How to Solve the Foreclosure Crisis:
National Short Sale Program

by Andrew Dewar
Kennesaw State University

Grand Prize Winner

A primary driver of the global recession which began in 2008 is the broad default on home loans across the country and the resulting tumble in home values of other still performing loans. The resulting home price collapse has crippled the real estate market and left as many as one in five homeowners underwater on their home loans. The causes of this crisis are myriad and assessing fault is somewhat subjective.

Many have blamed naive homeowners for agreeing to home loans that they did not understand and really had no way of paying at the outset. Others blame the banks for making ill-advised sub prime loans to less than credit worthy applicants. Blame can also be put on the investment banks that packed these loans into complex mortgage backed securities called CDOs (collateralized debt obligations) and marketed them to investors around the world as safe investments with great returns. Or one could blame the ratings agencies that dubiously gave these CDOs AAA investment ratings. Investors bought up these AAA high return investments as fast as the investment banks could package them, thus increasing demand for lenders to issue more and more mortgages to package and resell.

Surely some amount of blame can be directed at congress and past presidents for driving legislation aimed at the seemingly altruistic goal of encouraging broader home ownership. The resulting deregulation and slackening in borrowing requirements set by quasi government mortgage clearing houses Fannie Mae and Freddie Mac has carried with it dire unintended consequences. Regardless of who you choose to blame or how you distribute your blame, each error in judgment from each offending party comes down to a singular incorrect premise, that home prices would continue to rise year after year.

The false premise that home prices would continue to rise and could never fall is the common thread between all offending parties and therefore both the source of the debacle and should therefore be the focus of the solution.

Nearly every homeowner has been affected in some way by the collapse of the housing market. In normal times there is always some level of what one might, albeit insensitively, call "natural" foreclosure. Every year people lose their jobs, or themselves or a loved one fall ill and very real financial struggle leads to loan default and eventual foreclosure. In these so called "normal times" surrounding home values are not significantly impacted beyond say literal neighbors of a foreclosed property. The real estate market can process and reabsorb these distressed properties while maintaining a healthy market overall. We have obviously stepped way beyond "normal times" in the amount of distressed property on the market today.

In 2008, roughly 30% of all home sales were distressed sales. As of November 2009, nearly 10% of all home loans were in default. The rampant, wide spread foreclosure crisis is not limited to these aforementioned "natural" cases, but now includes the speculators that purchased multiple properties that can longer be flipped for a quick profit, home owners with poor credit who were never reasonably able to make their mortgage payments, and increasingly those homes that have fallen so far "underwater" that it makes financial sense for those homeowners, who may otherwise be able to keep paying on their mortgage, to electively stop payment. A new study conducted by economists at Northwestern University and the University of Chicago suggests that as many as one in four foreclosures are elective foreclosures. The huge volume of distressed property on the market has brought down the price of the entire market. Even non-distressed properties on the market have had their prices dramatically lowered in order to compete with the glut of distressed property. The volume is so great that these foreclosed properties can no longer be absorbed without impact as they could in the past. The impact has spilled over and brought down the value of all homes across the country an average of 30% since their peak in 2005. Furthermore, there is untold pent up supply of underwater properties on the market that will slowly bleed their way into the market for years to come in the absence of any outside market clearing catalyst.

In order to resolve our current real estate crisis, the goal must be to clear the market of distressed and underwater properties as quickly as possible. For homes already in foreclosure, the properties themselves will find a market-clearing price and be placed back into healthy performing loans. The solution lies in getting ahead of the problem and curbing the inflow of future distressed property. Defaulting loans and underwater loans must be replaced with manageable, positive equity loans. Currently, millions of homeowners are stuck in underwater, negative equity situations where they are unable to move because they cannot sell their home for more than what they owe and they either cannot or are unwillingly to pay the difference. The only option for these homeowners is to either stay put, default, or become reluctant landlords and ultimately default when they are eventually saddled with an un-rented property. A recent report from the real-estate information company shows that more than 15 million household mortgages are underwater, or 32% of all mortgaged properties. A market clearing solution could have an immediate impact on the growing trend of elective default. Defaults caused by a job change, or other moves, or by simple choice can be immediately cured with the proper market clearing incentives in place.

GOAL: Curb the inflow of future distressed property by replacing underwater loans with positive equity, healthy performing loans. Facilitate this replacement by incentivizing and streamlining the short sale process.

SOLUTION: Subsidized Streamlined Short Sales

Recent loan modification programs put in place have been aimed at achieving affordable loan payments for homeowners facing some hardship. Because these are case-by-case situations, without a uniform approach, they have been slow developing. These plans also do not address the broad prevalence of home loans that exceed the value of the home, as principle reduction has not been made a part of these modifications. The most effective way to replace these underwater loans is through short sale.

