Short Sale Primer For Brokers, Sellers and Buyers
Since I wrote the Short Sale Primer (2009) and Back To Basics (2008) articles, the short sale methodology used by lenders has morphed several times and most recently even the United States Government has gotten involved by creating "Regulations" through the Home Affordable Foreclosure Alternatives (HAFA) Program. The passage of time requires that the original article and its revision, which was very popular (thank you!), be extensively updated to reflect new policies by the lenders and realities in the marketplace. I have also updated or added several pertinent links to more detailed discussions on the various subjects in this article. (The end result is that this article is even longer than the previous one. Think about changing its read companion from a cup of coffee to a double espresso).
Short Sale and Loan Modification procedures are very different than they were 2 year ago. Lenders have reacted to the market place and evolved methods and internal rules to reflect the "tried and true" from recent experience, and through these rules seek to reduce their financial losses. The lenders are also reactive to government financial incentive programs (HAFA, for example - see link below), and implement them when the economics are to their benefit.
Short sales are not a new idea. When I represented a few national lenders for all of their foreclosures in the State of Florida several years ago, we negotiated "loan workouts" or "quick sales" which are now called "short sales". Since loan workouts have been around so long, I did some digging with my old pals that were the executives I worked with in the loan workout and REO department of these national lenders (one of the lenders has since been merged into Bank of America).
I found one in Atlanta, one in Texas and another in Washington. Our discussion about short sales showed that nothing was new under the sun - the formulations and decision making processes were unchanged from 18 years ago - and only some of the terminology had changed (and thanks to government programs, keeps changing with new acronyms being created each week).
Elements of the Mortgage Loan
First, understand that there are two elements to a mortgage loan.
1. The first is a promissory note. The promissory note is a financial instrument that is itself an enforceable contract to repay a debt for money loaned to the borrower.
2. The second is the mortgage. A mortgage is a security instrument. It acts as the security or collateral for the promise to repay the money loaned which is described in the promissory note. Usually it cannot be enforced if the promissory note is paid off or cancelled.
Many are of the belief that thousands of promissory notes are lost and cannot be produced in court and thus the borrower does not have to repay the money. If you are of that belief, I suggest you read the article, FORECLOSURE DEFENSE FALLACY.
We are seeing 2nd mortgage lenders that whose mortgages have no equity value in the home skip foreclosing on the mortgage and instead just sue the borrower on the promissory note. For a more detailed discussion of this process and results see link A LAWYER'S EXPLANATION OF THE FORECLOSURE PROCESS
Short Sale Defined -
A few years ago I sent a fax to the Associated Press because they kept writing that a short sale includes the forgiveness of the deficiency on the note and mortgage. That statement was completely false. A full explanation of the various types of short sale scenarios - some with and some without forgiveness of debt - is in my article link LENDER SHORT SALE ACCEPTANCE LETTER EXAMPLES - READ WITH CAUTION!.
The Federal Government has gotten into the definition business as well. They define a short sale as, "A "short sale" is specifically designed to help borrowers who are unable to afford their first mortgage and want to sell their home to avoid foreclosure, even if the sale price may not pay off the amount owed on their mortgage". (see Exhibit A to Help For America's Homeowners - Supplemental Directive 09-09 Revised).
Don't confuse the stock investment definition of "short sale" with the real estate parlance. Short sales are a process of "shorting" the debt (the mortgages) that encumber a parcel of real estate (the house or investment property). Shorting the debt means that the person holding the debt (the lender) agrees to release its lien on the real estate for less than the amount the lender is due according to the promissory note.
The explanation is simple. The execution and the details of a short sale are highly complicated. The chemistry of each short sale situation is not identical and quite often the goal you want to achieve is a moving target seemingly and frustratingly impossible to reach. More detail in some of the methodology to a short sale is in a previous article (see link - What do I do? - I can't pay my mortgage).
