Calculated Risk

by Tanta on 4/07/2007 08:51:00 PM

The following is not an exhaustive discussion of all of the issues involved in foreclosures and REO. It’s a start at unpacking some of the concepts and definitions. We have been seeing, and are going to continue to see, a lot of information presented on foreclosure sales, REO sales, and their impacts on existing home transaction volumes and prices in various market areas. As always with “UberNerd” posts, this is long and excruciating. Proceed with typical motivation as you may consider your own best interest in an open market in blog postings.

Don’t expect a discussion that deals with every possible issue in all 50 states, the District of Columbia, and the odd territory. If you’re a beginner, please note that foreclosure law is made by the states, not the federal government, and that each specific market area will be impacted differently by foreclosed and lender-owned properties, because of the specific rights and obligations each jurisdiction gives property owners and lenders, the way it taxes deed transfers, and a host of other issues. If you want a state-by-state breakdown, you might start here. I do not make any representations about the accuracy of that website; I will only say that so far I haven’t seen anything I know to be incorrect and I have spent very little time looking.

First of all, we need to understand what a foreclosure really is. We talk about lenders “taking back” a property at a foreclosure sale, but that’s misleading. Foreclosure is the forced sale of a property owned by the debtor in order to satisfy the debt(s) secured by the property. The owner of the property, on or before the date the mortgage loan is made, is the borrower. The borrower continues to be the owner of the property until that property is sold one way or another. As long as there is a valid mortgage on the property, that borrower/owner may not receive proceeds from selling it until the indebtedness to the mortgage-holder is satisfied.

What a security instrument (better known as a “mortgage” or “deed of trust” or a “security deed” to you weirdos in Georgia) does is to pledge the property the borrower owns, or is about to buy with the proceeds of a loan, as security for that loan. The document gives the lender the right to force the borrower to sell that property in order to satisfy the debt if the borrower does not repay. The lender, therefore, does not end up with REO (Real Estate Owned) because it owned the property before the mortgage default; it ends up owning RE if and only if it bought the property at the foreclosure sale. What it “owned” before the foreclosure sale was only a lien: the right to force that sale to take place, and to be paid first out of the proceeds of it in order to satisfy the debt.

Foreclosures can be “judicial” or “non-judicial.” Some states require judicial foreclosure; most states allow one or the other at the lender’s election or in certain other circumstances. A judicial foreclosure requires the lender to sue the borrower in court for satisfaction of the debt. A non-judicial foreclosure allows the lender to use the “power of sale clause” in the mortgage document to force sale of the property without a court order.

Because the non-judicial foreclosure uses powers granted to the lender in the mortgage document, which is executed by the borrower at the time the loan is made, the property sale is, in essence, already “authorized” by the borrower. When you sign a mortgage document, you are agreeing in advance to sell your property at public auction if you do not pay the debt as agreed in the note.

Non-judicial foreclosure is almost always faster and cheaper for the lender than a judicial foreclosure. Most of the time, when there is a choice, the lender chooses the non-judicial option for that reason. The big benefit to the lender of a judicial foreclosure is that the lender can ask the court, when appropriate, to enter a “deficiency judgment” against the borrower; this makes the borrower liable for any difference between the proceeds of the sale and the debt owed when the borrower is upside-down. Practically speaking, a lender who chooses non-judicial foreclosure generally waives its right to seek a deficiency judgment. The lender’s calculation, obviously, comes down to weighing the benefit of quick sale and reduced expenses against the cost of (potentially) writing off part of the debt.

The actual power of sale verbiage in a security instrument differs among the states, but it’s as uniform as the lenders can make it. Here’s a relevant bit from the standard California Deed of Trust:

If Lender invokes the power of sale, Lender shall execute or cause Trustee to execute a written notice of the occurrence of an event of default and of Lender’s election to cause the Property to be sold. [Tanta: this is the “NOD.”] Trustee shall cause this notice to be recorded in each county in which any part of the Property is located. Lender or Trustee shall mail copies of the notice as prescribed by Applicable Law to Borrower and to the other persons prescribed by Applicable Law. Trustee shall give public notice of sale to the persons and in the manner prescribed by Applicable Law. After the time required by Applicable Law, Trustee, without demand on Borrower, shall sell the Property at public auction to the highest bidder at the time and place and under the terms designated in the notice of sale in one or more parcels and in any order Trustee determines. Trustee may postpone sale of all or any parcel of the Property by public announcement at the time and place of any previously scheduled sale. Lender or its designee may purchase the Property at any sale. Trustee shall deliver to the purchaser Trustee’s deed conveying the Property without any covenant or warranty, expressed or implied. The recitals in the Trustee’s deed shall be prima facie evidence of the truth of the statements made therein. Trustee shall apply the proceeds of the sale in the following order: (a) to all expenses of the sale, including, but not limited to, reasonable Trustee’s and attorneys’ fees; (b) to all sums secured by this Security Instrument; and (c) any excess to the person or persons legally entitled to it.

