Bloomberg reported today that banks are paying large sums of cash to delinquent homeowners as an incentive to sell their homes for less than the outstanding balance on their debt — something known as a short sale. Why are banks paying out of pocket while essentially writing down the value of the loans on their books?

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According to Bloomberg, homeowners have been offered as much as to $35,000 to sell their home short, apparently in an effort to get bad loans off of their books. Short sales help banks avoid dealing with courts, sheriffs, evictions and all the unpleasant trappings of the lengthy foreclosure process.

CNBC reported in December that the average home in foreclosure has now been delinquent for 631 days — a record. According to a 2009 report by the Federal Reserve Bank of Cleveland, Freddie Mac’s “sweet spot” for foreclosure length is four months from the due date of the last payment.

Banks such as Chase, Wells Fargo, Citibank, Ally and Bank of America® have all been engaging in this practice, according to Bloomberg. Banks aren’t exactly forthcoming about their motives, however. And the story is largely anecdotal; these aren’t nationwide programs. Bloomberg speculates that banks simply want to speed up the process by which they get the troubled loan off their books and move on.

Guy Cecala, publisher of Inside Mortgage Finance, doesn’t agree.

“I don’t buy that [banks] are speeding up the process,” he said. He suspects instead it’s a case of banks “not having the paperwork to actually foreclose” — that banks might not be able to prove title in court, or are missing certain necessary documents.

Title issues have been in the news recently, as New York Attorney General Eric Schneiderman filed a lawsuit against three big banks for using MERS, an electronic mortgage registry system that side-steps local laws and obfuscates chain of title in the process, potentially making many foreclosures technically illegal under local statute.

But Cecala explained that MERS likely isn’t the source of the title confusion that he believes spurred this strange short-sale incentive program. Because homes with debts securitized and registered with MERS are owned by investors who likely have no clue where they underlying assets actually are, it’s more likely that these homes loans were kept in the lender’s portfolio and not securitized. So even though Chase, to use an example from Bloomberg’s story, is the beneficiary of a mortgage, they might be missing a document they need to file for foreclosure, explained Cecala, especially considering the massive legacy portfolio of loans they picked up from Washington Mutual.

Short Sales vs. Foreclosure

Then why would banks pay $30,000 for people to walk away from their homes, while forgiving any difference between the proceeds from the short sale and the outstanding balance of the debt, when they could give up as much to do loan modifications?

Cecala said that the mortgage industry is very averse to loan modifications. “You’re not going to get rid of the borrower,” he said, and they’re the problem from the industry’s point of view. They could be delinquent again in a year’s time, said Cecala, better to get them out of the home and move on.

Between these two desires — avoiding foreclosure due to a lack of proper paperwork and getting rid of delinquent borrowers — Cecala thinks he has the only reasonable explanation as to why banks are giving away massive amounts of money to borrowers in trouble on their loans, in order to lose money still on a short sale.

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