Why would the bidding on a foreclosed property start at the outstanding amount of the loan?

Question

I've read from several reliable-looking sources that if a foreclosed house goes up for auction, the bidding usually starts at the outstanding amount of the loan (plus fees, etc.): Example Money Talks, Consumer Affairs, Biggerpockets.

My question is: Why? Under what logical set of assumptions should the starting bid have anything to do with the outstanding amount of the loan?

I know a lot about math and econ theory and nothing about mortgages. So I feel like I'm just missing a key assumption here. But without that key assumption, the idea of starting the bidding at the outstanding loan amount makes no sense.

Suppose someone bought a house for $300,000. After time, the fair market value of the house dips to $250,000, and the buyer owes $100,000 on the mortgage. They stop making payments, so the house goes up for a foreclosure auction.

In that situation, why on earth would the bank start the bidding at $100K? It has nothing to do with the expected market value of the house. A bidder might get really lucky and walk away with the house for $101K even though it's worth $250K. More likely, if the marketplace is efficient, the bidders will end up bidding the value to about $250K anyway. But why bother starting the bidding at $100K? The only number that seems to make sense for the bank to start the bidding at, is the estimated free market value of the house (or maybe a little less, just so the bank can be sure someone bids). Anything else seems completely arbitrary.

I feel like maybe these articles are leaving out some key fact, like: "If you bid the outstanding loan amount, you win the right to live in the house, but you don't own the whole house; the previous owner still retains the equity that they had before they got evicted." Now in that completely hypothetical scenario that I just made up, it actually would make sense for the free market bid to be $100K -- however, I'm pretty sure that's not what happens in a foreclosure auction.

Answer 1

The bank only cares about getting paid the owed amount as quickly as possible. Anything more than that the bank has to give to the owners whose property they're auctioning.

Also, a house that could sell for $250k on the open market if the sellers wanted to sell and move out might be worth a lot less if the sellers don't want to move, might refuse to leave and might even be expected to strip the copper from the air conditioners on the way out.

Answer 2

As Patrick87 cogently points out (+1), anything more than the outstanding debt on the property being foreclosed on (plus various fees for filing the foreclosure paperwork etc) belongs to the original owner (the person(s) being foreclosed upon), and not the bank. Remember also that the bidding starts at the price the bank sets, and the bank can choose to accept the highest (or best) bid if it wants to, which could be higher than the starting price for bidding that has been set by the bank. If the property is worth $250K and the starting price is $100K, it might be that some prospective buyer will bid more than $100K to get the property instead of buyers who bid the minimum. Hey, getting a $250K house for $110K is still a great deal, though not as good as getting it for $100K, and some buyers might choose to bid more than the minimum to improve their chances of having their bids accepted.

There are also other matters to be considered such as the property is typically not available for inspection prior to purchase because the original owner is still in possession of the property, and might not cooperate. So the prospective buyers have no way of verifying that the property is indeed worth that $250K, other than by looking at the tax rolls and taking a wild guess. Nor, as Patrick points out, is there any guarantee that the property will be worth $250K when the original owner vacates the premises; the built-in appliances (which ordinary real-estate contracts spell out are included in the purchase) might have been ripped out, the interior painted black out of spite, etc. In fact, in many cases, evicting the original owner is something that the bank (forecloser) leaves to the new owner to handle; the bank just issues a new warranty deed transferring title to the buyer once the full amount of the accepted bid has been paid to the bank, and then it is the buyer's responsibility to evict the previous owner and take possession of the new acquired bargain. Possession is indeed nine points of the law, and the buyer may well need to go to court to get an eviction order which the sheriff can then execute (for a fee, of course) and so there is more expense yet to come, etc.

Answer 3

Why? Under what logical set of assumptions should the starting bid have anything to do with the outstanding amount of the loan?

The lender is primarily interested in getting the property sold, getting his money back and recover from the situation.

It thus makes sense for the lender to ensure that the house gets sold. If the starting price of the house is lower; chances of it getting sold are higher. How low is low ... this is where the lender says as long as I get my money back; thats the low. If I get more, I have to give the excess to the original owner.

Thus starting point is generally set to outstanding amount. If the property goes for the said amount; then lender takes the money. If the property gets more; the original owner get the money.

Under no circumstances the lender will make more money that the outstanding loan amount.

The only number that seems to make sense for the bank to start the bidding at, is the estimated free market value of the house (or maybe a little less, just so the bank can be sure someone bids).

Here the Bank needs to then appoint a 3rd party for valuation and since one maybe subjective, they may need to get opinion from few. This is additional cost and delay. If the valuation is incorrect or the market doesn't agree; the house goes unsold. The Bank has to again get a re-valuation done. All this costs time and money for the Bank and this will increase the outstanding amount. Thus it is easier for the Bank to skip it.

It is also to be noted that the original owner before the foreclosure procedure begins, can sell the house for what he believes is right value; pay back the lender. So there is a choice that the original owner has not exercised and hence lender has forced a closure to get his due.

