This article clarifies a homeowner’s contractual promise to repay purchase money debt and his contractual right to default, free of moral obligation.
In California, homeowners borrow funds to assist in purchasing a home and sign a trust deed and a note containing a promise to pay the lender the entire amount borrowed. Lenders want homeowners to perform on that promise to repay their debt. Lenders do not want the note and trust deed to be used to force them to buy the home for the amount owed on the debt. But this is the contractual bargain lender’s strike when lending in California.
Lenders want homeowners to live up to their “moral obligations.” They want homeowners to do good so that lenders will do well.
But lenders never require homeowners to sign a moral statement. Morals and ethics arise in agency relationships and fiduciary duties. Morals involve personal conduct and personal relationships, both of which have nothing to do with contracting between a homeowner and a lender.
While those involved in agency relationships and fiduciary duties must consider their moral conduct, those involved in contracting need only consider their performance expectations under an arms-length agreement. In a contract, any nonperformance is accounted for with legal repercussions. A homeowner who is fully aware of the repercussions on nonperformance has every right to make a contractual decision to face those repercussions.
Lenders are aware of the repercussions as well and of the homeowner’s exit strategy created by the put option. The put option, contained in all trust deeds, requires the lender to purchase the home for the loan amount if the homeowner defaults. Thus, lenders attempt to approach the homeowner from outside of contract law, making an appeal to the homeowner to live up to his moral obligations by insisting on a (nonexistent) good faith obligation on the part of the homeowner. [For more reading on the limits on lenders, see the February 2007 first tuesday article, Short payoff on recourse and nonrecourse loans.]
The contract
A property owner’s promise to pay evidenced by a trust deed note falls into two liability categories:
- nonrecourse purchase money debt, the promise to pay for a purchase-assist loan secured by a one-to-four unit owner-occupied home or carryback trust deed on the sale of any type of property; and
- recourse debt, the promise to pay on a loan of money secured by real estate other than a purchase-assist loan on a one-to-four unit residential property. [California Code of Civil Procedure §580b]
A purchase-assist loan on an owner-occupied one-to-four unit property (which includes carryback notes secured solely by any type of real estate sold) is not a personal promise. It is considered solely as a real estate loan, should the homeowner fail to fulfill his contractual promise by defaulting.
The promise to pay in this instance is not a personal promise. The loan is attached to the real estate and lenders can only look to the real estate to fulfill that promise — nonjudicial foreclosure. They cannot look to the homeowner on any amount under the note. [CCP §580b]
Editor’s note – The defaulting homeowner is not liable to the lender for a drop in the property’s value below the loan balance unless the homeowner damages the property to an extent which decreases its value, called waste. [Cornelison v.Kornbluth (1975) 15 C3d 590; California Civil Code §2929]
On the other hand, any other kind of real estate borrowing (investment property, equity loan, agricultural loan, refinance) does leave the homeowner vulnerable to personal attack from the lender — by judicial foreclosure exclusively.
California judicial and nonjudicial foreclosure
Every trust deed contact or mortgage provides that, following the default of a homeowner, the lender must foreclose.
There are two ways a lender can foreclose:
- judicially, commonly called a sheriff’s sale; or
- nonjudicially, commonly called a trustee’s sale.
Judicial foreclosure is the court-ordered sale by public auction of the secured property. The process can last one to one and a half years, minimum.
A judicial foreclosure is the only foreclosure method which allows a lender to obtain a money judgment against the homeowner for any deficiency in the value of the secured property to fully satisfy a recourse debt. [CCP §580d]
A lender holding a recourse note can foreclose judicially and obtain a deficiency judgment for a money award if the fair market value of the secured property, on the date of the judicial foreclosure sale, is below the amount of the debt. However, when a money judgment for the deficient value is awarded to the lender, the homeowner has the right to redeem the property within one year after the judicial foreclosure sale by paying the amount of the bid (plus interest). The money judgment is a separate debt, unconnected to the right to redeem the property for the price bid at the foreclosure sale. Thus, the owner could recover the property and still owe on the deficiency judgment. [CCP §729.030]
As a consequence, a judicial foreclosure is costly to the lender both in time and money. Also, the lender faces the risk of a further decline in the property’s value during the one-year redemption period after the foreclosure sale, as well as the risk of being unable to recover a money award.
Nonjudicial foreclosure is a much more frugal, less time-consuming process taking somewhere between six-to-eight months. Lenders will nearly always pursue nonjudicial foreclosure in California, with rare exception.
