I applaud the recent announcement by Secretaries Geithner and Donovan expanding the government’s ‘Making Homes Affordable’ Initiative to include the ‘Foreclosure Alternatives’ Program…which was in my mind the #1 missing piece in the Administration’s policies to date…and should vastly increase the ability of Americans in trouble to avoid foreclosure and get back on their feet faster…even they cannot afford to continue to own their home.
Full details on the program are not available yet, and I admit I am biased in my enthusiastic response to this policy change as I have been advocating for exactly such a change over the last 6 months and feel/felt so strongly about this program/policy that I have focused a major part of my time and business on Servicer Offered Short Sales.
I will say more once the government releases further details, but in the meantime here’s a memo I sent to key local and national policy makers and influencers in mid-April on exactly this topic. This would be a good read for anyone seeking to understand the rationale for and potential benefits of the new ‘Foreclosure Alternatives’ program.
To: Key Local (Los Angeles) and National Policy Makers and Influencers
From: Ray Mathoda, Founder and CEO, HausAngeles, Inc.
Date: April 15, 2009
Re: Closing the (Large) Gap in our National Foreclosure Prevention & Loss Mitigation Initiatives with Systematic Servicer Initiated Short Sales
I applaud the leadership and efforts of the Obama administration, FDIC and Treasury Department to help consumers, stem foreclosures and stabilize the housing market. Providing responsible homeowners a viable opportunity to stay in their home via an expanded set of loan modification and refinance options designed to lower their monthly housing costs significantly is a welcome and necessary development. Current government and non-government led initiatives in isolation however will prove insufficient in preventing a large number of avoidable foreclosures.
The purpose of this memo is to propose and request your support for a foreclosure prevention solution that simultaneously mitigates investor losses for a currently unaddressed large segment of troubled borrowers: systematic servicer initiated short sales.
Despite generous concessions to payments and loan terms, systematic modification efforts will continue to fail to help those troubled homeowners who are not offered, do not qualify for, or fail a loan modification. The fact is that our collective public and private sector efforts to help troubled homeowners have been focused on providing borrowers with two primary resolution options: loan modification or foreclosure. As a result, those that don’t qualify for or succeed at a loan modification remain “in limbo and uncertainty” until they are foreclosed on and are either offered a small cash payment (typically $1000) to vacate the property or evicted involuntarily.
I strongly believe it is not only possible to significantly mitigate the adverse impact of a likely foreclosure for these millions of responsible homeowners who cannot realistically expect to retain ownership of their homes; it is our responsibility to attempt to do so.
How many troubled homeowners will face foreclosure despite the Obama Loan Modification Plan?
According to the Congressional Oversight Panel’s March Oversight Report, an estimated 1 in 9 US homeowners is likely to be in foreclosure over the next few years. This equates to approximately 10+ million possible foreclosures. Assuming the Obama modification program successfully provides a loan modification for the 3-4 million homeowners it is expected to help, this leaves us with approximately 6-7 million likely foreclosures.
What is a short sale and why is it better than foreclosure?
A short sale is simply the process whereby property ownership is transferred by a borrower to a third party with the servicer and investor’s approval when the loan amount is in excess of the sale proceeds from the property. In short sales, a “deficiency” is created in the amount of this difference and if/when this deficiency is forgiven, it has historically been treated as taxable income resulting in an IRS obligation.
There are three key factors which make short sales a compelling alternative to foreclosure today:
• Scale and scope of the foreclosure issue and its adverse impact on the housing market: The likely number of foreclosures we will face in the coming years is very high (6-7 million as noted above). Foreclosures have a demonstrated and well understood significantly adverse impact on both the communities in which they occur as well as the overall housing market. As a result, there is a macro-economic rationale for preventing as many foreclosures as realistically feasible.
• Tax law: The Mortgage Forgiveness Debt Relief Act of 2007 temporarily changed the tax rules such that most troubled borrowers in owner occupied properties can complete a short sale before January 1, 2010 without incurring a large IRS obligation related to the deficiency.
• Declining home price environment and related investor incentives: We continue to have a (rapidly) declining home price environment in many regions with high numbers of at-risk borrowers. In this type of environment, short sales can help significantly reduce the negative externalities associated with foreclosures, which have the potential to destroy entire neighborhoods.
The potential savings here are material enough that it is possible to create programs that re-invest a portion of these savings to help troubled borrowers relocate to rental housing. I am aware of and personally involved with at least one pilot program which offers borrowers cash payments of between $5,000 and $15,000 for cooperating with their servicer to complete a timely short sale.
