I remember a fine lady I met at eHarmony.com a few years ago telling me over the phone that foreclosures would hit California like a flood. Now that I see it before my own eyes, she was dead right. We have heard or read that California, Nevada and Florida lead the nation in the number of foreclosed homes. I remember going to Stockton with a client of mine in late September and every active listing we saw was either a short sale or an REO.

You are a businessman, a producer of goods and one of your main objectives is to grow your business. You do so by generating profits. Imagine now that some of your customers order goods from you but never make payments. You can survive for a time provided that the majority of your customers make payments on time and their timely payments guarantee you a good margin. However, if this trend continues you will definitely find yourself on the edge. Being on the edge is not the place to be for a long time as one misstep may find you in the deep abyss.

That’s what has happened to so many lenders in the past couple of years. So many of them were lending money on a highly inflated and faulty premise.

Before I get to the meat of my subject, I’d like to first of all talk about loan types. The average home in the San Francisco Bay Area where I live comes with an average price tag of $670,000. This price is way above what the average Californian can afford. To be considered a qualified applicant, one would have to earn in excess of $150,000 a year and fork out at least 10% for the down payment for a decent qualifying front-end debt to income ratio (i.e. one that does not exceed 45% of income).

Because of this low affordability index, most Californians qualify to buy a home only through exotic loan programs, most of which are predicated on their FICO scores. I am going to brief you on the different loan qualification scenarios.

This is where the borrower/buyer/trustor/mortgagor has to provide his W2s for the past 2 years, the last 2 paystubs and bank statements for the last 2 months.  Generally, this loan type offers the best rates and terms but sadly enough, this is the type of loan program that the average Californian can not afford, especially if you take into consideration the backend debt-to-income ratio (the type that includes their mortgage as well as their other debts: credit cards, car/student loans, etc.).  

The bank needs to know that the borrower is capable of making mortgage payments. If the borrower meets the lender’s underwriting guidelines and the loan in conforming, then this type of borrower can qualify for up to 100% of the loan the bank is willing to lend. Even at the time of writing this piece, right in the midst the mortgage meltdown, some lenders can lend up to 100% of the loan amount.

Next in line is what we call SIVA (stated income verified assets). Typically, this type of loan serves borrowers with good credit (FICO) scores, scores higher than 700. Besides the high FICOs, these types of borrowers must show that they have assets: i.e. bank reserves, 401K, IRA, etc. While some banks will allow 100% financing for these types of borrowers, the trend nowadays (especially after the 2007 mortgage crisis) is for such borrowers to demonstrate some ability not only to make mortgage payments after the COE (close of escrow) but prior to it as well by coming up with some sort of down payment. The lender wants to see some sort of commitment from the borrower and such commitment is demonstrated by the amount of down payment or shared risk, which in turn indicates the amount of built-in equity or risk involvement on the part of the bank. The higher such equity, the better the rates and terms the lender can give the borrower.

Generally, this is the type of loan that people with excellent FICOs qualify for. As a rule of thumb, banks do not advance 100% financing to these types of borrowers mostly because they can not verify assets. If they did, that would be very dangerous territory that would result in nefarious fraud and an avalanche of foreclosures and even a broader economic downfall. For these reasons, lenders levy unfavorable rates and terms on this type of borrowers and normally require substantial amounts of down payment as a loan qualification prerequisite.

This is the most risky mortgage loan banks can give borrowers; risky mostly because the subject borrower can not prove that he works and can not show any assets (i.e. bank reserves, 401K, IRA, etc.). For these scenarios, banks require high FICOs, high down payments, low LTVs (loan to value) and low DTIs (debt to income ratio).

The last category I’d like to discuss is hard money. Hard money is the most expensive form of financing. Not only do these lenders (can be banks or private lenders) charge their borrowers tons of points upfront, they also require a ton of equity in the subject property. Moreover, their interest rates are much higher, too. Hard money is always the last resort and is only good for people with terrible credit or an investor who wants to nail a sweet deal quickly without having to go through all the norms that conventional borrowers subject themselves to.

Many real estate gurus laud using OPM (other people’s money) instead of one’s own money. They encourage no money down for real estate deals. However, if you followed what I mentioned above then you’ve noticed that the less money a borrower puts down on a real estate transaction the worse the rates and terms.  By this token, I personally favor using cash because with cash you can have the best terms. For one thing, the buyer doesn’t have to go through the conventions that the average buyer/borrower has to go through. There are no prequalification, pre-funding or post funding conditions to meet. The transaction can close in as little as a week. Cash is king, the lingo goes, and what I have stated above are some of the reasons why this is so true. The buyer with cash in hand can get the best price and inherit a ton of equity while the seller, especially one who is very motivated, can dispose of his property fast with little or no hassle.

