How banks fail at foreclosure auctions

By Felix Salmon
December 8, 2009
James Hagerty's WSJ article today does a good job of explaining many of the potential pitfalls -- up to and including finding concrete poured down the toilet. But what really puzzles me is the degree to which banks seem to be just giving money away here:

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Buying homes at foreclosure auctions is not for the faint of heart, and James Hagerty’s WSJ article today does a good job of explaining many of the potential pitfalls — up to and including finding concrete poured down the toilet. But what really puzzles me is the degree to which banks seem to be just giving money away here:

Lenders, or the loan-servicing firms that represent banks and investors, are increasingly likely to set the minimum much lower [than the mortgage balance]. Their goal is to tempt others to buy the house and spare banks the headaches and costs that come with taking possession.

Sean O’Toole, chief executive officer of ForeclosureRadar.com, a research firm, estimates that in November about 21% of homes sold in trustee sales in California went to investors rather than to a foreclosing lender, up from 6% a year earlier. The trend is similar in some other areas with high foreclosure rates, including Phoenix and Miami…

“The banks are so screwed up,” says Mr. Mirmelli, the Phoenix investor, that they don’t always have a clear idea of the value of the property they are foreclosing on.

It seems to me that lenders are simply allowing their plum properties to be picked off by these vulture-like speculators. (And I mean that in the best possible way.) What the flippers are doing makes perfect sense; what the banks are doing makes no sense at all.

The key thing here is that the banks know full well that they’re working in a world of imperfect, asymmetrical information: the buyers at auction know significantly more about the local property market than they do. The banks have a good idea of how much it will cost them, on average, if they take ownership of the property and sell it. And they then use that number to determine the minimum price that they’ll accept at auction in order that they don’t need to go through that hassle and cost.

But here’s the thing: the average loss associated with selling a foreclosed home is just that — it’s an average of homes where you lose a little, and homes where you lose a lot. What happens when you start allowing speculators to pick off the best homes at auction? They’re going to buy the 21% of houses where the bank would have lost only a little money (relatively speaking), and leave the bank with the 79% of houses where it’s going to end up losing a lot of money.

The bank then sees its average loss go up, since it no longer takes possession of the good properties to offset the bad. It then determines that this particular property market is even worse than it had thought, and lowers its minimums even further. It’s an outright gift to the speculators, directly from the bank and the owners of the underlying debt.

But it gets worse. Here’s Hagerty focusing on one property in particular:

Citigroup initially set the minimum bid at auction at $1.3 million, far more than the market value, given comparable sales in the neighborhood. Then, on the morning of the sale, Citigroup lowered that minimum to $379,900. PostedProperties, which monitors Web sites for such price changes, sent out an email on the opportunity to Mr. Mirmelli.

Mr. Mirmelli has his iPhone set up so he can call up the address of a home due to be auctioned, see a map of the neighborhood with a tap of his finger and then see panoramic photos of the street with another tap. While he researched the home, one of his partners drove out to see the exterior and make sure there were no occupants. A PostedProperties employee bid on their behalf and won the house for $486,300, a sum that then went through the trustee to Citigroup.

After expenses of about $54,000, including real-estate commissions and minor repairs, Mr. Mirmelli and his partners expect a profit of about $150,000 on the flip. “It turned out to be a very good return,” he says.

What on earth did Citigroup think it was playing at here? It’s much worse than just setting a minimum bid of $379,000 on a property which turned out to be worth $690,000. In fact what Citi did was set the minimum bid at $1.3 million in advance, well above the conceivable value of the property, basically telling anybody who might be interested in bidding that this one wasn’t for sale. And then, at the very last minute, it slashes the minimum bid by $921,000, setting off a mad scramble of mobile-enabled speculators who get in their cars to try and determine the most basic information about the house before the auction is concluded.

If you’re going to set a lowball bid at auction, it’s a no-brainer to do so well in advance, so as to maximize the number of informed bidders on the property. There’s no conceivable reason to lower the minimum at the last minute like this — if anything it just sends the message that you’ve discovered something horrible about the house (like a previously unknown first lien) which a last-minute drive-by inspection wouldn’t necessarily pick up.

It’s almost as if Citigroup was trying to lose as much money as it possibly could on this property: maybe it was just the servicer, and had no connection to the ultimate owners of the debt. But anybody holding mortgage-backed loans should be very worried about this story. If you think you’re going to get remotely market value on foreclosed property, think again.

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