The U.S. government would rather see troubled homeowners refinance their home loans, modify their loans or, if all else fails, sell their homes in preforeclosure transactions to stave off foreclosure and clear the market.
The administration's May 14 initiative to facilitate short sales and deeds-in-lieu transactions encourages these attractive alternatives to foreclosure, and it follows efforts by Fannie Mae, Freddie Mac and a number of major banks to resolve default properties via short sales. Major servicers are expecting an eightfold increase in short sales by this summer.
It's no wonder. It can cost a bank $30,000 to $50,000 to foreclose on a home, plus carrying costs that equate to 1.0% to 1.25% of the value of each home each month.
Short sales, on the other hand, carry a cost, but it is wholly known. That offers a distinct advantage in today's market.
As most know, short sales are when the lender allows a distressed property to be sold at a price lower than the homeowner's mortgage indebtedness, with the difference generally but not always forgiven. This relieves borrowers of their ownership and debt burden without marring their credit report the way a foreclosure would. It also typically allows the purchaser to buy into the neighborhood at a substantial discount to the mortgage's face value — at a price much more in line with the property's current market value.
In other words, short sales facilitate efficient clearing of the market.
Historically, short sales have not been very appealing to lenders. It is a complex process that requires an agreement by all the lien holders to accept a lesser amount. The paperwork and number of players involved can easily overburden a servicer that is already dealing with hundreds of thousands of loan modifications, real estate owned dispositions and more.
But with about 4 million loans in default so far in this cycle and as many as 10 million defaults possible in a prolonged recession, according to Credit Suisse, major lenders and servicers are fired up for short sales.
The Home Affordable Modification Program guidelines published in March by the Treasury Department mandate that a short sale or deed in lieu be attempted if a distressed homeowner does not qualify for a modification by servicers that have or will seek access to federal funding support.
As regulators and many others see it, if just 25% of the current loans in default could be resolved through short sales, it would stave off a million foreclosures (good for homeowners) and replace a million nonperforming borrowers with a million performing ones (good for lenders).
The industry's challenge in accomplishing this is twofold: evaluating portfolios to determine which homes and borrowers are well suited for short sales, and scaling what has historically been a very manual process with newer technology.
Banks and servicers evaluate their short-sale prospects by reviewing quantitative and qualitative criteria. First and foremost, lenders identify borrowers who are upside down; that is, their loan balances are higher than the current market value of their homes. The bigger the spread between the mortgage balance and home value, the more likely the borrower is to consider a short sale.
New federal guidelines have standardized this analysis. If the homeowner has a negative present value — that is, the cost of modifying the loan is more than putting the homeowner into foreclosure — a short sale must be attempted.
Another important criterion for evaluating short-sale prospects is the number of liens on a given property. Since all lien holders must agree to a short sale, the less encumbered a home is, the better the chances that a short sale can be consummated.
If a borrower is willing to engage in a short sale, presumably because the borrower cannot afford the current obligations and because a modification would not materially improve the payment situation, lenders look next at the borrower's ability to afford the current mortgage.
Clearly, lenders and servicers do not want to take a hit if they do not have to, and if a borrower is underwater but still able to afford the debt service, most institutions do not want to release the borrower from the contractual obligation to pay the current mortgage. On the other hand, if the borrower cannot afford the mortgage and the only alternative is to let the property fall into foreclosure, a short sale offers the lender and the borrower a way to cut their losses.
How to determine if a borrower is truly unable to pay? Lenders and servicers must verify employment and income, pull a credit report and assess the borrower's FICO score. The same due diligence also reveals whether a borrower could pay back some or all of the forgiven indebtedness — which some lenders require as a condition for a short sale.
The second part of the challenge is how to process the actual sales, considering that the legacy technology was not built to handle either the volume or the complexity of today's short-sale transactions. Document management is one of the biggest obstacles. There can be a dozen or more documents associated with a short sale, including the original mortgage, the mortgage insurance agreement, all delinquency notices and preforeclosure filings and the items related to a borrower's employment, income and credit status.
Mollifying lien holders also remains a difficult challenge. Holders of second and third liens, if there are any, must agree to the terms of a short sale. And if there is insurance, so must mortgage insurers, because, presumably, there is a payout.
Lastly, an important consideration is getting brokers and agents on board. To compensate them for their time, many agents charge a minimum fee for facilitating a short sale, notwithstanding the final price of the home. This practice is reasonable.
According to federal regulators, short-sale volume tripled from the first quarter to the fourth and rose 18% from the third quarter to the fourth. Given the market's unusual conditions and the expectation that the number of properties in default will remain high, we will likely see more short sales completed this year than ever before.