THE LONERGAN LAW FIRM PLLC
The Lonergan Law Firm PLLC
12801 North Central Expressway
Suite 150, Dallas, Texas 75243
866-679-9551
jbroyles@lonerganlaw.com
August 26, 2010
In today's real estate environment of flux and uncertainty, the topic of short sales seems to elicit plenty of discontented groans. While there are many reasons for such reactions, the situation could be far worse, and in our estimation, it will be. We offer this article as a means not to make the process simpler - nobody can do that - but rather, to deconstruct the moving parts and then reassemble them piece by piece. We want to show you how this black box really works, and why it often doesn't.
Grab some coffee and roll up your shirt sleeves.
What is a Short Sale?
Technically, this is the process of negotiating the reduction of a payoff to a promissory note attached to real property via a mortgage, deed of trust, etc. for the purpose of a release of lien(s) to allow for an insurable transfer of title. Simply put, it's getting a bank to take less than they're owed so a homeowner can sell their home for less than full payoff - "short" of what they owe. Remember, the "mortgage" is just the glue that holds the debt to the asset. We'll talk about the importance of this distinction and its implications to future liability later.
Why do banks do that?
The lien holder or their agent - the servicer - attempts to mitigate further, larger losses through an agreement today in lieu of foreclosure sometime in the future. That is, a bird in the hand beats a foreclosure. While this is conceptually straightforward, it's remarkably difficult in practice. We won't go into net present value calculations in this article, but the idea that a dollar today is worth more than that same dollar in the future guides the short sale decision-making engine.
What do short sales look like?
Short sales can manifest in a thousand unique ways, but there are some attributes present in every instance. Knowing these traits can then guide our ability to uncover what the true financial picture looks like for a homeowner. To simplify, we've broken into two groups the attributes which comprise a good short sale situation: (1) the loan details and (2) the borrower details.
Loan Details
- Current interest rate: if a borrower has a 9% interest rate in a 5% environment, ask why
- Down payment amount: if a borrower has less to lose, they're more likely to
- Time since purchase: most foreclosures happen in the first few years.
- Servicer/Investor: not all mortgages are serviced equally.
First, let's discuss the typical short sale loan: An interest rate markedly above current rates demonstrates that the borrower cannot refinance; the borrower has most likely and unsuccessfully tried to do so. This could be due to credit problems, underwater value, lack of income to procure a new loan, etc. Statistics guide the next two characteristics. If a borrower puts no or little money down on a purchase or refinance, they are statistically more probable of going into foreclosure. Tangential to a low down payment (due to the subprime and alt-a era) is the time since the last origination. That is, the amount of time since the borrower purchased or last refinanced the home. Predominately, we see borrowers heading to foreclosure in the first five years since their last origination. Finally, let's review the quality and manner in which the loan was serviced. While we all hope for excellent loan servicing, the reality is that loan servicers often play a large role in the resolution of the loan breaking down.
If a borrower has a terrible loan servicer, then the longer the resolution time and the more frustrated the borrower will be with the servicer. Ironically, these same servicers are quick to trigger a foreclosure because it is easier to foreclose than to properly service the loan. Further, different investor types have drastically different underwriting guidelines for accepting a short sale offer. We will discuss underwriting guidelines later in the article. By knowing these attributes of the loan, we can predict with higher certainty the likelihood of this borrower needing a short sale.
Borrower Details
- Geography: market values have some impact on short sales, but less than you think.
- Hardship: a financial hardship must be caused by a real-life hardship, not a decline in home value.
- Income: a demonstrable, verifiable reduction of income.
Next, let's review the borrower profile. We understand that California and Florida steal the headlines when it comes to declining home prices, but that doesn't mean homes in relatively stable markets don't fall into the short sale classification. Any time a home cannot sell and yield a full payoff to the lien holder(s), a short sale is required. Whether the shortage amount is $10,000 or $100,000, the processes, negotiations and results are quite similar.
The real-life reasons, on the other hand, tend to be very different. Often, these are undervalued if not completely overlooked. While nobody wants to lose his or her home, there is a real-life reason that causes an individual or family to sell. Understanding what this real-life reason is will help us know if the situation is temporary - such as the loss of a job for a few months - or permanent - such as a death or a divorce. The temporary reason can be a legitimate short sale hardship if the replacement income is less than what the previous job was earning. In fact, in all cases, a non-recoverable financial hardship will satisfy the lender's requirement that a real hardship exists. However, a situation that does not qualify as a real-life hardship is a home underwater by $100,000, owned by a doctor making an annual salary of $300,000, and fully capable of making payments.
The Underwriting Process
When the short sale process begins, just like when the borrower applied to obtain the mortgage in the first place, the short sale requires fully documented underwriting of financial information. Ideally, such information was fully documented when the loan was originated. During this underwriting process, the demonstrable reduction of income must be proven. In order to be considered a real short sale borrower, an individual must have a reduction of income to the degree that it becomes untenable to continue making payments. Here again, each investor or bank will have different guidelines. As was the case with loan details, knowing the nuts and bolts of a homeowner's financial situation can help us determine if this borrower is in need of and would qualify for a short sale.