Who Qualifies - And Why A Lender Would Want The Loan Paid Off For Less -
You can read discussions on who qualifies for a short sale in a previous article (see this link Some Sellers Think They are Entitled to a Short Sale and Economics 101). The qualifications over time have actually broadened over the evolution of the short sale although if you just restrict yourself to what is written in government directives, you would think they have narrowed. This is because the "rules" and "regulations" written by the Federal Government in the HAMP and other programs is actually a voluntary program.
Technically, everyone can qualify for a short sale. To understand this we need to become much more "technical".
Logically, a lender is not going to want to keep a secured loan on its books where it has evidence that the security has decreased in value dramatically and the loan-to-value ratio under which the loan was originally made is now "upside down". This upside down terms means the current market value is less than the principal amount unpaid on the loan. The portion of the loan that is not in compliance with the original loan-to-value ratio is, for bank auditing purposes (or investment valuation purposes if the loan is not a portion of a mortgage backed collateralized security) a liability and therefore is no longer considered secured. That is not appetizing to the lender since it makes the lender set aside reserves of cash for the lack of value in the loan. The lender needs to do something to change that situation. Commercial loans are treated differently than residential loans. (See "Loan Modification - and Refinancing" later in this article)
Depending on the language in your mortgage or your promissory note, the valuations being upside down could be reason to put your loan into breach and accelerate the promissory note. I have not seen a declared breach for merely being upside down on valuations by any institutional residential lender. But technically, if a property is in this upside down situation, the loan could already be technically in default even if it is "current" in payments.
Often, the borrower's desire to unload the upside down property is based on economic calculations. Those calculations usually show that it is better to take a loss now of a known amount of money rather than continue to pay interest, insurance and taxes in excess of the income from the property for an unknown period of time until rental or property values increase so the economic cash drain is reversed. I call this "quantifying the economic cost of ownership of the property". Many articles have called it the "strategic default", and have been addressed in my articles SHOULD I PAY MY MORTGAGE? and WALK AWAY FROM THE PROPERTY - STRATEGIC MORTGAGE DEFAULTS GROW TO 26%. A fascinating statistical article is found at Moral and Social Constraints to Strategic Default on Mortgages.
In any event, the lender would prefer to have the loan right-side-up or off its books. In some cases the property owner has excess cash laying around and can just sell the property (if that is their plan) and pay the amount to the bank that they are "short" at the closing so the loan is paid off in full. This is also a "short sale" but it does not involve the lender making any concessions - the property owner has to pay the shortage at the closing.
Ultimately, qualifying for a short sale hinges on two elements:
1) Can you sell the property for an agreed price, and 2) Can you exhibit a financial hardship.
Regarding #1, I say an "agreed" price and not the "market" price because we all too often see lenders mis-value properties and remain unwilling to take another look at those valuations. To make a short sale work, not only do you have to bring a buyer to the table who is willing to pay market value (or higher), but the bank needs to agree that this is indeed an acceptable price. Keep in mind, the bank has no legal requirement to accept your short sale or value the property in line with the market. Regarding #2, you must be able (via tax returns, pay stubs/financial statements, etc) to prove to the lender that you cannot pay the mortgage or the deficiency and need the short sale to occur to avoid a complete financial meltdown. Some lenders are more strict about this point while others allow some wiggle room, but in all cases some sort of hardship, either in keeping payments current or the need to sell but without the ability to cover the shortfall, must be clear and evident.
Financial Indigestion -
In other cases, where either the borrower has become financially distressed or where the borrower is asset rich but presently is lacking liquidity (I call it "financial indigestion" or "real estate rich - but cash poor"), other arrangements satisfactory to the lender can be accomplished.
These other arrangements usually come in two flavors: (1) providing alternative secured collateral to the lender, such as a first or second mortgage on another borrower owned property that has equity value, or (2) having the borrower sign a new or modified promissory note that is unsecured and payable over a fixed period of time, usually 3 to 10 years from the date of the short sale. Depending on the financial circumstances and the lender -borrower relationship, interest can be at market or othertimes at zero.
