New Fannie, Freddie short-sale incentives akin to principal reductions

Commentary: Program gives underwater homeowners chance at fresh start without 'moral hazard'

Could the new Fannie-Freddie program on short sales provide what are essentially mass principal reductions to homeowners who are underwater but current on their mortgage payments, and would like to sell and get a new start?

Didn’t Edward J. DeMarco, acting director of the Federal Housing Finance Agency, which oversees both agencies, rule out wide-ranging principal reductions on Fannie-Freddie loans just recently, despite intense pressure from congressional Democrats?

Yes to both questions. Though the revised Fannie-Freddie rules on short sales weren’t presented this way when they were unveiled last week, look at the facts:

  • DeMarco himself has estimated that the two giant companies have a combined 4.63 million underwater loans in their portfolios, of which 80 percent are being paid on time.
  • The new guidelines open the door to people like these — the "good guys" who kept their loans current, despite depressing declines in the value of their houses. Since they weren’t delinquent, typically they weren’t offered short sales or principal reductions in the past . That sort of relief instead went to folks who stopped paying and were headed down the slippery chute toward foreclosure.
  • The new program, which takes effect Nov. 1, requires underwater, current borrowers to demonstrate that they’re facing some form of "hardship." The list of qualifying hardships is broad and includes: loss of employment by the borrower; divorce; a business failure; long-term disability; an employment transfer or relocation more than 50 miles from the present home; the death of a primary or secondary wage earner in the household; plus "increased housing expenses."

FHFA says it has no idea how many of the 4.63 million underwater borrowers now paying on time might be able to qualify on hardship grounds, or would want to. But the number could be significant, certainly in the tens of thousands.

Add to that the new plan’s automatic approval of military families who have underwater homes and are issued permanent change of station orders — even if they’re current on their loans — and you’ve got the potential here for a sizable, even dramatic, increase in short sales. And with the plan’s streamlined processing and delegation of key decision-making to lenders and servicers, short sales might get processed and completed quicker than the traditional, sluggish five months and up.

So yes, even though DeMarco and FHFA don’t label the new program as their answer to principal reduction demands from congressional critics, in a way it serves that function. But the reductions will only go to those who paid their mortgages every month, not to the abusers who knowingly took on unsustainable loans too big for their budgets, then stopped paying. The moral hazard DeMarco and others worried about so publicly won’t be an issue.

Of course, even for the good guys, there’ll be a price to pay and some pain. They’ll have to leave their homes and find a new place to stay, plus deal with a newly tarnished credit history and depressed scores.

Moreover, in cases where borrowers have assets or income to tap, Fannie and Freddie plan to require them to make some level of compensatory payment — either in cash or in a promissory note — toward reducing the difference between the principal balance and the net proceeds of the short sale. This would be in lieu of any recovery efforts by Fannie and Freddie in the majority of states where they are permitted by law to go after deficiencies.

Are there some tricky issues looming in the program? You bet. Will banks holding large second liens be satisfied with the $6,000 FHFA has set as their maximum payoff for cooperating with the short sale? They won’t be happy, but some of the more artful of them already have developed workaround techniques for squeezing more money out of short-sale transactions.

For example, banks who currently hold out for higher payments on seconds go behind the curtain and negotiate directly with the sellers. They say: "Look, we don’t want to bust up your short sale. We’ll release our lien if you’ll simply make a payment to your account, say $10,000. The payment doesn’t show up as part of the short sale itself; it just lowers the balance on the existing second lien."

According to Sacramento, Calif., short-sale broker and author Elizabeth Weintraub, some banks "routinely" do this today, and she sees nothing in the new rules that would stop the practice.

Here’s another potential complication. What about other types of liens on properties, such as those placed by condo associations for unpaid fees on the unit. What slice of the pie will they get for their cooperation? Does it come out of the $6,000 or are other arrangements possible?

Fraud is still another issue lurking in the background. As Alexis Eldorrado, managing broker of Eldorrado Chicago Real Estate LLC, said to me in an interview last week, what’s to stop a married couple with an underwater loan who can’t otherwise qualify on hardship grounds from filing for divorce, getting a principal reduction through a short sale, then moving to another state and remarrying?

"There are no short-sale police," said Eldorrado, "so you just might see" ploys like this along with other hardship frauds. Eldorrado, it should be noted, thinks the overall effort by FHFA to spur short sales for underwater borrowers who are current on their loan payments "is a very good idea" and is virtually certain to be a boon for large numbers of families as well as — needless to say, perhaps — for the real estate professionals who work with them.

Ken Harney writes an award-winning, nationally syndicated column, "The Nation’s Housing," and is the author of two books on real estate and mortgage finance.

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