Borrower Exposure to Deficiency Risk

“To be forewarned is to be forearmed.”

The term “deficiency” arises in the context of a borrower’s default to their lender.  It refers to the difference between what the lender/servicer recovers, e.g. through short sale, deed-in-lieu-of-foreclosure (“DIL”), or foreclosure, and the total debt owing.  Let’s go through each one, and see how and when the issue is likely to arise:

1.     Short Sales. This is a sale of the distressed property where the net sale proceeds [after deducting costs of sale, such as real estate commissions, escrow, title insurance and recording fees] are insufficient to pay the total indebtedness due, i.e. principal, interest, late fees, and lender advances, such as property taxes and insurance. The difference between the amount recovered and the amount due is the “deficiency.”

When the original lender made the loan, it took back a promissory note and mortgage, or trust deed.  The note was the “debt instrument,” i.e., it was the document that promised to pay the loan balance upon certain terms and over a certain period of time. The mortgage or trust deed was the “security instrument,” meaning that if the borrower failed to pay the note as promised, the lender could execute on, and sell, the property which served as security for the note.

When the short sale seller receives an offer, their real estate agent will send it to the lender or servicer for approval.  The approval process requires that the borrower also provide (a) a “hardship letter”; and (b) a complete financial disclosure.  Although these two requirements are essential to the approval process, in my experience, they are not relevant to whether the short sale will be approved.  Absent extenuating circumstances, I have never seen a short sale offer rejected because the borrower’s hardship was not “hard” enough.  [If that should occur, it’s likely because the borrower failed to identify any hardship, was transparently untruthful, or simply had too limited a view of what constitutes a “hardship.” For example, I’ve had clients who do not have a “financial” hardship, i.e. they can afford the current home mortgage, but they want to start a family – or vice versa – they are empty-nesters.  In either case, the home they now have does not fit their current situation.  Their need to up-size or down-size can be just as much a hardship as other circumstances that result from being “stuck” in a home with negative equity that one cannot sell without bringing cash to the closing table.  In short, being forced to put one’s life on hold, is a legitimate hardship.]

So when a short sale is headed for closing, eventually, the lender may – but not always – ask for some “contribution” from the borrower toward the deficiency. In my experience, the request for contribution is relatively rare – in most cases because the borrower/short seller has little, if any, extra funds.  And in those cases in which the borrower/short seller does have some extra funds, a request for contribution – assuming it’s reasonable – is something that should be considered.  Why?  Because the goal is to close the door on this chapter of one’s life.  The payment of say, $2,500, may be worth the cost, considering a foreclosure will take many more months.

In a short sale, it is always important for the seller/borrower to address with the lender what will happen to its claim for the unpaid deficiency after closing – even in those cases in which the short seller has agreed to make a “contribution” at closing. In the past, say from 2010, when short sales began appearing with some frequency, seller/borrowers and their real estate agents often failed to insist upon a written commitment from the lender or servicer to “waive” or “forgive” the remaining debt.  This technically meant that although the seller’s security instrument had been released by the lender, the deficiency due under the promissory note, i.e. the shortfall between what the lender was owed and what the lender received from the net sale proceeds, was still subject to collection.

Short Sale Tip: So, with regard to short sales, it is imperative for real estate sales agents and their seller clients, to make sure that the bank’s final consent to the short sale [which is usually issued shortly before closing] includes language that a reasonable person could understand to mean that the deficiency is being released, and no one – the lender, servicer, or their assigns – can later pursue it.

2. Deed-in-Lieu-of-Foreclosure (“DIL”).  This is where the lender or servicer takes the property back.  It is “in lieu of” having to foreclose the homeowner.  I tell clients that the DIL is, at best, a “Plan B.”  This is because the bank doesn’t want the home back in its REO inventory, which would mean that it will now become responsible for any deferred maintenance, carrying costs, marketing and expenses of sale, including the real estate commission.  Rather, the bank would prefer to see the borrower try to sell the home into the marketplace – i.e. short sell it.

