Short Sale update

Homeowners struggling to sell their homes in a short sale are getting some relief, thanks to the federal government's Home Affordable Foreclosure Alternatives, or HAFA, program.

Tom Merton | OJO Images | Getty Images

Up to now, many short sales -- in which the lender accepts a sale of the property for less than the full amount owed -- have taken months to complete. Sometimes, the complex and lengthy process has failed, resulting in foreclosure.

HAFA establishes streamlined short sale rules and incentivizes borrowers and lenders to work together to avoid foreclosure. The rules -- in effect between April 5, 2010, and Dec. 31, 2012 -- also are intended to speed up the short sale process.

"The streamlined short sales process will definitely help homeowners," says David Liniger, Re/Max International chairman and co-founder.

Prior to HAFA, homeowners often listed their home for sale without an idea of what the lender would accept.

"A lot of sellers and their Realtors have not been able to sort out the problems with short sales and have given up on the process because, even after sending in the correct paperwork, they have sometimes waited three or four months for their lender to respond," Liniger says.

Under HAFA, borrowers receive preapproved short sale terms from the lender prior to putting the home on the market.

Lisa Matykiewicz, a Realtor and Certified Distressed Property Expert in Gilbert, Ariz., says the updated short sale rules establish an easy-to-understand process with predefined steps that "make it easier for everyone to understand."

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Eligibility requirementsThe HAFA guidelines apply to lenders who voluntarily participate in the HAMP program. The Department of Housing and Urban Development says more than 100 servicers have signed up to participate in HAMP, covering more than 89 percent of mortgage debt outstanding in the country.

To be eligible for HAFA, homeowners must first apply for a loan modification through the Home Affordable Modification Program, or HAMP. Owners who do not qualify for a loan modification or miss payments during the initial loan modification period qualify for HAFA.

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Other HAFA requirements include:Property is principal residence.Mortgage originated before Jan. 1, 2009.Mortgage is owned or guaranteed by Fannie Mae or Freddie Mac. Borrower is delinquent or default is foreseeable. Homeowner demonstrates hardship.Borrower's total monthly housing payment exceeds 31 percent of gross income.Unpaid principal does not exceed $729,750.

According to HAFA rules, lenders now must offer a short sale in writing to the borrower within 30 days if the borrower does not qualify for or complete a loan modification. Borrowers then must respond within 14 days to the lender's short sale agreement.

"I think it's great that the lenders in this program have to offer a short sale before going to foreclosure," Matykiewicz says.

When a purchase offer is made, borrowers must submit the sales contract to the lender within three days, along with the buyers' mortgage preapproval and the status of negotiations with other lien holders on the seller's property.

Finally, lenders must approve or deny the contract within 10 days.

HAFA rules also state that lenders must release borrowers from the obligation to repay the difference between the sales price and the loan amount. No deficiency judgments are allowed for a first or second loan.

Other incentives

In the past, short sales were especially difficult for homeowners with more than one loan on their home, since the home sale typically repaid only the first mortgage. HAFA's financial incentives include a payment of up to $3,000 for second mortgage holders.

"Second trust lien holders are often owed five or 10 times that $3,000 payment," says Liniger. "But if the property goes to foreclosure, the second trust holder is not likely to get any money at all. This at least guarantees they get something."

Other HAFA financial incentives include $1,000 to loan servicers to cover administrative fees, up to $1,000 for mortgage investors who agree to share short sale proceeds with second lien holders and $1,500 to the homeowners for relocation.

"The moving expense allocation acts as an incentive for them to stay in the property until the short sale goes through," says Liniger. "Owner-occupied properties are usually in better condition than vacant homes."

Whose to blame?

Is The Government Facilitating The Next Housing Bubble?

Moses Kim from Expected Returns discusses the government intervention in the housing market which could be facilitating a new housing bubble. The artificially low interest rates and tax credits may be artificially inflating homes above what they would be in a purely-free market. See the following post from Expected Returns.

The ongoing economic crisis has brought about massive government intervention in the free markets- intervention which, if history is any guide, will cause more harm than good.

There is a prevailing view that the housing bubble has popped for good, and that clearer skies lie ahead. The thought that housing can once again reach bubble valuations after such a steep decline seems laughable. However, bubbles are formed on the foundation of low interest rates and excessive credit, which promotes an unrealistic illusion of prosperity. These are the conditions the government is currently actively supporting.

Government support of the housing market, if left uncontained, will eventually lead to bubble-like conditions. From Marketwatch, Mortgage Bubble Warning:

The government's $700 billion bank bailout bill has met its goal of helping bring the financial markets back from the brink, but has so far failed to increase lending from the banks who received the taxpayer assistance, a key government overseer reported Sunday in a generally critical review of the program.

