Sunday, October 24, 2010

Foreclosures vs Short Sales vs Principal Modifications

When homeowners are unable to pay their mortgage, there are basically a few options that the banks have.   First, they can foreclose on the home - take back the home which is the collateral for the loan they made.  Second, since so many of today's homeowners are "underwater" on their mortgages - owing more than the value of their home, and are unable to pay, banks could write down the value of the outstanding loan, since the collateral isn't worth as much as the loan is anyway, in an effort to keep the homeowner in the home and eventually recoup the market value of the home via a .  A third solution is allow a "short sale" where the homeowner sells the house for less than they owe on the mortgage - ie, they sell the house for $200k and the banks takes that money instead of the $250k that's owed on the mortgage.

I previously discussed a reason why banks may not want to do principal writedowns, and MISH touched on it again last week - it creates incentive for people to fall behind on their mortgage.  Although the bank may actually be better off by allowing the person in the home to replace a $250k mortgage with a $200k mortgage that reflects the current value of the home, which is the value that the bank would get if they foreclosed (actually, the bank typically gets less by foreclosing, because of all the expenses involved), doing so creates incentive for other borrowers to seek the same deal, which is potentially disastrous for the banks who are desperately trying to avoid a massive wave of strategic defaults.  By taking a hard line against principal writedowns, the banks avoid giving borrowers the impression that they can get a "benefit" of sorts by deliberately becoming delinquent. 

Short sales, on the other hand, seem like a slam dunk for the banks - instead of having to foreclose, remove the borrower from the house and sell the house themselves -  the banks merely have to accept less than the value of the mortgage in a sale of the house.  Since the value of the house bears no resemblance to the outstanding mortgage, I would think that the banks would like this deal - homeowners are hardly going to take advantage of banks by executing short sales (although there are potential ways that people try to beat the system with short sales, like having a friend buy the house on the cheap and then sell it back to them).  As long as the banks have a decent estimate of the market value of the home, it seems clear to me that they should prefer a short sale at fair market value to a foreclosure which would then result in the bank attempting to garner fair market value anyway through their own sale process.

Which brings me to today's NY Times article about how hard it is to get short sales done - banks prefer to foreclose, for some mysterious reason.  I still talk to my realtor regularly, and he confirmed that it's extremely difficult to get responses - never mind acceptances - from banks on short sale related transactions.  The only "sensible" explanation I've seen is the one in the NY Times article:

"But less obvious financial incentives can push toward a foreclosure rather than a short sale. Servicers can reap high fees from foreclosures. And lenders can try to collect on private mortgage insurance.

Some advocates and real estate agents also point to an April 2009 regulatory change in an obscure federal accounting law. The change, in effect, allowed banks to foreclose on a home without having to write down a loss until that home was sold. By contrast, if a bank agrees to a short sale, it must mark the loss immediately."

Ahhh - so we have the "pretend we aren't really taking a loss on this" extend and pretend game, and also the interesting angle of the potential ability of lenders to collect on mortgage insurance in foreclosures, but not short sales.  Of course, there are also the skewed incentives of servicers who process foreclosures.

Am I missing anything else?  Is there any other reason banks should prefer foreclosures to short sales - aside from this accounting quirk?  I guess if banks were bullish on the real estate market and simply felt that they'd make more in the foreclosure process than the short sale process as housing prices rebounded, that might make sense, but I doubt the banks are so delusional in today's market.

NOTE:  this post has nothing to do with ForeclosureGate, and I don't want the discussion to revolve around ForeclosureGate either - I'm just trying to understand the banks' seemingly bizarre actions in preferring foreclosures over short sales.



scharfy said...

My 2 cents:

The servicers of the mortgages don't "care" - in the financial sense. They are disconnected from the financial effect of a foreclosure. They in fact generate fees, while the securitized lender takes the hit - anonymously, based on the decisions of the servicer.

Everyone knows foreclosure is the worst financial decision one can make (25-50 cents on the dollar studies suggest ) and I'm not buying Mish's argument on setting a" bad precedent."

Google "mortgage servicers incentivized to forclose" and see if you buy what they're saying.

