Why does it matter if a preforeclosure is "under water"?

[Benjamin Cowles]

When qualifying a property, why does it matter how much it is under water if the bank will still only be able to get the highest bid at auction? Isn't the bank just as likely to accept a short sale vs going through a FC regardless of the equity? What am I missing here or what misconception might I have?

[Ron S.]

@Kris, you're watching too many late night television shows if you conclude "Bail Out Money" is why a bank does or doesn't do anything. That urban legend has long been debunked. First, not all banks got TARP money. Second, those that got TARP money had to pay it back with interest. Third, TARP has nothing to do with foreclosure sales. Fourth, banks don't "Buy it back" at the steps (They credit bid). Fifth, they lost the difference between what they lent and what it sells for 3rd party, or through REO if it reverts back so yes, they do suffer losses. Massive losses that made many banks go under. Sixth, "pressure"? Pressure in the past that doesn't exist today? Pressure from who?

While banks may well be silly, there are as many silly investors that don't seem to want to learn how banks actually work or how the foreclosure process works. Not saying that's the case here, just that there are a couple of silly investors out there without a clue.

Back to the OP's question. @Ben, underwater doesn't matter to anyone in the situation other than a potential agent trying to sell it (If a sale is the objective). Being underwater doesn't matter to the borrower although strangely, I get "I'm underwater" as a reason for their default every day. 99% of all borrowers that buy a car are underwater the minute the brake lights hit the curb when they purchase. They owe more than it's worth. 100% of borrowers that purchase on credit and don't pay it off within 30 days are underwater when they bought that TV for $1,000 at 29% interest. Borrowers that finance a home purchase or refinance may be underwater if they go through an economic meltdown like we all did in 2008 but at the end of the day and all things being equal, that doesn't matter. You still have the home, you still make the payment, you still get the tax write off, the bank doesn't foreclose. All is good.

When all is NOT good and you lose your job, lose a spouse or co borrower, have a catastrophic medical condition with massive bills, being underwater still doesn't matter. What matters is you usually will get behind on your payments and in the absence of intervention, will go into foreclosure and, (Wait for it...) being underwater won't matter!

So now your in deep doodoo and the bank intends to foreclose. They don't care if you're underwater or not. You haven't made your payment. "Wait" you say. "I'll sell the property" you say, and find out you are underwater. The bank doesn't care if you are underwater but, because you are underwater, a potential sale will require a short sale so, you go through the exact same hoops that you would go through for a loan modification to determine if the bank will agree to participate in a short sale. The only difference between a short sale and a regular sale is the short sale addendum (For the most part). Buyer doesn't care, borrower doesn't care, bank doesn't care. The agent cares because they want to close the short sale and get paid but no one else cares if its underwater. Buyer isn't going to pay more than fair market. Bank isn't going to get anything more than fair market. Seller MIGHT be subject to a deficiency if the state they are in allows it but at least they are out of it and at the end of the day, they don't care if its underwater.

Does the bank want a short sale over a foreclosure sale? Only if the bank's financial model says its in their best interest to do a short sale. What's in their best interest is a reduction in loss and/or maximum recovery so, whichever path leads to the greatest recovery and the least loss, that's the path they will go. The issue we find common is that the buyer wants to pay as little as possible and will utilize the agent to facilitate that. The agent is going to try to come up with data to support their purchase price offer if that offer is below the minimum net proceeds of the bank. If the agent is any good, they will succeed. If they suck, they won't. It's as simple as that.

If there is equity, there is no short sale. If there is equity and the borrower defaults and the lender starts foreclosure, only a full payoff prior to the foreclosure sale will stop the foreclosure.