naked capitalism

Even though the mortgage settlement deal was without a doubt massively lawyered from the bank end, and should have received similar levels of scrutiny from the Federal and state officials, a major fly in the ointment may have been overlooked. The tax rule allowing a reduction in mortgage debt not to be counted as income expires at the end of this year. As the Seattle Times explains (hat tip Lisa Epstein):

Before 2007, all cancellations of debt by creditors — whether on auto loans, personal loans or mortgages — were treated as taxable events under the federal tax code. If you owed $200,000, but paid off only $150,000 through an agreement with the lender, the $50,000 difference would be ordinary income, taxable at regular rates.

Under the debt-relief law for qualified homeowners, you can avoid taxation on forgiven mortgage amounts up to $2 million if married filing jointly, or $1 million for single filers. To be eligible, the debt must be canceled by a lender in connection with a mortgage restructuring, short sale, deed-in-lieu of foreclosure or foreclosure. The transaction must be completed no later than Dec. 31…

Picture this scenario: You negotiate for months with your lender, realty agents and potential buyers. Finally you pull together a short-sale package calling for the bank to forgive $100,000. But the deal runs into hitches and doesn’t go to closing until after the Dec. 31 expiration date. Now your house is gone, your credit is shot, you’re looking for a place to rent, and the IRS demands taxes on your phantom “gain” of $100,000 on the sale.

The Seattle Times article estimates the odds of renewal of this program at less than 50%, since Republicans claim a two-year extension would cost $2.7 billion and would help deadbeats.

Consider how this interacts with the mortgage settlement deal. $10 billion of the total headline amount of $25 billion is to come from mortgage mods, which the Administration expects to come to a much bigger number in actual value, since banks are expected to get a credit of only 50% for mods of securitized mortgages. Since the Administration estimates that 85% of the mods would be on mortgages not on bank balance sheets, that would give a total value of $18-$19 billion. Another “up to $7 billion” is for “forbearance of principal for unemployed borrowers, anti-blight measures, short sales, and transition assistance.”

Look at the timetable. The mortgage deal is supposed to be finalized by the end of the month and submitted to court for approval by a Federal judge. We have been told the great unwashed public won’t see the actual terms prior to its submission. Given that various press leaks have indicated that some items are less nailed down than the officialdom would have your believe, there is good reason to think the court filing will come after the planned date of the end of this month.

Let’s assume the filing is made by the Ides of March. Since there is not a precedent for this sort of deal, I would hope the judge would allow for an adequate amount of time for interested parties to submit amicus briefs on the filing. The Administration, of course, will press for fast track approval. Let’s assume 60 days from a mid March filing, so mid May approval. The banks are given three years to accomplish the required principal mods, with 75% to take place in the first two years. Let’s assume the other $7 billion is on the same timetable.

If the banks are to be on track for their 75% in two years, you could expect them to do 37.5% in the first year. That’s actually likely to be generous, since they’d be ramping up in the first year, plus it will take time to get any mod or short sale done (the article said that short sales take four to twelve months).

Take (7.5 months/12 months)N x 37.5% and you get less than 25%. So the bank are likely to be at the very best a bit over 20% of the way though their required mods and other forms of relief, and given start-up and lead time factors, may be well below even that level.

What happens as of December 31? What borrowers will remain interested in short sales and principal mods if they will be hit with large tax bills? The benefit of the mod will take place over time, but the adverse tax consequences will be immediate.

With the old tax rules in place, foreclosure is likely to wind up being the least bad of poor choices for most underwater borrowers who are under financial stress. Even if they would like to reduce the damage to their credit record via a short sale, the tax consequences may make that unaffordable.

And what does this mean for the banks? A substantial portion of the value of the settlement was to come in the form of mortgage mods and short sales. Even though the banks are supposed to be liable for the dollar amount in the settlement, what happens if they can legitimately argue that demand for principal mods and short sales has evaporated thanks to the expiration of tax relief? Is there any penalty or Plan B in the deal if the banks fail to produce the required level of mortgage modifications? I have a sneaking suspicion that this scenario is not reflected in the pact, and it gives the banks a perfect excuse for underperforming on an agreement that was already badly skewed in their favor.