Can Mods Stem the Tide of Foreclosures?

In my recent article Opportunity in Troubled Times, I made the case that foreclosure volume is headed up before it heads down. There has been a recent trend to view pre-foreclosures–short sales, loan modifications, workout agreements, etc.–as an area of focus both for individuals scrambling to avoid foreclosure and for investors looking to capitalize on the distressed property opportunity. So which end of the pool should you play in? Where is the best opportunity to make money and how can you tell?

Big disclaimer first: I am not, nor do I have access to, a crystal ball. I can’t tell you what the future holds at the macro level any more than I can tell you what the right move is in your particular situation.  BUT, I can point to a few data points that I am using to guide my decisions in a marketplace as rife with opportunities as any I have lived through (like the 8 to 1 ratio of REOs to short sales).

First, I truly believe that most of what we see in the news, like HUD Secretary Shaun Donovan’s wistful hope for price recovery in 2009, underestimates the magnitude of the foreclosure situation. For example, in California and uptick in home sales is reported in a way that offers false hope in light of the deluge of overhanging foreclosures about to hit that state.

Second, are short sales theoretically better for banks and borrowers than foreclosure? Sure. Borrowers keep a full blown foreclosure off their record and banks can avoid the cost of foreclosure (as much as $50,000 or more). But short selling is also a gamble. As Mike Bell nicely points out, attempting a short sale often can’t be completed before foreclosure sets in. I would add simply that the volume of defaults we are seeing now makes what was difficult for banks before–evaluating short sale offers ahead of foreclosure auctions–now impossibly difficult.

Third, loan mods aren’t necessarily preventing foreclosures. In 2008, the redefault rate was nearly 60% within 8 months. In other words, when the Administration calls for more loan mods, they are not fixing anything, they are just delaying the inevitable.

Fourth, I believe that you capture your margins as an investor when you buy distressed property, not when you sell. Your selling price is nearly always a function of the market you are in. So, are overwhelmed lenders more likely to sell low during pre-foreclosure? Or, after the property hits their books as REO? In the spectrum of pain that banks feel over properties in some stage of distress and foreclosure, where is it the most acute? My contention is that as banks exhaust every alternative, they are forced to abandon the belief that the value of their loan has any resemblance to the real value of the property.  For that reason, my efforts continue to be focused on REOs as the best opportunity to buy at a level that gives me the highest chances of a return.