Mortgage Short Sale
Mortgage Short Sale - An Exit Strategy or an Investment Opportunity?
On June 28, "Johnston" responded to HUD Pushes Mortgage Lenders to Avoid Foreclosure Loses. The article was about the FHA Loss Mitigation Program which gives lenders the authority and responsibility to assist homeowners in financial trouble with their home mortgages. HUD/FHA lenders have options in dealing with distressed homeowners to stop foreclosure and HUD has recently pushed them to pursue these including a pre-foreclosure short sale where the borrower sells the property for its appraised value even though this may result in a "short sale."
What, Johnston asked, is a short sale? "I'm familiar with the term in stocks, but not real estate or mortgages."
Stocks are sold short when an investor sells securities that he does not own in anticipation that the price will plummet so that he can buy the stock back at a lower price and "cover" the sale. A short sale in the mortgage world amounts to an accommodation on the part of the lender in hopes of avoiding or mitigating an impending loss.
Let's say that, during a short-lived housing boom, Joe buys a real estate investment property in Arizona for $150,000. He puts down $30,000 and takes a $120,000 mortgage loan from Sunburn Bank and Trust (SBT) and, immediately after closing, a second mortgage loan for $10,000 from his credit union to make improvements to the property. He rents the property out for a year or two, nicely covering his mortgage payments then, just as he is about to sell and take his profit, the local economy hits the wall. First Joe has trouble renting the property for enough to cover his mortgage payments and then loses his own job, runs through his savings, and begins to fall behind both on his home mortgage and the first and second mortgages on the investment property.
The banks are calling him weekly but Joe claims he can do nothing. His unemployment insurance is gone, both houses are for sale with no takers, and his last tenant left owing two months rent after virtually trashing the place.
SBT hires an appraiser to inspect the investment property and he reports that it appears to be in bad shape and probably not worth anywhere near the $120,000 that Joe owes the bank. The bank's loss mitigation specialist estimates that a non-judicial foreclosure will cost about $4,000 and there are property taxes due in the amount of $800. The appraiser estimated repairs in the amount of $5,000. With the second mortgage still outstanding, the bank is looking at a substantial loss.
The bank has several options.
Foreclosure is the most obvious recourse. While it seems unlikely that the bank can sell the house at auction for enough to cover the mortgage amount and legal fees, foreclosure would at least wipe out the second mortgage.
If there is a shortfall following foreclosure the bank could seek a judgment against Joe for the balance owed. It looks, however, that he might be the proverbial turnip out of which one cannot extract blood.
A workout or restructure of the loan also looks futile. Joe is clearly underwater so it is unlikely that he would be able to pay any restructured amount that the bank might propose.
The bank could accept a Deed-in-Lieu-of-Foreclosure in which Joe would sign over all rights to the house. The bank, in return, might promise to forgive Joe the balance of the debt owed. This, however, still leaves the bank faced with the outstanding tax bill, some legal fees, and the second mortgage.
Or they could search (or encourage Joe to search) for a private party who would buy the property possibly even before foreclosure begins.
Joe has had the property on the market for some time so apparently the amount needed to pay off the first and second mortgagees and the back taxes (and possibly a real estate commission) is more than the market will bear.
It looks like everyone in this deal, except for the city which will collect its taxes no matter what, is going to get burned.
And that is where a real estate short sale comes in.
We have painted an unusually complicated scenario in order to demonstrate some alternatives that might take place.
Let's say that Joe's friend Carl has had his eye on the investment property and is willing to pay $115,000, even in the current depressed market. He approaches Joe with this offer.
Joe has already given up on the idea of recouping his original $30,000 investment and just wants to get out with his credit history somewhat intact and without the possibility of a summary judgment against him for any shortfalls on the payoff to first and second mortgagees.
The $115,000 offer that Joe presents to Sunburn B&T looks like the answer to both their dreams. Granted, the bank is owed around $120,000 on the original loan along with several months' unpaid interest and some appraisal and collections expenses, but it is still facing $4,000 in legal fees and, if the property does not sell at auction, a second mortgage (which may have to be paid off immediately after the new deed is filed) $800 in property taxes, and untold future expenses managing and marketing the property and making needed repairs to keep the property from deteriorating any further.
The bank might be delighted to take the $115,000 offer but there are still the issues of the second mortgage and the tax bill. Carl will have to pay the taxes before closing on the house so the big problem is the second mortgage. Carl however, can negotiate that just as he has the first mortgagee. SB&T will probably encourage Carl to approach the credit union with a nominal offer to release its second mortgage and might even offer to reduce its payoff a thousand or two to assist in the negotiation. The CU is not in a position to argue as a foreclosure by SB&T will wipe out their lien position although a deed transfer in lieu of foreclosure would put them in the catbird seat. Any pre-emptive strike by the CU to foreclose would force them to pay off Sunburn's senior $120,000 mortgage to recoup its $10,000 second - not a smart move to explain to your shareholders.
Both lenders will have to jump through some regulatory hoops to prove that the deal is the best they can do - a formal appraisal of the property, financial statements and possibly an asset search to prove that Joe is in financial extremis - but basically such a real estate short sale can ultimately work to everyone's satisfaction.
So it is possible that Carl will buy the property for $115,000 to $120,000, Joe will walk away a free man with only the remainder of his financial collapse to worry about, and Sunburn Bank and Trust will clear somewhere in the vicinity of $113,000 to $115,000, a loss of only $5,000 - 7,000 to explain to their stockholders and federal regulators.
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