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Short Sale Flip, Flop or Hold – A Legal Perspective

This is one of three white papers written by my attorney, Ron Ballard regarding the legal issues, misunderstandings and misrepresentations surrounding short sales.  Its a little long, but worth the read.  Also read:  Short Sales Negotiations – A legal Perspective of Compensation .

A copy of the DRE “Update” can be found and downloaded at http://www.trademarklossmitigation.com/Articles_and_White_Papers.html .

REAL ESTATE STRATEGIES INSTITUTE, INC.

White Paper Study Regarding:

Flip, Flop or Hold – A Tale of Three Myths Current as of: September 21, 2010
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 legal and market analysis and results in labeling legitimate business practices as “fraud.”

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 HAMP 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 agreed with 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, not a pending “offer.” No more offers can be accepted. “Acceptance” of a offer creates a binding contract and there can be only one binding contract to sell a property at a time. The short sale package is submitted to the lender. Fortunately, there is a smart “negotiator” on the file (acting for either buyer or seller – not the loss mitigator for the bank) 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 private 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 has even followed up with the agents for several completed sales and learns several of them had seller’s concessions which reduced the effective price to the buyer. These sales are duly noted and adjusted. 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 counter-offers, 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 our “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 (“loss”) 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 hold and rent out the property but as the course of negotiations for more than three months 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 and the owner of record. 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 endbuyer’s financing process is completed and the second sale closes at $460,000. This totaled a 58 day escrow period for the end buyer, which is not exceedingly fast.

The second sale was able to appraise for $460,000 because the properly trained appraiser had factual information that the investor-buyer was purchasing a preforeclosure, 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 “distress sale” 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 “fraud report” is fatally flawed due to insufficient analysis. 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. Therefore, the $460,000 is rightfully the investor-seller’s offer. The bank did not own the property nor do anything to market the property and earn the sale. The investor-buyer did.

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 and processors.

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.” [Emphasis added.]

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 preselected buyer at a much higher price.” [Emphasis added.]

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. If the buyer was properly informed and properly represented by a competent, independent professional and was still willing to pay a “higher price” knowing that the property was in pre-foreclosure and required a short sale, then that buyer’s offer likely represented the “distress sale price.” The “appraisers or real estate agents” who “colluded” with the “perpetrator” must have been “undervaluing” the property below “distress market value,” not properly representing distress market value with valid data.

The TARP Inspector General’s andthe FBI’s discussions assume the uncommon and entirely 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 approved by the bank. In my hypothetical above, let’s assume that a dishonest real estate 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 current bank valuation processes are not easily manipulated. Maybe they were in the past, but that’s not the feedback I’m receiving from scores of private negotiators and short sale processors. 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 real estate markets and few buyers who can be tricked into a market priced deal for a short sale property pending foreclosure. The data regarding distress 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 may 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 listing 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 in that case the bank should be considered as in collusion with listing agent who is defrauding the end-buyer).

Conclusions

In all three (well, technically four) cases, the discount approved by 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 approved discount was not an actual loss to the bank because a foreclosing bank cannot participate in a non-distress sale. The bank publicizes the distress circumstances by commencing foreclosure. 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. The timing in obtaining the end buyer is the key difference 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 higher sales value or wide valuation differences 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.

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This White Paper is submitted with permission by:

Trademark Loss Mitigation
Provider of No Cost Short Sale Negotiations
www.trademarklossmitigation.com

This White Paper was written by California real estate attorney Ronald M. Ballard on behalf of Real Estate Strategies Institute, Inc. (RESI) www.theresi.com . Mr. Ballard earned his law degree from UCLA and was admitted to practice in California in 1983, where he has actively practiced continually. He represents many real estate licensees and investors who seek to pursue fully legally compliant real estate and short sale investing strategies. He is not paid by any seminar or training company other than RESI, but directly by active, independent real estate businesses. Mr. Ballard publishes online at www.CaliforniaShortSaleLawyer.com . More information about the author is available at www.ballardlaw.com .

Published by and © 2010: Real Estate Strategies Institute, Inc. (RESI), 22996 El Toro Road, Lake Forest, CA, 92630. All Rights Reserved. For distribution by RESI subscribers only.

Comments (1)

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  1. Lynn Chase says:

    A huge part of the scheme that was left out of this flopping education is that the top CEOs of the top 5 banks in the world are okay w the flopping. Here is why. They are bribing negotiators to foreclose on the property during the short sale process and closing the file. Then they collect the PMI for the loan at full value. They also file against the seller for the deficiency in a deficiency states. Then they contact the buyer that was involved in the short sale process before it was pulled out from under him and sell the home directly. They make out like the bandits they are after robbing the middle class and ionvolving the borrowers in a dirivatives scheme while representing to them that they were getting loans. Ha! What a joke. They are a giant criminal organization and the only difference between them and the Mafia is that they don’t come come and break your legs or chop off your fingers if you can’t pay. They will however make you a slave and if you don’t pay will ruin you financially, and economically. It’s all a scam.