If you were one of the many who bought your home at or near the top of the market in 2006 (and even in the 2 years prior), and still find yourself making that monthly payment, but questioning your financial sanity for continuing to do so, you may be a candidate for efficient breach.
WHAT IS EFFICIENT BREACH?
Efficient breach is really a time-honored principle in contract law where one or the other party to a contract determines that it is no longer in his/her interest to continue to honor the terms of a deal previously struck with the other party. The analysis of the contract breach then moves to what remedy is available to the non-breaching party; and, the defenses available to the party who has breached. In the context of stopping payment on your home mortgage to the bank, some commentators have termed this strategy ‘strategic default.’ However, that really is a misnomer, since, ‘default,’ interpreted literally in this context, occurs when one misses that first payment to the bank. ‘Efficient breach,’ on the other hand, embodies the notion and recognition that a comprehensive, and unalterable change will take place between the positions of the parties as to that prior contractual relationship.
WHAT DO THE NUMBERS TELL YOU?
It’s clear if you haven’t the money in the first instance, i.e. you aren’t paying other bills or are limiting your expenditures in every other area of your life—food, clothing, car, credit cards, health insurance, etc., in order to make that next monthly payment, that you are hemorrhaging to death. The only question is: when do you bleed out? But, what if you aren’t in those dire straits, and, you simply are not able to save and get ahead, inasmuch as the banker’s position is intractable, i.e. ‘No loan modification for you; we are happy to continue taking your monthly payments on time,’ as has been the case. And so, why would the lender modify the terms of your loan, given your good pay history? Here is the formula for you to work through to determine if it makes more sense to rent rather than own a home:
Costs to own: [Costs of mortgage(s) monthly, to include monthly impounds for property ins. & property taxes + HOA dues (not deductible)] X 12] – [annual tax benefit to own = your combined state & federal tax rate X (allowed itemized deductions of annual mortgage interest & annual property taxes)]
Costs to rent: Annual cost to rent a comparable property + personal property insurance reduced by (1- your combined federal and state tax rate) X (itemized deductions of annual mortgage interest & annual property taxes–which is the out of pocket $ you spend on mortgage interest and taxes which you can’t deduct, which stays in your pocket] reduced further only, if you are contemplating buying, by the opportunity cost of alternatively investing any required down payment [here, this could range conservatively on the low end, from that principal amount X a market rate of interest on some cash-bearing instrument, to an expected capital appreciation component (“G”) + dividend (“D”) on an investment of that same down payment in a mutual, or index fund or a particular stock of some company. (And surely, there can be tax implications here, current, deferred, or none (assuming a Roth IRA is the investment vehicle used); but, this goes beyond the scope of this article.)].
Do the hard numbers analysis– no throwing darts here anymore. If we assume, conservatively, that property prices can only simply go sideways and not down any further (and that is a big assumption—see below), one is likely to be better off renting, rather than buying. Only in an environment where one is assured of rising property values over the long term, is one better off owning.
WHAT ARE THE PROSPECTS FOR FUTURE PROPERTY APPRECIATION– WILL YOUR HOUSE EVER GET BACK TO YOUR ORIGINAL PURCHASE PRICE?
In that regard, there was an article written by Peter Hong—LA Times, 09/27/09, which I would commend to you to read (http://articles.latimes.com/2009/sep/27/business/fi-cover-housing27), which also depicts by way of a price chart, the multi-generational bubble in RE prices, adjusted for inflation, we have experienced going back to pre-WWII. The last leg of the move constituted an unsustainable parabolic progression; and hence, the ultimate expected crash in RE prices. For example, in the 5 yrs. leading up to the top in RE prices in Southern California, houses appreciated at a 19.8% compounded rate of growth. That took a $1 and turned it into $2.47. So, if a house had a base price of $225,000 in 2002, by the end of 2006, it was ‘worth’ $555,222.
