Does Everyone Win in a Short Sale?

May 20, 2009 in Uncategorized

I often say to clients and sellers that I strive to make win-win-win situations using short sales as the main tool. The seller avoids a foreclosure, the listing agent is guaranteed their commission and possibly double commissions (on the resale), I make money, the community wins with one less foreclosure and the bank does not end up with a bad asset on its books. I have however been asked many times “Does the bank really win?” Especially when they are taking $100,000 plus discounts on some of the short sales we negotiate? The short answer is… more than you could possibly know! I am going to take this opportunity to make sure that you never feel bad about negotiating down a bank again and are driven to get every penny negotiated out of them possible. I will do my best to make this brief but this is a condensation of years of learning into workings of our modern banking system. I have used this knowledge against negotiators time and again. Not really by spitting out facts and figures but just knowing this information gives you the mental leverage and right mindset you need to get what you want from the situation

When a modern home loan is originated we are seeing the culmination of centuries of development in the way banks operate. Unfortunately this development is not what I would call progress. Let me explain. In the early days of banking, goldsmiths would agree to warehouse gold for a fee. The gold smiths would issue receipts for the gold placed in storage. The owner of the receipt then owned a title to the gold in storage which could be redeemed at the goldsmith at a later date. The goldsmiths then realized they could loan out some of this gold they had on hand and be paid interest. “How is any of this history mumbo-jumbo related to short sales?” you might ask. Soon you will see! The goldsmiths who took on these practices soon ceased their smith work and took this much more lucrative path of warehousing gold for clients, lending it out and being paid interest. As warehousing of gold became more common so did warehousing receipts, more commonly called bank notes, redeemable to their bearer in gold at the issuing bank. People began for convenience accepting bank notes from reputable banks as payment for goods or services. Bankers took special note of this and a moral hazard emerged. If a banker’s notes, which are just worthless pieces of paper, can be traded for goods and services, then the issuer of that paper has the ability to create wealth through a process which is now referred to as fractional reserve banking. Let’s make a basic example. If the banker took friends out to an elaborate meal at the finest dining establishment in town, he would have two options when the check arrived. 1) Pay for the meal with gold he earned making his living. 2) If the restaurant is known to accept his bank notes as payment he could simply pull a note from his ledger and make it redeemable at his bank for the correct amount of gold and give it to the restaurant. So now we have a receipt to redeem gold created with no deposit of actual gold made in the warehouse. Now imagine if the banker realized he could lend out bank receipts to borrowers instead of gold and receive interest without having drained any gold from the vaults. This interest was true money for nothing! This also allowed banks to lend out more money than they had on hand and receive more money in interest. However, the marketplace had a remedy for such unscrupulous business practice. If word got around that the bank had issued far more bank notes than could be redeemed for actual gold, it could cause a run as people feared their savings would not be left. This safely kept fractional reserve banking in check for much of 18th and 19th centuries as a run on one’s bank meant complete ruin, both financially and in reputation, for the bankers associated with that institution. Now there have been books as thick as my arm written on the subject I am about to delve into. I will attempt be very, very brief. If you want the comprehensive source read “The Creature from Jekyll Island” by G.E. Griffin. That’s right Jekyll Island, Georgia. I am sure many of you may have visited there for a family vacation and perhaps even stayed at the Jekyll Island Club Hotel. Before WWII this island was privately owned and the Jekyll Island Club was owned by many wealthy share holders who vacationed there. It was there that the framework was laid, behind closed doors, to what we now know as the Federal Reserve Bank. Pushed through congress during a holiday break and ratified by a later regretful President Woodrow Wilson, the Federal Reserve Act of 1913 was brought in as a means to stabilize the economy of the USA which had suffered some upheaval in the early 1900’s. Little did the people know that “The Fed” would soon oversee the largest economic depression in modern history. The Fed’s real role essentially was to create a private entity chartered by congress to oversee banking in the United States. Prior to The Fed thousands of various bank notes circulated alongside US dollars. The Federal Reserve basically formed the banks of the United States into a banking cartel under one note, The Federal Reserve Note. The Fed would dictate interest rates, took over the issuance of money from congress, and acted as lender of last resort to banks in trouble (we’ve seen this in action recently). Of course the problem with any cartel is that if one party involved decides to leave the cartel, the price fixing scheme, in the case of the fed fixing interest rates, would fall apart. Every