Comment: Senator Elizabeth Warren and Short Sale Fraud

I like Elizabeth Warren, but I was shocked to see this commentary from her: Commentary: FHFA’s Senseless Arm’s-Length Policy on Short Sales (ht jb). Warren argued for having the FHA allow short sales to family members and friends so the owner can stay in the home.

Apparently Ms. Warren isn't familiar with short sale fraud. I've covered this extensively, from Tanta in 2007: Let the Short Sale Scams Begin, from the FBI in 2009: FBI: U.S. Mortgage Fraud "Rampant" and "Escalating" (see short sale fraud), from John Gittelsohn at Bloomberg in 2010: Banks Face Short-Sale Fraud as Home `Flopping' Spreads, from Jim the Realtor in 2010: Jim the Realtor on Short Sales: "Rampant Fraud and Deceit" and Short Sales: Arm’s Length Transactions and many more ...

Lenders have always been afraid of short sales because of fraud. Short sales increased after lenders put many fraud protections in place - such as having all parties sign that there is no undisclosed consideration, that the transaction are arms-length (not to related party) and more. This hasn't stopped all short sale fraud, but it has helped.

Warren writes:

Short sales can make good sense, and private lenders have gone along with them in many cases. But the FHFA – the regulator overseeing the bailed-out housing giants Fannie Mae and Freddie Mac and the financing of about half the country’s outstanding mortgages – has blocked the way.

In some of those short sales, friends, families, or nonprofit organizations are willing to buy the home at fair market value, then work out a rental or re-sale to the family living in it. The mortgage company gets the same amount as in a sale to strangers, but the homeowner has a last-chance to save the family home.

Uh, one of the reasons private lenders have "gone along with" short sales is because they require that the sales be "arms-length". The FHFA has the same requirement - for good reason.

Warren seems to think that the lender will get the same amount either way ... not likely. She writes:

The FHFA claims that its policy prevents sweetheart insider deals that benefit the homeowners at the expense of Fannie and Freddie. But that makes no sense when the house is sold at market value or when people affiliated with the homeowner put in the highest bid to save the home. In those cases, the identity of the bidder makes no meaningful difference because Fannie and Freddie’s bottom line stays the same.

Warren doesn't understand that short sales don't go to the highest bidder.  The first chance to negotiate with the bank goes to someone the homeowner (or agent) picks. Since the homeowner has no financial interest in the property, this creates an agency problem, and opens the door to fraud (I've suggested having the lender hire the agent). The "arms-length" protection is an important tool to prevent fraud.

If friends and family want to help, they could contact the bank about modification and offer to pay down some of the debt, but eliminating the "arms-length" rule would just mean more fraud.