Now that I have discussed the various loan types, it’s appropriate to delve into the next step in my discourse: The foreclosure process.

When a buyer enters into an agreement to buy a property that is listed by a seller, the first thing they do is open escrow. The escrow or title company acts as the go-between or agent for both the buyer and the seller. The purchase contract is sent to escrow and so are the deposit check and other documents. It is also the escrow company that acts as an agent between the buyer and the lender, in cases where the purchase is financed and not paid in full in cash by the buyer. The buyer who borrows money from the lender to finance his new purchase is called a trustor. The bank or lender is the beneficiary and the title company is the trustee. The trustor authorizes the trustee to foreclose on the property, which is also the security or collateral, should he default on making mortgage payments. In California, if a trustor has not made payments on a property for 90 days, the beneficiary can instruct the trustee to foreclose. The latter has 21 days to carry out the sale, typically called a trustee sale.

Who wouldn’t be irate when the person they trusted betrayed their trust? Who would not be irritated when their debtors fail to make any payments on the money they borrowed? Now imagine you making calls to the borrower only to be ignored all the time? What if the loan you made out to the borrower cost you money in the first place?

Most mortgage loans are originated by mortgage brokers who are paid rebates for the loans they bring to banks. Internally, these banks also have employees or account executives, whom they pay commissions to originate loans. These banks have other financial obligations, just like the rest of us. They have PGE, leases and other bills to pay. Their business is to lend money and their livelihood is dependent on borrowers honoring their promises.

Foreclosure is the last resort for the lender and there are many reasons why this is so besides what I have already mentioned above. This is particularly true in a soft market where demand pales in comparison to supply, the market is deluged with inventory that would take months to deplete. Foreclosure adds more inventory to an already depressed market and makes it worse.

Foreclosure adds to a lender’s financial woes. First, the lender would have to hire a new trustee to start the foreclosure on a defaulting trustor. That costs money. Then the lender has to pay the person who helps auction off the property. Legal fees also come into play and those are not cheap.

In a soft market, not many investors show up at auctions, the result of which is the foreclosed properties become bank-owned properties (or REOs). The bank’s woes aren’t over. Now they have to hire an asset management company. This means more expenses. There are companies out there, called asset management, whose only function is to manage properties taken back by lenders. These companies aren’t cheap.

Asset management companies aren’t in the business of selling properties. Their main goal is to manage these properties. They assign real estate brokers to start the sale process. The first thing the broker has to do is give the asset manager an occupancy status, to let the asset manager know whether or not the foreclosed property is occupied. If it is occupied, the broker is encouraged to give cash to the occupant to entice the occupant to vacate the property voluntarily and timely so that the broker can prepare the property for the market. The broker is authorized to give the occupant up to 1% of the appraised value of the foreclosed property. That’s more money down the hole for the bank. The asset management companies believe that the cash for keys (CFK) may mollify the occupant and compel him to cooperate. The train of thought here is that the occupant would leave the home broom clean when he leaves.

Broom clean doesn’t mean that the subject property would not need any additional work before it is put back on the market. It may need cosmetic work. A home inspection may need to be ordered and termite clearance may be necessary as well. An appraisal will have to be ordered. These all cost money. The financial setback may be aggravated by the borrower who doesn’t accept cash but is bent on wreaking havoc on the property before he leaves. I have seen homes in bad shape! Such homes may require a lot of money to fix up or may have to be sold substantially below market. And did I mention the commission that has to be paid out to the broker? Oftentimes, that commission is at least 5% of the final purchase price.

Besides the cash for keys, the cost of eviction, the repairs and broker fees, there are holding costs associated with the default period and marketing period. What’s more, banks may be compelled to cut the prices of the properties monthly, the goal of which is to dispose of them quickly. This doesn’t bode well fiscally.

Any business with poor accounts receivable ledgers places itself under the microscope of scrutiny. Typically, banks whose portfolios are jammed with foreclosures in excess of 7% are rated poorly. Poor perception because of non-performing loans may lead a lender to the depths of financial chasm. That’s why lenders like New Century, Fremont Investment and Loans and Greenpoint are no longer around.

See why banks hate foreclosure! It’s better for them to do a short sale; at least they can count on the trustor’s cooperation at this time than when the trustor is forced to move out of the house through foreclosure