Part I

Banks to unleash flood of REOs

Part I: Impact on inventories lags foreclosures

Inventories of unsold homes are likely to swell in coming months as lenders begin to push a growing backlog of repossessed homes up for sale -- often in communities already awash in distressed properties.

While builders have cut back drastically on the production of new homes (see story), it's likely lenders will soon be putting pressure on inventories even if they succeed in efforts to keep more troubled borrowers in their homes rather than foreclosing on them.

Because it can take weeks or months for lenders to put repossessed homes on the market, the impact of real estate-owned (REO) properties on inventories lags behind foreclosures. Government efforts to recapitalize banks through the Troubled Asset Relief Program (TARP) and other bailout measures may also have taken some of the heat off of lenders to unload REO properties at fire-sale prices.

But with the emphasis of TARP and other government relief efforts now expected to shift to creating jobs, helping troubled borrowers avoid foreclosure and providing incentives for home buyers (see story), lenders could soon unleash a torrent of real-estate owned, or "REO" properties -- even in markets already flooded with an oversupply of homes for sale.

"It's almost like a tsunami -- you can see it coming and you know it's going to hit but you cant get out of the way," said Ann Stickel, vice president of affiliated services with Sarasota, Fla.-based brokerage Michael Saunders and Co.

The value of REO property on the books of FDIC-insured banks at the end of the third quarter surged 21 percent from the previous quarter, to $23 billion. That total -- which includes single-family to four-family homes valued at $11.5 billion and another $1.5 billion in property purchased with FHA-backed loans securitized by Ginnie Mae -- represents a 134 percent increase from a year ago, according to the latest quarterly report from the Federal Deposit Insurance Corp.

Repossessions by Fannie Mae and Freddie Mac grew by nearly 25 percent from the second quarter to the third quarter of 2008, hitting 15,196 homes, according to a recent foreclosure prevention report by the Federal Housing Finance Agency (FHFA). With Fannie and Freddie repossessing homes faster than they could sell them, the companies were left with 95,553 REO properties to dispose of at the end of September -- a 25.5 percent increase in just three months.

Not all of those homes are in areas hard-hit by speculation and subprime lending, either. About six out of 10 homes in Fannie and Freddie's REO inventory were purchased with prime loans available only to borrowers with good credit.

Fannie and Freddie both stopped foreclosing on loans they own over the holidays (Fannie's moratorium is in effect throughout the end of January -- see story) and several states have passed legislation that's intended to slow down the foreclosure process. Lenders are also stepping up their efforts to do workouts and loan modifications with troubled borrowers, rather than foreclosing on them.

But those measures may only be slowing down the foreclosure process for many borrower, and the downturn in the economy and rising job losses have many convinced that foreclosure filings will continue to rise.

President Obama is promising Congress that $50 billion to $100 billion of the next round of TARP money will be committed to foreclosure-relief programs aimed at reducing mortgage payments for troubled borrowers, and broadening the scope of FHA's little-used "Hope for Homeowners" refinance program.

With more than half of the loans modified by lenders in the first half of 2008 already in default again (see story), it's clear that lenders will have to take the more drastic step of reducing the principal balance to make loan mods work, said Sean O'Toole, founder and CEO of ForeclosureRadar.com, a company that tracks California homes through the foreclosure process.

Forgiving loan principal is something lenders and loan servicers haven't been very willing to do so far, O'Toole said -- in part because of the potential for legal objections by investors who own the securities many mortgages were packaged into.

"We likely have $4 trillion in bad mortgage debt created created during a period of inflated home prices," O'Toole said. "Any program that doesn't directly deal with eliminating that debt only delays the inevitable and makes this problem worse. Foreclosure remains the only working mechanism for clearing this bad debt at the moment."

If lenders aren't willing to do more meaningful loan modifications, Congress could give bankruptcy judges the power to "cram down" loan principal -- a bad idea, lending industry critics say, because that's likely to raise the cost of borrowing for all home buyers. Another idea is for the government to provide incentives to servicers or guarantee a portion of lender's losses when they agree to do loan modifications that involve principal write downs.

Some states have also attempted to address foreclosures, with limited success. O'Toole has been monitoring the impact of a California law, SB 1137, like similar statutes in other states including North Carolina, Maryland and New Jersey, is intended to slow down the pace of foreclosures by creating new hoops for lenders to jump through.

California's law, which requires lenders to reach out to homeowners and extends the waiting period before initiating foreclosure proceedings, put a significant dent in notice of default filings when it took effect in September. But foreclosure filings rebounded in November and December as the new extended waiting period called for in the law expired.

