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Short-Sale Killer: 'Arm's-Length' Rule

Ginny… I owe about $150,000 more on my home than it’s currently worth, and my hours were recently cut back at work. I applied for the Obama Home Affordable modification, and after many months my lender refused to give me a permanent modification. However, my sister and her husband were interested in buying my house from me. So, we worked with a real estate agent to put together the short-sale application and my sister’s offer to buy the place.

After about five months, the bank approved the price and my sister paid for an appraisal. Then, at the last minute, the bank’s negotiator asked me if I knew the buyers or was related to them, and I explained that the buyers were my sister and brother-in-law. The bank canceled the whole deal, and now it looks like I’m going to lose the house to foreclosure!

I don’t understand why they care who the money comes from. I really feel disgusted, and wonder if my real estate agent should have been able to anticipate this problem from the beginning, when I might have still had enough time to find another buyer.  Am I off base here? Jan A., Phoenix

Jan… Short answer: No, you’re not.

Longer answer: It’s not the case that the bank cares who the money comes from, per se. Rather, the bank cares about ensuring that it is getting the full fair market value for your home, and not taking any more of a loss on your home than necessary. Remember, the bank is always of the mind that if a modification or short sale fails, it’ll end up owning your home as a foreclosure.

While we’ve all hear the party line that your bank doesn’t want to own your home, it would absolutely rather own your home and resell it at its full value on today’s market than authorize a short sale at a price significantly less than that.

The bank has several ways of assuring itself that the price it accepts on a short sale is as close as possible to the home’s fair market value. One is to obtain documentation that your agent listed the home on the open market. Another is to request to see all offers that have been made to purchase the property, where more than one offer was received. Yet another is to compare the offered purchase price against a value estimate procured from a real estate broker or agent of the bank’s choosing, called a broker price opinion or BPO. (The formal appraisal done in a short sale is for the benefit of the buyer’s bank, not the seller’s.)

One additional guideline every bank and mortgage servicer puts in place to help assure its investors that they are receiving a fair market value for the asset (i.e., your home) is to require that all transactions be “arm’s-length” transactions. This simply means that the parties are not related, either by family relation or by contract.

In a short sale, this arm’s-length transaction requirement is meant as another check to make sure you’re not cutting your relative a sweet deal, at the bank’s expense. It’s also intended to deter fraud by diminishing the likelihood that you are, say, short-selling your home to your sister at a super-low price, and then continuing to live in it or buying it back from her — again, at your mortgage servicer’s expense.

As you can see, what sounds like a pretty bizarre requirement that short sales be arm’s-length transactions — in your case, a prohibition on short-selling your home to your sister — actually is grounded in a reasonable effort to prevent fraud and the wholesale short selling of homes to friends and relatives in an effort to turn upside-down equity positions right side up, at the lender’s loss.

Now to the question of whether this snafu was avoidable. With the caveat that I’m not aware of what information your agent did or did not possess, what warnings she did or did not issue, or what she represented (or did not represent) in terms of her familiarity with short sales. I will say that the average short-sale agent is aware of the arm’s-length transaction requirement.

Generally speaking, an agent would warn clients up front upon learning that an interested buyer was a relative, that the lender would be extremely unlikely to approve such a short sale — so unlikely that it would behoove you to market your home for sale on the open market and seek out offers from unrelated parties, if indeed you desired to do a short sale in order to avoid foreclosure.

However, I have seen time and time again where sellers choose to work with a friend who is a full-time nurse, say, but also has a real estate license, to do these sorts of deals and end up paying for it.

The reality of today’s market is that it changes so rapidly and that only agents who do these specialized transactions on a regular basis can stay sufficiently up to speed on lender’s guidelines and short-sale success strategies to give you the full scope of advice, troubleshooting and strategy your short sale takes to get the deal done.