This article discusses the history, purpose, and present application of anti-deficiency laws.
Rational owners have nonrecourse options
Consider a home buyer who obtains a purchase-assist loan from a lender to fund the purchase of a one-to-four unit residential property he will live in. The homebuyer puts up only the minimum downpayment required by the lender to buy the property.
A few years later the local economy becomes depressed, causing the fair market value of the property to drop below the amount of the loan balance, a financial condition called negative equity. Concerned about continuing to own a home with a negative equity and being a rational person, the homeowner considers his financial options. They include:
- sell the property in a short sale arrangement, contingent on the lender accepting the net proceeds of the sale in full satisfaction of the loan and cancelling the remaining unpaid loan balance [See first tuesday Form 150-1];
- continue to pay on the loan and retain ownership, maintaining his credit score but drowning under a debt which is no longer supported by the value of the mortgaged real estate; or
- default on the loan and force the lender to foreclose on the property, bruising his credit but freeing himself of a dead-end debt, with payments greater than the rental value of the property (known as implicit rent which the lender cannot collect).
The homeowner knows that if he remains in the property until the lender completes a foreclosure, he will be able to accumulate savings by not making payments. He can later use the savings as a downpayment on another home. The owner decides to exercise the loan’s put-option by defaulting and the lender taking the property as provided by the trust deed.
The lender now forced to take the property by foreclose, eventually acquires the property at a foreclosure sale. At the foreclosure sale, the lender does not make a full credit bid but underbids. The result is a balance remaining unpaid on the debt.
Can the lender holding a purchase-assist loan secured by a one-to-four unit residential property which was occupied by the borrower, enforce collection of the remaining principal balance still owed on the note?
No! The loan proceeds funded the purchase of a one-to-four unit residence which was the sole security for the loan and was occupied by the buyer–borrower on acquisition, called a purchase-money loan. Thus, the loan is a nonrecourse debt since it is subject to anti-deficiency laws, a complete bar to the lender obtaining a money judgment in any amount of the loan. [Calif. Code of Civil Procedure §580b]
The lender’s risk of a deficiency in value
The anti-deficiency laws, first enacted during the Great Depression of the 1930s, were designed to protect individuals who lose their homes in foreclosure from being subjected to personal liability for any deficiency in the value of the home to cover the balance due on the mortgage.
In the late 1920s, the economy was booming. Real estate prices were high and rising, and real estate prices and public confidence in the future were even higher, not unlike the giddy early 2000s.
However, the economy in the 1930s devolved into a depression which, due in part to the abrasive foreclosure practices of lenders and carryback sellers (as well as a penurious, moral-stricken Federal Reserve), further devastated values in the real estate market.
For example, a lender holds a note which evidences a debt secured by a trust deed on the borrower’s principal residence (one-to-four units) that was purchased by the loan funds advanced by the lender. The note and trust deed lien held by the lender is generally called a mortgage.
The homebuyer stops making monthly payments on the loan, which is a default on the trust deed. The lender forecloses by a trustee’s sale and recovers the property by entering a credit bid for less than the dollar amount due on the loan, called an underbid.
Prior to the mid-1930s, the lender would then be able to sue the borrower and obtain a money judgment for the unpaid principal balance, the difference between the amount of the underbid and the amount due on the loan. Also, the money judgment was awarded without regard for the FMV of the real estate at the time of the foreclosure sale.
On payment of the money judgment, the homebuyer would not be entitled to recover the property. Foreclosure by a trustee’s sale barred any later redemption or recovery of the real estate by the wiped-out homebuyer.
Thus, in addition to losing the secured real estate, the homebuyer or investor would also remain burdened with the responsibility of paying off the balance of a debt he incurred to buy the property which he now no longer owns.
This scenario of the Great Depression, allowing the lender to acquire the secured property on an underbid at a trustee’s sale and also obtain a deficiency judgment against the borrower for any remaining balance owed on the note, came to an end in California in the late-1930s. Mortgage lenders in California soon learned to factor the risk of loss on default into the interest rates they charged on 30-year fixed rate loans.
