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This article debunks the myth behind the difficulty in obtaining credit after a bankruptcy, digests the motivations of a mortgage lender, the fallacy of the FICO score as basis for credit, and the effects these conditions have on buyers of real estate.
After hearing several advertisements on the radio about the current record-low mortgage interest rates, an employed homeowner makes inquiries into refinancing his mortgage. In the process, he discovers that the loan balance on his mortgage is greater than the current value of his home. In other words, he is underwater and making payments to a lender on a loan amount unsupported by the loan’s collateralTangible assets attached to a loan which are worth more than the cash value of the loan.. He has a negative equityThe condition of a property owner owing more on a mortgage than the current fair market value of the encumbered property. and is paying on a dead-end loan.
While the homeowner still holds a job, the recession has taken a toll on his personal finances. Knowing that his mortgage payments are essentially holding him hostage as a prisoner in a property losing value, he stops making his monthly payments, a default on his home loan. After the notice of defaultThe notice filed to begin the nonjudicial foreclosure process. Generally, the NOD is filed after three or more months of delinquent mortgage payments. is filed, he continues to live rent-free in the property. With the money he saves by not making his mortgage payments, he begins to save his money for a 20% downpayment on another property which will have mortgage debt at 80% of value.
This scenario, a familiar one in the current recession, begs the following question: how easy would it be for an individual with a similarly “derogatory” financial history to obtain credit — a new mortgage?
According to a recent paper entitled “Forgive and Forget: Who gets credit after bankruptcy and why?” written by Ethan Cohen-Cole et.al from the Federal ReserveThe central bank in control of regulating the U.S. financial and monetary system. Bank of Boston, it may be easier than the media-at-large, or your current lender, would lead you to believe. While the study deals mainly with credit card debt, it is not any stretch of reality to imagine that access to other types of credit (namely, mortgage credit) is similarly available. ["Forgive and Forget: Who Gets Credit After Bankruptcy and Why?" from the Federal Reserve Bank of Boston]
It is a popularly-held belief that after an individual suffers a major financial setback — be it a mortgage delinquency, foreclosure, or personal bankruptcy – the individual becomes subject to a period of time during which he is essentially blacklisted by creditors as a kind of punishment for his financial misbehavior, i.e., a penance paid in exchange for a fresh start. This period during which the individual is excluded from obtaining credit is taken for granted – assumed – in several studies referenced by Cohen-Cole. However, the assumption simply doesn’t bear up in light of the facts. Indeed, Cohen-Cole’s study reports that an astounding 90% of individuals who file for bankruptcy have access to some sort of credit within 18 months of their filing – not a very long penance period for expiation of major financial sins, and just enough time to save up monthly “rent” for a downpayment on another home.
The word “sin” is not used here without weight; we mean to point out that the disparity between “belief and reality” arises from the inherent difference between your viewing the extension of credit as a moral dogmatic arrangement instead of as a rational business arrangement. A consumer’s sensitivities aside, from a business perspective the
“punishment” by excluding the transgressors from borrowing is simply not in the best interests of the lenders. After all, they’re not in business to protect any real or imagined moral code – they’re in it to be profitable by making rational decisions. And, right or wrong, it simply isn’t profitable to ostracize individuals who have the ability to pay, i.e., the defaulting employed.
In fact, as Cohen-Cole points out, lenders will chase profits as far as they can go without violating the laws of the land. His report pulls proprietary data from one of the three large credit bureaus in the United States. He then posits that lenders target the defaulting employed – our negative-equity homeowner – of the lower-income, lower-credit-score echelon for higher credit limits. And why? Because of their proclivities towards overspending and paying only the minimum amount due, behaviors which fatten the lender portfolios with ever-increasing interest income.
So if, as Cohen-Cole’s research suggests, lenders will simply act in the interests of their profit in spite of it all, what does that say about the predictive power of the supposedly almighty FICO score? Even viewed conservatively, the FICO score has become something of an industry inside joke. It didn’t mean terribly much before (witness the infamous mortgage lending debacle), and it will continue to be disregarded by the industry insiders when it doesn’t support their profit margins.
Now, back to our original defaulting homeowner. As a mortgage is a secured debt not discharged with bankruptcy, and as the judiciary is currently powerless to cramdownThe reduction of the principal balance of a loan. In first tuesday context, cramdowns are a tool used to provide debt relief for underwater homeowners. the loan balance to align with the collateralTangible assets attached to a loan which are worth more than the cash value of the loan. value of the real estate, bankruptcy is not an option. He’s on the verge of having his property foreclosed upon, and with that foreclosure will come a hefty ding to his FICO score. However, as we’ve previously stated, he’s saving up a 20% downpayment and he’s still employed, and he makes timely payments on all his debts – with the single exception of the toxic real estate loan made by a mortgage banker.
In other words: he can pay! The FICO score will conveniently be balanced out with a higher rate, and our homeowner will be financed for the purchase of another home. He may not be able to qualify for
the lowest rates and he may not be able to find financing immediately, but he has the ability to create profit for the lender by paying interest and will therefore be in demand. In the end, the lenders will always follow the profit.
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