Tuesday, September 21st, 2010 at 6:22am

Flip, Flop or Hold – A Tale of Three Myths

Posted by Ron Ballard

There’s a lot of discussion and warnings in residential real estate circles regarding various forms of “short sale fraud.” Unfortunately, too much of it neglects realistic market analysis and results in labeling legitimate business practices as “fraud.”

Usual disclaimer:  this is a lengthy post because it provides in-depth analysis of complex issues. It’s not just repetition of brief “sound bite” type of statements that are all too common about this topic.

The Setting

When a person buys a short sale property, one of three transactions may be involved: a “flip”, a “flop,” or a “hold.” Various commentators engage in diatribes about how flipping and flopping increase lender losses. In short, these arguments are myths.

Any kind of resale of a short sale property does not INCREASE a lender’s loss, it merely REVEALS or quantifies the magnitude of the loss.

The Hypothetical

Let’s assume the following hypothetical. The current owners bought their home in 2007 for $600,000 with a $500,000 loan. Three years later the home now appears to be worth no more than $500,000 IF there is no distress and the seller has unlimited time to find a buyer who totally falls in love with the house and doesn’t need a strong appraisal for financing. Unfortunately, one of the two homeowners has been out of work for nine months, the owners are six months behind in their mortgage payments, and the lender has just begun foreclosure proceedings. Due to the lack of income, the borrowers cannot qualify for a loan modification (of which only about 15% of the applications ever result in a permanent modification per government figures).

This is now a “distress sale” in which the sellers need to unload the property to avoid foreclosure.

Distress sales are common occurrences that can result from divorce, illness, death, job loss, relocation, tax or other debt enforcement, bankruptcy and many other unexpected or uncontrollable factors. Every real estate agent I have asked who has been in business for five years or more has admitted to me that “distress sale” properties sell for far less than “fair market value.” Usually, the discount is somewhere between 10% to 30%, depending on the seller’s circumstances and the particular market (whether a “buyer’s market” or a “seller’s market”). This is particularly true when buyers know the seller is in distress. If a property has a foreclosure commenced against it, or even if the property is advertised as a short sale, then prospective buyers know the distress and approach the deal seeking discounts. This is the case whether the buyer is an end-user for occupancy or an investor.

The less market activity there is, the more difficult it is to value a property. High end markets with few transactions see the highest valuation difficulties. Less than 10 miles from my office is an estate which had $10 million of loans against it. Presumably, it appraised for $10 million at one time. Even after more than 18 months on the market, it could not attract any offers (even at auction) for even $3 million! That’s a paper loss of more than 70%.

For the hypothetical, let’s assume a reasonable market discount of at least 15%. That would make the high end sale price about $425,000. Let’s also assume that comparable sales over the last six months have ranged between $450,000 and $350,000 because this is an established community with a wide range of housing stock.

The sellers’ agent lists the house for $430,000 in order to try to get the “highest” possible price. However, buyers know there is a pending foreclosure, so they are unwilling to make a high price offer. Over the next few months, several offers come in between $350,000 and $400,000 but the sellers reject them because they thought they could get close to $430,000. Now the possibility of foreclosure is even closer. A buyer offers $375,000. The sellers counter at $380,000 and the buyer accepts the counter-offer.

There is now a binding contract between buyer and sellers. No more offers can be accepted. The short sale package is submitted to the lender. Fortunately, there is a smart “negotiator” on the file (acting for either buyer or seller) who has completed exhaustive market research and has found that the local distress sales are mostly in the $350–$400,000 range.

The short sale request triggers the bank to order a broker’s price opinion (BPO). The BPO broker is usually paid very poorly and is not often inclined to do very extensive market research. Basing the BPO on regular market closings in the MLS, the BPO agent comes in with a value of $425,000. However, the bank’s loss mitigator does not disclose this valuation. The bank responds that it wants a minimum sale price of $430,000 to see what the negotiator will reply.

The negotiator compiles and provides the bank with the true and accurate records of recent distress sale closings for comparable properties by using public records of non-MLS sales in addition to MLS records. The negotiator also compares these prices to true public records of the foreclosure sale prices and failed minimum bids for which banks took back comparable properties. These values are in the $350–380,000 range. Now true negotiations begin based on comprehensive, accurate and truthful market data.

