The Illusion of Mortgage Collateral

By Charlie Elliott, MAI, SRA

Real Estate Appraiser and Consultant

CEO ELLIOTT & Company Appraisers

Our current economic crisis in the minds of many, was caused primarily if not exclusively by the issuance of hundreds of billions of dollars of bad real estate loans. In addressing the issue of defaults on loans, most would have assumed that the losses on the loans by the banks would have been largely mitigated by selling the property for which the loan was collateralized. After all, people borrowing money whether it be on a residential or commercial property, must make down payments which serve to account for part of the purchase price of property, while loan to value ratios offer protection on refinances.

Even if the borrower looses his job or business, falls on hard economic times or just proves to be a bad credit risk, most of us probably thought that the bank would have a large measure of protection. Here we had a perfect storm of things that went wrong. While there is a plethora of blame to go around, the purpose of this article is to address the issue of collateral. As the owner of an appraisal company and as one having many years of real estate experience, I offer you a hypothetical case demonstrating that banks had no collateral on some mortgage loans. That is right zero collateral.

1. Many people getting loans did not make material down payments. We have seen those T V commercials offering 125% LTV loans in the months leading up to the wheels falling off of all of the banks. Yes 125% LTV! Who in their right mind would expect to have a sound loan under such circumstances? Let’s say that this causes damages of 20% on an average.

2. Property values whipsawed wildly in the months leading up to the economic crisis. There were reports of values increasing as much as 40% per year in areas such as Las Vegas, California and Florida. The economy could not support this kind of appreciation and the property values headed south. Borrowers paying $500,000 for homes suddenly found themselves paying for $400,000 mortgages when the property was only worth $300,000. To put it simply they bailed, leaving the bank holding the bag. Let’s say here that the typical damage is 20% of the value of the value of the property.

3. Some unscrupulous lenders and appraisers added insult to injury by fraudulently participated in schemes to inflate appraisal values in order to make “loans work”. This usually occurred where borrowers were least capable of paying back the loan or it would not have been necessary to tip the scales in the beginning. In this subtle fraud the lender pressures the appraiser for values high enough to make the deal. The appraiser did not realize a big cash kickback; he only received the normal appraisal fee and stood first in line to do the next appraisal for the lender. The loan officer made his normal commission on the transaction, paid his bills for the month and protected his position to make more similar loans the following month. Its effect inures primarily to the short term benefit of the borrower, and to the lender and appraiser to a lessor extent. Here we could be dealing with damages at or near 25%.

4. Another evaluation issue I will list is that of the borrower trashing the property upon departure. First he performs zero maintenance on the property for the last few months there, anticipating that the property will be lost. No yard maintenance, no painting, no cleaning no nothing. Finally during the last few weeks and days, he goes on a sort of redneck rampage, breaking everything in the home that can be broken, knocking holes in the walls, staining the carpet beyond reclamation, and finally stealing everything he can possible take from the property, nailed down or not. Let’s estimate that these damages reduce the property value by 35%.

5. Finally and to add insult to injury, it is expensive for a lender to foreclose on a property. Selling cost alone typically are 6% of the sales price, if the property lies idle for 18 months the loss of interest income could cost the lender 9%, the cost of property taxes could cost another 1%, then add maintenance, insurance, utilities, court costs, legal fees, well you get the picture. Final estimated damage here 20%.

In summary do the math. In this hypothetical case there is nothing left for collateral, zilch, zero. I submit to you that while most collateral related losses may not total or exceed 100% of a property’s value, most foreclosed homes in today’s market suffer to some degree, from some if not all of the above diminution of collateral issues, giving real meaning to the term sub-prime mortgage.

When we look at the situation as a whole one must wonder, who in their right mind would make a loan under the circumstances as described. Some of the above may seem farfetched, but all of it has gone on everyday in the mortgage business. I have personally witnessed it all. This is not an indictment against lenders and appraisers as most are honest and ethical, but some are not. Our system is set up in such a way, as to tempt those who may be work on the edge of questionable integrity or ethical misbehavior. Perhaps lenders and regulators will pay more attention to collateral and collateral valuation issues going forward.