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.]
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.]