Ominous statistics

Statistics compiled by data aggregator RealtyTrac hint at the magnitude of the problem nationwide. RealtyTrac tracked foreclosure-related filings on 2.3 million U.S. properties in 2008, an 87 percent jump from the year before, with 861,664 homes making it through the entire process to become REOs (see story).

The Mortgage Bankers Association's surveys of members suggest one out of 10 mortgages was either delinquent or in the foreclosure process at the end of September, and Moody's Economy.com estimates 12 million homeowners are "upside down" -- they owe more on their homes than their properties would fetch in today's market.

RealtyTrac senior vice president Rick Sharga told attendees at the Inman News Real Estate Connect conference in New York City this month that an analysis of 500,000 distressed properties in four states in the company's database found only about one in four were listed for sale in a multiple listing service, or MLS.

That suggests that as many as 75 percent of distressed properties have yet to hit the market, Sharga said, and that many of those homes will soon be putting pressure on inventory and prices as banks repossess them and put them up for sale.

Those are ominous numbers, given the 11-month supply of new and existing homes available at the end of November -- well above the six months generally considered to represent a healthy balance of supply and demand.

Joshua Olshin, president of New York, N.Y.-based Tranzon Integrated Property Group, said that the possibility that a wave of REO properties is about to enter the market creates uncertainty and puts downward pressure on prices.

"People see the foreclosure numbers, and that banks are not even selling what they have, and then we have a whole new load (of REOs) coming on, and that's causing people not to price things effectively and accurately," Olshin said. "It's kind of compounding the problem, I think."

Tranzon helps institutional property owners like financial institutions, corporations, developers and investment groups market and sell property through auctions or a sealed bid process.

The government's TARP purchases of preferred shares gave some banks a thicker capital cushion -- if only fleetingly -- which regulators hoped they would use to make more loans. Instead, some banks have moved to acquire weaker competitors.

"Last summer, we began seeing banks be much more aggressive in the way they priced things," Olshin said. But banks may also not want to recognize losses that accompany the sale of properties at deep discounts when they are having difficulty raising the capital they need to meet statutory minimums, Olshin said. "To be frank, since the TARP money came in, they are still selling off (properties at auction), but they kind of took a step back."

In the process of acquiring troubled rivals, banks may write down the value of some of the bad loans on their books. Once the loans are written down -- often to as little as 20 cents on the dollar, Olshin said -- some of the pressure to foreclose on properties and sell them is gone.

"The loans are being carried for what they are worth, and they think there's upside potential" to hold onto properties and sell them when prices rebound, Olshin said. "We think there's not an upside potential -- that we're going to be in this problem for awhile."

Lenders are trying to stretch out some of their losses, and avoid the need for massive new reserve funding when possible, said Norm Miller, a professor at the Burnham-Moores Center for Real Estate at the University of San Diego. At the same time, Miller said lenders are "overwhelmed with the sheer volume of defaults which may turn into foreclosure."

Auction boom

Regardless of any pullbacks by lenders, Tranzon and other auctioneers had a banner year in 2008, and expect this year will be even better.

"I think we'll see a lot more properties moving to auction as banks realize they need to sell at the market price," Olshin said.

Real Estate Disposition LLC (REDC), which claims to be the nation's largest real estate auction company, held 300 ballroom auctions in 2008 and sold nearly 33,000 foreclosed homes for $3.4 billion -- a seven-fold increase in sales volume and nearly triple the proceeds the company generated in 2007.

Company CEO Jeffrey Frieden said he expects to "smash that record" this year as banks and lenders continue to amass a huge inventory of foreclosed homes and are more motivated than ever to sell their inventory.

"I'd say all of the top 10 loan servicers have an auction strategy in place, and that between 5 and 15 percent of the (REO) portfolio is sold through auction," said Michael Davin, president and co-founder of Hermosa Beach, Calif.-based discount brokerage CataList Homes Inc.

CataList, which provides marketing and transaction management expertise for sellers, is a partner with the Los Angeles Times Media Group and others in Zetabid, an online auction marketplace for bank- and builder-owned properties.

Industry groups like the National Association of Realtors, the Mortgage Bankers Association and the National Association of Home Builders have been pushing for more emphasis on incentives for buyers, such as tax credits, subsidized interest rates, and higher loan limits for Fannie, Freddie and FHA loan guarantee programs (see story).

But O'Toole thinks such subsidies were what "got us into this trouble in the first place. Subsidies may increase demand, and in the case of subsidized interest rates might even increase prices, but for how long?"

Some observers fear that if the massive amount of debt the government is taking on to stimulate a recovery, inflation -- and higher interest rates -- are inevitable consequences. Inflation can spur home sales because households are looking for an inflation-proof place to park their assets.

But rising interest rates can also reduce consumer's home-buying power, undermining prices. If interest rates shoot up, buyers who close a deal on a home with a subsidized mortgage could see the value of their homes plummet when subsidies end and interest rates shoot up.

