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When First Doesn’t Really Mean First

When Third-Party Tax Lenders Jump to the Head of the Line

Mark Liu    |    Mortgage Performance, Property Valuation

In the event that a homeowner defaults on his or her mortgage loan and the home is to be sold, who would be first in line to receive funds? The obvious answer seems to be the first-lien mortgage holder, right? Well, think again. In some states like Texas and Nevada, others may legally be able to jump to the front of the line in the foreclosure process, bumping even first-lien mortgage holders. One such example is third-party property tax lenders.

Third-party property tax lenders serve a special segment of homeowners who are in short-term financial trouble and are trying to get back on their feet. Finance companies who provide tax lending solicit property owners, typically those with non-escrowed accounts, to secure loans to cover their property tax payments. These tax lenders can offer more flexible payment options than governmental taxing authorities and, if used properly, homeowners can gain valuable time to overcome financial woes. When the tax lien lender pays off homeowners’ taxes, they then receive the priority lien on the home, just like government taxing authorities. These finance companies are typically not the banks that initially financed the mortgages, and a notice of tax lien transfer only occurs after the transfer happens.

The third-party property tax lending process poses significant risks to the financial institutions that underwrite and service mortgages. It is well known that in the event of default, lenders first in line to receive payments have significantly lower losses than those holding the second- or third-lien positions. These property tax loans diminish collateral values for all parties. Also, property tax loans usually carry much higher interest rates and fees that can negatively affect a borrower’s ability to pay as debts quickly compound over time. A study from the Financial Commission of Texas1 showed that in 2011, the average property tax loan amount in Texas was $8,810, with roughly a 10 percent closing cost of $866 and an average interest rate of 14.37 percent. During the same period, the 30-year fixed-rate mortgage rate ranged from 4-5 percent.

So, given the risks associated with third-party tax lending, what can banks or servicers in the first-lien position do? Re-acquiring the properties through the lengthy foreclosure process generally incurs significant legal and operational costs. It is similar to closing the barn door after the cows have escaped – it is at least a day late and a few dollars short. The practice should be caught much earlier in the process.

One way to manage this risk is to utilize the Tax Delinquency Scorecard, developed by the CoreLogic Decision Analytics and Research Team. The scorecard ranks borrowers based on their likelihood of tax delinquency over a six-month timeframe. Borrower mortgage payment behavior is examined to identify those who have financial issues and may not be able to make subsequent tax payments. Mortgage payment history tends to be very predictive because mortgage payments are ordinarily due more frequently (usually monthly) than property tax payments (ranging from quarterly to annual frequency). By observing the mortgage payment history prior to the tax due date, the possibility of borrowers becoming tax delinquent can be evaluated. Since tax liens usually take precedence over mortgage liens, borrowers who are current on mortgage payments are less likely to miss tax payments than those who are delinquent on mortgage payments. When borrowers who have shown financial difficulty making mortgage payments suddenly pay off past-due and current tax payments, it is likely that a third-party lender made the tax payments on the borrower’s behalf.

The Tax Delinquency Scorecard is built with the standard logistic regression technique widely used in the industry. Similar techniques have been applied by banks to underwrite mortgages and collect delinquent payments. A number of borrower and property attributes are used to predict the likelihood of tax delinquency, including owner occupancy, loan-to-value ratio at origination, mortgage payment history in previous 12 months and other factors. The Kolmogorov-Smirnov statistic value from the scorecard is around 30, indicating good performance of the scorecard in separating tax delinquent cases from non-delinquent cases. Figure 1 displays the lift chart of the Tax Delinquency Scorecard with the cumulative percentile of cases in descending order of probability of being tax delinquent on the x-axis and the cumulative percentile of actual tax delinquent cases on the y-axis. It shows that the top 10 percent of cases can be reviewed to capture 30 percent of all tax delinquency cases. It is much more efficient than the baseline case, in which reviewing 10 percent of the cases only captures 10 percent of all tax delinquency cases.

Using a tax delinquency assessment like this can be beneficial in a number of ways. First and foremost, it flags potential trouble before serious damage is done. For example, a lender or mortgage servicer can use the scorecard to identify high-risk borrowers and properties in order to take preemptive actions. Such preemptive actions may include contacting the borrower to negotiate payment, directing the borrower to federal or state-level tax relief programs, or making a property tax payment on behalf of the borrower to prevent the property from becoming delinquent. It is particularly useful for non-escrowed mortgages, as lenders ordinarily have little or no advance warning of imminent tax delinquency for such accounts. From a mortgage lender’s perspective, the scorecard can be used on an aggregated basis to predict, for example, how much they will have to pay out during a defined time period to protect a mortgage portfolio from tax delinquency. Or it can be used to predict the amount of a tax revenue shortfall for a specific jurisdiction or region.

Tax lien lending is tricky and reflects the financial troubles of homeowners. Everyone involved is ultimately impacted, including borrowers, banks, servicers, property tax lenders and taxing entities. It’s best to identify and capture these potential cases as early as possible. The Tax Delinquency Scorecard does that, and, in turn, financial institutions in mortgage first-lien positions are able to work with troubled homeowners as soon as possible. After all, as the old saying goes, “The difference between a minor glitch and a full-blown catastrophe often hinges on how much time goes by before someone notices it.”

Contributions from Teik Francis.


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