June 7, 2006

The Return of the Short Sale

If you lived in California about fifteen years ago you probably remember short sales - it looks like they're about to make a comeback. A report from Sacramento this week sounds eerily similar to the 1990-1996 California real estate bust, except home prices are multiples of what they were back then.

The possibility of a short sale arises when you need to sell your house, but you owe more than it's worth - like a fully-financed new car being driven off the dealer's lot, you are "upside-down" on your loan. That's a phrase we might be hearing a lot more of in the years ahead - "upside-down".

With home prices apparently falling in Sacramento after a phenomenal run-up in recent years, many of those who purchased real estate at last summer's peak and put little or no money down, today owe more than their home will fetch in a real estate market now crowded with inventory.

If, for one reason or another, these homeowners must sell, then they are faced with a few choices, none of which are very appealing:

1. Sell the house, and pay the difference to the lender
2. Walk away, and give the house back to the lender
3. Make a deal with the lender to accept less than the loan amount

According to the story, Scott L. Williams of Re/Max, who specialized in this sort of thing in the 1990s, has dusted off his short sale notebook and is now out helping people hand their homes back to their lender with the least amount of fuss and muss. Going seven years without a single short sale, his office has done nine in the last few months.

The two cases cited, one seller upside-down by $30,000 and the other by $60,000, are likely a sign of things to come in Sacramento and elsewhere in the country as the real estate market continues to cool and prices continue to weaken.

Back in the early 1990s, this became routine ... but not at first.

When homeowners first began losing their defense jobs as a result of the Cold War ending, and as the S&L scandal widened, banks were reluctant to negotiate with distressed sellers who bought near the peak and then wanted out.

This was back in the days when most people had to put money down before a loan would be made, so lenders had a bit of a cushion to start with. It wasn't until housing prices declined by 20 percent, then 30 percent, and in some places 40 percent or more, that the problems really began.

In 1992 and 1993, lenders were adamant.

The seller had two choices - make good on their obligation or face foreclosure. Many people just walked away, "Oh yeah, Ernie got laid off about six months ago, so when the money ran out, he and Betty just packed everything up and left. It's too bad, because they just got finished remodeling the place before he lost his job".

So, houses like Ernie and Betty's would revert back to the lender and they would sit there for a while until the paperwork was final and the bank had time to take a look at the place to see what had to be done to get it ready to sell. By that time, the lawn had died and there were a few broken windows and maybe somebody had taken up residence on an occasional basis.

As the number of people taking the same approach as Ernie and Betty multiplied, the banks quickly fell behind and the amount of time it took them to get the abandoned houses fixed up and back on the market stretched out to a year or more. After a while, some lenders would immediately nail plywood over all the windows so that "guests" would at least have to break a sweat to take up temporary residence.

Lenders then realized that maybe they should be a little more receptive to offers of partial loan repayment, as the mounting inventory was requiring an increasing amount of repair work to get back on the market, and the worst part for the bank's bottom line - prices were still declining.

By 1995 and 1996, lenders were embracing short sales - they were becoming routine.

With a reasonably competent realtor, a seller could simply fill out a few forms with all their financial information (kind of like when they bought the house), and the bank would come back with their offer. Based on a sale price estimated by the realtor, depending upon their assets and income, the seller would be asked to make a lump sum payment and/or agree to a repayment schedule.

Depending on the particulars, this would amount to anywhere from zero to maybe half of the difference between the sale price and the outstanding mortgage balance.

If you lost your job and had little or no savings, it was fairly straightforward - the bank didn't ask you for much, unless of course you were dumb enough to leave thousands of dollars in a savings account and include that amount in the paperwork submitted to the lender. Usually it was just a matter of selling the house, paying all the transaction costs, and what was left was send back to the bank.

For those who remained employed but still had to sell, it was much more complicated. Then the bank would ask for at least some sort of a monthly payment to get the deal done. Sellers could always try to negotiate the terms with the lender, and some had reasonable success, but the banks quickly got good at this and the realtor was always ready to offer advice that would help an agreement be reached.

The funniest part about the whole process was how the asking prices were set.

The seller didn't really care - he just wanted out. The bank was inundated with borrowers in similar situations - they just wanted it sold and off their books. The realtor was the one that influenced the asking price most - he just wanted a commission.

These homes were priced to move and the neighbors hated it, "They're asking how much? They're destroying property values in this neighborhood."

Most sellers agreeing to a short sale didn't realize the income tax implications of the deal when they signed their paperwork. When a deal was made with the bank, money squirreled away in retirement accounts was untouchable, so if you had no other savings and very little or no positive monthly cash flow, you usually go off pretty easy.

Many were surprised to hear at tax time that they were liable for taxes on something called "debt forgiveness", where, to the extent that it does not make you insolvent, an individual must pay taxes on the amount of debt "forgiven" by a lender.

The idea was that since the bank was going to write this off as a loss, the IRS would attempt to collect it elsewhere, and the tax laws at the time required that if you were forgiven $40,000 in debt when your short sale was complete, and you had a net worth of $25,000, you owed taxes on $25,000.

If you were able to show zero net worth, then all was forgiven. The really bad news for some people was that the IRS insolvency calculation included retirement savings. In many cases this allowed sellers to get off easily as far as the bank was concerned, but not with the IRS.

News of short sales and of goings on in real estate in general didn't travel very well or very fast back in the mid 1990s, as the internet was still in its infancy and there were no such things as blogs, where individuals could report what was going on in their neighborhood.

It will be interesting to watch how the lender/borrower, foreclosure/short sale relationships play out this time around.