cartel ever to exist always seeks collusion with government in order to enforce the cartel for this reason. Exactly as the banking industry sought to do and succeeded with the Federal Reserve Act. Oh my God Rich…! Seriously get to the point here! Ok, so under the Federal Reserve System banks (particularly banks which owned stock in The Fed) took riskier positions as far as lending out on fractional reserve. After all, the Fed had mandated certain reserve requirements and if the banker fell short on reserve he could always appeal for an emergency line of credit from “the lender of last resort,” The Fed. Everyone learned from school that massive bank runs paved the way to the great depression. This means that far too many banks had issued far more receipts for deposits than they had deposits on hand. The Fed did bail out many banks, mostly banks who were shareholders in the Fed. Those banks then purchased competing banks for pennies on the dollar (Sound Familiar? Think Bear Stearns. If you recall, Bear Stearns was mandated by The Fed to be taken over by JP Morgan for pennies on the dollar in late 2008). I am almost done PROMISE!!! In 1933 we saw the Glass-Steagall Act passed in the midst of the Great Depression. You’ve probably never heard of it but I say that it was one of THE BIGGEST PR successes of all time!!! This act formed a little company called the Federal Deposit Insurance Company. Everyone in this business knows about that. Heck everyone who has a bank account or has ever set foot in a bank is probably familiar with the FDIC. They plaster it everywhere, a proud moniker that “Your money is safe here!!!” People love it! Their deposit is insured by Uncle Sam. What no one realized is that the Glass-Steagall Act actually was the culminating event of literally hundreds of years of banking effort and planning. The banks had managed to find a way to operate on a fractional reserve basis with no risk of bank runs. No longer was writing the proverbial bank note for dinner a moral hazard of banking it was now public policy. Today as we speak, The Fed mandated reserve rate for all banks in the USA is approximately 10%. That means that, in fundamental terms, if a bank receives $100 as a deposit of cash from you or I then the bank can legally lend out $1000 on that deposit with no risk of bank runs or legal recourse. Why would anyone or another bank accept $1000 check from a bank they knew to have only $100 on hand? Well because that person would take that check to their bank which, as are all banks in the USA, is a part of the Federal Reserve System and takes advantage of the same lending practices. Don’t believe me about the 10% reserve requirements? Just read it here on The Federal Reserve’s site The FDIC in reality is a bailout plan which allows banks not only to loan on a fraction, but also loan out 90% of its liabilities, or outstanding receipts, without assets to back them. In the days of old if a banker kept an 80% or 90% reserve he stood great risk of a run if word got out. We now have 10% reserve requirements. So from now on when you see the FDIC logo proudly displayed on/in your bank, just know that that symbol means INSOLVENT not INSURED! Every FDIC insured bank is self admitting insolvency. So when Bob Smith wants to buy a property for $350,000 with 15% down ($50,000 down) the bank grants a loan for a property for $300,000. Let’s pretend for simplicity sake that the bank writes a check to the seller’s bank for $300,000 which will be deposited in the seller’s account. In the issuing bank’s account they only are required by The Fed to have $30,000 in the bank to write that check. So for $30,000 the bank is going to collect interest on a $300,000 loan. In the first year alone at 6% rate, that is $17,900 in interest to the lender plus the lender has the power to foreclose on and control a $350,000 real asset for $30,000! Oh and I forgot, the buyer made a down payment. That puts the total outlay of the bank at -$20,000. So after they are given the down pay and they must commit the $30,000 as reserves they still net a positive $20,000 from the FRONT end of the transaction. So now the bank may go out and loan $200,000 out based on that $20,000 in new reserves. After the first year’s interest comes in from Bob’s loan of $17,900, they can make a loan of $179,000. Now do you see why banks have the tallest buildings in most cities in the world, including our own Bank of America building? So I know it has been a long journey with me this week but I hope you have stuck it through and perhaps even learned something new. Now you see that in a short sale situation the bank wins. Even in a 0% down situation, if the bank has collected even a couple of year’s interest on the property that alone can recoup the bank’s real investment in the property. Even if they gave the property away they would not be terribly worse for wear. These banking processes are far more convoluted than shown here and I have not even discussed the banks selling these notes to investors and Wall Street, etc. I just wanted to engender the basic concepts of Fractional Reserve Banking and the implications of it on our industry. Last little note. Fractional reserve banking is also the main engine of inflation of the money supply. Inflation is not rising prices as most teach and discuss. Rising prices are a symptom of inflation which is quite simply, expansion of the money supply. And as history has shown, most recently in our little housing bubble, more money chasing after the same amounts of good and services (houses), leads to rising prices. It’s simple supply and demand. But that’s another story.