Are sellers, brokers and buyers in a short sale transaction being set up by the big banks?

Most lenders routinely require that the seller, listing agent and often the buyer and their agent sign some kind of certification, representation, or declaration/affidavit that the short transaction is being conducted at “fair market value” (FMV) or “market value” or “based on market value.” Often the certification takes the form of a sworn affidavit or a declaration under penalty of perjury.

By definition, it is IMPOSSIBLE for a short sale to occur at fair market value. By refusing to approve the short sale without the FMV certification, the banks are requiring the signers of the certification to engage in an active misrepresentation for which the bank may come back in the future and make a claim of fraud against all involved.

Accordingly, one signs these certifications only at their own peril of liability for the bank’s payoff discount and possible prison time.

Definitions of “Fair Market Value”

Most residential short sales involve some kind of federally insured financial institution. Hence, federal government definitions of “fair market value” can be applicable.

The classic federal definition of fair market value is found at 26 C.F.R. 20.2031-1(b) stating: “The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” [Emphasis added.] This definition was affirmed by the United States Supreme Court in United States v. Cartwright, 411 U. S. 546, 93 S. Ct. 1713, 1716-17 (1973).

Regulations under the “Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989,” (which was intended to deal with the previous major financial “melt-down” in the savings and loan industry) expanded on this definition with respect to financial institutions (as opposed to the tax code reference above). The following definition was published in the Federal Register:

“The most probable price (in terms of money) 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 and 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: the buyer and seller are typically motivated; both parties are well informed or well advised, and acting in what they consider their best interests; a reasonable time is allowed for exposure in the open market; payment is made in terms of cash in United States dollars or in terms of financial arrangements comparable thereto; and 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.” Federal Register Vol. 55, No. 163, August 22, 1990, pages 34228 and 34229. [Emphasis added.]

Under both definitions one sees that the seller is assumed to be acting without compulsion or undue stimulus and reasonable time is allowed for marketing.

To the contrary, in a short sale the seller is acting under a tremendous amount of pressure, duress, and coercion from the very same bank that is requiring the certification!

Accordingly, a short sale will NEVER occur at fair market value.

What price, then, is applicable?

Distressed Property at Liquidation Value

“Distressed property” is defined as “real property that suffers a reduction in its market price because of pressures operating on the owner, such as threatened foreclosure, divorce, settlement of an estate, or fear of economic changes that might decrease the value.” (The Complete Real Estate Encyclopedia by Denise L. Evans, JD & O. William Evans, JD, 2007.)

Freddie Mac, in Attachment A of the Guide Bulletin 2009-24 dated October 9, 2009, affirms the concept that distress properties, including short sales, ordinarily sell at a discount, which makes them attractive candidates for a “flip.”

Key excerpts from Attachment A state: “Properties targeted for property flips generally include properties that can be acquired at lower prices than other properties in the same neighborhood and often include real estate owned (REO) properties, properties subject to a ‘short sale’, other distressed properties or newly constructed properties where the builder or developer must liquidate housing inventory quickly. . . Property flips are not inherently illegal and not all transactions involving a rapid purchase and resale are improper. Legitimate property flips are acceptable transactions in connection with loans purchased by Freddie Mac. Some indications of property flip transactions that may be legitimate include . . . Sales of properties that the property seller acquired at below market value after purchasing as a result of a distress sale (i.e. REO sale, short sale, tax lien sale, bankruptcy trustee’s sale, etc.), where any increase in the sales price over the property seller’s acquisition cost can be clearly shown to be a result of the difference (if any) in the market’s reaction to distress sales and typical arms-length market sales.” [Emphasis added.]

One sees three key factors here: 1) properties often become “distressed” due to seller circumstances, not necessarily physical characteristics; 2) the market reacts to distress sales by discounting the price when compared to “typical arms-length market sales;” and, 3) the sale is priced according to what it takes to liquidate the property.

Ironically, Chapter B65.40 (9/1/10) of Freddie Mac’s Seller/Servicer Guide requires an “arms-length” affidavit to be executed by the parties to a short sale transaction. The affidavit is to provide that each signatory agrees to indemnify the servicer and Freddie Mac “for any and all losses resulting from any negligent or intentional misrepresentation made in the affidavit including, but not limited to, repayment of the reduced payoff of the Mortgage.” Further, “each signatory understands that a misrepresentation may subject the responsible party to civil and/or criminal liability.”