When a trust deed holder nonjudicially forecloses by a trustee’s sale, the property is sold by private agreement at a public auction. Trustee’s sales can be completed on property other than a one-to-four unit residential property within four months after a property owner defaults. Unlike a judicial foreclosure sale, the completion of a trustee’s sale denies the foreclosing lender the opportunity to obtain a money judgment for any unpaid balance remaining on the note after the trustee’s sale due to an underbid or insufficient value in the secured property. [CCP §580d]
Thus, a trust deed lender holding a recourse (or nonrecourse) note can foreclose quickly and inexpensively through the trustee’s sale procedure. The property owner’s right to redeem the property by payment of the debt in full is terminated on completion of the trustee’s sale.
To counterbalance the beneficial right of a recourse lender to a swift foreclosure by use of a trustee’s sale, the recourse lender is barred from obtaining a deficiency judgment after foreclosing nonjudicially on the property. [CCP §580d]
Recourse and nonrecourse states
The Federal Reserve of Richmond found that states with no restrictions on judicial foreclosure (termed “recourse states”) have a much lower percent of homeowners that default when they are underwater when compared to nonrecourse states like California.
In states that allow lenders to hold homeowners personally responsible for any real estate loan — recourse states — homeowners who have a lot to lose will stay in underwater homes. Wealthy homeowners are most susceptible to this imprisonment.
The mere threat of judicial foreclosure is enough to frighten homeowners into keeping their homes. In recourse states, lenders rarely pursue judicial foreclosure; instead they brandish their ability to do so, keeping homeowners in fear.
Lenders, in reality, see judicial foreclosure as a last-ditch effort due to its high cost. But in negotiations with homeowners, lenders in nonrecourse states will promise to forego the right to pursue a deficiency judgment if the homeowner agrees to a lender-friendly default:
- short sale;
- voluntary conveyance (deed-in-lieu of foreclosure); or
- uncontested foreclosure.
The opposite occurs in nonrecourse states like California, with heavy restrictions on judicial foreclosure. In nonrecourse states, default is much more common. The probability of default in nonrecourse states (as compared to recourse states) is:
- 20% higher for homes worth $200,000 or more;
- 59% higher for homes worth between $300,000 and $500,000;
- twice as likely for homes worth between $500,000 and $750,000; and
- 66% more likely for homes with $750,000 to $1 million. [Federal Reserve Bank of Richmond, Recourse and residential mortgage default: theory and evidence from U.S. states]
Strategic defaults: exercise the put option
The drastic difference between recourse and nonrecourse states has demonstrated homeowners’ determination to default as a matter of financial strategy.
These homeowners are exercising their put option, which forces lenders to purchase the homeowner’s residence for the loan amount remaining due.
In states that have given lenders the upper hand, homeowners with more to lose from judicial foreclosure chose not to default because the option has significantly less value when personal assets are at stake. But for homeowners in California, it is financially prudent to walk away from an underwater loan, since the promise to pay is made against the real estate and not a personal promise.
It is vital to California’s economic recovery that underwater homeowners walk away from excess debt. Lenders who insist on homeowners fulfilling an artificial moral obligation to their contractual promise have no interest in allowing homeowners to contribute to the future economic recovery of our state. Lenders (and congress who crippled the saving grace of bankruptcy in 2005) want homeowners to lock every cent of their income into supporting depressed assets.
Homeowners who walk away from underwater homes free up their income and are able to spend more freely on consumer goods. Disposable income spent on consumer goods boosts both the job market and the economic health of our sales tax dependant state. [For more discussion of strategic defaults, see the October 2009 first tuesday news blog, Financially savvy homeowners turn to mortgage defaulting as a strategy.]
The premise that morals, at least those of the borrower, somehow cease to be be important at the door to the bank is faulty. A promise is a promise, regardless of who that promise is made to. People of integrity only make promises they fully intend to keep. Personal inconvenience is not a moral excuse to break a promise. Only impossibility is, and then only when the person making the promise fully believed they could and would keep the promise at the time that they made the promise.
Thanks, Nick. I have been wondering over this question for some time and you have clarified it perfectly.
The failure to distinguish between the moral and the contractual can have tragic emotional results.
I am getting a lot of questions on non-purchase second trust deeds which are left hanging after the first. Any thoughts on what happens to those in our state?
What is stopping them from attaching the wheels and hauling off the triple-wide….? If they can do it with the garage and firetanks, why not the whole darn house?
Give us their name or the HomeDepot and maybe we can make a deal ….
You better borrow the money to protect what’s left…If this is family? Your Brother or Sister’s kid?
What do they say? The buyers may not have a moral obligation to make the payments, but they have a moral obligation not to steal the collateral….that is criminal and depending on the AITD verbiage…a police report could be filed.