Where the borrower is experiencing extreme financial hardship and there is no horizon (projected end) to that hardship a third alternative can occur - actual forgiveness of the unpaid amount due the lender. This seems to be the "Holy Grail" for short sale sellers.
Loan Forgiveness = Income = Income Tax - The 1099 Issue
This leads us to the issue of the unpaid portion of the short sale. Some lenders will not provide a release of the balance due. This causes some good and some bad issues for the borrower. The good part is that without a final disposition of the unpaid portion, the borrower has not received any phantom income (i.e.: that 1099 stuff). This good news does not last forever. Once the statute of limitations on enforcement of the promissory note expires, then the borrower has that income to report to the IRS. The bad news is that the lender very well may sell the unpaid promissory note to some investor for 5 or 10 cents on the dollar and then that investor will definitely come after the borrower for as much as they can get above that 5 or 10 cents on the dollar. The small element of good news here is that as long as they are trying to collect on the unpaid portion, that unpaid portion is not income that the borrower has to report to the IRS.
As a short reminder, the big deal about 1099's is really an illusion. 1099 or no 1099, if the debt is forgiven the borrower has income to report to the IRS. No exceptions! Too many people come to me and say they want me to negotiate with the lender so that they don't get a 1099. I ask them why? They tell me that if they don't get a 1099, they don't have to report the income they would get on the debt they did not pay. The next question is why does the bank get to decide what the IRS usually has jurisdiction to decide? The answer is of course that the lender giving a 1099 means squat - unless the borrower is intent on committing criminal tax fraud by not reporting income (See picture to the left - do you know of this woman who said, "Paying income tax is for the little people.") There is relief available to the borrower are two opportunities to not recognize up to all of the income. These are discussed in detail in my article called (see link) Sellers Always Have Income and include the 2007 Mortgage Debt Relief Act.
Loan Modification - And Refinancing
In March 2009 a government incentive program was initiated that involved "financial encouragement" to lenders to reduce the principal obligation of a mortgage under certain circumstances.
Theoretically this reduction in principal triggers a 1099C cancellation of debt. However two observations: The program regarding reduction of principal has been a flop, and The Treasury Department has now issued new "directives" (read "HAFA") that focus more on getting some standardization for short sales than principal reduction. This is not to forget that the principal reduction concept is still alive, but now it is in concert with the Federal Housing Administration and a goal of providing certain refinancing based on 125% of current value and having the existing lender on an upside down mortgaged home take a loss for the balance. For many parts of the country this 125% goal could work and make a difference. But for the hardest hit areas, especially Florida, California and Nevada, the gap in valuations is still too great to make this a successful program for distressed homeowners.
The Making Homes Affordable Program (HAMP) was originally targeted to help in the modification of mortgages by providing financial incentives to Lenders and Loan Servicers to modify mortgage terms for certain qualified borrowers. Originally the program provided for a 4 tier modification "waterfall", but that has since become more realistic to the marketplace.
The 4 tiers of the waterfall were (1) forbearance or restructuring of the delinquent payments, (2) reduction of the interest rate (usually temporarily), (3) extension of the term of the amortization (usually from 30 to 40 years), and (4) reduction of principal. That has changed by removing the 4th waterfall reduction of principal, since almost no loans were modified in that way by the lenders. Just this week we did obtain a classic new definition HAMP modification that included forbearance of the delinquent past due payments (into a no-interest end of loan payment) and a reduction of the interest rate from 6 to 2% with incremental increases over a 5 year period. That borrower is now paying 40% of the payment he could not afford and the payment is now firmly within his financial ability. To achieve this, the interest is only being charged (and amortization applied to) less the 50% of the outstanding principal. The remaining principal is still there, but is lying dormant until either the loan matures or is repaid ahead of schedule. Perhaps this is the evolution of the 4th step in the waterfall.
