As media coverage has made clear, and as many homeowners have experienced firsthand, there has been an unprecedented number of foreclosures in recent years. The mortgage finance industry has been forced to come to grips with some challenging new realities and complexities before, during and after the foreclosure process. In the midst of a sustained recessionary cycle and a bleak economic landscape, a spike in defaults has forced all parties to rethink previous assumptions and grapple with a host of troubling new challenges. Perhaps the most significant of these challenges is the growing number of deficiencies: instances where there is a difference between what is still owed on the mortgage and what the lender can recoup at auction.
In the past, the process was relatively straightforward. In the aftermath of a home loan default and subsequent foreclosure, the matter was resolved and both the homeowner and the lender parted ways. The former homeowner could then move on, and the property that had been foreclosed upon would be readied for sale so that the lender could recoup its loss.
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Unfortunately, for all parties, recouping that loss can be an unrealistic dream in today's shaky housing market. In the past, the current value of a home was what had been owed on the mortgage or was at least in the proximate range. However, in the last several years, that dynamic has changed. As a result of falling home values, there are more and more instances where the fair market value of a home at sale is not enough to cover the remaining amount left on the mortgage. This has created a deficiency that is owed on the obligation, for which the homeowners are generally liable. The deficiency amount is deduced from a state-specific calculation that takes the total debt owed and the amount bid at sale to determine the amount that may still be owed. The dilemma that most lenders now face is how to handle these deficiencies.
First and foremost, lenders and servicers need to familiarize themselves with the legal landscape before making any decisions. It is critical for the lender to understand the laws governing deficiency matters for each state in which it may choose to pursue an action. In fact, not every state allows an action on the deficiency. States that do allow an action to be brought each have their own laws that govern the timing of the action, as well as what steps can be taken to enforce the action.
While a lender's decision whether to pursue an action (and if so, how aggressively) will be based on individual internal policies and circumstances that vary from state to state and even from case to case, there are some consistent priorities that every lender needs to consider. Perhaps most important is the legal and professional responsibility to protect the interests of clients and investors, but it is also wise to weigh the impact of deficiency actions in the media and in the court of public opinion. Perhaps the best solution is to work to educate and inform borrowers before, during and after the foreclosure process to help them understand their options and make informed decisions in the event of a potential default.
Unfortunately, for many homeowners who might not understand the full implications of a deficiency, it may seem like one of those options is to simply walk away. As Patrick Newport, an economist with IHS Global Insight, stated in a recent article in USA Today, ‘There's a lot of incentive for people to walk away.’ While this may be an understandable impulse for a homeowner who feels helpless and frustrated, it is vital that homeowners fully understand the potential consequences of such an action. Walking away in the face of a deficiency can leave a defaulting homeowner exposed to further liability and legal action, essentially making a bad situation worse.
A lawsuit can be filed to enforce the action, and depending on where the deficiency has occurred, there are various legal remedies available to enforce collection if a judgment is obtained. These enforcement remedies can be garnishment of wages or bank accounts. There are also some states where a judgment lien can be placed on any subsequent real property the borrower may purchase. And some states allow a writ of seizure to be filed with a court that allows personal items of the homeowner to be picked up by a court officer and sold at a public sale in an attempt to satisfy the judgment obligation.
Another common response is to declare bankruptcy. Once a lender reaches out to the borrower for repayment of the obligation and the borrower understands that he or she may still be liable for a significant amount of money, the decision to file bankruptcy may seem like the only remaining option. Bankruptcy is not a decision to be taken lightly, however. Filing for bankruptcy can have serious financial and personal consequences and should truly be a last resort.
A far better option for all parties is to work together to achieve a mutually acceptable resolution. In those states that allow legal action on a deficiency, it is standard practice for the lender to reach out to the borrower for a resolution of the outstanding balance before filing suit or taking other legal action. Lenders can help themselves not only by providing clear and consistent information, but by engaging homeowners with tact and sensitivity to help foster a more collaborative and constructive negotiation. It can be a shock for homeowners who have gone through the foreclosure process and have moved out of the house to discover that they are responsible for a potentially significant financial obligation as the result of a deficiency. After all, they do not live in the house anymore, and it was worth less than what they paid for it, so why should they still be legally obligated on the note? The fact that this is a relatively new and not particularly well-publicized problem only adds to the confusion. In the past, a foreclosure sale deficiency was almost unheard of, and the notion of a lender going after a homeowner once the foreclosure process was final seems counterintuitive to the average homeowner.
While the best-case-scenario goal should be an acceptable resolution that benefits all parties, even the best intentions may come up short. Ultimately, if there is no resolution reached between the homeowner and servicer with regards to the repayment of the debt created by the deficiency, legal remedies may be the only remaining option. The more lenders can work with homeowners, however, to help them understand their options in the event of a default and subsequent foreclosure and to appreciate the potentially significant financial penalties and legal ramifications that may result, the better the odds that a foreclosure can be avoided in the first place. The hope is that a concerted good-faith effort on the part of responsible lenders to inform homeowners of their rights and responsibilities in the event of a deficiency will go a long way to reducing the amount of ‘strategic foreclosures’ and ‘casual’ bankruptcies. If homeowners are better able to make an accurate assessment of all the factors involved in the decision, perhaps more of them would be convinced that staying in their home is the best thing for them over the long term.
Going forward, it is encouraging to note that current data shows that there are fewer bad loans being made. Lenders have tightened their standards, and, as a result, the loans that are being processed now are of a better quality. Along with more encouraging mid- to long-term economic data, there is reason to believe that defaults can reasonably be expected to fall. But that only addresses the problem of deficiencies going forward. In the meantime, current loan modification programs present a good opportunity for a resolution to be reached. Data from HOPE NOW, an alliance of mortgage servicers, investors and other industry professionals, shows that there was an increase of 42% in the number of homeowners getting a modification in 2010 as compared to 2009.
With home prices continuing to fall and the near-term economic future seemingly looking less and less robust with each passing day, this is not an issue that is going away any time soon. It seems likely that, in the immediate future at least, the number of deficiencies will continue to rise. As the practice of placing a specified bid at the foreclosure sale becomes more commonplace, servicers need to implement internal strategic guidelines of how to proceed in the event of a deficiency. The people, processes and policies surrounding the foreclosure process will need to adapt to an evolving industry and a volatile and uncertain marketplace.
Doreen Hoffman serves as the supervising attorney of recovery services for Trott & Trott PC, a Farmington Hills, Mich.-based law firm serving the mortgage banking industry. She can be reached at dhoffman@trottlaw.com.