Five years ago, few knew what a short sale was, and fewer still remembered how they were done, or what the tax consequences of a sale were to the seller. The Great Recession reminded us all of the details of this hybrid transaction in which the bank (mortgagee) agrees to the sale of a house for less than the amount owed, forgiving the balance over the net sales price, and removing the first (purchase money) lien on the property thereby allowing the unencumbered sale of the property, and taking a loss on the loan.
Now short sales are becoming more common as other programs, such as federal and private mortgage modification programs flounder – mostly because unemployed or underemployed borrowers find themselves better off in foreclosure or short sale, than attempting to temporarily reduce their monthly payments. The exacerbating factor, of course, is that as many as 30% of all houses are worth less than their mortgage; it makes little sense to modify a mortgage, or even lower the principal if the loan is greater than, or even equal to, the current value of the property. With home prices continuing to fall in almost all markets, it makes even less sense.
Banks and servicers have been slow to warm up to short sales in many geographical areas. This is not surprising, since no financial institution can long survive if it consistently writes off investments from its balance sheet. A complicating factor in the current mortgage environment is that much of this paper has been bundled into CDOs (collateralized debt obligations) or other forms of securities, and releasing the mortgage for less than face value affects the value of the security. This does not make the investors happy.
(For convenience, I use the term “bank” or “lender” to cover all of the financial institutions that hold or service mortgages, in whatever form they may have been sold, securitized, or held as an asset. Even though CDOs were sold to investors, the entities which assembled the securities still have some obligation to the investors, as numerous lawsuits have underlined. )
However, as the banking industry struggles to fully recover from the Great Recession, the need to clean up balance sheets and to liquidate underperforming or nonperforming mortgages becomes more important. Traditionally, the former were considered candidates for loan modification, and the latter candidates for foreclosure. But with an estimated 1 million houses in, or eligible for foreclosure, banks face a new reality. The existence of this “shadow inventory” – houses not actively on the market but which will end up there soon, has changed the business calculus of foreclosure. In rising or stable markets, where a house value is not underwater and where the locality has a normal sale inventory, a bank could readily calculate the sale price of the house at foreclosure. They did not always recoup the mortgage principal, but they did have a good idea of how much they would lose.
Today’s environment, with the continuing loss in value of the housing inventory (see my blog of May 9 for a current scan of the market), and the large inventory overhang makes an educated prediction of foreclosure prices very difficult. When carrying and opportunity costs are figured into the net recovery, mortgage holders find that getting rid of the offending asset as quickly as reasonably possible is the least costly alternative. Thus the large scale foreclosures we saw in the latter part of last year – the process which turned into the “robo signing” fiasco for which banks are still being investigated.
At this point foreclosures are mostly back on track, though not at the level of last fall. Lenders are back into the process of disposing of their bad or underperforming loans. And it is likely that as this process continues over the next year or so (at least), the inventory will further depress house prices, causing even greater bank losses.
Short sales can yield the lender a greater net return on the nonperforming loan than foreclosures and REO sales. In my opinion, we will begin to see them become a greater part of distressed property sales in the near future, increasing to cover underperforming mortgages as the Great Depression pushes more unemployed and underemployed workers into financial distress and the value of their houses lower.
Short Sale Basics
Short sales are in essence controlled foreclosures in which all parties, the borrower, bank, and usually buyer, are better off than in a traditional foreclosure. The bank is better off because it has more control over the sale price, and it has a better idea of how long it will have to carry the property. The seller receives multiple benefits, including less stain on its credit (this varies with individual) and an easier sale. In many cases the buyer gets a cleaner title and does not have to go through the more intimidating foreclosure purchase.
There are also downsides to short sales; these are primarily the time it takes for bank approval and dealing with secondary liens. The lien issue is perhaps the most important in that a bank can only release its own liens, and cannot, in a short sale, remove a secondary lien as is automatically done in a foreclosure. Thus properties with large secondary liens – usually found as second mortgages or equity lines of credit – are not currently likely candidates for short sales.
The other impediment to short sales is the time it has been taking many banks to approve them, and to provide the documentation necessary for the process. There are currently some signs that banks are becoming more comfortable with the process; indeed, I suspect that short sales will become a larger and more accepted part of the residential market as more inventory floods many local markets. More on that below.
At this point it is useful to look at foreclosures and short sales in the context of a domestic relocation; there are several touch points between transferring employees, employers, and relocation management companies. The most interesting is on the departure side of a relocation, where an underwater employee would like to sell the house in a BVO (it could also be arranged in an AVO) program. Here the employee negotiates with their lender to lower the payoff of the note. There are companies that can perform this service, but in almost every state they need licenses (although real estate brokers are most often allowed to do so under state laws).