This "bifurcation" of the loan into a "secured performing" portion and an "unsecured non-performing" portion is the same as the commercial loan audit guidelines issued by the FDIC in November 2009. See Policy Statement on Prudent Commercial Real Estate Loan Workouts.
Modification of a mortgage loan is continuing to evolve as a fast developing part of the housing recession resolution solution. Not everyone is entitled to a modification and even someone with a high interest rate that cannot refinance in this current financial market may not be qualified for a loan modification. Numerous factors are in play in determining if a loan modification is justified and chief among them is ability to pay - not desire to pay. Generally speaking, if your total housing expense is more than 31% of your household income, you should speak to a professional to discuss if you are a modification candidate. Yesterday an attorney who has a housing expense of $25,000 called me to modify his mortgage. He told me the $25,000 was about 10% of his household income, but the mortgage debt was about 110% of the value of the home. That lawyer is not a modification candidate. Likewise, someone with a mortgage that is 60% of their gross income is also not a modification candidate. Generally, if your mortgage is between 34% and 50% of your gross income, modification of the mortgage should be explored.
Government Directives - Home Affordable Foreclosure Alternatives Program -
Effective April 5, 2010, the Home Affordable Foreclosure Alternatives Program (HAFA) is part of Home Affordable Modification Program (HAMP) (both created as "directives" by the Treasury Department - not laws or rules created by Congress as the media would make you think). This program provides "financial incentives" to servicers and borrowers who utilize a short sale or a deed-in-lieu to avoid a foreclosure on an eligible loan under HAMP. According to the Treasury Department, these foreclosure alternatives reduce the need for potentially lengthy and expensive foreclosure proceedings by helping preserve the condition and value of the property through minimizing the time a property is vacant and subject to vandalism and deterioration. The Treasury Department believes these options generally provide a substantially better outcome than a foreclosure sale for borrowers, investors and communities.
Any reader of this article must understand that this "directive" is not a law and it does not force lenders to do anything against their will. We live in the United States and we all have the Constitutional Right to enter into contracts and to own property. The mortgage lenders own promissory notes and mortgages securing those promissory notes. The United States Government is not allowed to take away property (all or a portion of the value of the promissory notes) without fully compensating the owner of the promissory note. That is one of the things our forefathers fought for in the Revolutionary War. The Treasury Department has not made any rules that violate our rights to own property - and that includes the mortgage lender's rights to foreclosure as opposed to a short sale solution.
The "financial incentives" to the lenders and to the servicers are outlined in detail in the HAFA document Supplemental Directive 09-09 Revised, and I would love to review all aspects of it but since it is 45 pages long, this article is just not the place. Click on the link and read it - actually it is very interesting and for the most part, well written. (I will dissect it in a later article on this blog). But these financial incentives are a mere pittance of the amount of loss the lender will usually experience in a short sale result, so it is not the "just compensation" reference in the preceding paragraph.
Short Sale "Bookends" - and Stories From Outer Space!
Note that these are the general parameters that we have seen over several years of dealing with loan workouts. There are always exceptions where the decision of the lender is simply without logic.
Illogical example #1 - The borrower is without a job, has moved out of the house and is living with one of the spouses' parents out of state. The house is now valued at $190,000 to $210,000 and the loan is at $350,000 and has been on MLS at $200,000 for 3 months. One quarter of the homes in the neighborhood are in some kind of pre-foreclosure or distress. The lender refuses to accept a contract at $178,000.
Illogical example #2 - The borrower owns two businesses and shows annual gross income of $500,000. Borrower has 4 homes all investment and lives in another (5 altogether). Lender accepts a short sale on one investment home at 10% under value, leaving $70,000 short on the mortgage payoff. Borrower asks for a letter of release from the lender that it will not pursue the shortage on the promissory note and the bank gladly provides that letter, letting the borrower off from every having to worry about the shorted promissory note.