So normally, when asked by a defaulting borrower whether the bank will take the property back in lieu of foreclosure, their response is “Why don’t you try to short sell the property, and then get back to us in a few months if you’re unsuccessful.”

Frankly, it’s easy for me to understand the banks’ position here.  Moreover, at least in many parts of Oregon, short sales are booming, which suggests that (a) banks are finally realizing that they can recover more on a short sale than a foreclosure; and (b) they are getting their protocols in place so that fewer buyers are backing out in disgust, after waiting months for a response.

For borrowers considering a DIL, they will find the initial protocol similar to the short sale, i.e. they will be asked to submit a hardship letter and current financials. What is different is that they will be expected to also sign documents conveying the property back to the lender or servicer.

DIL Tips: First and foremost, borrowers must be sure that the documents make clear that once the property is deeded back to the bank, there will be no further liability under the promissory note. In other words, the deficiency [in this case the difference between what they “book” the property in at when they take it back, and what is owed under the promissory note] will be expressly waived or forgiven.

However, there are two other issues of importance: One, if you’re in the “DIL line” queuing up to get your DIL papers, you cannot also try to short sell the home.[1]  So, you will have to step out of the DIL line, and go to the back of the short sale line, starting all over again, including submitting new paperwork. [I suppose this can be analogized to waiting three hours at the multiplex to see Daniel Craig in “Girl With the Dragon Tattoo,” and then deciding at the last minute that you’d rather see him in “Skyfall.” You simply have to start all over again. And no cuts! – PCQ]

The other tip is more dicey, and perhaps something that is hard to resolve; unlike the short sale, where you know the amount of debt cancelled [i.e. the difference between the total unpaid loan balance minus the bank’s net proceeds at closing], you can’t really know that in a DIL transaction.  This is not important if the home is a “Qualified Principal Residence” for purposes of avoiding any income tax on the cancelled debt, but it could be important if the home does not so qualify, or, if the tax exemption is not extended in 2014. All I can say in such a situation – which I’ve not addressed before – is that I would at least ask what the lender will be booking the home in at for 1099-C purposes.  I suspect the servicer or lender would say they don’t know, but, nevertheless, the issue should be vetted in situations where there is income tax exposure and the amount of the 1099 income is important.

3.    Foreclosure. This is the name of the legal process that all lenders must follow if they are going to involuntarily take the property, i.e. their security, back from a defaulting borrower. The laws of each state can vary, so I am going to limit my analysis solely to Oregon. Here is a brief summary; it should not be relied upon to the exclusion of either reading the applicable law, or going to an attorney familiar with Oregon’s foreclosure laws:

  • Lenders use trust deeds almost exclusively in Oregon real estate transactions.
  • Trust deeds may be foreclosed by “advertisement and sale” i.e. non-judicially, by following ORS 86.705 et. seq.
    • This process does not occur in court; it is handled exclusively by a foreclosure trustee appointed by the beneficiary, i.e. the lender or one acting on behalf of the lender, such as a servicer.
    • The effect of all non-judicial sales [regardless of whether the property is residential or not] is that all of the borrower’s promissory note liability is extinguished.[2]
    • Trust deeds may also be foreclosed judicially, i.e. by filing a complaint in court seeking a judgment for the total amount of the debt, plus court costs and attorney fees.
      • If the borrower was living in the property as a “primary residence” as of the date of the default that resulted in the foreclosure, the trust deed is deemed to be a “residential trust deed” and there can be no deficiency liability sought against the borrower. For example, if I lived in my home on September 1, 2012 and fell into default that month, and then the bank filed a judicial foreclosure against me in January, 2013 for the default in payments, I would have no personal exposure for a deficiency judgment [i.e. the difference between the total debt owed and the amount received from a third party bidder (or the amount of the bank’s “protective” bid) at the foreclosure auction.] This result would be so, even if I vacated the property before the foreclosure was filed – so long as I lived there when I first went into default in September, 2012.[3]
      • If the property does not qualify as a “primary residence” e.g. it is a vacation home or rental held for investment, a judicial foreclosure of the trust deed would entitle the lender to seek a judgment for the deficiency.
      • As noted above, if the bank were to conduct a non-judicial foreclosure, it could not obtain a deficiency judgment since the statute [ORS 86.770(2)] says that the effect of a non-judicial foreclosure is to extinguish the debt.
      • As most observers know, in Oregon, the banks have largely abandoned non-judicial foreclosures, due to issues with MERS – which will not [mercifully] be discussed here – and a state law that requires mediation, when requested by borrowers, for all non-judicial foreclosures.  This means that almost without exception today, Oregon borrowers in default will ultimately face a judicial foreclosure unless they can negotiate a short sale, DIL, forbearance, or some form of loan modification.