Would like to know if anyone has gone through this situation? My partner and I deveolped a piece of property. A construction loan paid off the land + the new triple wide manufactured home. We got a line of credit on our LLC to pay for County fee’s , metal garage building, cemet work + etc. We sold this property a year ago back in June 08. It was offered to the new owner with a A.I.T.D. due in 7 years. It was an opportunity for her and her boyfriend to own a new home in a real nice setting. Payments were made, sometimes not on time but we worked with them. We notice that they didn’t pay the property taxes, which we paid for them also. July this year no payment was made, through her changing her phone number was differcult to get a hold of her. Finally got her e-mail. She told me that they cannot handel the payments anymore. I sugguested to her that it would be to her best interest just to sign the home back to our LLc. I called our escrow person to prepare the necessay paperwork. She mentioned that they are in the process of moving out and will sign the paperwork when then are done. I even offered to let them leave their belongings in the big metal building until they find a place to go. Now after a month and a half has gone by she still hasn’t signed over the home. Since I live in another state, I decieded to come and see if they have moved out. I noticed a chain in front with a lockset and no trespassing signs. A nice neighbor had the combo lock, and let me in the lot .It’s 2.5 acres. The home was empty with only a few things left. The garage is what distrubed me. There was bars on the windows, with water lines going into the garage. My feeling is that they are growing pot plants. I was upset with this findings. I finally got to e-mail her and called her mother and told you that she is in violation of doing suspious activity.On the note it said that no owner will do any suspious activity on a property. I gave her a deadline until Friday of that week to go and sign the home over or we will proceed with notice of default. On the following Tuesday I got a call from my partner that the metal building was being dismantled. He proceed to call the police and went there. The guys who were taking down the garage said they saw it on craig’s list and paid her boyfriend at a local Home Depot. Now the garage is collateral for the loan in place, also it is REAL property attatched to the land. The police told them they cannot remove the garage. The guys called the current owner, and the police told her the same thing. The guys were to drop off them remains of the garage the next morning. No such luck. On Thursday I got another call from my partner and said someone is removing the rest of the garage. Again police were called out there with my partner and my daughter. The guys called the owner and she told the police tht they are trespassing on her property and to get off. Which they did. The garage left without any incident. Any evidence now is gone. It costs us over 20,000 dollars with permits and electric work. She sold the garage to these guys for 3,500. We filed a notice of default a few days before but were waiting for the recordation. We obtained some legal advice about filing an injunction. We are both tapped out of money to do that retainer fee. It seems to me that we as a note holder really do not have any rights. We can’t go on the proiperty to stop anymore nonsence from going on because she is still on title. Last week another phone call gave to me from my partner saying someone is dismanteling the mandated fire tanks on the property. And that they already have 2 tanks on their truck. I told him again to call the police. they sais this is a civil matter. He went to the property with our notice of default and a letter from the lender securring the property. These guys also said they saw the ad in the Craig’s list and met him – her boyfriend there and he left right away with their toyhauler after they paid him 1,750 dollars that they left on the porperty to make people know that they were still there, which in fact they have abanded the property. My daughter showed those guys the paperwork, and they were upset , They did leave the tanks there. We have been in contact with them they provided us with the bill of sale from her boyfriend who sign the bill of sale -he is not on title, and not authorized to sell ANYTHING!. Now we have a property where we carry a note, with no water available to the firedepartment in case of a fire. They have devalued this property to nothing in just over a month. Where are our rights? To stop this maddness! They have also taken the frig, stove, micrwave and bathtub from the home. What is next!. The insurance company has been notified of this situatiuon since this started, and has contacted my partner as of dec. 1, 09 they will cancel the insurance. The holder of the first morgage, has sold the note to another servicer as of Nov.5 09. My partner has notified the holder of the first of what has gone on there, and has requested the lender for a loan monication, which they seemed to be responding, we think. The Calif. real estate maket is bad, this property has loss alot of value. The neighbor next door lost his home similar to this one for 260,000 less. we have 3 years invested in this project and lots of money tied up with both of us .It has taken one month to destroy everthing that we have worked so hard for. Our filing the N.O.D , we will get this property back in mid Febuary. Who knows what’s going to happen next. I’m affraid for the worst .We can’t enter the property because she’s still on title. We did install chain locks and lender postings to prevent any further loss. I’m now worried about those fire tanks, I believe someone is going to remove them soon, and then you will have nothing there to protect the home from fire. And then what? Is there any other wording that must be there in the note on a A.I.T.D. ? How do you protect yourself from this happeneing again. How can she just sell everthing without any recourse? If we do get this back, we will proceed civil action against her. What does she have – nothing, when we win we will get nothing.. This whole situation has worked in her favor. I feel bad that we both do not have the finances to proceed with this. Our monies were in that home. And you know the sad thing, this was my wife’s niece.
