Anatomy of a Foreclosure: When Flippers Get Into Trouble, Everybody Loses

You may have seen Bob Shallit’s recent Sacramento Bee article highlighting Sacramento Area Flippers in Trouble.  This is a local real estate blog that lists 470 area homes purchased in the last two years and now relisted at prices much lower than those paid.  

I’m familiar with this blog, so Shallit’s article was not a revelation.  But one particular paragraph caught my eye.  Regarding flips gone bad, a local Realtor is quoted saying “many sellers won’t bear the full brunt of the loss. That’s because lenders sometimes agree to forgive whatever debt remains after a house is sold to save themselves the costs of a foreclosure.”   Okay, that just sounds too pretty, too…forgiving.  Would you like to know how it really looks ?

Here is a true story of one recent Sacramento flipper in trouble.

The Facts

Last October, a buyer purchased a brand new home in South Placer County for $650,000.  She qualified for 100% (80/20) owner-occupied financing with stated income of $9,000 per month.  She is a self employed rep for a well known, direct-sale cosmetics company and at the time she had excellent credit scores.  Although a risky loan, her qualifications met the investor’s guidelines, so the bank had a salable loan.

Uh… I Mean the True Facts

After the close, the buyer never occupied the home.  In fact, she never intended to occupy.  She was a flipper.  Like so many speculators, armed with greed, hubris, and the encouragement of her Realtor, she had set out to make her fortune.  But by the time the home was completed, the market had turned.  Prices plummeted.  She couldn’t sell.  Nor could she rent the home for anything close to the payment.  Her agent suggested a short sale but told her that in order to convince the lender that she really was in trouble, she should not make payments on the loan.  She became what we refer to as a first payment default.      

Pretend You’re the Bank 

Let’s imagine for a minute that you have an old friend Bubba.  One day Bubba comes asking to borrow money for an investment recommended by his financial planner.  He’s been to the seminar and met others who have already turned quick profits.  Because Bubba’s always been straight with you and because the recommendation came from a reputable source, you loan him $5,000.  But a few days later, you get a call.  

“Hey,” slurs Bubba, “I’m at the Casino having a few drinks.  I got some bad news.  You know the money you loaned me?  Well, I kind of made up the investment part.  I’ve been watching Poker on TV and well, I was sure I could win if I started with a big enough bank.  Sorry dude.  I lost all the money.  I’ll give you my old Buick.  Maybe you can sell it and get some of your money back.”  

Two Bubbas

Now, Bubba just lost $5,000 and made it your problem.  He gave you a car you don’t want.  He lied, destroying his credibility and the friendship with it.  How does that feel?  Would you be inclined to loan Bubba money again?  Would you warn your mutual friends?   Hopefully.

Ms. Bubba’s foreclosure wiped out the $110,000 2nd, and she made it the bank’s problem.  The loss on the 1st may increase the bank’s loss.  This is no small sum, not an imperceptible drop in some giant corporate bucket.  This money belonged to people like you and me, local people.  And it was a lot of money.  To be sure, the bank will warn their friends in the credit and lending industry too.  They will make sure that this borrower will not be stealing money from any one else any time soon.  

Bubba Goes Free? 

Is that it then?   A slap on the credit wrist?  No, there is one more thing. The bank will issue the borrower a 1099 for taxable income in the amount of the “debt relief”.   Ms. Bubba will owe taxes on at least $110,000 of phantom income.  Chances are that this will force her into bankruptcy, adding that lasting achievement to the foreclosure already on her credit resume.  

So the bank loses money. The buyer loses credit rating and her grip on the American dream.  The mortgage broker loses any commission paid by the bank.  And the Realtor possibly loses her license.    It’s not pretty or forgiving.  It’s a mess. 

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