The bank reviews an automated valuation model (AVM) from a data vendor which shows the value as likely no more than $400,000 because the AVM looked at a broader range of data than the BPO did. Again, the bank’s loss mitigator does not reveal this information to the negotiator. After a series of give-and-take, the bank agrees to a sales price of $400,000 provided it nets at least $370,000 after sales commission and closing costs. The seller agrees to increase its price and the agents make sure that the commissions and costs work to meet the bank’s requirements. The deal closes.

Assuming the loan balance and arrears totaled at least $500,000, the lender appears to have taken a discount (or “loss”) of $130,000.

The “Hold” Examples

In “Hold” example number 1, the buyer does not resell the house within 90 days. The bank receives a 90 day “fraud detection” report that shows no resale and “no likely fraud” in the transaction. The buyer is an end-buyer who is living in the house.

In “Hold” example number 2, the buyer does not resell the house within 90 days but is an “investor” who decides he got a good enough deal to hold the property and rent it out. The bank receives a 90 day “fraud detection” report that shows no resale and “no likely fraud” in the transaction.

In these cases, the bank’s discount remains $130,000 regardless of the use of the property.

The “Flip” Example

Now let’s assume that the buyer is an “investor” who decides not to rent out the property but as the course of negotiations was tending to a price of no more than $400,000 decided to market the property to see what the new, current market would get for a non-distress sale. The seller markets the property with disclosure to prospective buyers that it is subject to the investor-buyer (as the new “seller”) taking the title as a result of a short sale acceptable to the investor-buyer. The market recognizes that this is no longer a distress sale, but a sale in which the investor-buyer will buy the property pre-foreclosure and clear title.

The investor-buyer markets the property with an asking price of $475,000 to test the upper limits of the non-distress property values. About the time the bank agrees to a $400,000 discounted distress sale price, the investor finalizes a contract for a new end buyer at $460,000. Within 30 days of receiving the short sale approval, the investor buyer closes the purchase for $400,000 in a fully funded cash purchase. Twenty-eight days later the end-buyer’s financing process is completed and the second sale closes at $460,000. This totaled a 58 day escrow period, which is not exceedingly fast.

The second sale was able to appraise for $460,000 because the appraiser had factual information that the investor-buyer was purchasing a pre-foreclosure, distress sale property but now was selling in a non-coercive, market environment. Moreover, the second sale went into contract more than 4 months after the first one and the local market had begun improving. Therefore, both the $400,000 distress sale price in “month one” and the market-based price in “month five” are realistic representations of the prices applicable in each different market time and circumstances.

Slightly more than 90 days after the first sale, the bank receives a “fraud detection” report that the property sold 28 days after closing for $460,000 and is flagged as a “potentially fraudulent sale.” The self-righteous data processing company advises the bank that it had an “avoidable loss” of $60,000 on the first transaction.

Unfortunately, that “avoidable loss” report is at its core, an illogical conclusion given the true market circumstances of the two sales. The $60,000 difference in sales prices was only a 15% increase over the distress market, short sale price. This is a normal market difference between distress sale prices and market-based prices.

The original sellers could not have obtained a $460,000 sale price (and in fact, didn’t receive any offers that high), because the pool of buyers knew the sale was a distress short sale due to a pending foreclosure. The investor-buyer was able to get a higher price ONLY because the investor’s purchase removed the pending foreclosure from the title records, cured the negative equity, and converted the sale to a non-distress sale. The original sellers could not create that market environment, nor could the bank. Only the investor who came in with the cash to pay the discount to which the bank agreed could get that sale price.

The “Flop” Example

“Flopping” is an interesting concept. It requires two key factors. One of which is conceivable. And one of which seems exceedingly rare in the feedback I receive from short sale negotiators.

The TARP Inspector General describes “flopping” as: a short sale “scheme” centering on “home values that are fraudulently deflated for the purpose of decreasing the cost of the short sale to a ‘straw purchaser.’ The property is then quickly resold for its true market value, leaving the difference in the crook’s pocket. Historically, these schemes often involve the participation of corrupt brokers and servicers.”

The FBI annual mortgage fraud report discusses flopping as follows: The perpetrators collude with appraisers or real estate agents to undervalue the property using an appraisal or a broker price opinion to further manipulate the price down (the flop) to increase their profit margin when they later flip the property. They negotiate a short sale with the bank or lender, purchase the property at the reduced price and flip it to a pre-selected buyer at a much higher price.

