In Defense of Borrower Default

In common parlance today, a “default” denotes either nonperformance – or inadequate performance – that falls short of a written rule, guideline, or criterion.  It is not something that, by itself, can be judged or evaluated absent the presence of a measuring stick. While a breach of contract is an objective characterization of someone’s failure to perform according to the terms of a legally binding agreement, a breach of ethics, is a subjective characterization of someone’s failure to perform according to the terms of the holder’s belief system.

However, what the lending industry has successfully done is to mix the objective nature of “default,” say under the terms of one’s mortgage, with the subjective inference that the breach is equivalent to a moral failing.  Hence, the term “strategic default,” used by Big Banks to stigmatize the folks who don’t perform in accordance with the terms of the note and mortgage or trust deed they signed.  [Admittedly, there are those who have no affiliation with the lending industry who are also guilty of this pejorative characterization.  Yet, I can forgive most of them, since they’ve never “walked a mile in the other persons’ shoes.”  Accordingly, their opinion is the result of unconscious ignorance – not conscious conflation. – PCQ]

So, the purpose of this post is to put the term “default” back where it belongs. In other words, to remove the judgmental conclusion that defaulting under one’s mortgage or trust deed is a morally reprehensible act.

Mortgages Versus Trust Deeds. In Oregon today, when people take out a loan to acquire a primary residence, the bank lends them money in exchange for the borrower signing two critical documents.

One is the promissory note.  This is technically called “the debt instrument.”  The note provides that the borrower will repay a fixed sum of money, principal including interest, over a prescribed period of time.  If the note is not repaid according to its terms, the lender may declare a default, and accelerate the entire unpaid balance of the loan – thus making it immediately due and payable.

The second document in a home loan transaction is the trust deed.  This is known as “the security instrument.”  It acts as a lien on the borrower’s home.  A lien is a financial “charge” against a property, granting a lender the right to foreclose if the note is not paid according to its terms.  In other words, the trust deed “secures” the borrower’s repayment of the note.

Judicial Foreclosures. Oregon’s trust deed law has been on the books for decades.  Before then, lenders had to go to court to judicially foreclose homeowners.  This meant that if the promissory note was accelerated because of a borrower’s default in payment, the bank had to file a lawsuit, get a money judgment for the accelerated balance due, and publically sell the home to satisfy all or a portion of that judgment.  If the entire amount of the judgment was not satisfied by the sale of the security, the lender would have a “deficiency judgment” against the borrower for the amount of the shortfall.  However, the law has always been that lenders may not recover a deficiency judgment after the foreclosure [judicial or non-judicial] of one’s primary residence – i.e. their home.

Significantly, judicial foreclosure carries with it a right of redemption to the homeowner – meaning that after the public sale, he or she can recover back the property within a fixed period of time, by paying all costs secured by the mortgage, including foreclosure costs and fees, due to the bank.  Today that period is six months; previously it was a year.

Non-Judicial Foreclosures. As opposed to a judicial foreclosure, Oregon’s trust deed law provides that if a borrower fails to pay the note, the lender may – but is not “required” to – foreclose the home “non-judicially.”  In such cases, a “Trustee” appointed by the lender may simply record a written Notice of Default on the public record, and send a Notice of Sale to the borrower, setting an auction date that is not less than 120 days following the Notice of Sale, and periodically publish notices of the auction in a “newspaper of general circulation.”  There is no right of redemption following the trustee’s sale.  Since there is no judicial involvement in this type of foreclosure – just recording, mailing and publication – there is no risk of a deficiency judgment upon completion of a non-judicial trust deed foreclosure.  This result applies regardless of whether the property in foreclosure is a primary residence or a non-primary residence such as a second home or a rental/investment property.  Additionally, in a non-judicial foreclosure, borrowers have the opportunity to “redeem” or “cure” the default up to five days before the sale, by paying the amount of the arrears then due, thus “reinstating” the note and trust deed, just the same as if a default had never occurred.  In other words, even though the entire note balance is accelerated because of the default, a borrower under a trust deed can prevent the foreclosure sale by simply paying the arrearages no later than five days before the sale.

Thus, under the trust deed law, in theory, it is harder for the lender to ultimately foreclose, since the borrower may reinstate by paying current arrearages.  This is because the right of acceleration upon default under the promissory does not kick in until the final five days preceding the sale date.  However, once a trust deed foreclosure is completed, since there is no right of redemption period; title becomes immediately marketable, and the bank does not have to wait an additional six months.  The general consensus in the lending industry has always been that non-judicial foreclosures are faster and cheaper than judicial foreclosures.  They are the preferred method of foreclosure in Oregon.

The Big Banks’ Big Bargain. So who wanted to replace judicial foreclosures with non-judicial foreclosures in the first place?  What did the Big Banks want?  A review of Oregon’s legislative history is revealing.[1] Back in the 1950’s, the Portland Bankers Association drafted and heavily lobbied the trust deed bill.  Low down payment borrowing, 10% or less, had become all the rage [sound familiar?] and East Coast insurance companies, wouldn’t buy those higher risk loans unless foreclosure was cheaper and easier.  At the time, there was a one year redemption period following a judicial foreclosure – which essentially held title in a sort of suspended animation for twelve months.  The entire process from the default through redemption took 18 months or more – back then.

