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.