Monday, June 16, 2008

The Buy-And-Bail

Foreclosure SignThe buy-and-bail is a rapidly growing real estate strategy in which homeowners who are underwater on their home quickly buy a new home at today’s low prices and allow the old home, with the inflated mortgage, to go into foreclosure. For example, say a pair of homeowners bought their home two years ago for $400,000 and now it is worth $200,000. So rather than keep the existing home and its inflated mortgage, before their credit gets damaged they go buy a new home for today’s price of $200,000 and let the old home go to foreclosure. Works great for them, right? Sure, their credit will be bad for a few years, but surely they find that is worth $200,000.

A debate has emerged in the real estate industry about whether this is a legitimate strategy or simply mortgage fraud. Nevertheless the practice is growing and there are even real estate agents out there who are coaching homeowners on how to do it.

I will start off by saying that the buy-and-bail strategy, as it is most widely used, is most definitely mortgage fraud. The main reason I can say this without a doubt is that in practice, homeowners typically lie to the lender when they apply for their new loan. The homeowner will tell the lender that they are planning to rent the home out and give an inflated value for what they expect to get in rent. Since the homeowners' intention is in fact to let the home go into foreclosure (and they may or may not even attempt to actually rent it out), they are deliberately deceiving the lender. Any time a borrower deceives a lender, you can bet they are committing fraud.

Lenders are starting to wake up to this scam, though. Fannie Mae recently upped the waiting period for borrowers with a foreclosure on their credit to get a loan from four years to five. In addition, they also will require a minimum down payment of 10 percent for these borrowers, according to The Wall Street Journal. They are hoping that borrowers will see how a foreclosure can ruin their future prospects and think twice about going through with strategies such as the buy-and-bail.

Lenders also have the ability to sue borrowers if they find that fraud has been committed. And while it is questionable whether or not they will actually start suing borrowers for damage, it is an option they have available to them. The most successful defense lenders have is the one that many lenders are beginning to turn to. Basically, they are changing the loan guidelines to require homeowners who claim they are going to rent out their old home to provide a fully executed lease agreement. In addition, borrowers are also required to have sufficient income to cover both mortgages, unless they have at least 30 percent equity in the home. IndyMac has already changed to these guidelines and Fannie Mae is planning to make the switch as well, according to The Wall Street Journal.

I think this last strategy will go a long way toward solving the buy-and-bail problem. People who have enough income to cover both mortgages are probably unlikely to default, and those who have 30 percent equity in their home would likely sell before losing their home and equity to foreclosure. The disturbing part to all of this is that there are real estate agents out there who think that this buy-and-bail practice is completely okay--and who are even promoting and coaching the practice. This is a scam that is costing lenders a lot of money, and whether or not you feel sorry for the lenders, it is still wrong. It is also my belief that these real estate agents and other promoters need to be punished right alongside the homeowners--and probably even more severely. The agents know, or should know, it is wrong, and the fact they are helping homeowners to do this is inexcusable.


Anonymous said...

I am not going to defend mortgage fraud and to the extent it exists in the "buy and bail" schemes then it should be stopped and the borrower and anyone who assisted them should be prosecuted. However, a home owner essentially has a non-recourse loan and assuming the absence of fraud it is hard to fault them for exercising their put option if they are willing to suffer the related hit to their credit. It happens all the time in commercial real estate and no one lectures them about morality. Here is a link to an article that amplifies these thoughts.

Eric Ames said...

Thanks for the comment Tom. You make a good point, however, here is my moral and legal problem to the buy and bail: 99 out of 100 times (my gestimate) these people are lying. Unless they are doing the new mortgage as a second home, or otherwise disclosing that they plan on carrying the full burden of both homes, they are either deceiving the lender or their tenant. Even in the case they are planning to keep the home as a second home they are still crossing into an ethical and legal gray area. And how many people who can legitimately afford to carry the costs of 2 mortgage payments, and still fall within the proper debt ratios, are going to even worry about undertaking this scheme? My guess would be not too many. And unless that is the case they are lying, and here is why:

In order to hit their debt ratios they typically have to claim that the house is rented, or is going to be rented. Now most of the time they aren't even bothering to actually rent the home out, and for good reason; they intend to let it go into foreclosure. So right off the bat they are lying to the lender (ie mortgage fraud).

Now what if they actually did rent the property out? Well the problem here then is with the renter. If you enter into a rental agreement with the renter and they move into the house, they are typically expecting the landlord to take care of their end of the bargain and actually pay for the home. How fair is it for a renter if after they move in the landlord stops making their mortgage payments, and in a few months they are forced out of the home they just moved into along with being out all the various moving costs? This one might not be exactly illegal, but it should be, because it isn't fair to the tenants at all and I have a big ethical problem with it.

Ethically speaking, and in most cases legally as well, borrowers should have to disclose their true plans for their old residence. If the lender knew that their plans were to let the old house go into foreclosure they certainly would not be lending them money for another house, so here lies the ethical dilemma. If you know that the lender would withhold funds from you if you told them something, should you have to tell them (even if they don’t specifically ask for it)? Ethically speaking I think you should have the obligation to tell them. This could be compared to a seller who is obligated to disclose defects to their home when they sell it. This disclosure is meant to protect the buyer from the seller covering things up and sticking the buyer with repairs that they otherwise would have never known about. The same is true in this case. By withholding your true intentions you are keeping information from the lender which would make or break their decision to lend money, ethically this is wrong. So to me in every case (unless you can find a lender willing to lend you money on the new home regardless of whether you let your old house go into foreclosure) this is either illegal or unethical, take your pick.

