Can the Current Financial Crisis Be a Blessing in Disguise for Condo Contract Holders Scheduled to Close?

Last Friday, I had the pleasure of having lunch with Jared Beck and Elizabeth Lee Beck of the business litigation law firm, Beck & Lee.  Jared Beck, who pens The Magic City Harvard Lawyer blog, raised an interesting question: Can contract holders of condos in Miami scheduled to close in the coming months use the current financial crisis and inability to acquire financing as a valid argument for nonperformance of their contractual obligation?

I know, I know…preconstruction condo contracts clearly state that performance is not contingent upon financing.  However, a recent federal ruling in Hoosier Energy Rural Electric Cooperative, Inc. v. John Hancock Life Insurance Co., contains language that may assist condo contract holders who are scheduled to close in the near future.

Here’s some background on the federal case, as provided by Jared Beck’s recent blog post entitled, “Federal Court Endorses Financial Crisis As Basis For Relief From Pre-Existing Contractual Duties; Could Real Estate Contracts Be Affected?”:

The background is somewhat complex but essentially involves the owner of an electrical generating plant in Indiana, Hoosier Energy, which in 2002 entered into a complex lease-back arrangement over some of its assets with an insurance company, John Hancock, aimed at creating a tax shelter for John Hancock.  As part of the deal, Hoosier Energy was required to obtain what amounted to a line of credit from Ambac,  a financial institution called a “swap provider.”

Until 2008, Hoosier Energy made all of its scheduled payments under the agreement.  Then, global financial crisis ensued, and the credit rating of Hoosier Energy’s swap provider sunk like a stone.  Hoosier Energy was unable to find another swap provider with a suitable credit rating who could be substituted in a timely manner.  John Hancock declared Hoosier Energy to be in default and demanded a large termination payment, shortly after which Hoosier Energy filed suit, requesting a protective injunction.

Mr. Beck went on to say in his blog post that “Hoosier Energy argued that the extraordinary freeze in the global credit markets at least partially excused it from performing under the contract as an instance of ‘commercial impracticability,’ mitigating the default declared by John Hancock”.  The court agreed with Hoosier Energy’s argument.

Mr. Beck concluded his post with the following:

How could this newly articulated doctrine be more broadly applied? One possibility rests with the large number of individuals who signed preconstruction real estate contracts several years ago, with the intention of obtaining mortgage financing once the project was finished. Now that many of those projects have been or will soon be competed, those buyers are unable to close because, owing to the global credit crunch, banks will no longer extend mortgage financing for certain new real estate construction at 2004 or 2005 prices.

While many of these purchase contracts were drafted with clauses stating that they were not contingent upon the buyer qualifying for a mortgage, it could be argued, on the basis of the reasoning set forth in Hoosier Energy, that the deals were signed under both parties’ reasonable assumption that financing would actually be available from somewhere once construction was completed.  To quote the Southern District of Indiana in Hoosier Energy, “The crisis was not anticipated by the most senior economists in the country.”  If that is true, why should the defense of commercial impracticability, based on the lack of accessible credit, be any less available to the individual real estate buyer seeking to mitigate the effect of a pre-existing contract then it would be to an electrical generating plant operator dealing at arms length with a multibillion dollar insurer?  (To some degree, the question overlaps the analysis of whether “bailout” principles should apply equally to financial institutions and individual homeowners, both of whom are victims of their own inability to foresee the mortgage crisis).

The newly revised Fannie Mae guidelines, which went into effect on January 15, state that the government-controlled entity will no longer fund loans for new Florida condos if at least 70 percent of the total units in the development have not be conveyed or under a bona fide contract for purchase to either principal residence or second home purchasers.  Contract holders who require financing and are scheduled to close in coming months are basically out of luck.  It’ll be interesting to see how the courts handle this argument in 2009.

New Fannie Mae Guidelines Turn Off the Lights on the Florida Condo Market

In December, Fannie Mae established new lending requirements for condo developments located in Florida which went into effect January 15, 2009.

Some of the updated lending requirements are as follows:

• Up from 51 percent, FNMA will now require that at least 70 percent of the total units in a condominium project must be conveyed or be under a bona fide contract for purchase to principal residence or second home purchasers.
• New and established condominium projects may have no more than 15 percent of the total units in a project be 30 days or more past due on the payment of their condominium/association fees.
• New and established condominium projects with more than 20 units will be required to have fidelity bond/fidelity insurance.  It was formerly only required of new condominium projects.
• Borrowers must obtain a “walls-in” insurance policy unless the condo development’s master policy provides the same interior unit coverage.
• No more than 20 percent of the project’s total square footage can be used for non-residential use.
• No more than 10 percent of the total units in a condominium project may be owned by a single entity (the same individual, investment group, partnership or corporation).