The report, which was authored by TARP's Special Inspector General, Neil Barofsky, also warned that the Obama administration's and the Federal Reserve's policies to support the mortgage market could in fact be creating another dangerous housing bubble.

"Stated another way, even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car," said the report.

Bubbles aren't necessarily characterized by prices way above historical norms, but merely valuations that are significantly above what they would be in a purely free-market system. Without the direct purchase of MBS debt, which effectively lowers interest rates, many more homeowners would be out of a home. As is, the government is simply delaying the inevitable readjustment in home prices that will come as a result of the lack of employment.

The report charges that high prices for homes between 2004 and 2007 were the result of unrealistic expectations for house values, low interest rates, in-accurate high ratings for mortgage securities, lax standards by lenders for mortgages.

It argues that that the Federal Reserve could be creating another housing bubble with its response to the crisis by keeping short-term and long-term interest rates low, setting up programs to support the mortgage market that also keep rates low, as well as a first-time homebuyer tax credit and a program near completion to purchase $1.25 trillion in mortgage-backed securities.

"Because increasing access to credit increases the pool of potential home buyers, increasing access to credit boosts home prices," the report wrote. "The Federal Reserve can thus boost home prices by either lowering general interest rates or purchasing mortgages and mortgage-backed securities."

"Both actions, which the Federal Reserve is pursuing, have the effect of lowering interest rates, which increases demand by permitting borrowers to afford a higher home price on a given income. Similarly, the administration is boosting home prices by encouraging bank lending and by instituting purchase incentives such as the First-Time Homebuyer Tax Credit. All of these actions increase the demand for homes, which increases home prices," said the report.

I would argue that many of the same conditions that led to the housing bubble are currently present, albeit on a smaller scale. It is quite amazing that we are not seeing a more powerful snap back rally in home prices given interest rates at 0%, sub-5% mortgage rates, and tax incentives.

The Inevitable Hangover

However, critics argue that long-term interest rates could increase in response to the Fed's decision to wrap up its $1.25 trillion mortgage-backed securities purchase program by March 31, along with other federal actions, could result in higher interest rates at a time where many regions continue to experience a depressed housing market and record foreclosures.

The coming double-dip in our economy will likely be led by a resumed decline in national home prices. Home prices still have a ways to fall, as price to rent ratios and price to income ratios have not adjusted to a point where one would be comfortable calling a bottom in housing.

I sense we are very close to a key inflection point in our economy. Sentiment will likely nosedive and hopes of a quick recovery will disappear. Keep an eye on housing, bond rates, gold and the dollar.

In response to the question of whether the Fed's low interest rate policy is responsible for the bubble, most respondents point instead to regulatory failures of one type or another. Ben Bernake has also made this argument. However, I don't think it was one or the other, I think it was both. That is, first you need something to fuel the fire, and low interest rates provided fuel by injecting liquidity into the system. And second, you need a failure of those responsible for preventing fires from starting along with a failure to have systems in place to limit the damage if they do start.

Bank regulators didn't have the systems in place to prevent bubbles, they didn't see the bubble developing until it was too late to prevent major damage, and the systems needed to limit the damage were inadequate, e.g. there were insufficient limits on leverage and other protections in the system. By analogy, the Fire Department's inspections were inadequate and there was much more fire risk than anyone thought, they didn't notice the fire until it was already out of control (even though Dean Baker and others had tried to alert them), when they did notice and respond they were initially confused and didn't have the tools they needed to fight the fire or prevent it from spreading, and they hadn't thought to require protections such as automatic sprinkler systems that might have limited the damage.

What fueled the housing bubble? There were three main sources of the liquidity that inflated the bubble. First, the Fed's (and other central banks') low interest policy added cash to the financial system, second, the high savings in Asia, particularly China, along with cash accumulations within oil producing nations, and third, some of the cash was generated endogenously within the system (e.g. by increasing leverage or by diverting other investments into housing and mortgage markets).

Once the fuel was present, something had to allow the bubble to inflate and then do widespread damage, and that's where the regulatory failure comes in. But I don't think the regulatory failure matters much without a large amount of liquidity within the system, and I don't think the large amount of cash in the system is problematic without the regulatory failures.

I've been making this argument for some time, so is there any support for the idea that bubbles are fueled by excessive liquidity? In the video embedded below of Nobel prize winning economist Vernon Smith that posted today at Big Think (http://bigthink.com/ "Dissecting the Bubbles"), he notes that in the experiments he has conducted that reproduce bubbles in the lab, the existence and size of bubbles depends critically upon the amount of "cash slopping around in the system."

