It’s been very difficult to get banks to agree to short sales (in which a home sells for less than the balance on the mortgage). This leaves a homeowner who has financial problems only three options: pay the mortgage as written; try to obtain a deferral or reduction in interest amount, perhaps using the Administration’s Making Home Affordable (MHA) program; or await foreclosure and file for bankruptcy to discharge the deficiency (the excess of the mortgage over the value of the home). The first two options generally don’t work for a distressed homeowner, who can’t pay the mortgage as it stands or even with an interest reduction. A principal reduction might have reduced payments to an affordable level, but principal reductions aren’t covered by the MHA program and the Senate recently refused to allow principal reductions (“cramming down” the mortgage principal to the home’s value) even in bankruptcy. If short sales aren’t available, that forces the homeowner into the third alternative: foreclosure and bankruptcy – which resulted in a larger loss for the lender than either a short sale or cramdown, a lose/lose scenario.

Now the New York Times reports that at least some lenders may be working out protocols for short sales – a win/win scenario under which the lender’s loss is minimized and the homeowner is able to sell his house and move on without being forced into bankruptcy. One major reason short sales have been hard to achieve is that there’s often a second mortgage on the same property, the junior lender isn’t willing to release its lien unless it shares in the sales proceeds and the senior and junior lender can’t agree on the division of the sales proceeds. But the Times reports that some lenders, such as the Bank of America, have now standardized a 90/10 or 95/5 allocation between the two lenders, allowing short sales to move forward.

Perhaps the Treasury, which has stated that it will encourage short sales, had such an arrangement in mind. In any case, achieving a conventional allocation between junior and senior mortgage lenders would have a stabilizing effect on the residential housing market as well as helping both individual homeowners and individual lenders.

It’s not a cure-all, of course. Many mortgages have primary mortgage insurance, in which an insurer protects the lender against the first 20% of loss and must consent to any short sale; those insurers would also have to consent to the new allocation. Also, a homeowner who participates in a short sale but doesn’t file for bankruptcy may, depending on the circumstances, have taxable income equal to the deficiency amount (or his or her newly positive net worth resulting from the short sale). But short sales would be a big help.

Kathleen Cully

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