Banks Choose Foreclosure Over Short Sale – Due To Accounting Rules

As you know the short sale business is not one in which every transaction closes successfully. There are dozens of variables that can put the brakes on a short sale and result in the foreclosure, and that pretty much sucks for everyone involved. And it’s happened to me too….albeit not that often.

Over the last 3 years of negotiating short sales, I’ve had a few transactions end up at the foreclosure auction only to sell for LESS than the short sale offer that we had on the table. Although there really is NO COMMON SENSE explanation for this, there are some more complicated ones that involve the investor’s (the actual owner of the note) asset position, overall portfolio size, overall losses within the portfolio, etc. Well, yesterday I was sent this article by a Realtor friend of mine, that had a hand in getting me into real estate about 5 years ago, and it deals with some simple accounting rules that may offer another explanation as to the “idiocy” we sometimes perceive of the lenders. It was written by a gentleman named, Michael Powell. Now, I don’t know who Michael Powell is, however I want to give him credit for his writings and found his article very interesting.

Article by Michael Powell:

EDITOR’S NOTE: It all seems so counter-intuitive, doesn’t it? Banks, if they were really acting like banks, would want and be required to mitigate their losses. So why take an $18,000 loss when you could have taken a $6,000 loss? And why is this the rule rather than the exception? The answer lies in the accounting rules. The banks are carrying illusory assets that they don’t actually own at a value that cannot withstand the reality of fair market value.

Let’s pretend that the original mortgages were valid. We’ll pretend that the note was correct in that it described and disclosed the creditor who advanced the money for the loan. We’ll pretend that the mortgage or deed of trust secured the note with an encumbrance on the home. (None of these things are true, but we’ll go along with the illusion for the moment). Now let’s also pretend that the proper assignments and endorsements were properly executed and delivered. (Also not true). And finally we’ll pretend that the the proper documents were properly recorded, so that the lender of record is the one who actually loaned the money. (Also not true). THEN we have to pretend that the mortgage loans that were, according to the securitization documents, assigned to a valid trust (REMIC, SPV). AND we are required to make a giant leap of faith and say that even though the trusts received the assignments, the servicers were allowed to record the loans as their own assets, even though they never loaned any money.

Okay, all of that is a stretch beyond the breaking point, but let’s assume it is true for the moment. Under that scenario, Bank of America through BAC and others like it would have the authority to execute documents. If they had a situation in which someone was selling the house and they were coming to the table with the money required to pay off the mortgage, BOA would have the right, power and obligation to execute a satisfaction of mortgage. You could even force them to, if they refused. If they had a situation in which someone didn’t have the extra money to come to the table and pay-off the entire loan, they would have the power to accept the lesser amount (a short-sale) and execute a satisfaction of mortgage (or reconveyance in non-judicial states). So if a foreclosure would cost them more than the short-sale, they would obviously accept the short-sale, right? Wrong.

Even accepting the ridiculously flawed scenario described above, BOA would avoid short-sales like the plague. The reason is that they are carrying the “assets” on their books at full value — the principal due according to the note (even though, if there is an asset it actually belongs to someone else). So if the principal due is $200,000 and they accept a short-sale at $100,000, they are required by the accounting rules to take the loss on their books. That means taking $100,000 off their balance sheet and taking a “one-time” write-off on their income statement of $100,000. Investors and shareholders might forgive one or two like that, but if it became a regular thing, then the whole “one-time write-off” thing might get a little tiresome — i.e., not credible.

But if they foreclose and the property is sold to their own REO at $75,000, even though they have increased their loss from $100,000 to $125,000, their books are unchanged. There is not write-down of assets and there is no loss to report in income. So the choice is whether they take a loss of $100,000 on a short-sale or not report any loss at all. For those of you who are not schooled in the world of equities and the stock market, that $100,000 loss may well translate into a $1 million loss in the value of their stock. That is because stocks trade at a price-earnings ratio. If investors use the $100,000 loss and compute it into earnings, and the stock is trading at 10 times earnings, then the short-sale decreased their stock value of $1 million whereas the foreclosure has no effect.
Now go back and take away all of the false presumptions and you can see the scope of the problem that BOA and others face. If reality is introduced into the picture, a substantial bulk of their entire capital structure is literally absent. Dig a little deeper and you’ll see that the “trading profits” are not real either. Whereas 7,000 banks report the their assets and income in accordance with reality, the mega banks are allowed to report based upon a grotesque hallucination. Something, I suppose arrogance, keeps the leaders of these supposedly large institutions in a bubble of belief that this won’t burst. When in all of human history has the bubble evolved into a permanent structure? I don’t know of any.
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Now let me say, do I think that based on this information that short sales will stop completely? No. Simply because there’s no way, even with these accounting realities, that all lenders/investors could afford to take EVERY property back as a foreclosure. If so, the impact on our financial system would be unlike anything we’ve seen.