In the next part of the series, we'll cover the complex and esoteric relationship between investors and servicers and how that relationship dominates the short sale process and therefore, the results.
Part II
The Servicer/Investor Relationship
Aside some technical exceptions, perhaps the most important factor that influences the success of an individual short sale transaction is the contractual relationship between the servicer and the bank/lender/investor. Strangely, this relationship is not only misunderstood but one that most borrowers, realtors and buyers are unaware exists. Therefore, let's illuminate this relationship and understand how it functions.
Typically, investors don't get their hands dirty by servicing the mortgage assets they own. As a result, they tend to employ large retail banks and mortgage servicing firms to handle the payment collection, taxes, insurance, payoffs and default mitigation. That is, lenders/investors loan the money and collect their principal and interest, while some other entity interfaces with the borrower. These investors come in all types: individuals, companies, hedge funds, governments, pension funds, etc. Their core business is the allocation of capital, not the day-to-day maintenance of mortgage assets. At the same time, large retail banks and mortgage servicing firms (collectively, we'll call them "servicers") have recognized that servicing the nation's mortgages can be a profitable business in its own right. Thus, the two form a mutually beneficial relationship.
But how do millions of mortgages get serviced without the servicer calling the investor each and every time a decision needs to be made regarding a single mortgage? Contractual servicing agreements spell out and manage all aspects of the investor/servicer relationship. To make the relationship efficient, specific guidelines dictate what can and cannot be done for a particular mortgage, mortgage-backed security or other type of collection of mortgages.
In reality, less than 20% of all mortgages are both owned and serviced by the same entity. So when a borrower says, "My lender is Bank of America.", a more likely scenario is that the borrower's servicer is Bank of America, while the actual investor/lender of the loan is unknown to the borrower. Sometimes a borrower may be confused when an investor buys or sells the asset. As a result of such a transaction, the servicer can and many times does change. Now that we have a better understanding of the relationship between the investor and the servicer, we can better understand why a borrower may face such confusion in the event of a purchase or sale of the mortgage asset. Note, investors actively buy and sell assets within their community, and the servicing often changes along with the sale. Such a change of servicer can manifest in multiple ways, but the end result and process for servicing remains the same.
To compound matters, a particular servicer will likely service mortgages for numerous investor types, each with their own set of guidelines on how their particular assets can be and cannot be managed. You can see how such a situation quickly becomes complex and why servicing firms are constantly having to make sure they maintain compliance with their own agreements.
Now that we understand how and why the relationship exists between investors and servicers, we can apply this framework to short sales. When a borrower becomes delinquent on his or her mortgage, or demonstrates a reasonable foreseeability that he or she will be delinquent in the near future, a servicer has specific underwriting guidelines as to how it must manage and respond to that loan. These rules govern everything from the occupancy status, income, valuation, delinquency, marketing period, hardship qualification, net acceptable payoff calculation, realtor commissions and many other factors.
By knowing the particular type of investor (private investor, government investor, etc.) behind the loan, we can determine what kind of guidelines we will need to meet in order to transact a successful short sale. Though some guidelines are public - FHA, Fannie/Freddie, VA - many private investors keep their guidelines unpublished and tightly held between themselves and their servicers. Over time, however, the majority of private investors have emulated one another's best practices, so by reverse engineering enough approved transactions, we can estimate a close range of guidelines for non-GSE mortgages. The scope of this article is too narrow to go into these specifics, but the important point is knowing that not all short sales fall into a standardized set of guidelines.
Current Issues
Recently the federal government has started a government-based approach to short sales. Home Affordable Foreclosure Alternatives (HAFA) began in April of this year as an attempt by the US Treasury to help speed up and lessen the confusion of short sale transactions. It is far too early to tell what the results from HAFA will be, but we certainly welcome any attempt to make the process more efficient.
HAFA is designed to help borrowers who were ineligible for the Treasury's HAMP (modification) program to employ a short sale or simply give back their home to the lender (deed-in-lieu) to solve their delinquency. Note that a deed-in-lieu has no specific benefit for the borrowers other than those outlined in HAFA, which also apply to short sales. By far the better solution for both the homeowner and the lender is the short sale, as the short sale is more likely to reduce the deficiency amount - the amount of the loan unpaid after the transfer of title.