Of course, reality has since set in; and, prices have dropped nationally on average 30% from the top and as much as 60% + in some markets. To further emphasize this multi-generational price spike, I would refer you to an article written by analyst Henry Blodgett—Business Insider, ‘The Housing Chart That’s Worth a Thousand Words,’ 02/21/09, (http://www.businessinsider.com/the-housing-chart-thats-worth-1000-words-2009-2), wherein he cites to the Case-Shiller Home Price index, which goes back to 1890, with that initial benchmark year represented at 100 on the chart. The reference numbers on the chart are inflation-adjusted.
What you see is that we have, and are, experiencing a return back to earth of that rocket trajectory— a regression or reversion of home prices back to the mean or average rate of growth [regression to the mean --a well-grounded mathematical concept]. Moreover, RE prices may very well overshoot that line of progression/the average rate of appreciation, as markets often do. Why? Credit has been damaged across the board–people can’t buy even if they wanted to— even if it made sense financially. And mortgage lenders have “toughen[ed] their standards for Federal Housing Administration-insured loans beyond what the agency itself requires. Mortgage lenders including Wells Fargo & Co. and Bank of America Corp., the two largest, have raised the minimum credit score on FHA-insured loans that they will buy to 640 from 620…The higher hurdles for FHA loans, used in about a fifth of U.S. home purchases, add to challenges for a housing market already struggling with record-low sales and surging foreclosures.” (http://www.bloomberg.com/news/2010-11-17/home-ownership-gets-harder-for-americans-as-lenders-restrict-fha-mortgages.html)
Additionally, what no one has written about is the baby-boomer phenomenon–the effect boomers had on rising real estate prices on the way up; and, the effect they will have on prices on the way down. [For an in depth analysis: http://rjzlaw2.com/the-baby-boomer-effect-on-real-estate-prices-going-forward/] On the whole though, generally, they owned their homes — no fancy interest-only, no-doc, stated-income, or neg-am loans. So, they have not been compelled to sell in this crash. But historically, at that age, people retire and then sell to move into smaller homes or apartments; move back to where they grew up; go into retirement homes, etc. That wave of selling has yet to hit the RE market.
According to the U.S. Census Bureau, the baby boomer generation consists of people born between 1946 and 1964. Thus, the first baby boomers will turn 65 starting in 2011. As of 2010, the estimated number of Americans 65 and older is approximately 40.2 million; and, the size of that population demographic is projected to increase to 88.5 million over the next four decades. [“The Next Four Decades--The Older Population in the United States: 2010 to 2050-- Population Estimates and Projections” (May 2010), authored by Grayson K. Vincent and Victoria A. Velkoff.] (http://www.census.gov/prod/2010pubs/p25-1138.pdf)
THE HISTORICAL RATE OF HOME APPRECIATION
And so, what have houses appreciated, adjusted for inflation, and what is that average rate of appreciation going all the way back to 1890? “Using data compiled by Shiller (2005), the real rise in home values between 1890 and 2005 has been 86.3%, with roughly 75 percentage points of the increase occurring [just] since 1995. Over the 115 years, this [constituted] an annual real appreciation rate of 0.54%, or approximately 3.25% per year nominally.” (Emphasis added.) Freddie Mac Working Paper #05-02, ‘Reversion to the Mean…etc.’, fn. 5, Amy Crews Cutts, Frank E. Nothaft, Nov. 2005. (http://www.freddiemac.com/news/pdf/fmwp_0511_housingpricegrowth.pdf)
Thus, rather than looking through a ‘stand of only 5 trees in the forest’ – the 5 yrs. preceding the once in a lifetime run-up of real estate prices between 2002-2006, the principle of regression to the mean tells us ‘from up in a plane or helicopter looking over the whole forest’ – and going back 115 years, one can expect RE prices over the long term to appreciate at a real rate of about 1/2% per year, after taking inflation into account. That does not bode well for anyone who bought anywhere near the highs between 2004-2006. In other words, the chances of your home price getting back to where you bought it are slim and none. That is the stark reality—with 115 years of data behind it.
