Sunday, October 11, 2009

The Forecloure Scam: How Lending Institutions Make Money on Foreclosed Homes

How is it that financial institutions granted home loans without checking income or other key indicators of a buyers ability to pay back their loan?  It is most peculiar when you take into consideration the fact that approach goes against decades of developed experience and documented best practices.  Most of those loans were granted knowing that the buyer’s qualifications and the ruinous terms of the loan made it probably, not just likely, that at some point there would be a foreclosure.  What is more puzzling is the fact that myriads of homes are sitting empty and deteriorating daily while lending institutions are not aggressively trying to prevent the damage done when a house sets empty. 

Empty Houses

My contacts in the business, particularly in Kansas City, indicate that empty homes are being pillaged by highly skilled teams of thieves who come in and take anything of value including copper and other accouterments such as windows, doors, and appliances if they are worth stealing.  These teams are very efficient and seem to operate with impunity with little public or private investigation into who they are and how they are disposing of the goods.  You would think that banks would be aggressively attempting to protect empty houses and pressuring law enforcement to increase enforcement efforts to stop the thievery.  It is fascinating that the holders of these mortgages have not raised a hue and cry in the media and through lobbying efforts to get something done.

Let me briefly summarize before going on.  So, lending institutions aggressively pursued home loans known to be risky, and there is little creativity or aggressiveness to somehow generate some income from the abandoned homes.  Instead houses languish abandoned to deteriorate, and creative ways of finding someone to live in them to generate some kind of income, even as a renter, have not really become popular.  Everyone is assuming that these lenders are losing money at a horrific rate even as the lenders remain remarkably passive. That just does not make sense.  The only thing that I can think of is that somehow many of these lending institutions counted on two strategies.

Two Strategies for Success

I think the first strategy was a cynical optimism that the “housing bubble” was a trend that would continue forever – or at least long enough for a terrific payday which indeed was the case at least for many individuals.   I think many of the lending institutions counted on either huge profitability from usurious rate, or repossessing homes that had appreciated in value past the original loan value in order to resell at a profit.   The other strategy became obvious when I learned about dead peasants insurance.  Many lending institutions had probably hedged their bets using various insurance strategies with the tax payer as the patsy. How did that work?

Insurance as an Investment Strategy

Is it impossible to make insurance profitable over the long run as an investment strategy?  Yes, unless something magic happens.  The reason is that insurance companies are rather clever and design their rates such that they are not in the unfortunate possession of having to pay out more claim money than what they take in as premium payments.  At best insurance would have been a conservative method of limiting losses in a worst case scenario.  The problem is that companies would have been very hesitant to spend the money on premiums for marginal, or no, returns.  The cost of the premiums would have come right out of profits. But, magic does happen for business in the form of tax breaks, and tax breaks change everything.

Tax Breaks

If insurance premiums are tax deductable for businesses then suddenly it becomes much more attractive for them to buy policies.  You also gain an ally in the insurance company which rightly divines that it will sell more insurance if the price of the policy is severely discounted, cost you nothing, or perhaps even saves business money in taxes.  That is the case with dead peasants insurance.  Tax breaks make dead peasants insurance not just a method of limiting losses, but an investment tool.  Turns out that lending institutions often take out policies themselves (often without letting the borrower know that it is happening and charging more interest), or have the consumer take out a policy to protect themselves from default.  As it turns out these are standard industry practices.

The point is that there is a distinct possibility, actually a probability, that this bursting of the housing bubble was not the financial disaster for lending institutions that we thought.  I am certain that the losses for many of those institutions has been minimal or nonexistent. 

Blaming the Victim

When the “financial crisis” first started most of the blame was being put onto the shoulders of the consumer and the government.  Pundits declared that banks and other lending institutions were perhaps guilty of nothing more than being a bit aggressive and under government pressure to liberalize loan policies.  More and more evidence is mounting to show that the greed and avarice of lenders was the primary cause of the problem. What is really disturbing is that the lenders, at least in some cases, might have actually profited from the whole experience while allowing the public to believe that they had lost their shirts.

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