Additionally, a house that is a short sale candidate is less likely to be a vacant because the bulk of short sale sellers remain in the home until it is closes, just like a regular real estate transaction. As a result, the cost of vandalism and maintenance are reduced, and the community weakens less. Again, the scope of this article doesn't lend itself to outlining full HAFA guidelines, but they can be found online. Here are a few of the highlights:
- Waiving of deficiency judgment option by lender (more on this in Part III: Liability)
- Up to $3,000 to borrower at closing for moving expense
- Must be borrower's primary residence
- Must have been originated before January 1, 2009
- Must be listed by a real estate agent
- Mortgage insurance company must waive any right to deficiency judgment or promissory note
Part III
Liability: Servicer, Borrower, Agent
Mortgages are litigious instruments. When they lose money, the blame becomes amplified, and litigation ensues. This leads us into the liability section of short sales. By its very definition, the short sale is a purposefully accepted loss of money on a mortgage asset. That loss has the potential to raise legal liabilities for the servicer, borrower and agent involved in the transaction.
Servicer Liability
Having an understanding of the investor/servicer relationship gives us a foundation for discussing the potential liability that rise for the servicer. The servicer employs hundreds if not thousands of people who navigate guidelines and execute the day-to-day operational needs of its short sale department. In recent years, the demand for servicing short sale transactions has grown significantly. As such, an increase in hiring and the re-allocation of existing workers have acted as a temporary measures for short sale negotiators, processors and managers inside the loss mitigation departments of major retail banks, mortgage banks, and mortgage servicing firms. However, the training doesn't always match real-world needs or pressures.
When employees of servicers conduct real-world transactions, two things tend to happen: mistakes occur as a result of the fear of making mistakes, and the short sale is frozen or foreclosed upon. That is, when a new processor, negotiator or manager (each of these works for the servicer) faces a problem that he or she does not know how to solve, most of the time no action is taken or worse, the file is sent to foreclosure due to some ambiguous reasoning. The reasoning is hard to pinpoint and therefore the blame is hard to assign. Neglect, therefore, is perhaps the single largest potential source of liability for a servicer. If investors knew what truly occurred in the servicing of their assets, there would be a paradigm shift in how the mortgage world functions and likely, a tremendous reduction in the number of mortgages originated. Though hard to isolate, neglect is a very real servicing liability.
Proof of servicer liability is more readily found by examining the guidelines. The best way to explain this is by way of an example. Assume an investor owns a note for $500,000, and the guidelines for an acceptable short sale state that the investor will take 85% of the fair market value. Now suppose that the fair market value is $400,000. Then, per the guidelines, the servicer would be allowed to accept $340,000 as payoff on the short sale. If, however, the new or inattentive negotiator issues an approval letter and subsequently closes the transaction with, for example, a net payoff of $338,000 we have a problem. In this case, the investor has a number of options to seek to a remedy from the situation. Though $2,000 doesn't seem like a lot of money on any particular transaction, the reality is that tens of thousands of short sales transact each month and the losses can add up quickly.
Borrower, Agent Liability
The improper handling of loans by servicers has come to light in the last few years and will continue to create anxiety for loss mitigation departments. But they're not the only ones who stand to inherit liability with short sales. Borrowers and real estate agents have risks in short sales as well.
We initially covered the distinction between debt (the promissory note), glue (the mortgage or deed of trust) and asset (the house). That is, the money owed on the home is attached to the home by way of a mortgage. Unless specifically agreed upon in writing, the promissory note can act as a ticking financial time bomb. The amount the investor is owed versus the amount they receive at the closing of the short sale is known as the "deficiency amount." This is, specifically, the amount that is owed on the promissory note, which remains unpaid at the conclusion of the transaction. A common misconception among borrowers and real estate agents is that the short sale agreement is the end of the story. Sometimes what that agreement lacks can be the beginning of a much more frightening story.
The potential legal nightmare of short sales is the deficiency judgment. When a bank, investor or mortgage insurance company (an MI company can effectively be viewed as the investor in cases involving MI), seeks to recoup the balance owed on the promissory note, they can take legal action against the borrower. In turn, that borrower will often seek action against the agent for lack of disclosure, among a handful of other possible choices. The borrower's accusation will likely state that had the agent known, the agent should have informed the borrower of the risk of deficiency judgment action by their lender and given the borrower an opportunity to seek legal counsel for help in the decision making process moving forward on the sale of the home.
Though the deficiency cannot always be negotiated away, it is possible to avoid this unpleasant situation. By obtaining language in the written short sale approval letter regarding full settlement of debt, the borrower and agent can know that the mortgage investor has waived their future rights towards a deficiency judgment. In cases where investors do not release their rights to future deficiency judgments, the agents and borrower should communicate thoroughly about the potential consequences.
Conclusion
We have covered a lot of material and given the high-level view for understanding the multi-faceted mechanism of short sale transactions. There's a plethora of knowledge regarding this ever-changing niche as it continues to expand and demand our constant acquisition and sharpening of skills. It is our hope that you will use this white paper to further your understanding of a sometimes mysterious apparatus. While no one can claim to know everything given the complexities and speed of changes, our expertise in the area can help guide and protect you through your next short sale transaction.