Foreclosure Tips:  I have several comments, but due to space, time, and my desire to retain an active law practice advising and counseling on the subject of distressed housing, will only briefly outline my thoughts.  These are my thoughts alone; others are free to disagree.

First, foreclosure is something that occurs simply as a result of nonpayment.  It occurs on the banks’ own timeline, and we, mere mortals, are generally not privy to what those timelines are.  Anomalies abound.  Some properties are foreclosed more quickly than others, and some have not been foreclosed for years. We can always speculate, but we really can’t know for sure what the decision-making process is.  And being somewhat jaded about “Bank Think” I can safely say the Big Banks are as inscrutable as the Sphinx.[4]  And even if they explained their thought process, I doubt I would believe it.  The point is that it is almost impossible to know when a foreclosure will commence.  And if the past is any indicator, the legal process is so slow that I would not be surprised if a judicial foreclosure that was commenced in January, 2013, would not be fully completed, including the sheriff’s sale, by the end of the year [And this does not include the 180-day right of redemption after the sheriff’s sale].

Second, delay being the rule and not the exception, for those wanting to close this chapter in their life, let me recommend the short sale process; the market is generally very good right now, and it’s guaranteed to be faster than hanging around waiting for a process server to knock on your door. For borrowers wanting to avoid the risk of an income tax levied on the cancelled debt, the protections that exist in 2013 may not necessarily be continued into 2014. The short sale is more likely to be completed this year than a foreclosure that has not yet been commenced.

Third – and here’s where uncertainty comes in – if there is a second note and trust deed against the property, it too will be foreclosed. The process of foreclosing a subordinate lienholder means that the second trust deed will be stripped away, leaving the unsecured, and unpaid, promissory note, alive and well. The holder of the note, or its transferee, thus has a right to pursue the borrower for the unpaid debt.[5] Since the statute of limitations is six years from the date of the last payment on the note, this can take some time – e.g. about the same amount of time it takes borrowers to get back on their feet.

Conclusion.  In all short sale and DIL transaction, there will always be a deficiency. When or if a lender asks for a “contribution” depends upon many issues, the main one being “Does the borrower have any available funds?”  In such cases, financial “weakness” is a strength, since most lenders will not insist on payment if the borrower has no funds with which to do so.  In Oregon foreclosures, the process is fluid, depending on the type of property being foreclosed and the foreclosure process being followed.  Currently,  lenders are primarily filing judicial foreclosures, but that could change depending upon 2013 legislation and the outcome of the Niday case, which was recently argued before the Oregon Supreme Court.

The good news – in my opinion – is that in most, but not all judicial foreclosures, I am not seeing the banks aggressively seeking deficiency judgments, even when they can.  For example, say the borrowers vacated the home before default, rented it out, and then got served with a judicial foreclosure.  Based upon experience with my own clients, I have found banks, servicers, and/or the owners of the loans generally agreeable to waiving the deficiency, and seeking the judgment “in rem” meaning against the property only – as opposed to “in personam” judgment, which means against the borrower personally.

Of course, this can change rapidly, depending upon the decision-maker’s view of the borrower and the use to which the property was put.  If the borrower has significant known assets[6] and/or the property is an investment rental or second home[7], the lender could have a different view of the deficiency issue.