Here's a taste:

See the problem? This is exactly why loan modifications are not happening in large enough numbers. This goes to incentives – mortgage servicers are not incentivized to make modifications. In fact the incentives go the other way – foreclosure.
Servicers have four main sources of income, listed in descending order of importance:
The monthly servicing fee, a fixed percentage of the unpaid principal balance of the loans in the pool;
Fees charged borrowers in default, including late fees and “process management fees”;
Float income, or interest income from the time between when the servicer collects the payment from the borrower and when it turns the payment over to the mortgage owner; and
Income from investment interests in the pool of mortgage loans that the servicer is servicing.
Overall, these sources of income give servicers little incentive to offer sustainable loan modifications, and some incentive to push loans into foreclosure.

Read more:

Definitely worth a thought. Its not like you are calling your local bank to see if they will approve a short sale. The chain of incentives are a twisted web. Love to hear any other thoughts...

(sorry for long post)

scharfy said...

one more along the same line:

Anonymous said...

Agent fraud - specifically where the agent arranges through an intermediary to rip off both the underwater borrower and the bank.

Kid Dynamite said...

anon re: agent fraud - yes - there are certainly ways to defraud the banks here - I'm going under the assumption that they have some idea what the house is worth.

Scharfy - I'm pretty surprised you aren't buying Mish's argument - it's pure common sense. If the banks lower the balance outstanding for borrowers who stop paying, more people stop paying to try to get that deal. The banks are running a vicious bluff where they do the thing that makes less financial sense for themselves in an effort to avoid an even worse scenario

Foolish Jordan said...

I think the answer is staring us in the face. Allow me to quote:
"I previously discussed a reason why banks may not want to do principal writedowns, and MISH touched on it again last week - it creates incentive for people to fall behind on their mortgage. "

It seems to me that the possibility of a short sale gives house buyers the exact same incentive to fall behind on their mortgage.

Kid Dynamite said...

Jordan - the borrower benefits massively from a principal reduction - they don't really benefit massively from being allowed to execute a short sale - they have to sell the house!

Foolish Jordan said...

If I have a loan for $300k backed by a house worth $250k, it seems to me I make $50k whether the bank reduces the principal to $250k or whether the bank lets me sell the house for $250k in exchange for the whole loan.

Sure, I have to go through the pain of moving, but it's not like I own the house scot-free after a principal reduction - I still owe a big ol' loan.

Kid Dynamite said...

Jordan - with the principal reduction, you're given a $50k "gift" - relieved of debt and allowed to keep your home. with the short sale, you're relieved of an extra $50k of debt in exchange for giving back the collateral (home). I think that the vast majority of people wouldn't view those equally.

Anonymous said...

Kid Dynamite said...

yep - saw that from CR

Transor Z said...


My view all along is that principal-reduction mods should also have been available for underwater borrowers who were current on their payments. Chris Whalen and others have been pointing out that banks aren't even providing refi's for creditworthy homeowners.

Lest we forget, this isn't a simple case of allocating risk of declining property value to the purchaser. It is now beyond dispute that the demand for RMBS encouraged RRE speculation and short-term/flipping purchases -- i.e., inflated the bubble.

So one of the many monumental wrongs in all of this is to disingenuously fall back on caveat emptor as a reason for not offering reductions in principal generally.

Kid Dynamite said...

TZ - allocating risk of declining property values to the purchaser? huh? when you're underwater you have a free option! it's the lender that has all the risk - you can just walk away! The LENDER is the one who has collateral that doesn't match the loan!

caveat emptor has nothing to do with this - it's about the banks wanting to avoid massive strategic defaults. I don't know how anyone can argue that principal reductions do not incentivize default.

Yes - in a perfect world, we could certainly construct a scenario where only the most worthy buyers received mods, which would make all parties better off - the borrowers who would then be incentivized to stay and pay, and the banks who would save the costs of foreclosure and recoup the same value in the end (current market value) anyway. Again- I think the banks are very afraid to do this - rightfully so - because it gives borrowers incentive to seek out such mods. Currently, the banks are betting that creditworthy borrowers will treat their homes like HOMES instead of financial assets and continue to pay anyway, even if they are underwater. Once you start messing with that delicate balance, the floodgates open. So the banks have to act "irrationally" by foreclosing instead of modifying. AGain, I wrote an entire post about this previously.