As i see it the seconed T.D. lost their right to judicial forclosure and obtaining a money judgment, when they they didnt protect their asset in the forclosure of the First T.D.—I.E its too late to do a judicial now cause the asset is gone in the 1st forclosure..Tell G.M.A.C to stuff it. No longer tax consequences on personal residence forclosure or short sale as i understand it . But definatley consult with a R.E. attorney. Terry Irmer—- Broker
Nick:
Please read my disclosure at the end of this comment.
I think your article is well written, organized well and legally accurate however I do believe you have missed some very important points. I agree with the premise that homeowners need not be shackled with moral issues relating to their home loans in California. I do believe that the issue is primarily an economic one. As an aside, there is an emotional impact to all of this this that should not be ignored. However, more importantly, I do note that you did not discuss the effect of foreclosure or “walking away” on the dreaded non-purchase money junior nor the potential tax issues and those issues certainly need to be taken into consideration. These issues can be very important to the decision of how a homeowner should move forward.
I believe that it is very important for every homeowner considering “walking away” to meet with qualified legal counsel to review all the possible consequences and potential solutions including the tax issues before making a decision to “walk away”.
Some of the potential solutions to some of the possible consequences must be undertaken before the ownership of the property is transferred (either by foreclosure, deed-in-lieu, or short sale).This especially true if there might be tax issues. I am very concerned that homeowners are obtaining wrong information on the internet and unknowingly not taking advantage of solutions available under the law.
There is not one answer for each homeowner. Every homeowner’s situation is different because there are some many variables.
In fairness, I must fully disclose that my office does such consultations so certainly I am not unbiased and do personally gain from homeowners having such a consultation.
Pamela Simmons
Thank you for a helpful article. My brother cosigned the purchase of my house in 2005, and I lost the house in Oct 07 since I could no longer afford to pay the high mortgage on a 100% mtg loan. The property value was dropping and I could not sell it at all. In 11/06, after 4 banks had turned us down, GMAC MTG accepted to refi our second mtg to get a cash out of $25,000 to continue paying the mortgage payments. However, at the last minute before close of escrow, they removed my name from the loan since I did not qualify. I felt bad about this since my brother was only helping me out and it was really my loan. After trying to do a deed-in-lieu around Jan 07, the first lien holder (Washington Mutual) said the second needs to agree to do so; and since GMAC did not agree, Wamu foreclosed after a year’s default and did a Trustee Sale. Since I no longer hold the property, why is GMAC still sending me bills for the second mortgage (worth $100,000). I understand this is a recourse loan, but isn’t this backed up by the property? What can I do at this point? Are we still liable for this loan? Please help. Thank you.
Bill,
If she has equity then the best thing is to get the house on the market and get it sold as quickly as possible. If she is going to lose the house regardless, at least get the equity out so she has some money.
Sal
Great article but just one question arises. Assume the home owner has for any reason still got equity in the property which exceeds the foreclosure sales price. What happens to that equity.
e.g. Distressed widow unable to manage her affairs loses the home to a foreclosure sale. Fair market value of home is $100,000 more than the loan balance plus costs of foreclosure. Bank, or 3rd party bidder takes the property at the trustee sale.
This is not an academic question as I am dealing with the exact situation right now. I was brought in at the last moment with the trustee sale scheduled for tomorrow.
Any guidance would be greatly appreciated.
Bill
p.s. I have got the lady talking with an attororney but even if we can delay legally she may still lose the house.
Beautifully done. In theory, lenders could shift to judicial foreclosure more, but that is highly unlikely. I have only seen it in big transactions like larger apt. buildings and commercial properties where they know the trustor has substantial assets.
Which brings one to the most important aspect of this… if you are going to do a strategic default, which I agree is quite wise as you point out, DO NOT PROVIDE FINANCIAL DATA TO THE LENDER FOR A LOAN MODIFICATION. The giving of this information will give the servicer the most current location of assets for them to make an informed decision on judicial v. non-judicial foreclosure on non-purchase money transactions. Keeping them in the dark by keeping one’s mouth shut is the best way to ensure that they do not give judicial foreclosure any thought and just complete a non-judicial foreclosure leaving the trustor only with the credit hit, which will not take that long to recover from.
Excellent article, somehow the details of your article need to hit a much broader audience.