I get a lot of calls these days from real estate agents wondering what effect a short sale or deed in lieu of foreclosure (DLF from here forward) will have on borrowers? credit. That is a really important and interesting question, since the last real estate downturn preceded the widespread use of Fico scores and automated underwriting (AU) systems.
Everyone now seems aware that debt cancellation creates taxable income. In a short sale, the amount of the lender?s loss is reported to the borrower as income, creating an income tax liability for the borrower. If the borrower is insolvent at the time, the tax liability can be avoided, but only to the extent that liabilities exceed assets.
But how will credit scores be affected? And if a loan is approved through LP or DU, Freddie Mac?s and Fannie Mae?s automated underwriting engines, will the underwriter overturn the approval when she sees the typical ?settled? comment on the mortgage tradeline?
For answers to these questions, I turned to my credit reporting agencies and representatives from the capital markets to see what is boiling inside the pot.
Credit Bureaus and Fico Scores
The word from inside is that short sales and DLFs are a hot topic. The scoring models are being revised to put them in parity with foreclosures. Although some agents are suggesting that short sales are not as damaging to credit as foreclosures, that would be a bad bet. Though it may be some time before we see credit scores for borrowers emerging from short sales, just assume they are going to tumble.
Given the inherent conflict of interest?a Realtor makes a commission on a short sale and doesn?t in a foreclosure?the real estate professional should proceed cautiously when counselling a seller. A short sale that leads to a tax liability and possibly to further financial hardship or bankruptcy could easily backfire on the party who profited most from the transaction. If the resulting credit scores also render the buyer unable to purchase another home or cause increased costs for auto loans or credit cards, it is easy to imagine the borrower taking a dive and hoping for a red card.
Automated Underwriting Approvals
Typically, there is no public record of a short sale to undermine an AU approval. Although AU may still see it, we?re not certain of the effect it will have. So I asked a couple of underwriters and the V.P. of American Pacific Funding what would happen if an AU submission was approved and the underwriter later notice a ?settled? comment on the mortgage tradeline. They didn?t know, but the question triggered a vigorous and immediate investigation.
Running that question up the flagpole in the capital markets illicited a blunt response and revealed a clarity of purpose from which we should take our cue. There will be no leniency shown toward short sellers. Investors dictate underwriting rules, and their instructions could not be more clear. Show no mercy. Punish the borrower who defaults. Make it difficult for them to do it again.
Waiting for Guido
Mortgage money belongs to people who expect to be paid back. Layoffs, health problems, and job transfers are the borrower?s problem. If the market takes a turn for the worse, the borrower needs to figure out how to make the payments until things improve. If the investor is dragged in to the mess by a short sale or deed in lieu of foreclosure, Guido will be paying a visit. He may leave your knees intact, but he won?t be so kind to your credit. And you won?t be buying a home anytime soon.
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