Program dangles cash to keep homeowners paying mortgages
October 25, 2010
That's the business plan for a startup that has signed up hedge funds and one major bank for its services.
With millions of desperate people struggling to avert foreclosure, it sounds counterintuitive, but Loan Value Group says its approach will help shield banks from the bigger losses inherent in foreclosures.
The raging crisis over improperly vetted documents that's thrown the nation's foreclosure process into turmoil underscores the need for Loan Value's services, said Frank Pallotta, executive vice president of the Rumson, N.J., company.
"We've seen a huge pickup in inquiries (by banks) with the robo-signing controversy," he said. "It's never been more important for them to keep their accounts current; nobody wins in a delinquency situation."
Strategic defaulters -- people who could afford their payments but chose delinquency because their home is underwater -- may account for about one-fifth of all defaults, some studies say.
Only homeowners selected by banks will get the offers; ones who have already let payments lapse are not eligible. In other words, the banks are singling out people who they think might strategically default, but have not yet done so.
Loan Value doesn't actually pay cash to homeowners. Instead, on behalf of their mortgage servicer or investor, it dangles a carrot for the future: If they continue making timely payments, a slice of their lost equity will be restored to them once the mortgage is paid off through a refinance or sale. That would have to be years down the road when the home has regained value.
The concept hinges on the behavioral economics theories that people respond to rewards and are loath to give up something in which they've invested.
The incentive averages about 10 percent of the unpaid mortgage balance, but can hit as high as 30 percent in areas of the country where values have really nose-dived, Pallotta said.
For instance, consider a home purchased four years ago for $120,000 with $20,000 down. The homeowner starts with a $100,000 mortgage. After the housing crisis, the home is now worth $80,000, leaving the homeowner underwater. Loan Value would offer that homeowner a $10,000 "reward" for staying current until the mortgage is paid off -- meaning that ultimate payoff would be $90,000, not $100,000. If the home eventually sells for $95,000, the homeowner would net $5,000 (plus whatever principal had been paid down).
Of course, future money is worth less than current cash. "The present value to the bank of that $10,000 could be as little as $3,000 to $4,000," Pallotta said.
That exposes a big downside for the homeowners who choose to participate, according to Brent White, a law professor at the University of Arizona who has studied the walk-away phenomenon.
"This may fool homeowners into thinking they're making a good financial decision when they may be making a bad financial decision," he said. "The homeowner thinks, 'Great, I'll get thousands when I pay off my mortgage' without the understanding that that may be worth just $2,000 (in today's dollars), and in order to get it they will have to pay thousands and thousands in interest."
Loan Value Group declined to identify its bank and hedge fund clients. The company collects some transaction fees from clients to help cover the program costs, but won't make money itself until the mortgages are paid off, which will probably be several years down the road. Its fee is less than 1 percent of the starting loan balance.
"If it doesn't work, it doesn't cost them a dime," Pallotta said.
How can the company survive without bringing in revenue?
Pallotta said it is working to branch out into other incentive-based programs for banks to use in a variety of ways.
Loan Value employs 25 people and is funded by its executives. Howard Hubler, the company's CEO, was a mortgage trader at Morgan Stanley. He was notably profiled in Michael Lewis' book "The Big Short" as responsible for a $9 billion trading loss, one of the biggest in Wall Street history, because of investments in securities tied to subprime mortgages.
The program rolled out in January and has enrolled a modest number of homeowners, about 2,500.
Pallotta said the company has no problem reaching homeowners.
"When you're offering somebody money, it's much easier to get them on the phone than when you're trying to collect a debt," he said.
E-mail Carolyn Said at csaid(at)sfchronicle.com