I call these the "bookends" to the short sale definition of what fits the parameters of the banks. As you can see, even the bookends can be moving targets, since neither makes any sense. Fitting everything else in the middle leaves a really big gray area on the fringes of the middle! For more examples of how it is impossible to reliably predict the determination of the lender on the status of the shortage, see link SHORT SALE DEFICIENCY DEMANDS AND DEFENSES - The Interstate Highway Analogy
And now that you think you can figure out what the lender is going to say to a short sale request, consider these two quirky lender instructions on short sale offers we presented:
Outerspace #1 - Lender does a BPO and rejects the offer at $88,000 since the BPO came in at $140,000. So they come back and say, we reject the offer and we won't accept an offer of less than $140,000. Makes sense? No, because the lender only had a lien of a first mortgage in the amount of $86,000!!!!! How can they hold up an $88,000 mortgage with a demand you can't sell for less than $140,000? Well, they did it! And the seller freaked!
Outerspace #2 - Lender is presented a contract at $210,000 and mortgage is $250,000.. Lender rejects the contract and tells the borrower to reduce the contract to $176,000. Scratching your head? Good, Now I don't feel alone.
Still No Science To The Short Sale - But "Standardization" Is Emerging -
Several lenders have now created their preferred form packages for short sale consideration. These packages are usually available on the lender's website for downloading. They all pretty much say the same but their can be nuances as small as their logo on the top - or the order the information is presented. If there is a specific lender form, use it.
Bank of America and others have also begun the switch to on-line data entry programs and often it is mandatory to have the short sale considered. Even if you already have a package submitted, we have seen lenders "mysteriously" (I use the word instead of "on purpose") lose the package they have had for 3 months and then ask for you to resubmit it via their on-line data entry program.
The on-line programs are a pain to deal with - but frankly they are better than the lost file method that still is rampant in the industry. Also, on-line information is less likely to create a true story that just happened to our client with BankUnited. The package was submitted by fax - all 95 pages of confidential financial information on the borrower - and acknowledged as received by the lender. 7 days later the lender happens to send out the entire 95 page package, along with a single page tax form that needed filling out from another customer, to the other customer!!! That is right, a complete stranger. He called our office and "said" he was returning our client's loan file to the bank. But the damage is done! Talk about privacy policies?
From a timing perspective, a lenders time for processing a short sale sometimes takes 12 days (we have done it four times so far) and sometimes takes 6+ months (...don't ask!). It depends on the lender. It depends on the borrower's situation. It depends on the property. It depends on the contingencies and price in the purchase contract. Notwithstanding, we find that the best opportunity for a short sale to be successful is to provide a complete package to the lender THE FIRST TIME - keep it simple - but back up the assertions made in the presentation.
The HAMP program is seeking to standardize and reduce waiting times. This remains to be seen as to reality vs. intention. Computer programs can reduce wait times once the computer says the file is complete. But ultimately it takes manpower - something the lenders have been slow to implement - especially with trained personnel.
Short sales have a long history of being in the arsenal of lenders for loss mitigation and loan workout issues. Used properly, the short sale can be a tool to the lender and the borrower and an opportunity for a buyer with patience to obtain a relative bargain in the marketplace.
Copyright 2010 Richard P. Zaretsky, Esq.
Be sure to contact your own attorney for your state laws, and always consult your own attorney on any legal decision you need to make. This article is for information purposes and is not specific advice to any one reader.
Richard Zaretsky, Esq., RICHARD P. ZARETSKY P.A. ATTORNEYS AT LAW, 1655 PALM BEACH LAKES BLVD, SUITE 900, WEST PALM BEACH, FLORIDA 33401, PHONE 561 689 6660 RPZ99@Florida-Counsel.com - FLORIDA BAR BOARD CERTIFIED IN REAL ESTATE LAW - We assist Brokers and Sellers with Short Sales and Modifications and Consult with Brokers and Sellers Nationwide! Shortsales@Florida-Counsel.com New Website www.Florida-Counsel.com.
See our easy to understand articles at:
TABLE OF CONTENTS - SHORT SALE AND LOAN MODIFICATION ARTICLES
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