The FBI discussion identifies the actual fraud in a presumed flop: the existence of a pre-existing, capable buyer willing to pay a higher price when the short sale package is first submitted.

Both discussions include the uncommon and unlikely circumstances of a bank accepting a seller’s valuation or low-priced offer without its own due diligence.

Both discussions are vague about how the “fraudulently deflated” price is obtained from the bank. In my hypothetical above, let’s assume that a dishonest agent is contacted by the seller and offers the property to known potential buyers before marketing the property publicly. The agent finds a buyer who is willing to pay $460,000 because the distress nature of the sale is withheld from the buyer. The agent now has a “confederate” make an offer for $350,000 and advises the seller to accept it. The seller accepts and the confederate enters into a contract with the original end-buyer for $460,000.

The agent now submits a short sale package to the lender. The lender orders a BPO and coincidentally the BPO agent is a friend of the listing agent who, like the listing agent, is not of the highest ethics. The listing agent, who is presently set for a full, double-ended commission on the deal, offers the BPO agent a secret referral commission of 2% if the BPO comes in around $350,000. The BPO agent agrees and submits a BPO of $355,000 based on inaccurate, incomplete or falsified data. The short sale negotiator for the listing agent also submit false comparable sale data to try to convince the bank of the low value.

In the “old days” when bank’s loss mitigation departments were not well-trained and did not use multiple valuation tools, this “scheme” might have (and maybe did) work. In most loss mitigation departments with which my clients deal the bank will at least order a computerized AVM to get a quick-check on the first BPO. As we saw above, the AVM came in at least $400,000. Since this is significantly greater than the initial BPO of $355,000, the bank orders a second BPO from a different agent from outside the area. This agent, although not as knowledgeable about the local market, is not a friend of the listing agent and is not offered the same “bribe.” This BPO is based largely on available MLS data and comes in about $425,000 like our earlier example.

Now with a wide variation in the BPO and AVM values the bank’s loss mitigator negotiates much more aggressively and will likely agree to a discount similar to the original case – around $400,000.

The “flop” does not succeed at a “fraudulently deflated” price because the current due diligence practices of loan servicer’s loss mitigation departments are likely to catch wide discrepancies. As a result, the dishonest agent and the confederate acquiesce to the bank’s $400,000 price because they know they have a $460,000 buyer under contract.

Presumably the “confederate” has a funding source to close the purchase and resells the property in less than 30 days to the original $460,000 buyer. Slightly more than 90 days after the first sale, the bank receives a “fraud detection” report that the property sold less than 30 days after closing for $460,000 and is flagged as a “potentially fraudulent sale.”

One reason why I think “flopping” is largely a myth is because bank valuation processes are not presently, easily manipulated. Maybe they were in the past, but that’s not the feedback I’m receiving from scores of outside negotiators. The “bribe” would also have to reach to the loss mitigator at the bank, but they change so often and must report to a supervisor, that this seems extremely difficult to make work.

Moreover, there are few markets and few buyers who can be tricked into a market priced deal for a short sale property pending foreclosure. The knowledge of property and seller circumstances tends to be too well-known in most areas. Further, most banks require a marketing history of the property as part of the short sale package. If the property wasn’t listed for sale, the bank’s scrutiny is much higher or the bank will refuse the short sale offer until the property has been publicly marketed. All this leads to the likelihood that the initial buyer who was tricked into a market price for a distress sale would be unlikely to stay in the deal. All but the most gullible buyer will figure out what’s going on or will have a buyer’s agent who becomes suspicious.

I agree that the listing agent’s attempt to “flop” the property would constitute fraud or other illegal or unethical conduct that must not be allowed and which should be punished. The agent violated its duty to the seller by taking the seller’s high offer for his own benefit. The agent also tricked the buyer by presumably not disclosing the distress sale in order to obtain a market price that would not otherwise be obtained. Finally, if the end buyer would have, or does, stay in the deal – even after learning that it’s a distress sale that should be subject to discounting – then the bank did have an avoidable loss because the early-stage buyer who stayed in the deal was the SELLERS’ buyer (not the investor’s buyer as in the flipping example). Accordingly, that was a deal that the bank conceivably could have obtained (so long as the buyer remained ignorant, but then maybe the bank should be considered as in collusion with listing agent who is defrauding the end-buyer).

