Friday, December 28, 2007

Economics of non-judicial foreclosures

(Felix Salmon) Have I mentioned of late how much I love my commenters? Many thanks to James Moore, who adds a very interesting twist to my obsession over the proportion of mortgages which are non-recourse.

Moore gets straight to the heart of the matter: the key question isn't how many mortgages are non-recourse, but rather how many mortgage lenders would go after their borrowers for unpaid mortgage debts even after the property in question is sold at foreclosure. Moore's insight is that just because a lender can pursue a borrower, doesn't mean it will. And the key distinction to be made here is between judicial and non-judicial foreclosure.

I'll let Tanta explain the difference:

Foreclosures can be “judicial” or “non-judicial.” Some states require judicial foreclosure; most states allow one or the other at the lender’s election or in certain other circumstances. A judicial foreclosure requires the lender to sue the borrower in court for satisfaction of the debt. A non-judicial foreclosure allows the lender to use the “power of sale clause” in the mortgage document to force sale of the property without a court order.
Because the non-judicial foreclosure uses powers granted to the lender in the mortgage document, which is executed by the borrower at the time the loan is made, the property sale is, in essence, already “authorized” by the borrower. When you sign a mortgage document, you are agreeing in advance to sell your property at public auction if you do not pay the debt as agreed in the note.
Non-judicial foreclosure is almost always faster and cheaper for the lender than a judicial foreclosure. Most of the time, when there is a choice, the lender chooses the non-judicial option for that reason. The big benefit to the lender of a judicial foreclosure is that the lender can ask the court, when appropriate, to enter a “deficiency judgment” against the borrower; this makes the borrower liable for any difference between the proceeds of the sale and the debt owed when the borrower is upside-down. Practically speaking, a lender who chooses non-judicial foreclosure generally waives its right to seek a deficiency judgment. The lender’s calculation, obviously, comes down to weighing the benefit of quick sale and reduced expenses against the cost of (potentially) writing off part of the debt.

If a mortgage lender wants to sue a borrower for repayment over and above the sale proceeds from the property, then, it basically needs to go to court and get a deficiency judgment. If you're going to go to court anyway, you might as well get a judicial foreclosure: if you opt for a non-judicial foreclosure, then the chances of your going back to court for a deficiency judgment are essentially nil.

Now Moore says that in California, at least (all this is complicated greatly by the fact that foreclosure law is made by the states, not the federal government), "you just don't see judicial foreclosures" – they're simply too expensive for the lenders, and the extra money the lender might be able to squeeze out of the borrower simply can't compensate for the cost of getting that deficiency judgment in the first place.

This surprises me, I must say. After all, California was ground zero when it came to mortgage innovations like 125% LTV mortgages, where the bank lent the borrower more money than the property was worth. Clearly, no one is going to do that unless you have a reasonable expectation that you can go after the borrower individually for any monies not received in foreclosure. The credit markets might have gone a bit crazy over the past few years, but they didn't go that crazy. (Please tell me they didn't go that crazy.)

But it's also obvious that in these stressed times when lenders can't even service their loans properly because they're overwhelmed by the volume of defaults, they're going to be extremely hesitant to go through the hassle of a judicial foreclosure, if they have a much easier alternative in non-judicial foreclosure.

So maybe even recourse borrowers might be able to walk away from their homes without declaring bankruptcy – "jingle mail", it's called – with the reasonable expectation that their bank won't pursue them for any extra money. If that's the case, it adds a whole new and rather unpleasant twist to the dynamics of the property market. Suddenly, it becomes economically idiotic for many prime borrowers to continue to make their mortgage payments, even if they can quite comfortably afford them. And the implications of that for properety prices are nasty indeed.


In 20 years as a creditor's rights attorney in California I have never seen a judicial foreclosure on a single family home.

First, purchase money debt is non-recourse. Moreover, the argument that the debt becomes recourse if you refinance is one that I have heard articulated, but I have never seen any cases to that effect.

Second, in California even where a deficiency judgment is available, the judicial foreclosure process results in the borrower/judgment debtor having a one year right to redeem the property at the sale price (i.e., buy it back), which would effectively make it unmarketable by the lender for a year after the judgment was obtained.

Third, under California law a lender cannot foreclose non-judicially and then go to court to seek a judgment against the borrorwer (this rule applies even to commercial real estate foreclosures). So the scenario of a non-judicial foreclosure then a lawsuit for the deficiency is legally impossible in California.

Finally, an issue that will definitely be on the table soon is whether the junior lien is recourse in the so-called "80/20" loan situation (a first mortgage for 80%, and a second "line of credit" used to pay the other 20% of the purchase). Although documented as some sort of "home equity" product, the second lien is, to the thinking of most California lawyers I know, just as much a purchase-money loan as the senior loan, and thus not recourse as well.

What I find fascinating is that the general public is just now getting around to thinking about these kinds of issues. Obviously the lenders aren't exactly advertisng the fact that most mortgage debt (at least in California) is non-recourse. What is odd to me is that so much of the population signs up for the biggest financial obligation of their life without even knowing the basic terms of the transaction (i.e. recourse/non-recourse, etc.).

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