The new guidelines are a train wreck to an already crippled Miami condo market but a godsend to vulture funds.  Step aside and let the bulk buyers clean up the mess.  They will effectively push the reset button and create a floor to a condo market that would otherwise take much longer to reach.  The guidelines set by FNMA will have a negative impact on established condos as well. Prices there will take longer to fall into place relative to the pricing established by future bulk sales.  Foreclosures will climb in established condo developments until an equilibrium of supply and demand is reached.  However, as one person commented in a discussion about this topic, the market will likely first overshoot to the bottom.   With very restrictive financing policies, true demand will not be represented as those with cash will comprise the large majority of the buyers.  Keep in mind that bulk buyers will either need to hold over the long run or resell the condos to cash buyers themselves due to the rule that no more than 10 percent of the condos can be owned by a single entity.

To get an idea of which new condo developments in Miami will be affected, read my latest condo closing rates published in December.

Cash is King in the Miami Condo Market!

Two local business papers, Daily Business Review and South Florida Business Journal, published articles yesterday morning discussing the fact that some lenders have blacklisted certain condo developments in Miami.

However, a few condo developments have it worse than others in Miami. The Daily Business Review article revealed that sellers in condo buildings riddled with foreclosures find that it is nearly impossible for potential buyers to obtain financing. The article uses Vue at Brickell to illustrate the point and states that “the project is widely avoided in the lending industry”. The same holds true for other condo developments in Miami that have experienced a high number of foreclosures. The doors are now closed! Well, unless, of course, you are paying in full with the almighty greenback.

BankUnited seems to have blacklisted the entire Miami condo market with over 160 condo developments on its list that are located in Miami. I’m not even exaggerating. I went through the list and tried to find one well known condo building in Miami that wasn’t on the list. The list included everything from condo developments built in the 1980s to condo buildings that haven’t even broken ground yet, and some that probably never will. The only building that I could think of that isn’t on the list is Grovenor House. Anybody else find one? Here is the BankUnited blacklist.

Declining market value and high investor concentration are the top two reasons cited by BankUnited for various condo developments being on their list. However, the other reasons provided are actually much more interesting. How about the pending litigation concerning structural issues at The Mark on Brickell and The Palace? I’ve known about the structural issues at The Mark on Brickell for months but I hadn’t heard anything about The Palace.

The Washington Mutual blacklist was far less interesting and the Popular Mortgage blacklist had the usual suspects such as Vue at Brickell, The Club at Brickell Bay, Jade at Brickell Bay, Solaris at Brickell Bay and Emerald at Brickell.

As a contrarian investor, one might say that the best time to buy real estate is in a market where everyone is saying “Mercy! I give up”. Looks like a few banks are finally throwing in the towel on the Miami condo market.  Once they all follow suit, then that’s when the real bargains in Miami will begin to enfold.

Questions to Ask Your Lender

Many of you may currently be shopping around for a mortgage. There have been many reports, as of late, about borrowers who didn’t fully comprehend what they were getting themselves into. As a borrower, it is your responsibility to understand what you are signing. Don’t be afraid to ask questions. After all, a mortgage may be the biggest debt responsibility that one undertakes in their life.

Kit Mueller, licensed mortgage planner, and author of the Mortgage Planner blog, is very knowledgeable about the mortgage business. The wealth of information that he provides on his blog has made me an avid reader. He is more concerned with his clients obtaining their financial goals than just closing a mortgage loan. Kit Mueller is licensed in Florida, Illinois, Wisconsin, Michigan, Indiana and Ohio. When it comes to finding a reputable lender he advises clients to ask the following questions:

1. What is the average number of days it takes for you to issue a firm loan approval?
2. Are the rates you are quoting today good 30 days from now?
3. If we are locked-in and rates go up, what is your policy if our rate lock expires?
4. What is the index on the adjustable rate from which you are quoting?
   • Can you give me a 24-month history on the movement of that index?
   • What is the margin associated with this loan?
   • Is this the best index to have? If so, why?
5. What are the total fees associated with our loan?
   • What is the difference between points and an origination fee?
6. How will this loan affect my financial goals?
   • How do I know what loan is best with regard to how long I’ll be in the home?
7. Are you closing at least 100 loans per year and/or how long have you been in the business?
8. Can I be pre-approved prior to submitting an offer on the property that I wish to purchase?
9. What is the APR on this program?
10. What percent of the loans you take actually close?

