Nonrecourse laws provide an exit strategy

The legal obligation requiring an individual to pay their debts is the general rule. Yet some 75 years ago, nonrecourse, anti-deficiency laws were established in California to equalize the lender-debtor relationship, but only when real estate is taken by the lender as security for repayment. Anti-deficiency rules bar a mortgage lender from obtaining a personal money judgment against a homebuyer on a purchase-assist home loan.

The social purpose for California anti-deficiency regulations is to motivate lenders to make only reasonable and prudent loans when they tie their risk of loss on a loan to the value of the real estate. If a nonrecourse mortgage turns out to be imprudently made, it is foreseeable by any lender in California that homeowners will default and the lender by that act of the owner will be forced to take the property by foreclosure.

It is prudent for a homeowner to conclude that his continued ownership of his largest asset (his negative equity home) is a mismanagement of his financial affairs now that its LTV has inverted. He must then consider ridding himself of the property by selling it – just as any investor or businessman would do with any non-performing asset.

A homeowner rids himself of underwater property by merely exercising his put option and preparing to move in about 12 months.

Instead of supporting an inverted asset, the homeowner rids himself of the underwater property by merely exercising his put option and preparing to move in about 12 months – the time it now takes on average for lenders to hold a trustee’s sale after the initial default. The homeowner is then freed to pay substantially less for his family’s shelter, either by paying fair rent for a comparable property or purchasing a similar replacement home – both options producing a monthly expenditure substantially less than the homeowner’s boom-time mortgage payment.

Fighting the negative stigma

The authors of the study note the 162% threshold is notably higher than the 120%-130% LTV threshold previously believed to exist based on anecdotal evidence. This elevated tipping point suggests that many distressed homeowners continue to pay their mortgage – even when it is not to their best financial interest to do so.

This condition is likely due to a lack of information on the part of the homeowner and the heavily stigmatized aura remaining on strategic defaults.  A 2010 housing survey conducted nationally by Fannie Mae concluded nine out of ten Americans believe it is not acceptable for homeowners to stop paying their mortgage if their property is underwater.

However, these individuals are mixing a moral judgment with a business contract. No moral obligation exists in our democracy to pay on any loan, upside-down or otherwise, and no purchase-money lender in California can legally enforce any mythically proclaimed moral obligation.

But what are the personal and family consequences of strategically defaulting?

It is a common belief that after a homeowner suffers a major financial shock — such as a strategic default — it is impossible for him to access new credit during a “penance period” of seemingly unknowable duration. Mortgage lenders (and the media) are quick to note that these items will taint a credit report for up to ten years. The myth holds that this period of self-flagellation and public ridicule must be endured as punishment for the homeowner’s financial miscalculations before he can be given a fresh start – the current equivalent to the archaic debtor’s prison.

However, this is pure fiction and unsupported by facts:

  • 90% of individuals who file for bankruptcy have access to some type of significant credit within just 18 months of their filing; and
  • 75% of individuals who file for bankruptcy even have access to unsecured lines of credit after 18 months – not a very long penance period for renting a home and atoning for a purportedly major financial “sin.”

Foreclosures stay on a homeowner’s credit report file for seven years and initially negatively impact a Fair Issac Company (FICO) credit score between 85-160 points. [For more information on the impact of negative events on a borrower’s FICO score, see the June 2010 first tuesday article, The FICO score delusion.]

However, if a homebuyer keeps his credit clean except for the mortgage default and foreclosure (what happens in a strategic default), his credit score will rebound significantly after as little as two years. In the meanwhile, he must make timely payments on his other obligations, such as auto loans and credit cards, and keep his use of additional credit in check. He will then be eligible for a mortgage with a 10% to 20% down payment after two years. Also, the Federal Housing Administration (FHA) will insure a home loan of up to $729,500 to an employed buyer with a 3.5% down payment who was declared bankrupt a mere two years earlier.

Good will for the agent

This California negative equity homeownership situation provides perceptive real estate agents with the opportunity to engage homeowners in a candid discussion about the options available to reverse course and head towards solvency.

When agents make negative equity homeowners more aware of the equivalent amount of rent a tenant would pay for the occupancy of the homeowner’s residence, as well as the amount of the monthly payment they would be making on a mortgage equal to 94% of their property’s current FMV, more homeowners will walk away. They can rent the identical property next door, so to speak, for a fraction of the cost of owning the property they now occupy, the high-standard “same-house, same-tract” price analysis. This is especially true in California where during the 2000s a larger percentage of the nation’s homeownership population overextended themselves to acquire or refinance housing that has since gone seriously negative.

Part of the homeowner’s education includes the awareness of the “right to remain” in possession rent- free until the foreclosure sale, and then retain possession until service of a three-day notice to vacate. This is just about enough time (12 months) for a negative equity homeowner who strategically defaulted to save up the 20% down payment needed to purchase a comparable home. Little wonder why carryback trust deeds, land sales contracts and all-inclusive trust deeds (AITDs) are becoming more ubiquitous throughout the state.

Brokers and their agents, as the gatekeepers to the public’s entry into real estate ownership, now have an opportunity to help property owners weather the current economic storm by keeping the cost of ownership down.

Agents who assist a homeowner in the LTV analysis will be remembered and appreciated when it comes time for that owner to purchase a new property.

Brokers and agents who assist a property owner to examine his negative equity position on a property will not likely close an escrow with them today, or even within two years due to their assistance. However, those agents who assist the homeowner in the analysis will be remembered and appreciated when it comes time for that owner to purchase a new property after sloughing off the old one (however it is disposed of). Thus, the broker or agent who invests time today educating and assisting the owner of his right to save money, at a time when the savings may be crucial to their survival as a property owner, will yield handsome fees when the pace of property sales picks up again.

Whole neighborhoods are underwater, waiting to be farmed by a broker or agent willing to think about his future income. By investing time and effort now – no money – owners will remember who helped them cut their living costs and significantly lift their standard of living.