Short Sales: Their Implication and Impact on the Real Estate Market
A discussion of short sales cannot be had without addressing the elephant in the room. Between 1997 and 2006, a period of only nine years, on average US house prices rose a staggering 124%.
[1] Appendix 1illustrates historic home values as of 2006 as generated by Robert Shiller, a widely cited visionary who accurately predicted the burst of the housing bubble. While the causes of the real estate bubble were multifaceted and inherently systemic, short sales were and continue to be one of the many ways for corporations and homeowners to deal with its aftermath.
Short sales in real estate borrow their name from the practice of short selling stock. On the stock market a trader can borrow securities with the intention of buying the security back at a later date. The trader who short sells or “shorts” a stock profits from a decline in the price of the stock by buying the stock back in the future at a lower price, in turn making a spread between the prices. Similarly, homeowners borrow against the equity of their home with the intention of buying back the house over a period of time, typically a 30-year mortgage. The comparison ends there – a homeowner can only profit by selling their interest in their house when the value of the house has appreciated.
Appendix 1 is an inflation-adjusted graph. Home values have indeed seen a nominal rise in value; the graphic summarizes that the average home in 1920 sold for $66,000 versus $199,000 in 2006 (a 201.5% increase). Over time real estate prices in the US have always increased. Home ownership is widely recognized as a vehicle for “forced saving;” typically saving-averse consumers who elect to pay a mortgage instead of rent are left with a considerable net worth when they complete their mortgage payments. At the height of the 2007 mortgage boom, loans were being issued oftentimes to sub-prime buyers on the presumption that home prices would always increase. Like in any bubble, when home prices crashed, they crashed hard.[2] While bankruptcy and subsequent foreclosure was a viable option for many, consumers turned to the negotiating table with their lenders for creative solutions.
A lender facing an onslaught of defaults has the simple goal of losing as little money as possible on the properties that they have an interest in. Foreclosure is a lengthy process, often allowing the mortgagor to remain in the house without paying for long amounts of time as the eviction and legal processes ramp up. A well negotiated short sale would move the house quickly out of the lenders hands (and off their balance sheet), preserve the credit of the consumer if that is part of the negotiation with the bank, and place the onus to sell on the consumer not the bank.
Legality & Federal Programs
Short sales can either be private or federally subsidized and regulated. The private sector, represented by the National Association of Realtors (NAR), lobbied the Federal Housing Finance Agency as well as key government-backed lenders Fannie Mae and Freddie Mac to improve the short sale process by regulation and subsidization. On May 14th, 2009, the Obama Administration announced the Home Affordable Foreclosure Alternatives Program (HAFA). HAFA is complementary to HAMP – the Home Affordable Modification Program.
Under HAMP monthly mortgage payments are reduced to 31% of ones verified monthly gross income. The Department of the Treasury and Housing and Urban Development cites a 40% average drop in monthly mortgage payments.[3] As of July 2010, HAMP was supposed to provide mortgage relief for 3 to 4 million borrowers, with only 1.3 million actually enrolling. US Treasury numbers cited approximately 530,000 borrowers leaving the program, and 390,000 having received permanent modifications with the remainder waiting to do so. Widely seen as a failure and an exercise in big-government waste, the expected cost to the taxpayers of HAMP is quoted between $22-49 billion depending on which department is giving the quote. According to Fitch, one of the large credit rating agencies, 75% of HAMP modification loans will eventually re-default. Another top rating agency, Barclays, issued a more conservative 60% re-default figure.[4] No matter which numbers are accurate, it is clear that HAMP was a failure – pouring even more tax dollars into an unsuccessful program attempting to help the very same private companies that helped cause the defaults to begin with.
HAFA went into effect on April 5th, 2010. A relatively new program, HAFA targets homeowners who are not able to stay in their home, even if they do have loan modification under HAMP. The program provides qualified applicants with financial incentives including: $3,000 for borrower relocation assistance; $1,500 for mortgage servicer’s administrative and processing costs; and up to $2,00 match for mortgage investors for allowing up to $6,000 in short sale proceeds to be distributed to subordinate lien holders (see Appendix 2 for a detailed information sheet on HAFA from the National Association of Realtors®).[5] Initial HAFA numbers were released by the Treasury Department on April 1st, 2011. The figures were generally low – through February 2011 only 4,488 short sales were transacted under HAFA, with Treasury spending around $4.3 million. House Republicans voted to end the program two years before it was set to expire, further amplifying the sentiment that the program was unsuccessful.[6]
Unsubsidized deals make up the lions share of short sales. Data indicates that the number of short sales increased throughout 2008 and 2009. Typically, buyers who wish to sell their home as a short sale have to jump through proverbial hoops to get the sale approved, even when it makes sense for both parties. According to Nancy Sarnoff of the Houston Chronicle, “It takes more of an effort from the seller, too, who must provide past paycheck stubs, hardship letters and other financial documents before a lender will agree to a short sale.”[7] Sarnoff goes on to describe a climate where short sale requests have increased exponentially and banks are buried in paperwork. Legally the lender owes no duty to consider a short sale, but is well aware of the other legal consequences should they not accept it, namely foreclosure.