WHY LOAN MODIFICATIONS, EVEN IF CONSIDERED, CONSTITUTE NOTHING MORE THAN THE USED CAR SALESMAN’S PITCH, ‘WHAT KIND OF MONTHLY PAYMENT WERE YOU LOOKING TO MAKE?’
As you may already know, loan modifications are not being extended on the whole by the banks. And even if they are being considered, banks are not reducing principal balances on anyone’s mortgage. Why? They have capital reserve requirements. And if the bankers were to reduce the principal owed on your loan, they would have to take an equal hit to the owner’s equity section of their balance sheet. [Never mind that your loan was acquired for pennies on the dollar, or even paper (stock for stock), from Countrywide, Washington Mutual, Wachovia, or Bear Stearns, as they each washed out, with their respective shareholders taking the hit to their stock holdings before the fact of the takeover, by the survivors, Bank of America, JP Morgan Chase, and Wells Fargo. But I digress.]
Your mortgage, while a liability on your personal balance sheet, is an asset on the bank’s. Recently, the Committee on Banking Supervision, central bankers from around the world, met to decide on changes in regulations governing how much capital should be held by banks on their balance sheets. They set the minimum amount of ‘high quality’ capital that a bank has to have on its books for every dollar of loans that is in risk of not being paid back. High quality capital is defined to include the amount of money a bank has collected from selling common stock, plus lifetime net earnings, less the cumulative amounts the bank has paid out in dividends. Under previous accords, banks had to have $2 of high quality capital for every $100 in risky loans and assets. LA Times 09/11/10 (http://articles.latimes.com/2010/sep/11/business/la-fi-bank-capital-20100911) “Now, the mandatory reserve known as Tier 1 capital would rise from 4 percent to 4.5 percent by 2013 and reach 6 percent in 2019. In addition, banks would be required to keep an emergency reserve, or “conservation buffer,” of 2.5 percent. In total, the amount of rock-solid reserves each bank is expected to have will be 8.5 percent of its balance sheet [by] the end of the decade.” LA Times 09/13/10 (http://www.latimes.com/sns-ap-eu-central-banks-basel-rules,0,6695307.story?page=1) So, that’s $8.50 of these assets for every $100 in loans. Thus, you can see how the banks have no interest in reducing principal on your loan, no matter how much they paid for it from one of the failed predecessor entities. Bottom line: the banks aren’t going to reduce principal on your loan.
And so, what they, and you, are left to tinker with, is massaging the interest rate on your mortgage; hence, the ‘What kind of payment can you afford’ metaphor. And maybe they even extend the term of years to pay-off on the loan, as well. But this doesn’t take into account the market value of the ‘car.’ That is not how one should buy a ‘car;’ nor, seek to ostensibly re-fi a house.
WHAT ARE THE TAX IMPLICATIONS FOR WALKING AWAY FROM YOUR MORTGAGE?
Normally, debts that are forgiven constitute taxable income, reportable to the IRS vis a vis a 1099 as ‘income.’ Not now, with regard to mortgage debt relative to your principal residence. “[U]nder the Mortgage Forgiveness Debt Relief Act of 2007, enacted Dec. 20, taxpayers may exclude debt forgiven on their principal residence if the balance of their loan was $2 million or less. The limit is $1 million for a married person filing a separate return…The new law applies to debt forgiven in 2007, 2008, or 2009. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may qualify for this relief… Note: Legislation enacted in October 2008 extended this relief through 2012. Thus this relief now applies to debt forgiven in calendar years 2007 through 2012.” (http://www.irs.gov/irs/article/0,,id=179073,00.html)
WHAT CAN I DO FOR YOU?
My objective, as an attorney, is to apply maximum leverage to the lender(s), which you cannot do on your own, to get you out from under the legal obligation on your promissory note(s), without filing bankruptcy, without undergoing a foreclosure; and, while minimizing damage to your credit. At the same time, should you decide to stay in the house, to change your status to one of renter with the lender, and recognize immediate savings for you on the differential between that fair rate and the mortgage payment you currently pay.
© 2010 Riordan J. Zavala, Esq. All rights reserved.