The parties are in an obvious “catch-22” of which there is no way out: Freddie Mac Bulletin 2009-24 says a short sale is a distress sale that occurs at less than a typical arms-length transaction yet the parties to the transaction are required to indemnify Freddie Mac of any and all losses to the degree that the sale price is less than an arms-length transaction!

FIRREA and Bulletin 2009-24 indicate that distress properties are to be valued at liquidation value. The appraisal standards one finds quoted in a liquidation valuation report typically state:

“DEFINITION OF LIQUIDATION VALUE: Liquidation value is the likely price of an asset when it is allowed insufficient time to sell on the open market, thereby reducing its exposure to potential buyers. Liquidation value is typically lower than fair market value. Unlike cash or securities, certain illiquid assets, like real estate, often require a period of several months in order to obtain their fair market value in a sale, and will generally sell for a significantly lower price if a sale is forced to occur in a shorter time period. Liquidation value may be either the result of a forced liquidation or an orderly liquidation. Either value assumes that the sale is consummated by a seller who is compelled to sell and assumes an exposure period which is less than market normal.”

How much is a distress sale discount?

The Federal Housing Finance Agency (FHFA) was created by the Housing and Economic Recovery Act of 2008 (HERA) as the primary regulatory of Fannie Mae, Freddie Mac and the twelve Federal Home Loan Banks. It prepares a monthly House Price Index (HPI).

The FHFA commissioned a study called “The Impact of Distressed Sales on Repeat-Transactions House Price Indexes” dated May 27, 2009. (Instructions for downloading the study by registered members of this site are at the end of this article.)

The sales data studied is ripe for this article as it was limited to California. It identified “distressed sales” as sales for which (a) a Notice of Default (NOD) was filed less than a year before the transaction, and, (b) no other sale occurred between the NOD date and the sale date. This is a far narrower definition than usual.

Figure 1 of the study shows that for 2008 and first quarter 2009, distressed sales constituted between 40%– 45% of the actual closed sales in California notwithstanding the narrow definition.

Figure 4 of the study tracks the “price difference between distressed sales and other” sales and separately tracks GSE (Fannie and Freddie) data apart from aggregate county recorder data. It shows that throughout 2008 and into the first quarter of 2009 the difference ranges between a 10% – 20% discount.

Remarkably, the GSE index regularly shows a higher discount than the overall recorder-based index. For the first quarter of 2009, the recorder index showed a 10% discount while the GSE index showed a 20% discount.

Where is the outrage when the agency responsible for supervising Freddie Mac finds that Freddie Mac short sales sell for 20% below arms-length market value but Freddie requires the parties to the transaction to execute a sworn affidavit that the sale is arms-length market value and the parties are forced to agree to indemnify Freddie for the difference??

Would You Sign The Affidavit?

I have seen FMV and arms-length affidavits which require the signature of the sellers, the buyers and all of their agents/brokers.

Can you imagine how many unsuspecting people are being set up for possible future damage claims by banks, GSE’s and short sale servicers? How many people are at risk of criminal liability?

I have been cautious about having clients sign these affidavits. It’s time that this information not be limited to private clients, but be spread to the general public.

The regulators, GSE’s and banks have been making exaggerated and unjustified claims and warnings about “short sale fraud” on the buyer’s side, particularly with respect to legitimate investor-buyers. Entrepreneurs, professionals and licensees who are “in the trenches” have long known that the fraudulent and coercive practices of the banks are far worse.

Finally, in mid-September, the “robo-signer” scandals at the big bank servicing departments started to be exposed. Short sale processors and negotiators know that this is only the tip of the iceberg of improprieties.

Until now, I have not seen anyone raise the racket that is being set up by FMV certifications. Today a new bank scandal in mortgage fraud is exposed: the routine requirement of a FMV certification in short sales appears to be part of a plan by the banks, services and GSE’s to set up short sale participants as the recovery targets for their losses. These affidavits will supercede waivers of deficiency liability in the short payoff approval letters because they are a separate cause of action for fraud, not the liability on the underlying promissory note.

Market value and arms-length transaction certifications are a looming time bomb of ever increasing liability and risk that ordinary people are taking on which the banks and GSE’s can detonate at an economically and politically expedient time to seek recovery for their losses from short sale buyers, sellers and their real estate agents.

Is that a risk that you are willing to take?

[If you would like a copy of the FHFA study, please register HERE if not already registered. Then you can go HERE for the report.]