By CoreLogic
Short sales have been, and will continue to be, a necessary part of the mortgage industry as it seeks stabilization. Historically, borrowers that were no longer able to sustain their mortgage payments were foreclosed on by the lender. However, during the months that the loan is increasing in delinquency, the property is more likely to become distressed, or wind up abandoned entirely. Either situation devalues the property substantially. In addition, there are the legal costs associated with the foreclosure process.
Therefore, lenders often consider short sales to be the lesser of two evils when compared to foreclosures. While significant losses may be incurred in both the foreclosure and short sale scenarios, the overall negative financial impact of a short sale is typically less than that of a foreclosure. In many cases, short sales represent the best way for lenders to minimize their overall losses. In general, all parties fare better when a foreclosure is prevented.
Hence, it is no surprise that the number of short sales in the market has nearly tripled in the last eight quarters. Figure 1 shows the recent trend in volume.
The need for short sales will continue. At present. CoreLogic data shows 23 percent of all mortgages in the United States have negative equity, i.e., the homeowner owing more than the property is currently worth. In some states, such as Nevada, that number may be as high as 65 percent.
Based on industry expertise and analysis of short sale trends, CoreLogic estimates the number of short sales is expected to increase by another 25 percent in 2011. Figure 2 shows the year-aver-year growth in short sale transactions.
Measuring the Risk
For the purpose of this study, we grouped short sale transactions into two categories -’suspicious’ and ‘not suspicious’. ‘Suspicious’ transactions are short sales that may have caused the lender to incur unnecessary losses. ‘Suspicious’ short sales are defined as:
- A new transaction less than one month after the short sale where the new sale price is at least 10 percent higher than the short sale price, OR
- A new transaction less than three months after the short sale where the new sale price is at least 20 percent higher than the short sale price, OR
- A new transaction less than six months after the short sale where the new sale price is at least 40 percent higher than the short sale price!
Not all transactions deemed suspicious using these criteria will result in a loss to the lender or mortgage note holder. For example, quick rehabilitations by savvy investors may meet the criteria for a suspicious transaction, but pose no significant risk to lenders. Often, however, these transactions cause unnecessary losses to the lender or servicer. This study illustrated numerous examples of short sale properties resold on the very same day, for example, making improvements to increase value highly unlikely.
Figure 3 presents the frequency of ‘suspicious’ activity in the first half of 2010. Our analysis indicates that only a small percentage of all short sales (3 percent) had a subsequent resale within six months. Significantly, however, 65 percent ofthese short-to-resale transactions were found to be ‘suspicious’. Said another way, 1.9 percent of all short sales (one in every 52), pose a risk of unnecessary loss to lenders.
This rate is not only significant, but it is growing. Figure 4 shows the rate of ‘suspicious’ short sales more than doubling in the last six quarters. In the first half of 2010, approximately two percent of all short sales were deemed ‘suspicious’, causing the industry potential losses of up to $150 million dollars. In addition, the suspicious rate for the second quarter of 2010 is not yet fully mature. We expect the rate to go up further when we get additional data during the next reporting period.
Figure 5 shows this same quarterly ‘suspicious’ rate increase as a year-aver-year metric.
The Perfect Storm
This latest study of short sales revealed a disconcerting convergence of data. Historically, the states with the highest ‘suspicious’ rates were states with relatively low short sale volume. Therefore, their overall impact on the industry was minimal.
The latest data, however, indicates that some ofthe states with the largest short sale volumes (i.e., California, Arizona, and Florida) also now have the highest ‘suspicious’ rates. Obviously, this results in maximum negative impact on the lending industry. Consider the following figures.
Figure 6 shows a rank ordering of states by highest ‘suspicious rate; along with their respective short sale volume. California, Arizona, and Florida are all clearly represented.
We then rank ordered the states by their year-over-year increase in ‘suspicious’ rate (figure 7). From this vantage point, California, Arizona, and Florida are even more conspicuous.
Figure 8 shows the intersection of all three key metrics. With California, Arizona, and Florida being at, or near, the top in each of these lists, the stage is set for an historic level of short sales and an unprecedented amount of unnecessary loss for the lenders in these areas.
In fact. 61.5 percent of all the suspicious short sales in the first half of 2010 (figure 9) took place in California, Arizona, and Florida (compared to 39.7 percent for the same states a year ago).
Investor Risk
Investors play an important role in the short sale process. On the purchasing end of short sale transactions, investors provide the industry with a substantial amount of cash offers, which provides much needed liquidity.
However, our latest data indicates that investment companies are involved in a largely disproportionate amount of ‘suspicious’ transactions. Twenty-eight percent of all ‘suspicious’ short sales involved an investor as the buying party, compared to just two percent of the overall population (figure 10).
Reasonably, an investor may buy a short sale property. perform verifiable improvements to the home over a period of time, and resell the property for a legitimate financial gain. Looking at the distribution of short sales by days between sales (figure 11) an interesting fact emerges: Nearly one in six (16 percent) ‘suspicious’ short sales is resold on the same day, making legitimate increases in value doubtful.
Lenders are incurring tremendous unnecessary loss in these situations. Short sales that are resold on the same day have an average of 34 percent ($56,947) gain between sale prices.
This same day turnaround of a short sale can be achieved by what is known as a ‘back-to-hack’ closing. In such, the investor has two separate contracts; a purchase contract with the short sale lender as well as a sale contract with a third party. The transactions are choreographed and presented to a title company on the same day.
The purchase transaction is first executed, followed immediately by the sale contract (figure 12).
Figure 13 displays some real life examples of investor-involved, back-to-back short sale transactions. Profits to investors mean unnecessary losses for lending institutions.
Mitigating the Risk
CoreLogic recommends that lenders continue to take fundamental steps that may alert them to any improper short sale to-resale transactions. Examples are:
- Review all short sale documentation carefully, including disclosures to resell the property at a higher price ~ Ensure the presence of an arm’s-length disclosure for all parties involved in the short sale
- Require borrower to confirm that he is not aware of any other parties, or contracts, associated with the property or short sale
- Apply appropriate due diligence to ensure the borrower’s income is accurate
- Apply appropriate due diligence to understand the current market value of property ~ Validate claims of significant renovation were actually completed
- Ensure that the seller is the current owner of record
In addition to these basic measures, lenders would benefit greatly by having knowledge of concurrent transactions pending on the short sale property. In most cases, lenders don’t have access to this information in real time, as two different lenders are involved in the two separate sales. Therefore, this information can only be leveraged collectively, or via consortium effort.
The CoreLogic Short Sale Monitoring Solution has proven to be a key in helping lenders reduce unnecessary loss. This consortium-based service enables lenders to benefit from both a pre-closing and post-closing perspective.
For short sales not yet closed, details of the transaction are matched against other pending loan applications in the consortium database for that same property. If a matching record is found, an alert is passed back to the lender prior to the short sale decision being made.
For short sales already closed, the property continues to be monitored in the months following the short sale. Any subsequent, new loans closed on the property causes an alert to be passed to both the original short sale lender as well as the new resale lender (if different).
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