Conclusions

In all three (well, actually four) cases, the loss to the bank was the same. In the two “hold” examples, a typical “fraud detection” system would not find an “avoidable” loss.

In the flip example, a “potential fraud” would be identified. In economic reality, there was no different loss than in the hold examples. The flip only revealed the potential magnitude of the discount. The loss was not an actual loss to the bank because a foreclosing bank cannot participate in a non-distress sale. The mere fact that a loan is in default creates a discounted sale environment which is magnified when the foreclosure is on public records. Hence, the bank cannot get the same deal as the investor who has cleared title.

In the flop example, fraud arguably existed because there was a pre-existing, capable, end buyer who was willing to pay more at the time the short sale package was submitted. This timing difference in obtaining the end buyer is the key between the flip and the flop. It is the difference between a legitimate market flip and a fraudulent flop. The flip obtained the ultimate end buyer as a result of the investor’s marketing after negotiations began. The flop obtained the original end buyer as a result of the seller’s agent’s marketing.

In reality though, it is difficult to imagine how a flop can actually be accomplished in today’s environment in which banks’ loss mitigation departments have quite tough negotiators who check values with AVM approaches – and with appraisals when the facts and value warrant it.

The primary myth is that a “flip” somehow “creates” a “loss” the bank could have “avoided.” Yet in all four cases, the “loss” was the same. It’s not the flip, the flop, or the hold that matters when calculating loss. At some point the bank agrees to take a discount on the loan balance as a result of the seller’s distress and the loss in value of the collateral.

The bank’s voluntary agreement to accept a discount actualizes the loss that results from originally poor lending practices. Loose lending practices created the current losses. A flip merely reveals the magnitude of the loss that cannot be seen in a “hold” transaction.

Blaming the loss on the investor appears as an ingenuous attempt to deflect accountability for prior excesses in loose lending practices.

6 Responses to “Flip, Flop or Hold – A Tale of Three Myths”

  1. Bill Patterson says:

    Ron, this is a great blog and is being passed along on Bigger Pockets. The comments have been great on that site, also! Thanks for the straight forward and credible analysis of this hot subject.
    Bill

  2. Richard graham says:

    Thanks Ron. I am going to forward this to every agent I know. Great post on my B-day

  3. tmpringle301 says:

    Ron,

    This is exactly the kind of information that needs to be heard in Congress and in those “behind closed doors” meetings we are now hearing about.

    I have another spin on this however – what about the banks “influencing” the valuation? I have had several recent BPO and Appraisal appointments where I have been told directly that the banks have given “specific instruction” NOT to use distressed sales in their valuation. How can accurate market data be gather when the MOST comparable sales in the area are being forcibly excluded by the lenders so as to not “deflate” the value of the property? Are they kidding?

    Isn’t that directly impacting the seller who is now under the impression that they have to market for a higher probably unattainable price for the property? Wouldn’t that also maximize the bank’s loss after waiting months (and losing interest and carrying bad paper) instead of truly mitigating the loss by using accurate market data?

    I don’t know who the banks think they are fooling but the the world is full of savvy buyers none of which are going to over pay for ANY property – especially not in a distressed situation.

    I especially like the concept that the short sale simply reveals the magnitude of the loss that was actually already present before the offer was made. Bad loans and loose lending are the TRUE causes of the market crash and I would venture to say that even though I’m sure the schemes you mention did exist in some markets, they don’t nearly make up the volume of the liar loans that the bank was well aware it was making each and every time, and reaping the profits month after month. It’s time for the banks to pay the piper and for people to realize that they need to be held accountable for their actions during the hayday.

  4. Aaron Ayotte says:

    Ron,

    Thanks for such a great post. I can’t tell you how many times over the past month I’ve had some agent tell me that flipping is illegal and we’re defrauding the banks by purchasing and reselling short sales. The fear driven ignorance is running rampant!

    Keep the truth coming, my friend!

    Aaron

  5. […] This post was mentioned on Twitter by Jeff Finlay, michelle simmons and Transaction Funding, Alex Cruz. Alex Cruz said: Flip, Flop or Hold – A Tale of Three Myths :: California Short Sale Lawyer http://t.co/QhlzdtR […]

  6. Tony B says:

    Ron: I am new to your blog. This is simply an excellent analysis and clear, easy to understand examples. Thanks for the info.

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