Bonus Questions (if a lender can’t answer these – run!)

1. What are mortgage interest rates based on?
2. What is the next report or event that can cause interest rate movement?
3. When Bernanke and the Fed changes rates, what does this mean and what impact does this have on interest rates?
4. What is happening in the market today and what do you foresee in the near future?

I think Kit’s questions will help borrowers become more educated about acquiring a mortgage in the future. Thank you Kit for your much appreciated advice!

Governmental Intervention in the Housing Market

Yesterday, President Bush discussed his plan to aid homeowners at risk of losing their homes. Most of the plan focused on assisting borrowers to refinance their adjustable-rate loans to more conventional loans provided by the Federal Housing Authority.

I took a look at his recommendations and of particular interest to me was his proposal to temporarily suspend the tax liability that is owed by homeowners when performing a short-sale. As of now, the IRS has the right to tax the loan amount that is forgiven by the lender. It is considered a forgiveness of debt.

Short-sales have become very popular, as of late, because home prices have dropped in recent years and adjustable-rate mortgages have begun to reset. It has become more common for the value of a home to be less than what is owed to the bank. For example, let’s say that you purchased a 2 bedroom condo in 2005 for $500,000 and financed 90 percent of the purchase price. Two years later the value of your home has dropped and you have fallen two months behind on your payments. In the past, when homeowners were in this situation they would tap into the equity on their home by refinancing to take cash out. This is no longer an option, however, to most, because home prices have fallen. Oftentimes, two possibilities exist: lose your home through foreclosure or sell your home through a short-sale.

In the example above, let’s say that the price of your 2 bedroom condo has fallen to $400,000. You owe the bank roughly $450,000. You’ve talked to some knowledgeable acquaintances and they’ve advised you to do a short-sale. Basically, a short-sale means that the bank is willing to accept a pay-off amount that is short of what is owed to them. You contact a local real estate agent to list your property and within a few weeks an offer of $380,000 is submitted.

What is important to note is that two parties need to accept the offer: the seller and the bank. The reason why the seller has to sign off on the offer is because the IRS has the right to tax them on the amount of the loan that is forgiven. In this case, a tax on the $70,000 forgiveness of debt will be due the following April.

The bank also has to approve the offer because they are the ones who are accepting the shortfall in the original amount owed. The banks will ask the homeowner to have an appraisal performed at their expense. Banks are not stupid. They realize that the market has declined but they aren’t going to accept just any offer.

Recently, I’ve come across a few short-sales in the MLS that just don’t make any sense. For example, there’s a 2 bedroom/2 bath listed for $295,000 at Vue at Brickell. There’s also a 1 bedroom/1 bath listed for $217,000 at The Club at Brickell Bay. I’ve written about both buildings in the past and how prices in each building are inflated due to the mortgage fraud that has occurred. However, these prices are a step in the wrong direction and are unjustified. The 2 bedroom at Vue at Brickell is the best priced unit in the entire building, including the 1 bedroom units. The 1 bedroom condo at The Club at Brickell Bay is better priced than even the studios.

Listings like these are a waste of time for everyone involved in the transaction: the seller, the buyer, the bank and the two real estate agents. Just because it is a short-sale doesn’t mean that you can list a property at a price that will get you an offer within a week. As of right now, it is also doing a great disservice to the seller who will have a large tax bill come next April should the offer get accepted by the lender.

As I mentioned earlier, however, President Bush has proposed to temporarily suspend the tax that is owed to the IRS on the amount that is forgiven when a distressed homeowner performs a short-sale. If this becomes a reality it will alleviate a lot of problems for distressed property owners. Short-sales will become more common.

It wouldn’t surprise me, however, if we start seeing mortgage fraud occur in reverse. Appraisals will start coming in very low to justify the offers that are submitted to the banks. It’ll be a nightmare for banks. Accredited local appraisers need to be in place for these banks to be able to cleanly wash themselves from the mortgage mess at hand.

Credit Crunch Impact on the Miami Condo Market

Many of you have probably already heard about what happened on Wall Street on Friday. For those of you who didn’t, the Dow Jones Industrial Average posted its third-biggest drop of 2007. Much of the drop occurred in the final two hours of trading. The Blue Chip index dropped 281.42 points. Much of the sell-off was attributed to the credit squeeze that Wall Street is feeling as a direct result of lousy lending practices in the housing market that occurred in recent years.

