I am currently working with a first time buyer who is purchasing a home encumbered by a first and second trust deed. The second trust deed holder, an institutional lender, has been asked to take a payoff, after the close of escrow, that is less than the current outstanding loan balance. By definition, this is a "short sale" or "short pay."
Short sales happen when loan balances are higher than market prices and the lender receives less than what is owing on the home. This homeowner (seller) is also behind on his mortgage payments with the strong likelihood that the first TD holder will begin foreclosure proceedings and totally wipe out all equity and consequently the little remaining equity that the second trust deed holder has.
Fortunately, the seller listed the home with a real estate agent and received an acceptable offer presented by another Realtor. When this happens the Realtor must present to the current lender the offer and notify the lender why it will be receiving less than the outstanding loan balance. Lenders must agree to participate in this type of transaction. Most do!
The majority of lenders do not want to institute foreclosure proceedings, if such proceedings can be avoided. Interestingly, the second trust deed holder in this situation has come back to the Realtors, both the listing and selling agent, and has asked for their participation (give up some part of their earned commissions from the sale) to offset some of its loss. We are not talking about a few dollars. No matter what amount of money is involved, does the lender have the right to ask innocent and nonparticipating third parties to assume part of a loss (risk) that was evaluated and calculated at the beginning of the loan transaction?
In my business I must defend the requests made by lenders to verify many aspects of a borrower's loan application. If you have applied for a loan, you know some hoops through which you must jump. Yes, there are loans that require very little information. You will, however, pay a premium for such limited disclosures.
If today's lenders want to originate loans based on limited or no equity, marginal credit criteria, high debt ratios and/or government mandates, they must assume the incumbent risks. During the past few years, we have seen loan products developed and investors buying loan portfolios that would have been anathema to traditionalists. Today, we are not living in traditional times. Lenders have at their disposal sophisticated resources to verify information to underwrite files. They also have investors to buy their loans and borrowers who need their products. Within and because of this mix, I do not think that lenders should ask innocent third parties who have not participated in the initial loan process nor reaped any of the benefits of the actual loan to offset the shortfall that may now occur.
Risks are involved in any lending transaction. Lenders compensate for these risks by higher interest rates, additional fees (points), prepayment penalties for early payoff and reduced loan to value criteria. These elements and more are factored into the lenders' underwriting evaluations to figure risk exposure. If as a lender, you are prepared to reap the rewards that accrue when borrowers return borrowed funds on time and with accompanying interest, you must also be willing to accept the underlying risks attached to loans offered to borrowers who will not or cannot repay.
We have seen, during the past months, how high flying Asian economies such as Indonesia, The Philippines, South Korea and Thailand can be brought to their knees by inappropriate monetary policies. Creditors, lending to each of these countries, are now looking to the IMF (International Monetary Fund) to bail them out. Yet, many of these private sector creditors should have understood the risks involved. All was well when repayment was made and conversely all is not well when threat of default looms. Risks were taken and along with those risks you have on the upside high returns or on the downside the potential for great loss.
If lenders or any other creditors continue to take risks and assume that there is little chance of capital loss, they will continue to take those risks. If they must insure those risks through their own reserves and forego any hope of a third party bailout, a more prudent course of action will be undertaken. If lenders can look to third parties to bail them out of either inappropriate loans or market reversals, then there is no reason to more fully "risk justify" the products they offer.
In the late 1980s real estate appreciation covered many problems. Bad loans became good loans because of ever increasing values. The decade of the 90s is a different story. The 1990s cannot, as history will soon attest, be called the decade of responsibility. If we are to undertake risky activities, we must also accept the accompanying potential negative results of such undertakings.
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