A middle-aged couple who bought a home in my neighborhood are in a terrible situation.   They paid too much for their new house, which needed a lot of repairs, and they failed to aggressively work to sell their existing home.  Therefore, they now have two houses.

They continue to live in their original home while their new house (two houses away from where I live) has been vacant for three years and it is falling apart.  I’m not talking about chipped paint.  There are huge holes in the roof that are causing the house to rot out.

Check out the garage roof too:

People who know a lot about rehabbing houses tell me that if this house and garage don’t get immediate attention, they will need to be completely torn down.

What can the owners do?  They paid $240,000 for a house that was worth $180,000, and now it’s probably only worth $90,000 (because the water pouring in through the roof after every rainstorm is rotting out the house).   They probably have a big mortgage on the house (I’d guess that it’s in excess of $200,000).   They seem to be current on their real estate taxes and their mortgage, but they are frozen, apparently panicked, and this inaction is destroying their investment.  If this goes on for another year, their house will be worth nothing at all.

The question, then, is what can they do about the situation?   Conventional thinking is that they should “sell short.”  Go to the bank and agree to sell the house for $90,000.  Get something rather than nothing.   This would also be better for the bank to get something rather than nothing, right?  But not so fast.

In our complex mortgage system, the banks (and other mortgage companies) “securitize” home loans as soon as they are made, as explained by Arthur Delaney and Ryan Grim:

Once the mortgages are bundled and sliced up into different pieces, known as tranches, the owners of the pieces get paid back according to a certain pecking order. Senior investors get paid back first and if there’s a loss, the most junior investors won’t get anything. It’s those investors who are blocking short sales.  “The people with the least senior tranches have no reason to agree to the modification because they take a complete loss and the people in the most senior tranches don’t lose anything. So they’ve managed to structure their mortgages in a way that makes it almost impossible to modify or sell short,” said [Rep. Brad Miller (D-N.C.)].

Therefore, if the owners of the house down the street could ever get over their panic and decide that they wanted to “sell short,” the bank would be likely to choke.    That’s because the low-echelon tranch owners of the note have nothing to lose.   Or at least, that’s how they often see it.   What is the net effect?

According to research firm Campbell Communications, only 23 percent of short sale transactions are actually completed. “Three out of four potential short sale transactions fail, principally because the mortgage servicer takes too long to respond to the offer,” said Tom Popik, author of a February survey of real estate agents. “When these same properties are later sold it further depresses real estate prices.”

Therefore, I’m concerned that I’m going to see that nearby house, which was a well-maintained beautiful house merely 10 years ago, collapse into a pile of rubble.   Multiply that situation by several million and you can see a national crisis developing.  First, let me make it clear that many of these people exercised terrible judgment in buying houses they couldn’t afford and yes, that was not smart of them.  But here’s the bottom line: Not only are the banks going to kick millions of people out of these houses; they are also going to saddle the neighbors with decrepit housing, which breeds crime and health hazards.  See here and here:

Many houses in Slavic Village have had their siding stripped up to the roof lines. A few criminal masterminds even stripped vinyl siding, apparently unaware of the difference in wholesale scrap prices between plastic and metal.  When a house is derelict, people will dump garbage in the yard, rather than pay for haulage. Windows are broken, and doors are stolen, opening up the interior to the elements. In Cleveland’s cold and damp climate, the houses deteriorate quickly. But some not badly enough to keep drug dealers out.

Miller sponsored legislation to address this problem, but it was recently shot down, mostly by Republicans, according to Delaney and Grim:

Miller sponsored legislation to reform the bankruptcy code to allow judges to rewrite those contracts, taking away the ability of junior investors to sue and encouraging them to negotiate. But the House-approved measure died in the Senate, 51-45, killed last week by Republicans and 12 Democrats, leaving it 15 votes short of the 60 needed to overcome a filibuster.