There were 3 major stories that unraveled throughout the day on Wall Street. The primary story in the morning was that of Bear Stearns. The S&P downgraded Bear Stearns’ rating from stable to negative. That sent shares of Bear Stearns plummeting. It recovered by mid-afternoon but once again sold off as a Bear Stearns conference call began. The CFO of Bear Stearns, Sam Molinaro, was quoted as saying “It’s (speaking of the recent credit crunch) been as bad as I’ve seen it in 22 years. The fixed-income market environment we’ve seen in the last eight weeks has been pretty extreme”. Shares of BSC once again sold off.

The second story to emerge was the reduction of Alt-A loans by major lenders. For those of you who don’t know what Alt-A is, it is a category of lending that resides between prime and subprime lending. Wells Fargo announced on Friday that they would curtail Alt-A lending. Other large banks followed suit. Wachovia announced that it would discontinue Alt-A loans altogether.

A large portion of mortgage loans are categorized as Alt-A. The suspension of Alt-A loans by major lenders means that a bulk of the demand for housing could become nonexistent. A hedge fund representative in New York told me on Friday that subprime and Alt-A represented 40% of the loans in 2006. A local, reputable mortgage broker feels that this number could be as high as 60% in South Florida. The following chart from Credit Suisse illustrates the growth in Alt-A and subprime lending from 2002 to 2006. In 2002, Alt-A represented 5% of loan originations while sub-prime represented 6%. By 2006, Alt-A and subprime loans each represented 20% of the overall loan originations.

The third major story to hit PR newswires was that Wells Fargo would increase their prime 30-year Jumbo rate to 8 percent. Other major lenders followed suit. Last week, a 30-year Jumbo rate could be acquired for 6.875%. That’s a huge increase. Potential home buyers could be priced out of the market.

So why am I reporting this you may wonder. The impact on the Miami condo market is inevitable. Many of the speculators who acquired preconstruction condos 2-3 years ago fall into the Alt-A category. Even if these speculators plan to close on their preconstruction condo units, they may not be afforded that opportunity. Major banks have begun to shut off the valve to extend credit to even the most credit-worthy. If this happens then the fall-out on Miami condos could be grim at best. These practices, however, will return full circle to the banks who loaned money to developers. If banks shut off Alt-A loans then investors will be unable to close on condo units which will mean that developers will get back a larger percentage of the total units in the building. Developers will then be unable to make payments on the loan and they’ll eventually go bust. Banks who shut off the valves will push the pain onto the banks who made these loans. I know that Corus Bank, a publicly traded company, was a major lender to condo developers in Miami. (You’re welcome for that information).

The good news is that smaller banks will fill in the gap to lend money to Alt-A borrowers. The bad news is that interest rates quoted to home buyers will be higher. The higher rates will price out potential condo contracts holders who plan to close or will lead to higher foreclosure rates down the road. If I were closing on a condo within the next 60 days then I would definitely contact a reputable mortgage broker ASAP to have them lock you in at a good rate. Who knows where rates will be in upcoming weeks. I can definitely point you in the right direction if anyone needs guidance in this matter.

Many feel that a rate cut by the Fed is inevitable. We should see one very soon.

Follow-up: A late story emerged on Friday, after the markets closed, that Option One Mortgage Corporation is ceasing all loans “secured by condos in Florida”. Option One is a top-10 non-prime lender and subsidiary of H&R Block. I don’t even want to think about what will happen to the Miami condo market if other major lenders follow their lead. I’ll leave it at that.

More Than $50B in Adjustable-Rate Mortages to Reset in October 2007

An article entitled, “Mortgage Resets: Record Bill Coming Due,” was published today on the CNN.com website. It provides great insight as to how the real estate market can go from bad to worse in upcoming months. Hybrid adjustable-rate mortgages, or ARMs, were a popular financing option for homebuyers in 2004 and 2005. Many of these homeowners will see an increase in their mortgage payment of over 30 percent once those resets occur. That is a significant increase which could lead to a tidal wave of late payments and, eventually, foreclosure for a large number of homeowners.

Deutsche Bank Leading the Way in South Florida Foreclosures

Daily Business Review published a very interesting article today entitled “Special Report: Condo Lending”. It provides a list of the top five banks who have filed the most foreclosure actions from January 1, 2007 to May 4, 2007 in South Florida. Below is that list:

The most revealing part is that these banks have no reason to be overly concerned. In most cases, the loans were repackaged as mortgage-backed securities and sold to Wall Street investors. Public records may reveal the banks as the possessor of these loans, because their names are still associated with the notes, but it is the investors who will bear the monetary loss due to the risky underwriting practices of these banks. In fact, the banks actually make additional money by charging fees to the investors by acting as custodians in managing the foreclosure proceedings for them. Helluva a gig! They’re making money on the front-end and back-end!