This is a complex situation. They can do what ever they like.
To let you know some of the situations with the lender:
1. Your lender is most likely only a loan servicer. A servicer (B of A, Wells Fargo, etc) has usually sold the loan to an investor. The investor gives them guidelines related to loan mods, short sales, etc.
2. For everyone involved, a short sale is better than a foreclosure. It costs the lender approximately $50,000 and a lot of lost time to foreclose on the home and then additional time to assign it to an agent and get it sold.
3. As you have heard from others, get professionals involved now. Many lenders file the NOD and delay the action date in order to process a short sale.
Get good advice and take it, you have options.
Mark & Kari Shea
Shea Real Estate
National Association of Realtors
CA DRE License 01713506