For our present purposes, the important part of this is the last sentence, regarding the order of application of the sale proceeds. Notice that after expenses and the mortgage debt are satisfied, any excess proceeds belong to the borrower (or a junior lienholder, if there is one). As a practical matter, of course, there are rarely any proceeds left for the borrower; if the property can fetch that much, it is usually sold before things get that bad. The point here is that a lender cannot take advantage of a borrower with a big equity cushion who for some reason is unable to make payments but also unable or unwilling to sell the property himself. You have to understand that in order to understand how lenders bid at auctions (and how other people bid to compete with them).

Notice, also, that foreclosures are always public auctions. The precise mechanisms (trustee sale versus sheriff’s sale, NOD versus lis pendens, etc.) vary by state and foreclosure type, but it boils down to the same thing: the lender must notify the public of the sale in advance, and the public must be allowed to bid (insofar as any member of the public meets the legal requirements in a given state for “qualified buyer”). While this requirement certainly humiliates the foreclosed borrower, it is not actually intended for mere puritanical purposes. It keeps the lender from forcing the borrower to accept a “sweetheart” disposition of the property. The lender can’t force you to sell privately for less than what the property would bring at public auction. (You also cannot force the lender to accept a short sale. Same coin, other side.)

The sale transaction in a foreclosure has legal constraints and issues that are not present in other real estate transactions. For instance, in some states the borrower has a “right of redemption,” which gives the borrower some period of time after the foreclosure sale to redeem or repurchase the property at the winning bid price. This means that any third-party purchaser of the property may end up having to sell it back to the borrower “at cost.” Furthermore, foreclosure and eviction are separate processes: one cannot “evict” the owner of a property, so eviction of the previous owner or tenants who do not voluntarily vacate does not happen until after the sale, when the new owner of the property then has legal right to evict any occupants. There are jurisdictions in which the buyer is subject to heavy transfer or “flip” taxes based on a percentage of the sales price. Borrowers declaring bankruptcy at any of several stages in the process can result in a stay on the foreclosure proceedings prior to sale or prior to eviction.

For these and other reasons, most people are more interested in buying REO than in bidding at a foreclosure sale, given the choice. Once the property is REO, you are buying it from the lender, not from the defaulted borrower, and in states where redemption is an issue or properties where eviction or bankruptcy is an issue, it’s generally wiser for most purchasers to let the lender take that risk or sort out that legal mess. This obviously impacts the bids people are willing to make at the auction.

For purposes of quantifying the activity in a real estate market, foreclosures are sales, in any measure using “transfer of deed for consideration” (or words to that effect) as the definition of a sale. They are not, however, “listed sales”: they are public auctions. REO can be and is listed, because REO means the lender bought it at the foreclosure sale, and is now able to offer it for resale in a private transaction. But foreclosures involve forced sales of properties by auction as remedy for breach of contract. They have no “list price” and are not handled by real estate agents. So those of you worried about “non-counting” or “double-counting” in a given statistical report: check the methodology to see whether what is being reported is deed transfers or sales reported by listing agents. Foreclosure sales will be included in the former but not the latter; REO sales will always be in the former and usually in the latter. (Lenders are not required to use a listing agent any more than anyone else is. There are FSBO issues in any report of sales based on listings.)

So why do most foreclosures end up as REO? Because of the motivation of the lender. It does not want to own real estate. It wants to be made whole, and it cannot do any better than made whole. In general, then, the lender bids at the sale in order to put a floor under the price: it doesn’t want a third party to win the property for a price less than the make whole amount. It also puts a ceiling on its own bids: it will not pay more than total indebtedness, because it has no reason to do so. If a third party pays more than total indebtedness (including expenses), the borrower receives any excess proceeds. You will occasionally see a lender starting the bid at some ridiculously low amount, like $100. That is because it is one of those fairly rare jurisdictions in which transfer taxes are not waived for a foreclosing lender. In this case the lender will start as low as the law allows it to, and bid all the way up to the total indebtedness if it has to. Most of the time the lender just bids its make-whole amount.

So the bid offered by the lender really has nothing to do with “appraised value.” The bids, if any, offered by a third party certainly should. And the lender’s decisions prior to the foreclosure sale—whether to forbear, allow a short sale or deed-in-lieu, pursue a judicial or non-judicial track, ask for a deficiency judgment—are certainly based on the lender’s assessment of the market price of the property. But you need to bear in mind that not only does “sales price” not always equal “appraised value,” the whole concept of “appraised value” as used by lenders is hard to apply to a foreclosure sale.