Purchase-money debts are not personal loans
To curb the negative impact that the dramatic increase in the number of foreclosure sales and the resulting money judgments and displacement of owners were having on California’s economy, the state legislature in the mid-1930s enacted anti-deficiency laws which included:
- a prohibition against money judgments being obtained by lenders and carryback sellers for any deficiency in the value of the secured property on foreclosure by limiting their recovery on the loan to the value of the secured property when the debt was a purchase-money debt comprising:
- a carryback note on the sale of any type of property when the debt is secured solely by the property sold; or
- the purchase-assist funding of a one-to-four unit residential property occupied by the buyer. [CCP 580b]; and
- a bar against any creditor secured by any type of real estate from obtaining a money judgment for a deficiency after completing a trustee’s sale. [CCP §580d]
Even if the property has insufficient value to satisfy the balance of the purchase-money debt on foreclosure, the lender cannot hold the original borrower, or an assuming buyer, personally liable for any deficiency in the property value, unless:
- the owner inflicts waste on the property; and
- the lender underbids to provide for the judicial recovery of the dollar amount of the waste.
A trust deed lender on a default in a purchase-money debt may only resort to a foreclosure of the property to recover the balance due. This contractual condition establishes the put option held by the owner to default (to exercise the option) and force the lender to take the property in exchange for the amount owned on the loan. [CCP §580b]
On the take-over of a purchase-money note and trust deed by an investor on his purchase of property encumbered by the trust deed, the debt retains its original nonrecourse purchase-money characteristics, regardless of whether the investor takes title subject-to or assumes the debt, or a novation (release of liability) occurs.[Jackson v. Taylor (1969) 272 CA2d 1]
An investor who buys property and takes over a purchase-money debt under any procedure is entitled to the anti-deficiency protection imbedded in the note and trust deed. Thus, purchase-money debts are tied exclusively to the property, never a person.
Marketplace drop in property value
The value of the real estate securing a purchase-money note may become inadequate to cover the debt due to a drop in real estate values brought about by a local or general economic downturn, which follows a virtuous cycle of inflated real estate prices.
Here, anti-deficiency laws are intended to ensure that an economic downturn is not aggravated beyond the usual cyclical increase in foreclosure sales. Thus, to avoid the vicious deepening of a recession into a depression, and as a matter of public policy, the homebuyer taking out a purchase assist loan as well as any buyer of real estate on an installment plan are not personally liable for their purchase-money debts. [Roseleaf Corporation v. Chierighino (1963) 59 C2d 35]
Consider a seller who carries back two notes on the sale of a single parcel of real estate after a 5% down payment. Each note evidences separate amounts of debt owed the seller, totaling 95% of the property’s total sales price. One note in an amount equal to 80% of the sales price is secured by a trust deed on the property sold. The other note for 15% of the sales price is secured by a trust deed on other property owned by the buyer. The notes are not cross collateralized and a default on one note does not constitute a default on the other under the dragnet clause in the trust deeds.
The buyer defaults on both notes.
The seller completes a foreclosure sale under the trust deed secured by the property he sold to the buyer. A judicial foreclosure is then initiated against the buyer’s other property under the separate note and trust deed in an effort to recover what will be a deficiency in the other property’s value to cover the amount due on the separate note at the time of the judicial foreclose sale.
The buyer claims the foreclosure on his other property violates anti-deficiency law since the second foreclosure is an attempt to recover a money judgment for a portion of the price paid for property the seller has already recovered by a trustee’s sale and the buyer no longer owns and cannot redeem.
Can the seller foreclose on the buyer’s other property which is security for the separate debt?
Yes! The foreclosure on the other property does not violate anti-deficiency law. A carryback debt secured by a property other than the property sold is not subject to anti-deficiency law. [Hodges v. Mark (1996) 49 CA4th 651]
In this example, the buyer providing a lien on property other than (or in addition to) the property purchased as security for the seller’s carryback note and trust deed should consider negotiating the inclusion of an exculpatory clause in the note when entering into a purchase agreement with the seller. An exculpatory clause converts recourse paper into nonrecourse paper by eliminating personal liability for a deficiency in the value of the secured property to cover the principal owed the seller. [See first tuesday Form 154 §4.4]
Waiver prohibited on forebearance
Consider a seller who carries back a note secured by a second trust deed on a property he sold. The debt evidenced by the note is classified as a purchase-money debt, sometimes called purchase-money paper. Later, during a real estate recession, the buyer of the property defaults and is unable to sell the property for a price sufficient to pay off the note. The seller commences foreclosure by recording a notice of default (NOD).
