Some Foreclosure News that Banks Can Live With

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Some of the largest banks in the country are paying attention to some news out of the housing market. The five largest mortgage originators -- which include Wells Fargo (NYSE: WFC  ) , Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , and US Bancorp (NYSE: USB  ) -- also service many of the loans used to purchase homes over the past few years, and they have been struggling through issues regarding foreclosure practices over the past few years. But there is some good news this week.

According to a report from mortgage data seller Renwood RealtyTrac LLC, the number of short sells increased 35% during the third quarter over last year. On the surface, this seems like great news, but what does it mean for investors?

Why the increase?
A short sell is a process in which a homeowner, who may or may not be heading to foreclosure, receives permission from their mortgage lender to sale the property for less than the remaining balance. Until 2007, the debt forgiven by the mortgage company because of short sale or foreclosure was considered taxable income. That all changed with the passage, and eventual extension of the Mortgage Forgiveness Debt Relief Act in 2007.

Unless extended, the act is currently set to expire on December 31, causing many folks to attempt to unload properties that may be heading to foreclosure. This helped contribute to the increase in short sells during the quarter, and I would expect similar numbers when figures from the fourth quarter are released early next year.

What it means for the banks
Though banks would prefer that properties are sold for close to the remaining balance, a short sell may ultimately be the best result in many situations. If a bank takes possession of a property through foreclosure, they are required to then sell the property to recoup a portion of the balance that was forgiven. A short sell, on the other hand, immediately transfers the property to a new tenant, limiting the financial impact for the bank.

The financial impact is felt most on a bank's balance sheet. In most cases, when a loan is more than 90 days overdue, it becomes a nonperforming loan and must be reported as such. This is an important metric that is used often when discussing banks and helps to measure asset quality at banks.

A short sell might take some time in practice, but it immediately removes a nonperforming asset from a bank's balance sheet. With short sales accounting for around 1.1 million transactions since 2009, billions of dollars in nonperforming loans have been removed from bank balance sheets, helping to strengthen an industry that is still recovering from the 2008 financial crisis.

What it means for investors
Strong balance sheets are always a good thing to see when investing in banks, and a continued increase in the number of short sells should continue to clean them up. This trend should continue through at least the end of the year, and another extension of the Mortgage Forgiveness Debt Relief Act could extend it well into 2013, allowing investors to benefit right along with affected homeowners.

As the nations largest mortgage originator, Wells Fargo is poised to benefit from a continuing increase in short sales and the resulting reduction in nonperforming loans. But does that alone make it a worthwhile investment? To help figure out whether Wells Fargo is a buy today, I invite you to download our premium research report from one of The Motley Fool's top banking analysts. Click here now for instant access to this in-depth take on Wells Fargo.

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