This is the definition of “market value” that Fannie Mae, and hence 99.9% of the rest of the industry, require an appraiser to use:

Market value is the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller, each acting prudently, knowledgeably and assuming the price is
not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby: (1) buyer and seller are typically motivated; (2) both parties are well informed or well advised, and each acting in what he considers his own best interest; (3) a reasonable time is allowed for exposure in the open market; (4) payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and (5) the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.

Not only does a foreclosure sale not meet these conditions, it is generally held by market participants that an REO sale does not meet these conditions, although REO sales are much closer to this set of transaction requirements. The lender, however, is not a “typically” motivated seller, and the very fact of the prior foreclosure implies a lot about how “motivated”—or not—a buyer might be. So in making a mortgage loan in the first place, the lender is interested in obtaining a professional opinion of market value. When it comes to making a foreclosure decision, a lender is generally more interested in obtaining a professional “price opinion” (a BPO or Broker Price Opinion).

We can talk more about appraised values later, but at this point it’s important just to focus on the crucial difference between “exposure time” and “marketing time.” According to the Appraisal Foundation (which promulgates USPAP):

Exposure time may be defined as: the estimated length of time the property interest being appraised would have been offered on the market prior to the hypothetical consummation of a sale at market value on the effective date of the appraisal; a retrospective opinion based on an analysis of past events assuming a competitive and open market. . . .

The reasonable exposure period is a function of price, time, and use, not an isolated opinion of time alone. As an example, an office building, an important artwork, a fine gemstone, a process facility, or an aircraft could have been on the market for two years at a price of $2,000,000, which informed market participants considered unreasonable. Then the owner lowered the price to $1,600,000 and started to receive offers, culminating in a transaction at $1,400,000 six months later. Although the actual exposure time was 2.5 years, the reasonable exposure time at a value range of $1,400,000 to $1,600,000 would be six months. The answer to the question “what is reasonable exposure time?” should always incorporate the answers to the question “for what kind of property at what value range?” rather than appear as a statement of an isolated time period. [Emphasis added]

Translation: “listing” a property at a ridiculously high price does not count as “exposing it” to the market for appraisal purposes. An appraiser preparing an appraisal at the time a sales contract is executed is asked to determine reasonable exposure periods, not to simply count days from the original listing to the present. In any case, you can see that a foreclosure sale transaction fails the “reasonable exposure in an open market” test for the determination of appraised value. For an REO sale, of course, reasonable exposure would be determined as it would be for any other listed property.

“Marketing time,” on the other hand, is a prospective opinion. Sayeth the Appraisal Foundation:

The development of a marketing time opinion uses some of the same data analyzed in the process of developing a reasonable exposure time opinion as part of the appraisal process and is not intended to be a prediction of a date of sale or a one-line statement. It is an integral part of the analyses conducted during the appraisal assignment. The opinion may be a range and can be based on one or more of the following:

· statistical information about days on market,
· information gathered through sales verification,
· interviews of market participants, and
· anticipated changes in market conditions.

Related information garnered through this process includes other market conditions that may affect marketing time, such as the identification of typical buyers and sellers for the type of real or personal property involved and typical equity investment levels and/or financing terms. The reasonable marketing time is a function of price, time, use, and anticipated market conditions, such as changes in the cost and availability of funds, and is not an isolated opinion of time alone.

As a general rule, lenders consider a real estate market to be weak—requiring more restrictive than usual financing terms—if marketing time exceeds six months. There is no doubt that a great deal of the grief we’re in lately has a lot to do with the assumptions that went into opinions that were formed regarding marketing time. A large part of this grief is that too many consumers (and their betters in the press, quite often) confuse the “exposure time” of a property they just bought with its likely “marketing time” should they need to unload it some day, and confuse “appraised value” with liquidation price. An appraisal prepared for a lender in a mortgage loan transaction is not intended to give you liquidation value, or the price someone would pay you today if you were so distressed as to need that cash pronto. The value indicated in the appraisal is contingent upon the allowance of reasonable exposure and marketing, and assumes that the seller is typically motivated, not desperate. Those appraisals prepared during the boom, when all the buyers were “typically” desperate to buy, may now be considered waste paper.

Therefore, foreclosure and REO sales are not “comps” or comparable sales used by appraisers to form an opinion of the value of a normally sold property. That doesn’t mean they don’t affect prices or marketing time: a market full of REO is a market full of existing homes somebody wants to get out from under and will likely undercut other sellers to do so. I have used the term “flood the market” before in reference to REO. I don’t just mean “flood” in the sense of a lot of REO. I mean “flood” the way we used to mean it when our cars had carburetors instead of fuel injectors. If that metaphor doesn’t make sense, we’ll have to let the engineers tinker with it in the comments.