Here is an illustration of the investor savings possible due to short sales: The Case Schiller index shows home prices declined at a 26% rate between January 2008 and January 2009 in Los Angeles . This translates to an approximately 2% monthly decline in home prices. Assuming the timing of home sale is accelerated by 6 months for a $200,000 home, the related savings on home price depreciation are approximately 12% of the property value or $24,000. This does not include the 10% – 20% discount attributable to “bank-owned” sales (i.e. distressed sellers) or the savings to investors through expenses avoided by preventing foreclosure which can also be significant.
The below summarizes at a high level, the key benefits of a short sale relative to foreclosure for key stakeholders including consumers, the housing market, investors, and servicers.
Key Stakeholder Benefit of Short Sale vs. Foreclosure
Borrowers (Consumers)
• Avoid emotional and reputational pain of foreclosure
• Credit impact reduced to 2-3 years vs. 5-7 years
• No continuing financial or tax obligation when deficiency forgiven/ not pursued on purchase money owner occupied homes
• Note: Deficiency can and should be treated differently for investors and owners of 2nd/vacation homes, and tax consequences are different for such homes, as well as in the case of cash out mortgages
Investors
• Lower losses due to reduction in duration between loan going delinquent and property disposition (see example above)
• Lower losses due to savings on foreclosure related expenses (e.g., legal, home maintenance/rehab)
Servicers
• Reduction in servicer advances (i.e., reduced liquidity stress and interest expenses on advances)
US Housing Market & Economy
• Home prices stabilize at higher level as property sold is not physically distressed
Don’t we already have short sales? How is this different?
Due to increasing realtor-driven consumer education on the borrower benefits described above, short sales are being attempted by more and more troubled borrowers. Whereas a year ago there were almost no successful short sales, I would estimate that of total distressed residential properties sold in any given month 5-10% are likely short sales and the remaining 90-95% are foreclosures. As a percentage of total short sales attempted, I have heard anecdotally (many times) that a majority fail. The practical reality on the ground is that servicers and investors just aren’t set up to make efficient, timely, economic decisions on short sales where the likely alternative is foreclosure.
While improved borrower requested short sale processes and timelines would help, that issue is not the focus of this memo. In order to do this right, I believe servicers must offer and approve short sales systematically and in bulk right at the time a ‘no’ loan modification decision is made, or a previously executed loan modification fails. While it is perfectly logical that a short sale would be offered to every troubled borrower as an option to foreclosure, this ‘common sense’ solution is not in place today.
It should be noted that the suggested process of systematizing, standardizing and bulk-offering this ‘make sense’ solution is no different than the evolution of our loan modification policies and efforts as a nation over the past year or so since FDIC Chairwoman Shiela Bair led an attempt to conduct bulk modifications at Indymac Bank after the institution was put into FDIC conservatorship.
Why would government leadership and support be helpful and/or necessary?
I believe government leadership and support would increase the total number of troubled borrowers who are ultimately able to avoid foreclosure, accelerate the pace at which these borrowers are helped, and reduce servicer and non-profit foreclosure prevention counseling and process expenses as follows:
• Borrower education and communication: By helping troubled borrowers understand that short sales are a legitimate option that should be considered if a loan modification is not offered or fails. Many troubled borrowers are so inundated by a variety of third parties – some well intentioned, many not – including their servicer constantly calling them that they stop listening to or trusting anyone who contacts them.
• Deficiency related contractual and tax issues: By eliminating uncertainty and creating simple standards regarding how the deficiency created in a short sale is treated contractually and from a tax standpoint by borrower type/situation (e.g., in the case of responsible owner occupied borrowers, investors and/or owners of 2nd/vacation homes). This is a critical issue that will require communication and coordination with investors and is unlikely to be resolved properly without government intervention (e.g., in the systematic short sale pilot program I am familiar with, the contractual language regarding the deficiency leaves the servicer the option of pursuing the deficiency even though there is no intention of doing so in the case of owner occupied borrowers). Finally, state tax laws are not always consistent with federal tax law, and only the government can resolve these differences effectively in a fair and expedient manner.
• Standardization: There is a critical need to maintain as much standardization as possible in both program guidelines and related forms/documentation requirements, and the government is the only stakeholder that can drive this much needed standardization effectively
• Augments the Administration’s Home Affordable Modification Guidelines: Although the Home Affordable Modification Program includes payments to servicers in the guidelines, there is no guidance for servicers as to how to execute meaningful numbers of short sales; this direction is required to minimize foreclosures
Disclaimer: This article is an opinion piece only. It should not be construed as legal or tax advice. Any individuals should contact their legal counsel, tax advisor and/or credit reporting agency to ensure they understand the legal, credit and tax implications of any decision they make.
