When homes can't be sold for enough to cover the mortgage(s) against them, homeowners may try to effect a short sale, which means selling for less than what's owed to the mortgage lender(s). You'd think it would be easy to get these done--after all, the sale prices are higher than foreclosure sales prices, buyers avoid bad credit, and mortgage lenders avoid taking more property onto their books. Unfortunately, things aren't that simple.

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It's the deficiency, stupid

I watched a client go through all kinds of hoops while trying to purchase a short sale property. For months, he made offers, waiting weeks for the banks to get broker price opinion (BPO) after BPO and appraisal after appraisal to sort out the home's value. Eventually, a lender approved his offer and escrow was opened.

When it came time to close, however, the lender refused to sign off on the deal unless the homeowner agreed to sign a promissory note for $67,500. The seller refused to do so, and the home went into foreclosure. Incredibly, once the property was on the bank's books, its asking price was less than my client's offer had been!

Why would a bank choose a foreclosure in the bush over a short sale in the hand? Because it had reason to believe that the seller had the means to pay off the deficiency--that is, the difference between what was owed and what the foreclosure sale fetched.

Dealing in debt

If the lender had agreed to sell the home to my client without getting the promissory note from the seller, it would have lost $67,500 and had no chance of recovering it. But if it foreclosed and sold the home itself for a loss of $75,000, it still retained the right to collect that deficiency from the previous homeowner. So if it felt that it had a decent chance of getting a deficiency judgment in court, the lender would be smart to choose foreclosure over a short sale.

In addition, if the lender did not itself choose to pursue the foreclosed homeowner for the balance, it could sell the debt to a collection agency. If it was able to get more than ten cents on the dollar, or $7,500, for the debt, it would recover more by foreclosing than by approving a short sale.

HAFA not being met halfway

What about HAFA, the Home Affordable Foreclosure Alternative? It's supposed to make short sales happen by making payments to first-lien holders and second mortgage holders too. But it isn't very popular with lenders because it requires that they waive the right to pursue borrowers for deficiencies, and because the payments are too small to be deemed worth the trouble of jumping through the hoops attached to any government program. And as long as the lenders' goals conflict with the desires of the homeowner or buyer, 90 percent of short sales will continue to fail.