Transor Z said...

It doesn't incentivize default when you offer it preemptively, i.e., do the smart thing and reflect current RE valuations and write-off the difference. Strategic default is not a great option for most individuals; it greatly harms their credit rating and impairs ability to get another mortgage anytime soon.

We agree on the underlying risk-shifting; it's just that the lenders aren't behaving as we might expect someone in their position to behave which, again, is the point of your post and the question it raises.

The NAR has been in full court press spin mode insisting that RE has bottomed and is on the rise. We all know it ain't. And the rhetoric from the banking industry has deflected blame back on the purchasers.

My point is that if I'm a good credit risk and you know that my house is now 15% underwater, you should be offering me a principal reduction before I get other ideas. Because what you realize on a default, strategic or otherwise, is much less than re-setting the principal to actual FMV and continuing to collect revenue.

I don't have an answer for you as to why the banks are not behaving that way. I'm baffled. But my point is that, because it truly benefits all concerned to have a re-set, we *should* expect to see banks aggressively marketing preemptive mods to good customers, not just people who are in financial meltdown mode.

MrDan242 said...

Do the servicers have the authority to do whatever they "deem appropriate" or is any approval required from the CDO trust for any/all of the three listed remedies (foreclose/prin write-down/short sale)?

Also, I’m assuming the big banks own some portions of the CDOs or whatnot, but don't really own any whole loans anymore. Any reason my assumption there is invalid? If so, is there any data as to what the big banks are doing with their own loans as opposed to serviced CDO loans?

Kid Dynamite said...

TZ wrote:

"My point is that if I'm a good credit risk and you know that my house is now 15% underwater, you should be offering me a principal reduction before I get other ideas. Because what you realize on a default, strategic or otherwise, is much less than re-setting the principal to actual FMV and continuing to collect revenue."

yes - indeed - but the problem is, your neighbor then hears about how Transor got this great deal, and says "WTF? I want the same deal!"

Of course, your neighbor isn't the great credit risk you are, and the bank doesn't want to give him the idea that there are any other options - the bank just wants to close their eyes and pretend that they live in a world where your neighbor is going to keep paying his mortgage if he doesn't have any alternative propositions from the bank. In reality, your neighbor will probably eventually default anyway.

Transor Z said...

@KD: Yeah, but he can't get my deal because he sucks... or maybe more accurately because I was luckier and he or his wife lost their job before me or my wife did. Because stuff that happens to people is the X factor. Initial claims stuck at ~450k for how long now?

Equity gives people incentive to stay. So get out ahead of it and make it happen.

Blurtman said...

I still cannot fathom why someone who was perfectly capable of paying his mortgage before his home was underwater, and is perfectly capable of paying his mortgage after the home is underwater, would strategically default. I can understand defauting when you lose your income and cannot pay.

Anonymous said...

I believe the main issue with short sales is worries about fraud, ie non-arms length sales or not really selling it. Remember the servicers are on razor thin margins in this environment so they have zero incentive to bulk people up to police it.

As for the nonsense about servicers earning "large fees" from foreclosure, it seems trivially obvious that if someone is not paying their mortgage they also aren't paying late fees and if you are selling the house below the mortgage amount then you are going to be scrutinised for every penny.


Anonymous said...

Blurtman, what stops someone defaulting? They stand to lose their home and maybe have their credit record trashed. Imagine where a situation where if you stopped paying your 300k mortgage the bank offered to let you pay 250k instead? Or imagine if you could stay come up with a technicality that allowed you to not pay a penny for say 8 years and still not be turfed out. Would you pay your bills then?


Blurtman said...

It is a clear cut thing to pay your mortgage. These other deals are not guaranteed and are highly risky. You pay your mortgage and you retain control of your domain. Any other move and you enter the world of great uncertainty. I don't see too many folks doing that if they can afford to pay their mortgage.

Parag said...

Do not wait until the bank has started the foreclosure process as you may find the bank will no longer care and go ahead and proceed with the foreclosure in order to get the property back. This is already happening and the banks are fed up with procrastinators who are trying to buck the system. While I don’t necessarily agree with these policies as it will truly hurt good potential short sale deals for homeowners, I can see their point in all of this.
Banks short sales