Answer 4

There are already several answers which talk about various considerations based on the house, and the lender's desire to get their money back. One consideration I haven't seen discussed yet is the cost/availability of funds to purchase a foreclosure.

The way most people purchase homes is via an underwritten mortgage process. This generally isn't an option for foreclosure auctions. Typically people purchasing a foreclosed property need to have the cash, a large line of credit, and/or access to a private lender. Since the private lenders and lines of credit are more expensive than a standard mortgage which affects the price people can pay. More importantly the difficulty funding the purchase means that only a small subsection of the population can make these purchases. In practice this subsection is generally doing this in order to make money, so there needs to be space for them to make a profit. If there is no space to make a profit then virtually all the buyers disappear and the lender is stuck with a house they don't want. By selling the foreclosed homes for less than "market rates" it helps everyone. The lenders win because they can recover their money quickly so they can lend it again to earn money. The buyers win because they can make a profit on the homes. The new lenders win because they can lend money at a higher rate for a shorter term. The previous owners win because they potentially get a small windfall and they can find a new place they can actually afford.

Answer 5

Typically there is more than the main home loan lein on a house that’s in foreclosure. The only way to guarantee clean title to a buyer is to foreclose eliminating most additional leins. IRS Leins for example don’t go away automatically but need to be paid. Even if you see someone buying a house for 100k it often has a lot more debt that a buyer takes on.

Answer 6

Why not start at $1?

This would maximize the chance of the house selling, but it could hurt the bank's balance sheet. While the bank owns the house, it can fudge the estimated value to some extent. When the bank auctions the house, the (assumed) value of the loan principal is replaced with (actual) cash from the buyer. If the bank were to sell the house for less than the outstanding principal, then the bank would immediately realize a loss in equity. This is one reason why banks in precarious financial situations would rather let the house sit vacant than lower the opening bid.

Why not start at the estimated value of the house?

As others have written, the bank wants to recoup the principal now and doesn't have an incentive to maximize the sale price, because extra money goes back to the foreclosed owner.

Answer 7

I feel like maybe these articles are leaving out some key fact

Right of Redemption often isn't mentioned (neither equitable nor statutory).

Under what logical set of assumptions should the starting bid have anything to do with the outstanding amount of the loan?

This post should not be considered financial advice.
I'm not qualified to give anything but my personal opinion.

The seller (let's say "bank") is interested in recouping its debt.
Where debt = unpaid loan amount, +taxes paid, +amount paid in fees (paperwork, lawyers, etc.)

if the marketplace is efficient, the bidders will end up bidding the value to about $250K

Markets are (reasonably) efficient at the moment, but as you said, "about 250".
If the market value is $250k, I would expect to see less than that as the sale price. Current occupancy, the time and money it takes to restore or upgrade the property (including permits), and Right of Redemption will generally put downward pressure on the $250k theoretical value.

I am not a lawyer (IANAL), but I understand Right of Redemption to mean that the person who lost their property/home to forclosure has the right to buy it back at bid price + allowed fees. Right of Redemption after Forclosure doesn't exist in some places, but for example can be up to two years in Tennessee.

See State Laws Regarding the Right of Redemption for what I assume is an accurate list.

Answer 8

If the opening bid was the free market value of the house, there is the risk that the auction will fail because either no-one would want to buy the house from the auction when they can buy the a house of equal value for the same amount of money on the free market instead of in an auction. Or even if one bids, a second bid would be waste by definition because it exceeds the free market value. Actually, the end price in an auction is by definition, so to speak, the free market value of the house because it is exactly the price at which supply (one house) and demand (only one buyer left) meet.

At any rate, the risk of no-one being willing to make a starting bit grows with the minimum bid, hence in order to be sure the house is sold, the bank should try as low as possible - so in principle they might start at a single dollar! But in that case, as long as the current bid is below the outstanding mortgage plus fees, it would be advantageous for the bank to bid the current bid +1$ themselves! So if instead they start at that amount as minimum bid, the outcome is the same except that the actual act of the bank buying from itself in case of no high enough bids is replaced by the auction failing.

Answer 9

The "opening bid" doesn't actually mean much. In your example, all it means is that bids below $100,000 won't be accepted. If that house is worth $250,000 and in the very unlikely case that nobody is willing to bid even $100,000 then the house would not be sold.

Usually the reason for a limit on the opening bid is to waste time. Imagine the Mona Lisa is on auction, and two hours are spend bidding her up from $1 to $1,000,000. That's just wasted time. Now if it was my property and I was selling it myself, I would want an opening bid close to what I want to get, and possibly have a limit so the property cannot be sold too cheap. Since it's the bank that is selling, and they are only interested in getting their $100,000 back, that's where they can set the opening bid.

Obviously if the house is worth $250,000 and the debt is $350,000, then the bank will not have an opening bid at $350,000 because nobody will buy the house. They know they are not getting all their money back, so they pick an opening bid that maximises their chances. (Something not too cheap, but cheap enough to get the auction started, and hoping that someone gets all excited and bids more than the house is worth).