‘Short Pay’ Requests Rise in Slack Housing Market : Real estate: Many owners ask to close out mortgages by paying less than is owed. Lenders usually say no.

Earlier this year John Knott made what he considered “an incredibly reasonable proposal” to the mortgage lenders on his West Los Angeles home.

Desperate to move his family to Nevada after the Jan. 17 earthquake, Knott was trapped in a house that was worth less than 75% of what he had paid for it in 1991 and well below what was still owed on two mortgages.

His solution: ask his lenders to share the loss by accepting less than they were owed to close out the mortgages. By his computations they would suffer a combined loss of about $75,000--but he would shoulder a personal loss of more than $70,000 in equity and cash on the sale.

Since California law would make it nearly impossible for the lenders to attach any of Knott’s personal property to cover the mortgage shortfall, he thought they would leap at the chance to avoid the even greater losses they would incur by foreclosing.

But both lenders rejected the deal. The finance company holding his first mortgage, Knott recalls, “said the only solution acceptable to them was foreclosure.”

Knott’s experience illustrates a bitter new reality of the Southern California real estate market. With thousands of homes now worth far less than their mortgage balances because of a four-year fall in housing values, homeowners are trying to persuade their lenders to share their losses in what has traditionally been the largest and most secure investment any American makes in a lifetime.

Nothing today illustrates the fall of the Southern California housing market as vividly as this issue. It has focused attention on a term that was never before an important part of the vocabulary of residential real estate here: the “short pay,” in which a lender agrees to accept less than the outstanding balance to settle a mortgage loan when a home is sold.

Many real estate agents now specialize in negotiating short pays. Banks and other lenders have set up special offices to field the requests and have re-examined their guidelines in an attempt to better balance the pros and cons of accepting such deals rather than foreclosing--an option that usually leaves lenders with larger losses than would granting homeowners relief.

Once the beneficiaries of California’s inflating housing market, lenders now find themselves in the discomfiting position of asking home sellers to write a check to unload property that would have sold at a fat profit five years ago.

The scale of the problem is hard to gauge because most of the negotiations are played out behind closed doors, in intense but secret talks between seller and lender. Most homeowners who have successfully negotiated short pays find the experience so painful and demeaning that they are loath to talk about it.

For all that, it is clear that most applicants come away disappointed.

Bankers and realtors alike say short payoffs tend to be accepted only when irrefutable and unavoidable hardships make carrying the mortgage nearly impossible. These include unemployment, business reverses and unexpected medical bills.

In cases of self-imposed difficulties or mere convenience--Knott, for instance, was not unemployed--banks will still foreclose rather than let homeowners walk away free and clear.

Many homeowners believe that California law allows them to virtually walk away without consequences from a home whose sale won’t cover the outstanding mortgage.

It is true that under state law the original loan used to buy a home is “non-recourse”--that is, the lender cannot normally attach the borrower’s personal assets to cover the deficiency. Homeowners generally lose that protection, however, for all subsequent loans on the property, such as second and third mortgages and refinances of the original loan.

Moreover, even protected borrowers can be penalized in other ways for failing to pay a mortgage in full. Foreclosure, a lender’s ultimate remedy against the holder of an original mortgage, is a black mark on a homeowner’s financial history that can hamper or prevent the homeowner from getting credit for as long as seven years.

“I have to educate my clients nonstop,” says Michael Lebecki, a real estate agent in the Santa Clarita Valley who says as many as half his clients are now seeking such arrangements.

“So many people think they have no responsibility,” he says. “But people who get short pay agreements from their banks are those with $1,500 left in an account to eat with, and that’s it. If you’re angry because your payments are too high, or you can’t refinance (because the home’s value has fallen below the loan balance), or you can’t go to a new job, the banks say: ‘We’re not interested,’ and they’ll foreclose.”