The Ethics of a Short Sale
Banks, however, cannot be faulted for requiring this information. Both parties signed a contract where the borrower agreed to pay back the principle plus interest of the mortgage over time, regardless of the rise or fall of the property’s value. Especially when short sales and foreclosures are the focus of the media, there will always be people trying to defraud the system.[8] Before writing off a loan on a mortgage, due diligence has to be undertaken by banks to ensure that the mortgagor cannot in-fact afford the monthly payment or an alternative payment plan. According to an About.com editorial guide[9] the process for the borrower involves the following steps:
- Call the lender (mentioning that it will often take multiple phone calls).
- Submit a letter of authorization including all of the parties that you authorize to discuss and negotiate the matter.
- Submit a preliminary ‘net sheet’, estimating a sales price and fees.
- Submit hardship letter (“The sadder the better”).
- Submit proof of income and assets.
- Submit copies of bank statements.
- Submit a comparative market analysis proving the decline in property value.
- Submit a purchase agreement and listing agreement once an offer is made.
As an avid reader of credit forums and related news sources, it’s no surprise that there is no streamlined process to obtaining a short sale approval (like other types of defaults). Banks do not advertise them, and only after the borrower has amassed all of the aforementioned paperwork and documentation would they consider the sale.
Banks are under no pressure to complete the sale or even respond to the request. Due to the volume of short sale applications, it is often mentioned that banks will drag out the process at various steps. As Stephanie Armour of USA Today puts it, “Instead, many homeowners are watching potential buyers walk away as months pass while they deal with lenders’ lengthy delays, lost documents and unreturned calls.”[10] The question inevitably surfaces; what ethical duties do the two parties owe to each other?
From the mortgagee’s perspective it makes financial sense to review all short sale applications and accept or reject them based on the risk of default and the comparative opportunity costs of either pursuing the short sale or the cost of a future foreclosure (including the probability that such a foreclosure will or will not occur). Once a short sale is accepted the bank does owe an ethical duty to see it through, but also a duty to its stakeholders to negotiate the best sale price and terms possible. What if that means taking months to reply to multiple offers, as was the case with Chase Bank and borrower Jorge DeMattos regarding a home in Pembroke Pines, Florida? Such negotiation tactics seem impossible to deal with – but when the facts of the case come out, it’s easy to see the bank’s point of view. DeMattos owed $355,000 on his mortgage with a short sale price of $225,000.[11] Facing a considerable loss, the bank does have options that include waiting out the short sale for a better market. Ethically, at the very least the bank owes transparency in its intentions.
From the mortgagor’s perspective they should expect to be treated with dignity and respect. While this might sound like common sense, anybody familiar with the collections industry and the harassment tactics that it employs will know that it is anything but the norm. Big banks such as Chase value relationships and brand image, two things that get tarnished quickly when defaults occur. DeMattos and other borrowers like him have usually already violated covenants of their contract by letting the account become delinquent. Another question arises with both foreclosures and short sales – whether the mortgagor is entitled to default and move on. Although the argument is by nature a slippery slope, defaulting is an unethical action. While the circumstances behind defaults vary and are personal by nature, an agreement was made and then violated.
Analysis & Conclusion
Very few were prepared for the real estate market to collapse in the late 2000s. Home prices had historically always gone up over time and the sky was the limit. Mistakes were made systemically. Buyers bought homes that they had no business buying and mortgagees issued loans that they had no business issuing. The Federal government was also guilty of mismanaging quasi-governmental agencies such as Fannie May and Freddie Mac as well as only loosely regulating rating agencies and financial institutions that would repackage and sell mortgages as financial instruments.[12] Programs such as HAFA and HAMP were politicized incentives towards economic recovery that encouraged more efficient short sales over foreclosures. While the program worked in theory, it was too little too late.
Banks were forced to shift their positions from holders of financial instruments backed by real estate to owners of depressed properties. Unprepared for millions of costly evictions, lawsuits, and foreclosures another viable option appeared. Much like the bulk of lawsuits, short sales became the mediated arbitration agreements of the real estate world. Borrowers do the legwork and reach out to their lenders when a foreclosure is imminent. In return, the two parties “settle” by agreeing to sell the property and forgive some of the debt in the original agreement simply to move on.
Admitting that you have a problem is the first step to recovery. For the big banks, moving some of their imminently tainted properties off their balance sheets was the way to salvation. There still remains a sense that companies are making it up as they go along. Standardized application processes for short sales and foreclosures are nowhere to be found. It is likely that we have not seen the end of short sales. As long as the real estate market fluctuates, there will be people driven to strike a deal with their lender and lenders willing to forego foreclosures by stopping them in their tracks.