New Housing Finesse: "Short Sale" Rather than Forclosure

A Bloomberg story, “Homeowners, Lenders Skirt Default, May Curb U.S. Housing Slump,” highlights a practice used by banks with borrowers in default, the so-called short sale. Rather than foreclose on the property, banks accept a price below the loan balance on a quick sale.

Although the Bloomberg piece doesn’t say so, this is a long established but not much discussed alternative. The process of foreclosure is costly and time consuming, and once the bank takes possession of the house, it requires additional time to find a buyer. If the local economy is experiencing an increase in defaults due, say to the closure of an important local employer, real estate value may be falling all through the foreclosure-sale process, so delay can increase losses.

Banks much prefer to avoid foreclosure, not simply for reasons of cost, but also because properties acquired through foreclosure are included in “other real estate owned” and analysts are sensitive to rises in OREO. A short sale is also better for the borrower, since it leaves his credit record undamaged.

But this practice also obscures the true number of people who lost their houses through inability to meet mortgage payments.

This story also discusses how defaults are rising as “teaser” loans, with very low initial interest rates, and other types of adjustable rate mortgages are resetting, resulting in sharply higher required payments. See here and here for a discussion of what this means for the economy.

From Bloomberg:

Homeowners….are finding their mortgage companies eager to accept a sale price that falls short of a property’s loan balance — a so-called mortgage short sale. The number of U.S. loans entering foreclosure reached an all-time high in the fourth quarter, according to the Washington-based Mortgage Bankers Association. That’s spawning a cottage industry of real estate investors who profit as lenders try to avoid adding properties to their portfolios….

The short sales may mitigate the impact of the housing slump as the properties avoid being tallied as foreclosures. At the same time, they will help push the U.S. median home price to a third consecutive quarterly decline in 2007’s first three months….

Both sides benefit from the transaction. Lenders absolve a portion of the mortgage and don’t end up owning property. Although borrowers lose their homes, they avoid the stigma of default, making it more likely they will buy another property in the future.

Overdue payments, or delinquencies, on all types of loans in the fourth quarter rose to 4.95 percent, almost half a percentage point above the 4.47 percent average of the previous three years….

Late payments by subprime borrowers, those with tarnished or insufficient credit, climbed to 13.3 percent, compared with 2.57 percent for prime mortgages, according to a report released last week by the bankers’ group [Mortgage Bankers Association]. Foreclosures on prime mortgages rose to 0.5 percent from 0.42 percent a year earlier, a sign of broader trouble in the mortgage market…

Wells Fargo & Co. and National City Corp. face the most risk among the largest regional banks from rising defaults by subprime borrowers, analysts at Merrill Lynch & Co. wrote in a report last month. About 12 percent to 14 percent of San Francisco-based Wells Fargo’s total loans outstanding and 8.5 percent of Cleveland-based National City’s were made to subprime borrowers.

Merrill estimated that subprime holdings at Bank of America Corp., U.S. Bancorp, BB&T Corp. and Wachovia Corp. were 3 percent to 5 percent.

The situation has provided plenty of opportunity for property investors like 30-year-old Dallas Alford of Wilmington, North Carolina. Business is booming, he said.

`More Forgiving’

“Lenders have become more forgiving in the last few months because defaults are rising, and they’re not in the business of owning houses,” Alford said. “Trying to put that kind of deal together a year ago was a waste of time because banks weren’t interested in a buyback.”

Alford said he handles about three or four mortgage buyback transactions a month with lenders usually forgiving $30,000 to $40,000 per loan. He declined to identify the banks involved.

In a typical deal, Alford finds a homeowner who has lost a job or had a business fail and gotten behind on his mortgage payments. He might be willing to pay $205,000 for a house that has a $235,000 mortgage, which would require the lender to forgive $30,000 of the loan.

Historically, only about 25 percent of mortgages that are delinquent end up in foreclosure. Some are resolved through a short sale and others result in a “deed in lieu of foreclosure” in which the owner surrenders the deed without a foreclosure and the bank ends up as a property owner.

Dwindling Options

In contrast, almost all mortgage forgiveness involves the sale of the property, said Regan Brewer, a counselor at Acorn Housing, a Chicago-based consumer group that provides free housing counseling to low- and moderate-income homebuyers. It’s not likely a bank will reduce the loan’s principal just because a house has fallen in value. In rare cases, borrowers can negotiate with banks to reduce late fees and charges that have been added to their loan’s balance, Brewer said.

About three-quarters of the 400 homeowners who have visited the Acorn Housing office in Chicago in the past two months have been subprime borrowers who can’t make their mortgage payments because their loans are resetting at higher rates, Brewer said. Some subprime loans reset every six months, she said.

“I don’t know too many people who can afford to see their mortgage payment go up $400 or $600 every six months,” Brewer said. “Most people don’t have the income to keep up with that.”

Borrowers who run into trouble paying their mortgages have fewer options in today’s market, compared with a few years ago.

During the five-year housing boom that ended in 2005, owners who fell behind on payments could sell their homes and pay off their loans or get better refinancing terms based on the higher value of their property….

Subprime mortgages have rates that are at least 2 or 3 percentage points more than safer prime loans. About 20 percent of all new mortgages made last year were to subprime borrowers, according to Duncan of the mortgage association.

Some subprime borrowers were given loans without income verification at rates that probably will jump to levels they can’t afford, said Federal Reserve Governor Susan Bies in a Feb. 20 speech at Duke University’s Fuqua School of Business in Durham, North Carolina.

“Products that had adjustable payments every month began to be mass marketed to subprime borrowers, and we found that there was just stated income, no testing of income,” Bies said. Borrowers “did not have the ability to absorb the higher payments when the payments started shooting up.”

While the loans may have looked good on the books during 2006, many of them haven’t performed well. Countrywide Financial Corp., the biggest U.S. mortgage lender, said payments at the end of 2006 were late on almost 20 percent of the subprime loans it tracks for other companies and investors who own them.

The situation may get worse, Bies said in a March 9 speech at a risk-management forum in Charlotte, North Carolina.

Back to Renting

“What’s happening is the front end of this wave of teaser- rate loans that are coming into full pricing,” Bies said. “So what we’re seeing in this narrow segment is the beginning of the wave. This is not the end, this is the beginning.”

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