In the last three or four years untold thousands of homeowners in the region have been hit by the double whammy of falling home values and high unemployment. Los Angeles County lost an estimated 530,000 jobs between July, 1990, and the end of 1993, while Orange County lost 195,000 jobs, state employment officials estimate.

Meanwhile, the collapse in home prices has made it difficult or impossible for some people to leave the area in search of better jobs without losing most or all of the equity in their homes or exposing themselves to foreclosure.

“During my lifetime we’ve never had a period (in California) when prices went down 30 to 40%, when you have people begging for this kind of relief and you also have high unemployment, so they can’t ride it out,” says Steven Gourley, a real estate lawyer in Culver City.

The number of Southland homeowners whose home values are lower than their outstanding mortgage balances is hard to calculate. But with prices in Southern California having dropped from their 1990 peak by more than 30% in many areas (and by 50% or more in some high-priced communities), brokers and bankers estimate that the figure may be in the hundreds of thousands.

Lenders agree that the demand to work out problem loans with strapped and trapped homeowners has mushroomed.

“A few years ago this just wasn’t an issue,” says Sandra Stewart, president and chief operating officer of Home Savings of America’s loan service center. “Home values were appreciating and if a person got into trouble he could just sell the house.”

Adds Dorothy Kviberg, a First Interstate Bank vice president and manager of its mortgage arm: “One year ago, we’d have one or two requests a month” for mortgage-term modifications, short payouts, or agreements to allow a homeowner to turn over the property deed in settlement. “A few weeks ago we had 96 calls in one week.”

The bank officer who once handled such requests by herself on an occasional basis now does it full time, with one assistant.

Notices of default recorded against houses and condominiums in Los Angeles, Orange, San Diego, and Ventura counties rose to a monthly peak of 6,150 this past March from 5,548 a year earlier and 4,432 in March, 1992, according to Dataquick Information Systems, a La Jolla-based real estate information service. In January, 1992, the first month for which Dataquick has figures, the number was 3,237.

Those figures probably understate the trend of mortgage delinquencies in the region, according to John Karevoll, Dataquick’s financial editor. Lenders are allowing borrowers to fall further behind in their payments--in some cases by six or eight months--before starting the foreclosure process.

“Three years ago if a homeowner fell behind, a notice of default would be filed one month later,” Karevoll says.

Lenders generally regard foreclosure as a last resort because most would prefer to avoid adding new properties to portfolios already bursting with overvalued homes, condos and office buildings.

“We don’t want to go into the business of owning these homes,” says Home Savings’ Stewart.

Moreover, foreclosure is a costly and time-consuming process, taking at least three to four months. What the lender gets at the end of that period is less than a prize: a vacant property that must be maintained and secured until sold. In most cases the final return is thousands of dollars less than the bank might have received in a negotiated short sale.

Bankers acknowledge that foreclosing rather than negotiating a short payoff looks like a money-losing policy in the short term. But they argue that maintaining the sanctity of the contract will protect them from bigger losses over time.

For one thing, they fear that overly liberal short-sale policies would open the gates to thousands of customers hoping to walk away from housing investments gone sour.

“It’s necessary to recognize there’s a problem,” says Bud Schmidtbauer, regional vice president for quality control and operations for the Federal National Mortgage Assn., the government-sponsored mortgage company commonly known as Fannie Mae. “But no lender wants to ignite a wholesale write-down. In cases where the borrower has a job but he’s incurring a loss of value in his housing investment, we’re not out to hold people harmless from loss in the market.”

This aversion to making things too easy is what keeps many lenders from accepting deals that look like rational compromises to homeowners.

“I thought if we could get the house on the market sooner rather than later it would be better for everyone,” John Knott says of his stillborn plan to pay off his lenders.

Among other things, he offered to continue paying down the mortgages and covering taxes on the earthquake-damaged house until it could be sold. He would consider turning over an expected insurance payment of $50,000 to $60,000 to reduce the shortfalls.