A short sale takes place when a property is sold and the seller's lender agrees to accept a pay off amount that is below what is currently owed on the home. The current process for short sales is lengthy and complicated and often involves more than one lender in cases where a property has a first and second mortgage. The requirements, process and acceptance are at the discretion of the lender, so the lender must assess whether they would be better off to foreclose and attempt to recoup the remaining balance through the courts or accept a reduced amount through short sale, which is itself part of their collections process. Banks are ill equipped to handle the massive volume of distressed property on the market and coming onto the market in the near future. Many short sale applications are not even addressed in time to avoid foreclosure. Most banks will not even entertain the possibility of a short sale until the homeowner is far behind on their payments and getting very close to foreclosure. Homeowners who try to remedy their default early on often get nowhere. The current process is inherently drawn out, distressing, and unfruitful for most participants. The longer the process takes the less likely they are to go to completion, as many buyers may not be able or willing to wait months for deal to be reached.

In order for the short sale process to serve as a market clearing catalyst, banks must be incentivized to accept them in larger numbers and the process must be streamlined by taking the process outside of the bank's collections department and placed within an independent agency that can apply a universal standard and set of requirements to all prospective applicants. To this end, a National Short Sale Program is proposed.

The 4S (Subsidized Streamlined Short Sale) Program will allow homeowners to apply directly to FHA for a short sale of their home. Homeowners will be empowered to remedy their situation and understand their options. The process will be clear and straightforward, not subject to the whims of whatever collections agent happens to review their file. Homeowners have obvious incentive to participate, but they will also share in the loss commensurate with the amount of the loss and their ability to pay. It is necessary for the seller to share in the loss in order to protect against abuse and moral hazard. Banks may choose not to participate, but they will have the incentive to do so because the loss will be shared and the burden of working through these loans on a case-by-case basis will be mitigated. The taxpayer will share in the loss as well, in a relatively small measure. However, the benefits of resolving this crisis will prove to be well worth the investment.

4S Program Key Components:

• Homeowners will apply directly to FHA for a short sale of their home.
• Homeowners will still be required to find a buyer for their home and submit a purchase agreement with their application in order to be considered.
• The purchase price must be at least 75% of the current fair market value of the home as determined by an independent home appraiser.
• The requirements for this process will be universal, clear cut, and equally applied to all applicants.
• Bank participation in the program is optional. By doing so they will outsource the short sale process to the FHA. The FHA will solely determine the acceptance of each application. Participating banks must accept the settlement of all FHA approved short sales. Their incentive to do so is that the loss incurred by the short sale will be shared and the workload of processing these applications will be relieved.
• Banks and homeowners will share in the loss from the short sale, and a portion will be paid by tax dollars
• 75% of the loss will fall with the lender; the remaining 25% will be made up with tax dollars and contributions from the seller.
• The seller's portion will be calculated by taking the lesser of 10% of their average reported income over the past five years or 20% of the loss of the short sale. The seller will pay this portion over the course of five years following the short sale in the form of a tax liability. Tax dollars will make up the remainder.
• Short sold loans will be reported to credit agencies as 'settled'. This negative credit report will further reduce moral hazard implications.
• The burden to tax payers may be as little as 5% of the principal loss in the short sale.

This program will allow applicants to remedy their situation at the outset of financial hardship and get ahead of their situation before it worsens. People that need to move for better employment opportunities or to move in with relatives to reduce their financial burdens will be able to do so.

Short sale is the quickest and most effective way to replace defaulting loans and underwater properties with healthy sustainable performing loans. A streamlined short sale process would quickly relieve the massive volume of distressed property on the market today and help prevent a large inflow of distressed properties from coming onto the market in coming years. This program would take an existing remedy and make it a faster, more efficient and more straightforward process for homeowners and make it more attractive to lenders. This program will result in a flushing out of distressed property and reset the real estate market to a healthy sound base from which it can grow, benefiting all homeowners, those underwater and those who are not in the process. Naturally, remedying the housing crisis is a key leg to rebounding the economy as a whole.

Homeowners who have equity in their homes that may cry foul must realize that stabilizing and growing the nation's real estate market is beneficial to all. Sellers that participate are by no means getting a free ride; they share in the loss where they otherwise may not in traditional short sale or foreclosure situations. They will also have the implications of damaged credit that come with a short sale. Their incentive to participate is great, but their greatest incentive is to resolve distress in their lives. Behind every distressed property is a distressed homeowner. Unless our country gets ahead of this problem, it will bleed us for years and years to come.

Footnotes:

"House-Price Drops Leave More Underwater", Wall Street Journal, May 6, 2009

"Foreclosures Dominate Home Sales", CNNMoney.com Feb 3, 2009 article citing Zillow.com report

"Mortgage Loans: Record number are late", CNNMoney.com, Nov, 19, 2009 article citing Mortgage Bankers Association report

"As Many as 1 in 4 said to Willingly Default on Mortgage", MortgageLoan.com, June 29, 2009

"S&P/ Case-Schiller Home Price Indices" (as of Aug 2009), Standardandpoors.com

"Almost one third of home loans underwater", Marketwatch.com, August 13, 2009

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