Analysis on the Short Sale “Wrinkle” (2nd Lenders, PMI, and Strategic Defaults)

An interesting article this morning from the Inman News discussing short sales and the reasons why approval can be difficult to achieve.

Are you wondering why it takes so long to get short sales approved? The real reasons may be very different from what you might believe.

It would seem when prices are down and millions of homeowners owe more than their home is worth that it is in everyone’s best interest to approve a short sale. All the more so when Mortgage Bankers Association statistics show that a foreclosure costs the lender 30 percent more than a short sale.

Judging from the numerous blog posts from both consumers and agents, this has yet to occur in a large portion of the short-sale market. To be fair, any lender could complete the approval process in seven days, but the delays often result from other parties in the transaction.

One of the biggest issues in closing short sales is secondary financing. If the holder of the first mortgage is going to have to take a loss, it usually is reluctant to give any type of payoff to another lender who is in second position.

No surprise here, we have talked about the 2nd position being tricky in this blog many times. HAFA attempts to mitigate this by giving up to $6k to the 2nd lienholder, but that still can be a relatively small amount depending on the size of the mortgage.

The holder (or holders) of the secondary financing can refuse to cooperate unless it receives part of the sale proceeds.

A common request that many secondary lenders seem to be making is for 10 percent of their loan amount. If the loan goes to the loss recovery department, the request can be $5,000 plus 10 percent of the loan balance.

What’s messy here is that the holder of the first mortgage may have a cap on what it will allow to be paid to any secondary lien holders.

The challenge for agents and consumers is how to negotiate through this complicated maze. If there is secondary financing on the property, one strategy is to approach the second mortgage holder first to see what its requirements are in terms of payoff.

You must also know what the first mortgage holder will require. Most lenders have specific guidelines about how big of a reduction they are willing to take, as well as how much can be paid to other lien holders.

Knowing this information ahead of time is critical if you want to avoid wasting your time on a transaction that won’t ever close.

Interesting here is the specificity provided. 10% of the loan amount can be quite a bit. $5k plus 10% is even more. Like any situation, though, if a homeowner is truly going into foreclosure, the 2nd lender would get a big, fat $0. I think the strategy suggested (approaching the 2nd lienholder first) doesn’t matter much. You should approach all lienholders aggressively and with a sense of purpose and urgency.

The second comment is that the lender will have “specific guidelines about how big of a reduction they are willing to take”. I don’t buy into that, either (with the exception being the new HAFA guidelines do require banks and lenders to pre-set their profits under something called “minimum net proceeds”). Lenders will of course have an idea about what they want for a maximum loss, but what really matters is the situation the property is in and the end result of the bank. Example: the bank may say, “We will only discount a maximum of $30,000 from this loan”. Well, if the home goes to foreclosure and the projected loss is $60,000, then the bank is making a very poor business decision and the so-called “mitigation” department isn’t doing their job. Mitigating losses means minimizing losses. What is less of a loss? $30k or $60k?

An additional twist in this scenario is that many first and second mortgage holders are now checking the homeowner’s credit. If the homeowner is keeping up other payments and is applying for a short sale, the lender may not agree to the short sale unless the homeowner is willing to sign a promissory note for the shortfall.

Otherwise, the lender may choose to foreclose, which could force the borrower into bankruptcy.

It doesn’t state it here in these exact words but this brings up the point of what is being called, “Strategic Default”. A Strategic Default is a situation whereby the homeowner can continue to make payments on the loan, but chooses not to, and decides to walk away from the home regardless. In that case, I don’t particularly blame banks for not wanting to accept a short sale offer. A short sale offer should always include hardship and inability to pay the loan. In other words, foreclosure should be imminent and certain. That is the primary motivating factor for a bank to accept a short sale. If you get rid of that, the motivation to accept a short sale offer also largely disappears. Have there been no-hardship short sales? Sure…. but that road is less traveled and even more difficult than a standard short sale that has a true hardship.

Complicating issues even further, many borrowers who placed less than 20 percent down on their property have private mortgage insurance (PMI).

Here’s an example of PMI: Assume that a borrower is putting 10 percent down and obtaining a 90 percent loan. The lenders normally would require a 20 percent downpayment and would give an 80 percent new loan. PMI insures the 10 percent “difference” between the borrower’s down payment and what would have been an 80 percent loan amount.

What seems to be a common source of frustration for both agents and consumers is that the PMI companies have joined the lender in asking homeowners to sign a promissory note for the shortfall amount.

PMI companies are insurance companies. Like other insurance companies, it’s simply good business for PMI companies to limit their losses and payout. If the consumer will agree to the promissory note, then that reduces the PMI company’s losses, which looks better on its balance sheet.

On the other hand, if the PMI company agrees to the short sale, it has to make an immediate payout on the lender’s claim. By refusing to approve the short sale, the PMI company forces the lender to foreclose on the property.

The foreclosure process can take months to complete, and then even more time before the property sells and closes as a bank-owned property (also known as real estate-owned or REO). The net effect for the PMI company is that it puts off paying its claim for 12-24 months.

Also, if the market improves, the lender’s claim may actually be less one to two years from now than it is today.

I’m glad to hear someone bring up PMI (Private Mortgage Insurance), because it is rarely discussed when it comes to short sales. However, there are two sides to the PMI coin. First, a lender with PMI may be more likely to accept a short sale because PMI is going to (theoretically) mitigate some of that loss. If the bank has to write off $20,000, and PMI pays it back to the lender, then the lender is ultimately made whole – a great way to end a pending foreclosure scenario. However, the PMI company may have complaints of their own, which can “wrinkle” the process as the author calls it.

Ultimately, the case to a PMI company however is the same as the case to a bank. If the property is going to foreclose and PMI has to cover a $60k spread vs. a $30k spread on a short sale, which are they better accepting?

Again, this all demonstrates the importance of a truthful hardship situation.

Here’s the final zinger, however.

Suppose that a property has declined in value by 20 percent, completely wiping out the holder of a 10 percent second mortgage. The holder of the first mortgage offers the holder of the second a 5 percent payout to close the transaction.

The second trust deed holder says “No,” because if they file a claim for mortgage insurance they get the full 10 percent. Thus, a number of major lenders who have made equity loans may have an additional incentive not to agree to a short sale.

This may explain why so many holders of secondary financing are unwilling to agree to a short sale and prefer a foreclosure instead.

This is basically mentioning the impact of HELOC (Home Equity Line of Credit), or a 2nd mortgage. This is a pretty valid point to place in the back of your mind when negotiating a short sale transaction.

What are your thoughts on these challenges? What methods have you used to overcome them?

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