Oregon was apparently the last of 23 states to adopt our Trust Deed Act.  Because of concerns about lender fraud and abuse [sound familiar?], the original Trust  Deed Act passed in 1959 had a provision allowing borrowers to convert a non-judicial foreclosure to a judicial foreclosure. The banks hated this borrower-option, claiming that big insurance companies still wouldn’t invest in Oregon unless it was changed.  The result was that the borrower-option was repealed in 1961.  Over the subsequent years, the Big Banks further refined Oregon’s Trust Deed Act making it more favorable to them.

So it is clear from the legislative history that the Big Banks desperately wanted the right to non-judicially foreclose borrowers in default, since it would be quicker, cheaper, and return the property to them or to an auction purchaser, free of any rights of redemption.  Marketability and transferability of title were enhanced.

The Take-Away. So what is the “take-away” in this discussion of legislative history? It is that the lending industry, together with their funding source, the big insurance companies, fervently wanted Oregon to pass the Trust Deed Act in 1959.  It was not, as some have erroneously suggested, foisted upon the banks against their will, “depriving” them of their right to judicially foreclose.  To the contrary – Big Banks  were the driving force in creating the trust deed law, which they viewed – at the time – as being in their financial interest, since it enabled them to foreclose cheaper, faster and more efficiently, than the old judicial foreclosure method. Moreover, the banks never “lost” the right to judicially foreclose. They still have that right today – although until recently, they have rarely exercised it.

Default in Oregon Today. So, the legally binding contract that lenders made when they began to secure their promissory notes with trust deeds rather than mortgages, included the following arrangement with borrowers:

  • It you pay off the note according to its terms, we will remove the lien of our trust deed that we recorded against your property;
  • If you don’t pay off the note according to its terms, we will have the following rights and duties:
    • We will notify you of your default and give you the opportunity to bring everything current up until five days before the scheduled sale date;
    • If we sell [or reacquire] the property at the auction, you will have no right of redemption thereafter;
    • But if we do sell [or reacquire] the property, we will have no right to recover a deficiency from you for any remaining amount due to us under your promissory note.[2]

Today, the same critics that call defaults “strategic” are the same ones accusing homeowners of gaming the system, staying in the residence for months, even though they are not paying any rent.  However, there is a nuance in Oregon’s Trust Deed Act that explains why this may be so: Protection against a deficiency judgment only applies to “residential trust deeds” and ORS 86.705(3) defines a “residential trust deed” as the borrower’s primary residence “…at the time the trust deed foreclosure is commenced.” [Emphasis mine. – PCQ] Since you can only have one primary residence at a time, this means that borrowers vacating their home before the foreclosure commences, do so at their own risk.  If the borrower is no longer living there, the home will not likely qualify as a “primary residence,” and the borrower could be subject to a deficiency judgment should the bank decide to judicially foreclose.  Is there ever a risk of a trust deed being judicially foreclosed today?  Absolutely.  Lenders have not only threatened to do so, they have actually begun doing so.

The Deed-in-Lieu Option. So why don’t borrowers just sign over their property to the bank?  A deed-in-lieu-of-foreclosure is a voluntary deed giving the property back to the bank “in lieu of” the borrower being foreclosed months later.  While this seems like a quick and painless way to dispossess of one’s home awash in negative equity, it is rarely done.  There are several reason, but the main one is that the lenders must consent, and they generally rarely do.  This means that borrowers must remain in their home, whether they want to or not, all the way up to the commencement of the foreclosure.  The banks and the trust deed law give them little choice.

Conclusion. Thus, in the final analysis, default has always been a contractually agreed-upon alternative to performance.  Without a default, the lien is lifted; but with a default, foreclosure occurs. Metaphorically, banks and borrowers “shook hands” on the arrangement, and all agreed.  However, inherent in this bargain was the unstated assumption that the security – i.e., the home – was – or would become – more valuable to the lender and borrower than the debt it secured.  [Of course, the banks had the ability – if they wanted – to hedge this risk, by requiring more substantial down payments.   We all know what happened there.  – PCQ] In short, based upon the assumption of rising home values, borrowers theoretically had more to lose by default, and  banks had more to gain.  We could probably find an economics term to describe this concept, but for simplicity’s sake, let’s just call it “common sense.”  Both sides assumed the risk that prices would never fall. But when they did fall, the “default option” became a viable alternative for borrowers.  It made perfect economic sense; both lenders and borrowers had contractually agreed that there would be no deficiency judgment following a non-judicial foreclosure.  And due to falling prices, the borrower’s right to reinstate by curing the default, became valueless.   The bargain swung against the banks – this time.  For the last 36 years the bargain favored the banks.

So in defense of default, I submit that there is nothing “unfair,” “unethical,” or “improper” about one party to a contract pursuing a course of action expressly permitted by the terms of that contract.  The trust deed never said that borrowers were prohibited from defaulting.  To the contrary, it anticipated the possibility, and contractually stipulated what the consequences would be – the bank recovered back the property.  Ironically, the default option chosen by many borrowers drowning in negative equity, arises from the very legislation the Big Banks lobbied so heavily for decades ago.  Until recently, the banks even agreed that this was a fair bargain.

[1] My thanks to Kelly Harpster, Oregon lawyer extraordinaire, for the extensive legislative history research and for sharing it with me.

[2] Under the Oregon Trust Deed Act, lenders do have the right of judicial foreclosure, but so far, have rarely used it except in instances in which they needed a judicial declaration about the title or similar issue.