Anonymous said...

Eric, if you go all the way back to the first transaction on the first house, you will very likely find that the $400K purchase was supported by a fraudulent appraisal, commissioned by the lender.

The loan processor wanted to make a commission, so s/he told the appraiser either to make the value needed work out, or to expect no further orders from them. The average consumer thinks all these loan people know what they're doing, and just sign when told to do so.

Who defrauded who?

Two wrongs don't make a right. Never have, never will. But I find it hard to have any sympathy for an industry that has systematically forced so many honest appraisers out of business.

Eric Ames said...

I agree that there are potential ethical issues that arise in the current mortgage system, especially since it is commission based, however, I do want to make one point about your comment. In my experience the bulk of the appraisal manipulation came at the hands of mortgage brokers, not the lenders themselves. This is a major difference because the lenders are the one ultimately on the hook when the homeowner bails, not the mortgage broker. Once the mortgage broker gets their commission they wipe their hands of the deal and they are on their way. The lender on the other hand (at least till they sell the loan) are on the hook. I think if mortgage brokers were lending their own money we wouldn't have the same problem.

On that note I also believe that the mortgage brokers who did this are also committing mortgage fraud, as well as the real estate agents (assuming they knew what was going on) in addition to the appraisers. Anyone who knowingly took part in deceiving the lenders is guilty in this case.

Again this isn't about feeling sorry for the poor lenders. I certainly don't feel sorry for them since they should have seen this coming, and in some cases did but neglected to do anything about it. I'm not defending the lenders in anyway, they were stupid to loan money to many of these people in the first place. However, the point here is that these borrowers are breaking the law, and deliberately deceiving these lenders, that makes their actions wrong.

The lenders on the other hand have their own ethical issues to deal with concerning how they were running their businesses and ultimately representing their investors.

Anonymous said...

I'm very happy you like the photo used in this post. I've put all my photos under creative commons license so they can be used in this way. In the future, you will want to include an attribution link, as the Creative Commons license requires. (Photo: respres) is all that is required. Thanks!

Eric Ames said...


I link all the photos I get from flickr. The link is actually the picture itself, if you click on the picture you will be taken to the flickr page from which the photo originated. I've found this method of linking back to be much better for the layout, as including the caption underneath the picture can be awkward in many cases.

It is my understanding that this is completely Ok as far as flickr's polices are concerned, however, if you have different information please let me know and I will take the appropriate measures.

Anonymous said...

My comment centers around the financial aspects here. If I have a house that I can not afford and am heading for forclosure/shortsale, Why not buy and bail? If a I buy a house and let my home go, I get two things accomplished. First, I now have a home I can afford. Second, I am now making payments to another lender and helping the credit crunch that currently exists as I am injecting money into the economy. If I were to just go into forclosure/shortsale, then I would not have the ability to get a loan, which means I would rent at a reduced amount and therefor not be injecting as much money into the economy. Also, the lenders have just lost a customer that has the ability to pay, albeit, at a reduced amount, but since I hadn't missed a payment before, I am unlikely to miss one when I purchase a new home. I see this as a win-win for the mortgage lending market, because I now continue to pay a mortgage on another home instead of my old house sitting while it goes through the forclosure process and I would no longer be paying any mortgage, unless you count rent, but it would be much reduced. The bottom line is the mortgage industry cannot afford to loose customers and just because there investment didn't pan out, does not mean that you should penalize people that would otherwise be able to make a payment or sell an assest if it had retained it's value. They took the risk knowingly and lost, so cutting those loses should be there primary focus. Just my two cents.

Eric Ames said...

In response to the last Anonymous commenter,

I do understand your points from the financial perspective, and you very well could be correct in your assessment, however, I still don't think it is right. In order for this to be okay you would need to tell your new lender exactly what you plan to do. If they are okay with you letting your old home go into foreclosure then great, however, the more likely scenario is that if you told them your true plans that they wouldn't want anything to do with you. If you withhold or otherwise lie about your true plans for your current home to your new lender than you are committing mortgage fraud. Investors who committed mortgage fraud back in the market heyday (ie occupancy, income, etc.) could have potentially made the same argument. Sure they are committing mortgage fraud, but at the same time they are contributing to the overall economy. Bottom line though is that isn't for you or I to decide. Mortgage fraud is mortgage fraud, the lender ultimately needs to know the full truth and the rest is for them to decide.

Anonymous said...

Well this whole fiasco was cause by lying. IMHO I feel that the liar loans caused more heacache than the subprime has

Anonymous said...

You would think people would use more common sense and know that this is clearly fraud but I have seen it done many times and there seems to be very little consequences for people who are "Buying and Bailing"! In the last 3 months I have seen lenders really start to crack down on this!

Anonymous said...

First - I just completed a buy and bail and contrary to your article I did not have to lie to do it. Buy and bail is NOT illegal. Lying on a mortgage application or any of the paperwork IS illegal. You should distinguish between the two. I was able to carry both mortgages and had a 45% DTI so I think there are a lot more than you realize in a position to do this legally.

Second - I don't understand how the individual can be demonized for making the best decision for their family when businesses (and Donald Trump!) go bankrupt all the time and get a "fresh start" or get bail outs. Staying and paying on an underwater home just to preserve your credit score and feel "ethical" is the dumbest thing anyone can do. And yes...the bank could come after me but I know it is highly unlikely...especially since I had PMI. They got their's and then some! I have NO sympathy for the banks. Bout time....