Our recent New York Times Magazine article on the use of cash-back transactions in home sales produced a mountain of e-mail responses. Among the most interesting was this one from New York attorney Nishani Naidoo, a former real estate lawyer and member of the New York State Bar Association’s Real Property group. He has been distressed by the growth of cash-back transactions, and has tried unsuccessfully to do something about it. He explains:
In order to buy a home, one typically needs to save 10 to 20% of the purchase price for a down payment. The remainder of the purchase price is typically financed by a mortgage. The need to save for a down payment is one of the biggest barriers for someone wanting to be a home owner. It involves living below one’s means; saving for several years; and discipline. To the bank, however, this all means that the new home owner has a vested interest in making their mortgage payments since their life savings is invested in the home from Day 1.
A new form of financing arose in recent years, however, that all but eliminated the need to save for a down payment. This new form of financing was called the “seller’s concession” and is easiest to explain by way of an illustrative example: A buyer sees a house she likes and bids $200,000 for it. Since she is the highest bid, the seller accepts her offer. However, the price written into the contract is $240,000 with a $40,000 seller’s concession. In other words, the price is simultaneously increased by $40,000 and decreased by $40,000. The reason for this is that the buyer can then apply to the bank for a loan based upon the $240,000 purchase price. If the buyer obtains 90% financing, then her loan will be for $216,000, or $16,000 more than the actual price she is actually paying for the house.”
While all of this may sound like fraud, it is not, at least according to the New York State Banking Department, which explained as follows in response to my inquiry:
“According to your letter, a ‘seller’s concession’ is an amount by which the bargain for sale price (the “True Sale Price”) for real property is increased for the sole purpose of enabling the buyer to obtain a higher loan. Effectively, at the completion of the transaction, the seller receives the amount of the True Sale Price, and the buyer gets a loan for an amount (the ‘Contract Sale Price’), which when added to the down payment is in excess of the True Sale Price. The excess amount (difference between the True Sale Price and Contract Sale Price), or seller’s concession is typically used to pay for some, or all of the closing costs incurred by the borrower in the transaction.
From the above related facts, it is clear that the Contract Sales Price, including any seller’s concession, is fully disclosed to the lending institution in the contract of sale. Based on the fact that this price is fully disclosed, the Department is of the opinion that a seller’s concession would not ipso facto constitute fraud since, generally, the determination by a lending institution as to whether it should make a loan is based on a fully disclosed Contract Sale Price. In reaching this conclusion, the Department also notes that under general underwriting guidelines, lending institutions make a decision on whether to lend, or not, only after such institution has received an appraisal of the subject property and has made a determination that the property’s value is in line with the loan amount and that the borrower has the ability to repay the loan.”
In other words, where is the fraud if everyone is aware that this is going on? However, an astute observer must ask two questions: (1) if the seller had advertised her house in the market and the highest bidder was $200,000, how did the appraiser just a few short weeks later appraise the home for $240,000?; and (2) why doesn’t the bank just advertise that they are willing to provide loans in excess of 100% of the contract price?
The answer to this riddle may lie in the fact that most banks securitize their home loans — that is, they do not hold these loans on their balance sheets but sell them to the capital markets. While there may be no fraud on the buyer, the seller, or the bank, there may yet be a fraud if this new type of financing is not fully disclosed to the capital market investors.
If this practice is disclosed, then it can be presumed that the investors factor it into their models and price their purchases of mortgage backed securities accordingly. If it is not, then it is a safe assumption that they are holding a portfolio that is much riskier than they had bargained for. If the loan was in excess of the market value from Day 1, as the housing market declines, this difference – and the capital market investors’ losses – will grow accordingly.
As they start to lose money on these portfolios, the willingness of the capital market investors to supply of capital to the housing market will decline. When people are unable to obtain mortgages, the demand for houses will fall. As demand falls house prices will fall. And as house prices fall, the losses that capital market investors sustain will increase, making them less willing to supply capital to the housing market …
Business Week just ran a story on the foreclosure rescue scams. It was an excellent article and, as far as I can tell, very accurate. I do not know how he got his information but he is right on. The National Consumer Law Center did a study on this as well. Even if you don’t agree with their politics, they are reporting on something that is real and that does happen. Part of why I think nobody paid much attention to this before was that it did not affect the rest of us: the people to whom this type of thing happens are often poor and minorities. It’s also pretty hard to gather data in this area. However, the fallout in the subprime market is making people start to realize that this does affect us all. And I am not sure if they’ve made the connection yet. But part of the huge rise in housing prices is because of this since — well, if housing prices in Jamaica, Queens, start to rise, then prices in the neighborhood next to it rise, and so on and so on. You could not get a house for less than $400,000 in Jamaica in 2004. If Jamaica commands that price, then Astoria is definitely going to be a lot higher, and Manhattan a heck of a lot higher.