Prior to the trustee’s sale, the buyer and seller modify the note to include a provision stating the buyer waives his anti-deficiency protection in exchange for the seller canceling the NOD and reinstating the note, called a forebearance.
Ultimately, the first trust deed holder forecloses, wiping out the seller’s second trust deed. The carryback seller now seeks to recover a money judgment for the amount owed him on the note since his security interest in the property established by the trust deed lien has been exhausted by the first trust deed lienholder’s foreclosure and no longer exists.
The buyer claims the seller is barred from any recovery on the note since enforcement of the debt evidenced by the carryback note is subject to anti-deficiency defenses which cannot, as a matter of public policy, be waived.
The seller claims the buyer waived his anti-deficiency protection under the waiver provision in the written modification of the trust deed note given the seller in exchange for the seller’s forbearance of foreclosure by canceling the NOD and reinstating the note.
Can the seller recover on the carryback debt based on the modification and waiver agreement?
No! Recovery on the modified note which evidences a carryback debt and is secured only by the property sold is barred by anti-deficiency rules, even though the buyer waived his anti-deficiency protection. Any waiver of anti-deficiency protection by the buyer while the debt remains secured solely by the property sold is unenforceable since it is against public policy. [DeBerard Properties, Ltd. v. Lim (1999) 20 C4th 659; CCP §580d]
Deficiency judgments and redemption
The public policy objective behind anti-deficiency legislation is to protect property owners and dissipate the “debtor’s prison” aura which would otherwise surround defaulting owners since they would both lose their property and be subject to a money judgment, a situation called a recourse note. [Palm v. Schilling (1988) 199 CA3d 63]
A lender holding a recourse note can foreclose judicially and obtain a money judgment if the fair market value of the secured property at the time of the foreclosure sale falls below the amount of the debt, called a deficiency. However, the borrower has the right to redeem the property within one year after the judicial foreclosure sale by paying the amount of the bid (plus interest) when a money judgment for any deficiency is obtained by the lender. The judgment, being a separate debt, would remain to be paid. [CCP §729.030]
As a consequence of setting the fair market value and allowing for the one-year redemption, 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 after the foreclosure sale, as well as the risk of not being able to recover the separate money award.
Thus, a trust deed lender holding a recourse (or nonrecourse) note can foreclose quickly and inexpensively through the trustee’s sale procedure. The 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 lender’s beneficial right to a swift foreclosure by use of a trustee’s sale, the lender is barred from obtaining a deficiency judgment after foreclosing nonjudicially (by trustee’s sale) on the property. While an owner has no right to redeem the property after a trustee’s sale, he does have the right inherent in a deficiency judgment to redeem the property after completion of a judicial foreclosure sale. [CCP §580d]
Exceptions to anti-deficiency provisions
Consider an investor who takes title to property subject to (or assumes) an existing home equity loan, a recourse (liability) loan. The loan proceeds were not used to purchase or improve the seller’s residence.
The investor defaults on the loan and the lender initiates and completes a judicial foreclosure (not a trustee’s sale) on the property. The fair market value of the property at the time of the judicial foreclosure sale is insufficient to fully satisfy the loan, resulting in a deficiency.
The lender now seeks a money judgment against the seller for the amount of the deficiency in the property’s value since the fair market value at the time of the judicial foreclosure sale did not fully satisfy the loan amount. The seller claims he is not responsible for the loan since it was taken over by the investor.
Is the seller liable for the deficiency on the recourse loan after the investor takes title to the secured property subject to (or by assuming) the existing loan?
Yes! When property is sold and its title is conveyed to a buyer subject-to (or by assuming) an existing recourse loan, the seller remains liable for any deficiency on the recourse loan should the buyer fail to pay. [Braun v. Crew (1920) 183 C 728]
Further, unless the buyer enters into an assumption agreement with either the seller or the lender, the buyer also is not liable to either the seller or the lender for a drop in the property’s value below the loan balance (unless the buyer damages the property resulting in a decrease in its value, called waste). [Cornelison v. Kornbluth (1975) 15 C3d 590; Calif. Civil Code §2929]
However, if the subject-to investor and the lender later enter into an assumption agreement that includes a significant modification of the terms of the recourse loan without the seller’s consent, the seller cannot be held liable for the loan. [Braun, supra; CC §2819]
In addition, the Federal Housing Administration (FHA) and the Veterans Administration (VA) have recourse to the borrower for losses under their mortgage insurance programs on a foreclosure and resale of the property.