“I’d be losing every cent I’d invested in the house,” he says, “and some more.”

As it happens, changes in the home-mortgage market over the last 20 years--including the role played by agencies such as Fannie Mae itself--have made it more difficult than ever before to work out problem loans.

Today, once a bank approves and funds a mortgage, it often sells the loan to investors, often through Fannie Mae or other intermediaries. (Fannie Mae will buy and package loans up to $203,500 and covering up to 95% of the appraised value of a home.)

The originating bank pockets a fee for servicing the loan--collecting monthly payments, keeping records and pursuing delinquencies. But before it can reach agreement with a strapped borrower it must get approval from the loan’s owner, which may be another bank, an investment house, Fannie Mae, or even an individual investor.

Consequently, homeowners often find themselves negotiating with bankers who have no vested interest in coming to a mutually satisfactory deal. Banking professionals say investors who bought mortgages in the secondary market are much more rigid about rejecting short-pay agreements than are banks negotiating over a loan in their own portfolios.

Despite all that, brokers say short sales can be negotiated in many cases--but they are far from routine transactions.

“The process is very grueling,” says Zizi Pak, a realtor at Prudential Rodeo Realty in Beverly Hills who has made short sales something of a specialty. “It takes a lot of hard work and a lot of experience. It’s not just a case of sending in the paperwork and saying OK.”

Borrowers and brokers who have gone through the system say there is little point in even beginning the process as long as one’s mortgage payments are current. Warren Griffin, a Beverly Hills homeowner who completed a short sale, says he first had to stop paying his mortgage and go into default “because otherwise (the lender) wouldn’t even pay attention to me.”

Griffin’s case also shows that the size of the shortfall often has very little to do with a lender’s pliability. The sale of his house was likely to leave his mortgage banker $200,000 short.

It is the degree of hardship that is the key factor in whether a bank will accept a short pay, brokers say. “The amount has very little to do with it,” Lebecki says. “I’ve had banks be as difficult over $5,000 as $50,000.”

Griffin, who is identified here by a pseudonym because he asked that his real name not be used, was facing a critical hardship.

He showed his bank that the income from his construction company had dwindled to practically nothing by February, 1993, when he realized he could no longer afford to make the payments on the house. By the time he found a buyer and closed the deal in October, the sale price was less than half what he paid for the property in 1989.

Nevertheless, persuading the lender to accept the short pay still required nearly 10 months of negotiation, according to Pak, Griffin’s realtor.

Lenders confronted with short-pay requests sometimes ask for more documentation than they did for the original loan: As much as three years’ tax returns (and permission to retrieve the originals from the Internal Revenue Service), pay stubs, business records in the case of self-employed applicants, and detailed information about personal assets.

Increasingly, lenders also revisit the original loan application, looking for signs that a borrower misrepresented his or her finances at the time.

Even though they may have no legal recourse against a borrower’s personal assets, banks are likely to insist that the applicant commit his holdings to satisfying as much of the shortfall as possible.

“If you have stocks and bonds,” Pak says, “they figure, why should they take a short pay?”

One San Fernando Valley homeowner represented by Gourley was refused a short pay even though he was paying mortgages on two homes. One was a Manhattan Beach house he bought and moved his family to before selling his original home in Canoga Park.

He could not afford to make payments on both, but the lender on the Canoga Park house decided to foreclose rather than accept a $25,000 shortfall. “The bank said it’s a hardship, but a self-imposed hardship,” said the homeowner, who asked to remain unidentified.

One of Pak’s clients lost his bid to avert foreclosure because his lender noticed that he had changed professions, opening a retail tile shop after losing the job as a research scientist that he had when he obtained the loan. The store was not producing enough income to cover the mortgage payments.

“They asked why he didn’t stay in his specialty,” she recalls. “I said he couldn’t find a job in it, but they said he shouldn’t have opened a store. So they foreclosed and lost $100,000. It was asinine.”