Real Estate Focus

There is much comment and opinion as to whether the proposed principal reduction for distressed homeowners advocated as one fix to the housing mess is good.  This idea is currently working its way through the Congress and is endorsed by the Administration.  Critics claim that this effectively rewards the moral hazard and forces the lenders to take a hit (loss) they would otherwise not have to take. In point of fact this is not true and this idea, what I call an Insider Short Sale, actually has real merit.  

If the lender can expect that the borrower will not be able to sustain the mortgage payments, then there is a quantifiable cost based on a probability and risk assessment that can be calculated.   The bank needs to weigh the anticipated total costs associated with taking back the property and reselling it under the usual procedures against the cost of doing the deal now with the current borrower.  The lender also picks up an FHA guarantee of the remaining debt; a significant boost to the credit at a time the lender can use it.

Someone (maybe that fabled guy with a green eyeshade) sits down and calculates the probability of the house being taken back, the total cost of doing that (everything from legal fees, time, fix-up, agent sales fees, closing costs, etc.) and the anticipated sales price likely to be received when the house is actually sold back into the market.  If that loss is greater than or equal to the proposed “Insider Short Sale”, then the bank would be better off taking the hit now and accepting the “Insider Short Sale”.  

It is not charity, nor is it forcing the bank to take an unexpected loss.  The bank realistically is poised to take the loss regardless. The bank benefits by taking its “best first loss” immediately, freeing itself to move on to other issues. This Insider Short Sale has the added benefit of keeping a family in its house, sparing the painful dislocation that is part of the process.