The guarantor is not protected
Whether called a “co-signer”, “surety”, or “guarantor”, individuals contracting as such are not protected by the anti-deficiency status of the buyer’s nonrecourse debt. The statutory purchase money protection is extended only to buyers who sign both the purchase-money note and trust deed.
A co-signor or guarantor is someone other than the buyer. A guarantor promises to pay the buyer’s purchase-money debt, but enters into a separate agreement which is not part of the note and trust deed signed by the buyer. Accordingly, the guarantor has no basis for claiming anti-deficiency protection since he is not the buyer.
Since guarantors are not protected by anti-deficiency laws, guarantors are exposed to liability for any loss suffered by the holder of the nonrecourse note, even when the property owner is not. [CC §2810]
The watering-down of anti-deficiency law
When faced with an economic downturn, such as the 2008-2009 sales depression, homeowners and installment sale buyers need the protection of anti-deficiency laws against claims of lenders and carryback sellers if they are to continue to live in California and contribute to the state’s economy.
However, signs of an erosion of the long-standing public policy behind the anti-deficiency defense against excess lending on secured debt can be seen in the California legislation which was passed to benefit lenders and carryback sellers in 1994, as well as changes in the federal bankruptcy law in 2005 adverse to owners (and, ironically, mortgage lenders).
Lenders are very good at lending too much money and then lobbying governments to cover for their mistakes, called prioritizing profits and socializing (nationalizing) losses.
Lenders and carryback sellers are now able to circumvent California’s anti-deficiency protection by requiring borrowers and buyers to provide a letter of credit as a condition for originating financing, unless the financing funds or extends credit for the purchase of an buyer-occupied, one-to-four unit residential property. [CCP §§580.5; 580.7]
The lender or carryback seller holding the letter of credit is no longer barred from drawing on the letter of credit after they have completed a trustee’s foreclosure to recover any deficiency due to an underbid. This procedure is quicker and slicker than a judicial foreclosure, which calls for appraisals, a money judgment and pursuit of its collection. Ultimately, under a letter of credit, the borrower is liable for repayment of any amounts drawn by the lender or carryback seller on the letter of credit.
Additionally, a letter of credit has been legislatively re-classified as something it is not. It is no longer legally considered a guarantee or additional security, although the economic function of enforcing a letter of credit has the same economic function as the enforcement of a guarantee or additional security since it is unrelated to the property or the foreclosure process.
Unlike a guarantor, the issuer of a letter of credit, usually a bank, does not receive the same protection a guarantor receives under a guarantee. A guarantor is entitled to a notice of foreclosure and an opportunity to purchase the guaranteed note before the completion of a foreclosure on the property, unless the guarantor waives his right to a notice in writing. [See first tuesday Form 474]
Further, and unlike additional security, a letter of credit can be drawn on by a lender or carryback seller before completing a judicial foreclosure. The draw does not then bar the foreclosure for having enforced collection without first resorting to the secured property, a protection long available to owners called the one-action rule.
Borrowers who are currently protected from the letter of credit device include homebuyers, small-time investor/occupants of one-to-four unit residential properties, and those borrowers who refuse to provide a letter of credit that would allow the lender to draw on it without the borrower’s further approval.
Ironically, the state legislature passed laws diminishing the publicly beneficial effects of the 1930s legislation designed to protect borrowers and create a viable financial environment which would induce borrowers who have gone bust owning real estate to remain in California as contributing residents.
A letter of credit is now legislatively considered a source of payment, not a form of security. The letter is available to be called on by the lender at any time, before and after a foreclosure sale. Thus, a borrower defaulting on any debt secured by real estate (excluding an owner-occupied, one-to-four unit residence) and accompanied by a letter of credit, has lost the much needed protection that anti-deficiency law provides against reckless lending, boomtime mentality and dramatic declines in the value of real estate.
The borrower’s anti-deficiency shield and economic cushion has been diminished by the permissible use of a letter of credit by a mortgage lender, in addition to the lender’s use of a trust deed lien on real estate. The letter now circumvents the right of redemption which follows an award of a money judgment under judicial supervision for any deficiency in the value of the secured property.