Well, we saw it coming, and sure enough, as a result of Senate Bill 458 2nd lien holders in California short sales are putting on the squeeze.  The bill was well intentioned, as it restricts 2nd lien holders in a short sale from issuing a deficiency judgment or demand that the sellers bring money to the table. 

But since the bill passed in July, I am increasingly seeing the 2nd lien holder holding out for a pay-off of as much as 35% of the remaining balance on the 2nd TD.  And they don’t care who brings it to the table.  I recently had a 2nd lien holder request that the seller ask her friends if they could contribute!  Are you kidding me?  The result of course is that 2nd lien holders may be blocking California short sales.

Case in point:  I have a short sale that I’m negotiating with servicer G—-T— in the 2nd position. They are demanding 25% of the outstanding balance on the 2nd, which is approximately $40K, so they want roughly $10K.  The 1st lien holder won’t allow more than 6% ($2400) to pay-off the 2nd.  The buyer is contributing another $2K and the selling agent and I are each kicking-in $1K…but that still puts us short of what the 2nd lien holder is demanding by $3600.

So, I’m in the process of trying to negotiate with G—-T— to lower their demand.  Don’t they understand that if they refuse to accept a lesser amount the property will foreclose and they’ll get nothing?  The 1st lien holder is holding firm at 6% and there is simply no other source of funds.  Will they lower their demand, or will this be a failed short sale, killed by the 2nd lien holder?

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Over the past two years we’ve seen an increase in the number of short sales as underwater homeowners try to avoid foreclosure.  Realtors and Federal policy makers have applauded this movement as a means to encourage sales and spur the market recovery.  Too often however, 2nd lien holders are blocking the short sale and forcing homeowners into foreclosure.

In a short sale, the property is offered for sale for less than what is owed.  Provided the final sales price is reasonable, and the homeowners can prove that they are unable to continue to make mortgage payments, most lenders will accept the short sale as it costs them far less to take the loss than to foreclose.  However, if there is a 2nd mortgage on the property it becomes a much more complicated transaction.

When there are two or more liens on the property, the 1st mortgage is in the primary position and when reviewing a short sale, the lender will generally approve only a token payment of $2000 – $3000 to the junior lien holder.  So on a sale of a $320,000 property with a $400,000 1st mortgage and a $50,000 2nd mortgage the lender in the first position will recoup approximately 80% of the original loan amount (less fees and expenses), but the 2nd mortgage holder will recoup only about 5 – 6% of their investment.

As a result, 2nd lien holders are in no hurry to approve a short sale and what develops is a sort of “chicken game” between the negotiator for the first mortgage, the negotiator for the 2nd, and the Realtor or negotiator representing the homeowner.  The poor buyer who is trying to purchase the home is at the mercy of everyone involved.  Often the lender in the 2nd position will ask either the homeowner or the buyer to come up with additional funds to at least get them a 10% return.  Although this might only be a few thousand dollars, that might be enough to kill the deal.  For the 2nd lien holder, they might choose to just wait for a better offer where the buyer will agree to pay, or they will agree to the sale but file a deficiency judgment against the homeowners.

According to CoreLogic, a company that tracks foreclosure data, of the 1.33 million homes that are in some stage of foreclosure, over a third have a 2nd mortgage.  Many of these 2nd mortgages were underwritten to allow the homeowner or buyer to borrow 90 -100% of the home’s inflated value.  Sorry if I’m not sympathetic, but it was a risk the banks knowingly took.  The strategy back-fired as values plummeted, but now the banks holding these 2nd mortgages need to just write-off the loss and get out of the way. 

How to protect yourself in a short sale transaction with a 2nd mortgage?  Make sure your Realtor knows how to play the game.