Lastly, although the topic is more complex, borrowers fearful of being pursued for, say, an unpaid $60,000 HELOC, following a foreclosure by the first lender, should take comfort in the fact that the “street value” of a $60,000 promissory note is nowhere near its nominal, or “face” value. Most such non-performing debt is bundled and sold to companies in the business of buying it for pennies on the dollar.  This means that the company has a very low acquisition cost, i.e. “basis,” in the paper.  Their business model does not depend upon recovering 100¢ on the dollar.  Nor does it depend upon recovering on every note.  Rather, it looks for the “low hanging fruit.”[8]  In other words, just because there is, or may be, deficiency liability, does not mean that it cannot be settled for far less than the face amount.  The company does not want to go to court to collect, nor do they want to drive the debtor into bankruptcy court for protection.  Their job, if it can be called that, is to put money in the bucket at the end of the day.  That is why, if it cannot be avoided, most deficiency liability can be negotiated.

Lastly, and perhaps most importantly, borrowers facing potential deficiency liability, e.g. for a non-primary residence, or a second lien that will be stripped away in an impending foreclosure by the first lender, should be proactive.  Although it is not always possible, it should always be considered, rather than waiting for the creditor to start the pursuit. Make contact and see if anything can be worked out.[9]  Once the risk of deficiency exposure is identified and eliminated or reduced – preferably in advance – the “distress” of a distressed housing event, such as a short sale, DIL, or foreclosure, becomes much more manageable.

[1] You can “double-down” in black jack, but the Big Banks won’t let their Beleaguered Borrowers “double-down” when trying to extricate themselves from a home awash in negative equity.  The Big Banks call this “hedging” and it’s a gambit only they are permitted to engage in when placing their billion dollar proprietary bets. [“Don’t do as I do – do as I say….”]

[2] Third-party guarantor liability is not extinguished, however.

[3] However, I would not recommend vacating a primary residence during the first month of default.  My example is not realistic, since a September, 2012 default would likely not result in foreclosure for 8-10, or more, months.  However, the law was changed, effective July 11, 2102, and I question whether the anti-deficiency protection is retroactive.  The reason the law was changed to read the way it does today, is precisely so borrowers did not have to wait in their home for months and months until the foreclosure was actually filed, before knowing they had anti-deficiency judgment protection. Now they are free to leave after default, so long as it is the default that led to the foreclosure.

[4] In the interest of flavoring the otherwise drab and depressing subject of “Bank Think,” let me refer the reader to a beautiful poem by Shelley, Ozymandias, inspired by the Sphinx.

[5] There is one limited exception in ORS 86.770(2)(b): If the second loan was obtained from the same lender as the first loan, and at the same time, the second note is also extinguished if it qualifies as a “residential trust deed.” [See above discussion about residential trust deeds.]

[6] But if they did have significant known assets, it’s doubtful the problem would get to this point, since a short sale or other disposition would address the deficiency issue much earlier, when it could be dealt with proactively.

[7] Though if it was a second home, and foreclosure was unavoidable, a borrower may decide to make it their primary residence.  However, doing so requires more than smoke and mirrors.  You can only have one primary residence at a time.  Caveat: The legal determination of a “primary residence” is very fact specific, so a borrower should not try to play games.  There are certain indicia of a primary residence that are hard to “fake.”  For example: What address appears on the driver’s license?  What about where the homeowners vote?  Where are their utility bills sent?  If they go to church, or a gym, where are the facilities located vis-à-vis the home claimed to be a “primary residence”?  In short, the change must be a bona fide move and the sooner it occurs [versus a move the day before the foreclosure is filed] the better.  [The preceding should not be construed as legal advice designed to avoid deficiency liability.]

[8] It may be too early to tell, but in my experience, “low hanging fruit” does not include borrowers who hire an attorney to demand that the collector actually establish they have a legal right of collection. In some instances, upon receipt of a strongly worded attorney letter, collectors have been known to crawl back under the rock from whence they came.

[9] However, be careful! Lenders asking for 30¢ or more on the dollar are dreaming.  In most cases, this is far more than they could get if they sold the paper to a debt collector on the open market.