Hello Jman and thanks for your post.
Kris Simpson has very thoroughly explained the process to you, and at this time, you have a hard choice to make: 1) agree to the bank's proposal or 2) not agree and cancel the contract. Unfortunately, ti appears that the bank's BPO or appraisal has revealed the fair market price of the home to be $225K or above, and the bank is asking you to increase your offer. You can certainly try to counter back, but its unlikely that the bank will agree to any counters at this point.
Depending on how much you like this home, it may well be worth the $8,000 difference to purchase the property. If not, however, feel free to move on to the next property I might caution you that a short sale is NOT and should not be construed as a 'fire sale' of a distressed property. While the banks are definitely willing to agree to take a loss on the mortgage owed on the home, most banks and lenders are not willing to take a huge loss on the sale of the home compared with the appraised or fair market value.
So talk it over with your Realtor, review the current comparables, and make the decision regarding whether to take the bank's offer or move on to the next property.
Grace Morioka, SRES, e-Pro
Area Pro Realty
San Jose, CA