A significant amount of documentation – which varies from lender to lender—is required to convince the bank. The information usually includes current financials of the seller and a realistic valuation of the house. Traditionally, the borrower needed to provide a “hardship letter”, essentially a sob story detailing changed circumstances that make paying the existing mortgage difficult or impossible. Loss of a job, death in the family, or similar excuses are often the most successful. However, there are indications that banks are becoming much more willing to entertain short sale offers based primarily upon the underwater status of the house, and the borrower’s need or desire to move. In these cases the seller need not be in distress or even in arrears if the house is seriously underwater, though the combination gives even bigger incentive to the lender to agree to a short sale. If there are large secondary liens or large balance home equity credit lines on the property, these lien holders need to be involved, and the bank has to make its calculations knowing that they will also demand some portion of the sale proceeds. Interestingly, often one lender has provided both a purchase money mortgage as well as a second mortgage or home equity line of credit. One would think that the negotiations regarding a short sale in this situation would be easier because of this relationship; however, often this is not the case, as large banks tend to segment product lines into different administrative divisions. I predict that this will change as short sales become more mainstream.
The timing of the negotiations depends on the circumstances. Short sales are not approved until there is a contract of sale from the borrower to a buyer, but some lenders will begin the process at or before the time the house is listed, requiring appraisals or other evidence of value until a contract can be obtained.
Once the short sale documents are approved by the bank, it will issue a short sale letter which is in essence an agreement to forgive a portion of the principal of the loan. However, there will be other requirements, some of which make the sale ineligible for a relocation transaction. The most common of these requirements are the “claw back” provisions which are less commonly seen recently, but which are still a part of many agreements. Claw backs are a requirement that the bank can unwind the transaction in the event of misrepresentation or fraud; often the agreement limits the time period for the claw back to 60 or 90 days, but in any case, due to the two sale nature of the relocation sale, this makes such an agreement unacceptable. They are explained in detail here: http://www.worldwideerc.org/Resources/MOBILITYarticles/Pages/0810-Tax-Legal-Update.aspx
If the secondary lien holders agree, and if there is no claw back provision, the sale goes through as any other sale, the buyer receives clean title, and the seller is relieved of the mortgage.
However, the time required for banks to initiative and process the paperwork, especially where “hardship letters” were required has traditionally taken months, souring many deals. But I suggest that as short sales begin to take over an even larger portion of the market, banks will begin to devote more personnel to their processing, significantly shortening the processing time.
Current Short Sale Environment
As mentioned above, banks have been slow to warm up to short sales, even though they can be a money saving tool in the proper situations. But this will likely change as the need to get underwater assets off balance sheets continues. As an example, one recent statistic shows that in the San Francisco Bay market, 18.6 percent of all existing home sales were short sales in April, up from 17.6 percent a year earlier and 12.9 percent two years earlier.
One reason for banks’ reluctance is the threat of fraud; in fact, CoreLogic, a respected real estate research firm has just released its 2011 short sale report which both shows the three fold increase in short sales in the past two years, and also shows the potential for fraud in these sales. A summary can be found at http://www.corelogic.com/About-Us/News/CoreLogic-Releases-2011-Short-Sale-Research-Study.aspx
. Interestingly, this firm’s latest statistics also show that while first quarter real estate values fell over seven percent, year over year, the figure for non-distressed properties was less than one percent. Yet another reason for banks to consider short sales as an effective method of clearing shaky assets from their balance sheets.
Concerning the issue of fraud in the short sale process, several reported cases show a common thread: a real estate broker or investor approachs a homeowner and convinces the borrower to apply for a short sale, using fraudulently prepared appraisals or BPOs. Then, the property is sold to a straw purchaser and immediately resold to a buyer at a higher price. The current description of this process is “flopping”. The CoreLogic report estimates that banks stand to lose as much as $375 million in fraudulent flops, unless they take more risk management efforts to weed out fraud. This is not an uncommon recommendation regarding the disposition of any distressed property, but it is an indication that banks are becoming more involved in short sale processes as their numbers increase. This is good news to the extent that banks formalize the process, and likely portends faster approvals as staff is redirected to analyzing short sales.
Note that what makes a short sale illegal is the use of fraudulent valuations and a phony fist sale contract, and other failures to disclose to the bank. In essence, this is just a twist on the type of mortgage fraud that was rampant during the housing bubble. There are legitimate investors who approach banks to purchase houses on short sales, the difference is that there are no fraudulent appraisals, and the bank is aware that the investors will sell the house as soon as they can, for a profit. Not all banks will do these deals, but often it is cheaper than foreclosing.
Spurring banks to clear underperforming (or potentially underperforming) loans from their books was the recent announcement by the FDIC that banks may be required by regulation to maintain even larger capital cushions in the near future, as the agency has reservations about their ability to withstand a serious double dip recession.
If I am correct in assuming that banks will streamline the short sale process and will be more willing to extend them to more transactions, then it is also likely that more relocation transactions, both on the departure and destination side, will involve short sale paperwork. In my next blog, I will publish a short checklist for relocation transactions.