by Steve Harney on July 9, 2010

I recently had an email conversation with a well respected real estate professional about the difference between strategic defaults and short sales. We both agreed that we needed to share our conversation with the readers of this blog.

Original Question:

I have heard that a short sale might be better than a strategic default. However, they are painfully slow and I’m really not sure they have any “different” effect on surrounding homeowners: it’s still a massive loss of value in the area.

Whether they short-sell or not, aren’t they going to be penalized by future lenders anyway? I’m not entirely sure there’s much of a different in the “outcome” at the end of the day – short sell or walk away, they are going to suffer in creditworthiness.

And don’t short sales actually harm the bank “more” than the borrower (perhaps) because it drags out the timeframe before the asset can be put on the market, where as a walk-away can put that home on the market right away – at TODAY’s possible sales price – rather than weeks more of declining value.

Steve:

I can fully understand your overall point. However, as always, the devil is in the details.

1.) There are VERY HEFTY penalties to a strategic defaulter vs. a person who short sales (ex. Fannie Mae has decided that they will “lock out” any strategic defaulter from getting a mortgage for a minimum of seven years and will also charge them with EVERY expense incurred during the foreclosure process).

2.) The average short sale sells for 85.3% of full value. Foreclosures sell for an average of 66% of full value. Every time a house goes to foreclosure vs. a short sale the neighborhood loses that 19.3% equity difference when these homes are used as comps.

Again, I understand your overall point. I am just worried about future ramifications.

Follow-up Question:

First, I didn’t know the data on short sale vs foreclosure; my point was the “time to market” was sooner – so one thing I’d love to see in the data would be “85% of what number” because if a short sale takes 16 weeks, but a strategic default could be moved into a rental in 4 weeks and the home put on auction on week 5, I wonder which would yield a higher amount.

As for Fannie/Freddie, that’s an entire other Pandora’s Box. On one hand, I’d love to say “who cares” but we know they are fueling the market right now (just like they fueled the problem years ago). I think of it like bankruptcy – you’re “supposed” to be locked out of credit for 7 years after bankruptcy, but PRIVATE lenders start sending you credit cards right away. Yes, at higher rates, but you ARE a higher credit risk. So, will “Fannie” penalties really be so bad? Plus, once the “political sob stories” hit the streets, do you think Fannie/Freddie policies will really be enforced?

Steve:

Actually, the average length of a short sale is 6 months not 4 months. The average length of a foreclosure is 438 days or 15.6 months. So it is the opposite of what many perceive it to be.

The only thing I can think is that you are actually talking about a deed-in-lieu in which case your argument is correct. But, a deed-in-lieu is nothing like a strategic default. People who strategically default STAY in their house and force the bank to foreclose.

Regarding penalties, you have to do some reading on that. For example, in most states there is a deficiency judgment for strategic defaulters while in most short sales, and in some deed-in-lieu cases, it is waived.

Follow-up:

Ok – that surprises me – is it the bank’s fault or regulators that it takes so long to foreclose? If it’s the banks’ fault, then it’s a problem of their own making. Once the owner decides to stop paying, they should get them out asap in order to sell the asset asap.

As for deficiency judgment, maybe the owners should do a strategic default and bankruptcy at the same time. I’m not saying it’s pretty, but it’s an option. If you credit is going to take a hit – AND you’re going to lose ANY savings you might have had as equity in your home (and even that’s an assumption!) then why not just clean it all up.

Steve:

The bank has to go through a legal process to foreclose. The laws definitely favor the borrower as they should. That is why it takes as long as it does. And most courts are backed-up. The bank can’t just make the person leave.

People made uninformed decisions five years ago that are haunting them now. I just want to make sure they are not making decisions now that will haunt them in five years.

I’ve done a tremendous amount of research on this point. I firmly believe, in most cases, a strategic default is a short term solution with devastating long term ramifications. People should be advised of these ramifications before moving forward.

http://kcmblog.com/2010/07/09/a-conversation-on-short-sales-vs-strategic-defaults/#more-4911