"Unless we want to continue the foreclosure cycle, we need to return to traditional home-buying practices -- with qualified buyers, in affordable homes, at market interest rates," O'Toole said.

Stickel said she is all for programs aimed at preventing foreclosures and keeping troubled borrowers in their homes, because that would help check falling home prices.

"I really think if we can just keep people in their homes, we're going to do wonders for stabilizing our market," Stickel said. "I don't know if that's what a real estate agent wants to hear -- that if I can keep someone in their home, then I can sell a home."

But Stickel thinks a strategy emphasizing foreclosure prevention would actually produce a healthier environment than a market glutted with REOs, because stemming foreclosures would limit the carnage among lenders and get buyers off the fence.

From his perspective in Oakland, Calif. broker-owner L.J. Jennings said the key to stabilizing neighborhoods hit hard by speculators and foreclosure is to get properties in the hands of homeowners, rather than investors. That means bringing homes up to livable condition, or providing loans that provide the funds for buyers to make repairs on their own.

Jennings, whose Pyramid Real Estate and Investments specializes in REO properties, also wants to see more TARP money channeled directly into foreclosure relief -- including government guarantees of loan modifications -- rather than used to prop up banks' bottom lines.

"Let's hope the next round of TARP reaches consumers," Jennings said

Part II: Obstacles delay REO sales 
Banks to unleash flood of REOs

While the government's efforts to keep lenders solvent may have allowed them to hold off on selling some properties at fire-sale prices in 2008 (see part one), real estate brokers and auctioneers expect REOs to be big business in many markets this year.

FDIC-insured banks had $23 billion of REO inventory on their books at the end of September -- a 134 percent increase from a year ago. That includes $11.5 billion in one- to four-family homes and $1.5 billion in property purchased with FHA-backed loans securitized by Ginnie Mae.

According to the latest quarterly report from the Federal Deposit Insurance Corp., three quarters of those one- to four-family REO properties were in the hands of very large banks, with assets greater than $10 billion.

In addition to the fear of selling properties into down markets for pennies on the dollar, lenders face other obstacles to liquidating their REO inventories that can vary from market to market. Some states, for example, have new laws that slow the foreclosure process, while others are dealing with an unprecedented volume of bank repossessions that has strained the capacity of the system.

In Florida, lenders are motivated to move properties off of their books, but are often thwarted by an overburdened court system that can leave properties in need of extensive repairs by the time they are back in the bank's hands, said Ann Stickel, vice president of affiliated services with Sarasota, Fla.-based brokerage Michael Saunders and Co.

"The national lenders don't want to hold the inventory any longer than they have to," Stickel said, but bankrupt builders often try to delay the foreclosure process in court, and homeowners may fight eviction.

"Courts have said we don't want to kick homeowners out, so we're not going to create an express lane" to facilitate evictions and foreclosures, Stickel said. "The banks will say, 'We have 50 properties for you (to list), but we can't get a hold of them.' "

Stickel is not unsympathetic to the plight of troubled borrowers -- she thinks keeping more of them in their homes is a key to stabilizing housing markets -- but said that the lengthy foreclosure process often leaves homes vacant and in disrepair.

In Florida's tropical climate, vacant homes can easily become infested with mold, and other damage and deferred maintenance issues can add significantly to the time and cost of prepping a home for sale, she said.

While Michael Saunders' newly created REO department is up to the challenge of rehabbing a mold-infested condo, "there is so much front-end prep on these properties, it's not very realistic to have an individual agent handle the process," Stickel said.

Once the lenders working with Michael Saunders have properties in their inventory, she said, "They are actually going to market very aggressively in price, and our inventory of REO properties turns very quickly -- in days, or hours -- rarely more than three or four weeks."

L.J. Jennings, an Oakland, Calif.-based broker-owner whose firm, Pyramid Real Estate and Investments, specializes in REO properties, also believes banks are motivated to get foreclosed properties off their books.

"Banks are not in the property ownership business, and I don't think philosophically they're going to change that position," Jennings said. "They will continue to dispose of them as quickly as they can."

But Jennings said that in California, the typical turnaround time for a bank to put a foreclosed property on the market has lengthened from 60 days to six months or more.

"I have some properties I've been managing for six or seven months that are not on the market because of tenant-related issues," Jennings said. Problems clearing title because notes have been sold and resold on Wall Street are also common, Jennings said.

Scott Thompson of Mortgage Resolution Services Inc. said that in many markets, asset managers for lenders and loan servicers are acutely aware that their actions can have an influence on prices.

Thompson said an employee at one of the nation's five biggest loan servicers has acknowledged to him that "the volume of foreclosures they have in the pipeline needs to be managed carefully" to avoid flooding the market.