In the video, he also notes that if you ask a different question, why was this bubble so devastating as compared to the dot.com bubble even though the initial losses were smaller -- $10 trillion in 2001 compared to $3 trillion in the housing bubble collapse -- you get a different answer: a failure of regulation. Here, he points to a failure to impose sufficient margin requirements as the key difference between the two episodes (I agree that leverage should be limited through margin requirements, and this would have helped to contain the damage, but I would have focused on the markets for complex financial assets rather than down payments on homes).

So I think the bubble itself was driven by "cash slopping around in the system" that originated from several sources, the Fed being one, and the regulatory failures (such as failing to provide sufficient transparency so that the smoke from the fire could be spotted in time, and failing to limit leverage) allowed the fire to spread rapidly and do major damage.

The Obama Plan

If only the President’s foreclosure-prevention plan worked as well as “cash for clunkers”. But it hasn’t. When the Administration announced the Making Homes Affordable plan in February of 2009, officials said they hoped it would help 4 million distressed homeowners to stay in their homes. As of this writing (8/2/09), the Administration has acknowledged that there are only 200,000 trial loan modifications under way.

Clearly, lenders have been reluctant to modify loans. (Moreover, there are good reasons for their reluctance according to a recent study by the Boston Federal Reserve.) Also, many borrowers have turned out to be ineligible for the programs or – because they are so far ‘under water’ – uninterested. Whatever the cause, the result is the same: a distressed borrower typically needs to choose between (1) a short sale (where the lender agrees to take less than the amount owed) in which, among other things, a commission (paid by the lender) is generated. (2) a foreclosure, or (3) a deed in lieu of foreclosure (where the borrower ‘gives back’ the property to the lender without a foreclosure proceeding). Which is better for the borrower?

Many real estate agents will say and advertise that a short sale is clearly preferable. In support of this view, two claims are usually asserted. (1) A short sale is less damaging to the borrower’s credit than a foreclosure. (2) A short sale provides the borrower with a shorter ‘waiting period’ until the borrower will be able to purchase a home again.

It is important to note that these are two different claims. For example, in a period of time a borrower could become eligible for a purchase loan under Fannie Mae/Freddie Mac guidelines, but he or she might still not have sufficient credit or income to qualify for the loan.

While many say that a short sale is less damaging to one’s credit than is a foreclosure, documenting that claim is another story. This writer has looked hard, but can’t find any verification from Fair Issac (the developer of the FICO scoring system) or any of the major credit providers. That is probably no surprise, because their systems are proprietary. Nonetheless, one wonders what might be the source of the claim.

On the other hand, people who apparently should know deny that there is any difference. Greta Guest of the Free Press (Freep.com) quotes John Ulzheimer, president of consumer education for Atlanta-based Credit.com. Ulzheimer spent seven years at Fair Issac. “The credit bureau sees those all as equal,” Ulzheimer said. “They are all essentially in the eyes of FICO a major delinquency.” Elizabeth Razzi wrote in the Washington Post (July 20, 2008), “A foreclosure and short sale inflict equal damage to your FICO score, according to Fair Issac…” though she provides no specific citation.

Moving on from the credit score issue, there is the question of being again eligible to buy. More precisely, it is a question of when, in the future, the defaulting borrower could get a loan that would be purchased by Fannie Mae or Freddie Mac. The issue is dealt with in Fannie Mae Announcement 08-16, released June 25, 2008.

When it comes to foreclosures and deeds in lieu of foreclosure, the policy distinguishes between events that were precipitated by extenuating circumstances (e.g. job loss, major illness) and those that were not (e.g. financial mismanagement). If you’ve had a foreclosure without extenuating circumstances, you can’t purchase with a Fannie Mae – backed loan for five years. However, if there were extenuating circumstances, it drops to three years. Suppose you chose the deed in lieu of foreclosure option. If there were no extenuating circumstances, the period would be four years, but with such circumstances, it drops to two. Fannie Mae doesn’t draw the distinction when it comes to short sales: the period is two years, the same as doing a deed in lieu with extenuating circumstances.

May 15, 2009, the Treasury Department issued an update to the Making Home Affordable plan. Among other things, it provides for financial incentives (e.g. a $1,500 moving allowance) to distressed borrowers who meet the general eligibility requirements for a loan modification and who will engage in an approved short sale or who will give a deed in lieu of foreclosure.

Distressed and underwater borrowers face a minefield of options for resolving their problems. Not the least of their problems is the vast amount of misinformation floating around. They need to step very carefully.