Make sure to read the following articles for more information on short sales and answers to common questions.
In our comments section we mainly hope to get a healthy conversation going among
readers, but one reader recently asked a question we really wanted to answer.
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
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.
And that is the story of not one, but two short sales. And, if you see a possible
creative real estate investing opportunity here - well good
luck to you.