MRS, a Fidelity National Financial Co., helps real estate brokers and agents work with lenders and loan servicers to complete distressed property sales. Before founding the predecessor of MRS and becoming its vice president of sales, Thompson did hundreds of short sales as a broker-owner.

"I have been in the business for 20 years, and never seen anything like this," Thompson said. Even though many markets are seeing houses changing hands at the same frenzied pace seen at the height of the boom, prices continue to fall. "Large transaction volumes, declining prices -- it's an oxymoron," Thompson said.

Asset managers are bidding prices down to keep buyers in the marketplace, "because they know what's coming down the pike, and how many more assets are about to be dumped on their desk."

In order to keep a floor under prices, "You have to move properties onto the market at a measured rate."

By disposing of some properties through auctions, asset managers can keep them out of the MLS, Thompson said. That way, agents running comps on their other properties don't have to factor in those discounted sales. This could be one partial explanation for RealtyTrac's discovery that as many as three out of four REO properties are not listed in the MLS (see part one), he said.

"Lenders have turned much more immediately to auctioneers as the best way to get rid of properties quickly," said Joshua Olshin, president of New York, N.Y.-based Tranzon Integrated Property Group. "When they realize the waiting game is a losing game, they are much more willing to move in to auctions."

Stickel said some banks may want to sell their REOs themselves because they don't want to pay a Realtor's commission.

"So it's not necessarily that the house is not on the market, it's just not in the MLS," she said.

Name a price

That raises the question of whether banks and loan servicers are able to accurately price distressed properties and REOs.

A recent analysis of more than 1,000 distressed properties in 25 states suggests lenders and loan servicers stand to lose billions of dollars because they are either underestimating or overestimating property values when deciding whether to foreclose on a property or do a loan modification or short sale.

In "Home Pricing in Rapidly Changing Real Estate Markets: The Need for Micro Market Metrics in Lending and Loss Mitigation," Norm Miller, a professor at the Burnham-Moores Center for Real Estate at the University of San Diego, and co-author Michael Sklarz argue that lenders rely too much on backward-looking valuation tools such as appraisals, broker price opinions (BPOs) and automated valuation models.

As many real estate brokers and agents are aware from firsthand experience, lenders may overestimate the foreclosure value of a property, and turn down short-sale offers or opportunities to engage in workouts or loan modifications with troubled borrowers. Instead, they foreclose on a home and put it on the market at an unrealistically high price. In rapidly declining markets, those homes may sit on the market while their real value declines, causing an even greater loss for the lender.

At the same time, Miller and Sklarz say lenders sometimes underestimate the value of some REO properties in their inventories by relying on macro-level data -- such as the Standard & Poor's Case-Shiller indexes -- that don't reflect the unique characteristics of individual neighborhoods.

Such undervaluations by lenders can create windfalls for savvy local real estate investors who purchase and flip these properties, Milller and Sklarz say, but fire-sale pricing can also hurt neighborhood property values (the two are the co-founders of Collateral Intelligence, a Sherborn, Mass.-based firm that helps lenders tackle valuation issues).

The challenge for lenders, Miller told Inman News, is to modify the loans which are salvageable and foreclose on those that are not -- but only after careful analysis of current values and price trends based on very localized data, and not aggregate indicators like the Case-Shiller index.

Michael Davin, president and co-founder of Hermosa Beach, Calif.-based discount brokerage CataList Homes Inc., said that REO homes will fetch fair value if they are listed in an MLS.

"I am a broker so I believe in the MLS and its market," Davin said. "It's just almost impossible to pick off deals that are below-market. Because if you price it really low, you'll stimulate a multi-offer scenario."

Davin said CataList recently handled an REO listing for Wells Fargo that had seven offers and sold above its list price.

CataList, which provides marketing and transaction management expertise for sellers, is a partner with the Los Angeles Times Media Group and others in Zetabid, an online auction marketplace for bank-owned and builder-owned properties.

Many auctions, like Zetabid's, involve agents and brokers in the process, and Davin estimates brokers are still selling 90-95 percent of foreclosed properties -- even though many of those properties are sold at auction.

If Davin is correct that lenders and loan servicers can depend on the MLS to help them obtain the fair market value for REO properties, Miller and Sklarz's work still raises questions about whether they are seizing opportunities to engage in workouts and short sales that are likely to provide better recoveries than foreclosing on a property.

"I think most everybody's intentions are good, but if you are Bank of America, Wells Fargo, Chase -- the big guys -- every decision you make given the size of your portfolio could have unintended consequences," MRS's Thompson said. "I think lenders are trying to be real careful that they don't take a step in the wrong direction that could ultimately hurt their franchise."