Selling Homeowners Short: Bank Strategy Backfires In Foreclosure Crisis

Housing investors and advocates are embracing a new strategy to keep struggling borrowers in their homes: Purchasing houses from homeowners who can no longer afford to pay the mortgage, then leasing the property back to the previous owner at an affordable rent.

The strategy looks like a winner for both homeowners and banks. The homeowner gets to stay put and the stress of paying what has become an unaffordable mortgage disappears. Meanwhile, the lender doesn't have to foreclose, which is costly and usually results in a vacant home they have to maintain until they can sell.

The problem is the strategy is prohibited. The nation's major banks and mortgage companies, as well as housing giants Fannie Mae and Freddie Mac, typically bar the previous owners from remaining in their properties after homes are sold for less than the value of the outstanding mortgage -- what is known as a short sale.

With nearly one in every five homeowners owing more on their home than it's worth, and millions of homeowners on the verge of foreclosure, short sales are on the rise. Last year, there were 26,000 more short sales than in 2010, according to Hope Now.

At the same time short sales are increasing, there continues to be an oversupply of vacant homes, with nearly one in every ten houses sitting empty, according to the Census Bureau. The flood of vacant homes is hampering a rebound of the housing market, say economists, by keeping home prices low. It makes sense, then, to try to avoid bringing more empty homes onto the market.

But in fact, the banks refuse to allow these kinds of transactions unless the buyers sign legal documents promising they will not rent the property back to the previous owner. The restrictions are designed to limit fraud: If a struggling homeowner can sell the property for less than what they owe the bank and remain in the home, they could find a partner to buy the home at the reduced price, and together they could then sell the home and split any profits.

However, this seemingly sensible provision is now having an unintended effect, staunching what many experts portray as a promising way to bolster the troubled housing market: inviting investors to buy distressed homes en masse and then rent them out.

"All these government agencies, Fannie, Freddie, the Federal Housing Administration, they all have this policy," said Jorge Newbery, director of American Homeowner Preservation, a company that buys homes and rents them back to the previous owner. "They have all this rhetoric about keeping families in their homes, but then it's just pushed to the side. What they're doing just seems punitive and illogical."

The short sale policy is recent. Freddie Mac and Bank of America adopted it in summer 2010, with Citigroup following in early 2011. Wells Fargo and J.P. Morgan Chase declined to comment on the timing of their policies.

Investors say the policy is just bad business. "Short sales are a third of our market, and they'd sell faster if we could just rent them back to the previous owner," said Steve Schmitz, chief executive officer of American Residential Properties, a firm that bought and then rented over 500 foreclosed properties in the Southwest. The firm is also nearing completion on a $100 million deal to acquire an additional 800 foreclosed properties.

According to Schmitz, the prohibition on short sales also makes impossible what could otherwise be a win-win transaction.

"The best deal for everyone is where we can lease it back to the previous owner," he said. "The homeowner isn't being kicked out. Their kids can stay in the same schools. For us, we don't have to pay a leasing commission or have a vacant home. The bank wins because we'd be willing to pay more money for that house if we could lease it back to the previous owner. The community wins because there's never a vacant home in the neighborhood."

Ivy Zelman, chief executive officer at financial analysis firm Zelman and Associates, disagrees with the assertion that the restrictions impede short sales. "I don't think it's an issue for the single-family rental market, as investors rehab homes and have enough tenants to rent them to other than the former mortgage holders."

Last month, the Federal Reserve Board released a 26-page paper that supports converting foreclosed properties to rental units. According to that report, now is an unusually good time for such a strategy because demand for owner-occupied homes remains low, demand for rental properties is rising, and the problem of banks' continued hesitance to offer mortgages to everyday Americans means the situation won't resolve anytime soon. The Federal Housing Finance Agency, which oversees Freddie Mac and Fannie Mae, is also currently reviewing proposals from potential buyers to convert the two companies' foreclosed properties to rental units.

Though the Fed report and the FHFA program focused on already-foreclosed properties -- as opposed to short sales, which function as an alternative to foreclosure -- the same argument applies to both, said Newbery of the American Homeowner Preservation.

"If you have a borrower who can't afford to own the home anymore, but can afford to rent it, and wants to rent it, why wouldn't you let them?" Newbery said. "Why would you bring another vacant home on to this market if you didn't have to?"