clients alike a window of time in which to firm up an equity base that will help them to withstand the vagaries of the market. For this, we are grateful. ---------- Dr. John F. Sase of SASE Associates, Economic Consulting and Research, earned his MBA at the University of Detroit and his Ph.D. in Economics at Wayne State University. He is a graduated of the University of Detroit Jesuit High School. Dr. Sase can be reached at (248) 569-5228 and by e-mail at drjohn@saseassociates.com. Gerard J. Senick is a freelance writer, editor, and musician. He earned his degree in English at the University of Detroit and was a Supervisory Editor at Gale Research Company (now Cengage) for more than 20 years. Currently, he edits books for publication and gives seminars on writing. Mr. Senick can be reached at (313) 342-4048 and by e-mail at gary@senick-editing.com.You can find some of his writing tips at www.YouTube.com/SenickEditing. Published: Wed, Mar 21, 2012