Why Short Sales Don't Work

Prior to a couple years ago, short sales were of little significance (and of little interest) here on the Coast. They happened so infrequently that few of us ever had to deal with them. That changed when the market began its collapse in late 2006.

Since that time, short sales have become relatively prevalent in many areas and have certainly had their impact in Bodega Bay and the surrounding areas. While I wouldn't consider any of the agents on the Coast experts in short sales, many of us do take our work seriously and keep up to date on most issues that come our way. And that is what makes this short sale debacle so befuddling. Why can't anyone seem to get a short sale completed?

On the surface, it would appear that short sales make sense for everyone involved. It makes sense for sellers because they get to relieve what may be an unrecoverable financial burden - with associated penalties like a damaged credit score and a significant amount of work to justify their position. It makes sense for buyers because they're getting a home for a fair market price and one that is presumably in good condition (compared to many neglected foreclosed homes). It makes sense to the banks because short sales inevitably bring in more cash than the eventual foreclosure normally does.

But that's where the buck seemed to stop. Reasonable offers were being submitted to the banks and those offers were sitting on their desks for several frustrating months before responses, usually declines, were returned. Even when agreement could be reached it seemed inevitable that the deal would dissolve, only to see the property go into foreclosure and show up on MLS for a price lower than the agreed-upon short sale price.

Why is that?
There are many theories that address this issue, including government subsidies that encouraged foreclosure, accounting policies, an inadequate infrastructure, inexperience and even flat-out fraud. But I recently read an article from May 2009 in the Huffington Post that seems to make perfect sense to me. It's all about securitization.

Securitization isn't an simple concept but it's well documented and there have been many stories that help explain it. If you haven't taken the time to listed to This American Life's two-part series called the Giant Pool of Money (Part 1) (Part 2), it's well worth the time if you're interested in how this all began.

Basically it works like this (and this is my simplified interpretation only)...a buyer gets a loan and the bank immediately sells it to an investor who bundles up loans for a living. The investor takes this bundle of loans and chops it up into pieces that get graded according to risk. These "portfolios" are called tranches. The tranches get sold to groups of investors who expect to get income from these investments. However, when the mortgages inside these tranches start going bad, the investors have no interest in getting shorted out of their investment and choose not to negotiate. So the banks end up holding onto the soon-to-be defaulted loan and get to dump them off their books as losses once it goes into foreclosure (I'm not sure how the accounting works here). It's not only the bank's fault - it's the Investors who are preventing the shorts.

What's the solution?
I'm certainly no expert, but it seems that the basic problem is that banks have no responsibility for the loans that they perform. Once the loan is funded, they sell it off and give up any responsibility for their work, leaving that risk in someone else's hands. That risk eventually exposes itself to someone who doesn't have to bear it. So it works it's way back down the chain. If the banks were required to hold a piece of their loans on the books ("skin in the game"), then perhaps they wouldn't be able to sell them off so easily and might act more responsibly in their decision-making process.

There are many more pieces to the solution and each one has it's consequences, but it's obvious that the system we have in place is broken and needs to be rebuilt. Regulation may or may not be the answer but I think there's an opportunity in here somewhere for a industry with a proper business model that looks at the long-term implications of their practices. That would be in everyone's best interest.

Let me know what you think...