Felix Salmon

When mortgage companies give up money

By Felix Salmon
March 16, 2010

The ultimatum game has shown repeatedly that people aren’t profit maximizers if they think that the profit-maximizing outcome is fundamentally unfair. And it turns out that the same is true of mortgage companies. Here’s Dean Jens, telling the story of a short sale of a house with two liens:

The total debt was on the order of $350,000 — I don’t remember the exact figure — and he and the seller had agreed to a price of $253,000. The primary lien-holder had signed off on an agreement allowing the second lien-holder to receive $11,500, while the second lien-holder had agreed to accept 5% of the sale price. 5% of $253,000 is $12,650, so they were a bit stuck.

The climax came when the buyer was in an office with his real-estate agent, on a speaker-phone conference call with lower-level employees of both lenders, neither with the real authority to renegotiate either agreement. In lieu of being able to negotiate, they began yelling at each other for a protracted period of time, over which it occurred to them that there was nothing in the agreements stipulating a minimum dollar value that either bank would accept. Accordingly, they lowered the sale price to $230,000, of which 5% would be $11,500, and the buyer walked away $23,000 richer.

This is a classic zero-sum game. The first option is that the buyer is out $253,000, with $12,650 of that going to the second lien holder, and $240,350 going to the primary mortgage holder. The second option reduces the payment to the second lien holder by $1,150 to $11,500, and reduces the payment to the first lien holder by $21,850 to $218,500. In percentage terms, they’re both out an identical 9.1%, and in both cases the first lien holder gets exactly 19 times the sum going to the second lien holder.

So why would they choose the second option, when the buyer — the only winner in the deal — has no negotiating leverage at all? Just because the first option didn’t seem fair to the primary mortgage holder, for whatever reason. This is a short sale, and the second lien holder by rights should be getting nothing, and the first lien holder simply wasn’t willing to pay them more than $11,500 to go away.

Over the long term, such a tactic might actually make financial sense. If these two companies negotiate with each other a lot, then it’s in the interest of the first lien holder to shoot itself in the wallet occasionally, just to prove the point that when it sets a limit on how much it’s willing to pay the second lien holder, it’s going to stick to that limit, no matter what. But in the short term, it’s certainly nice to be in a position where a pair of squabbling mortgage companies decide on the spur of the moment to just give you $23,000.

One comment so far | RSS Comments RSS

Not at all. The reason they chose the second option is because the deal is closed by people who (1) lack authority to renegotiate favorable terms, and (2) have no motivation to try to do that, or to relegate the matter to those who do have that authority, because they have no financial interest in the outcome. This might as well have happened in the Soviet Union.

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