California to Protect Borrowers from Recourse Mortgages

California is considering a bill that would convert most recourse mortgages into non-recourse loans…meaning that banks would no longer be able to go after borrowers to collect.

Right now in California, “purchase money” loans – loans taken out to purchase the property – are generally non-recourse and secured by the property only. This includes both first and second mortgages. However, if a loan is modified or refinanced, or if a homeowner takes out an additional loan, that loan is then a recourse loan, secured by both the property and the borrower. If a borrower loses the home to foreclosure, or sells it via a short sale and these recourse loans are not paid in full, then the lender has the ability to go after the borrower personally.

So far in this cycle, we haven’t heard too many stories of banks going after borrowers…but that does NOT mean that these borrowers are out of the woods. Banks generally have a full 5 years to collect. Worse for borrowers, many lenders are selling these loans to collections agencies and other distressed-debt investors. They might not bother trying to collect now because the borrower probably has no money…but as soon as borrowers get back on their feet, the collectors will come a-knockin’.

For many, bankruptcy will be the only way out.

Larry Roberts writes:

There may not be much point in going after these people today, but once their circumstances improve after the recession, lenders will come looking for that money, and many borrowers who may have long forgotten the house debt are going to be shocked.

…

The gold in second mortgage debt is in future collections. These loans have little or no value today — which makes them attractive purchases to distressed debt buyers — but these loans may have considerable value in the future as the financial circumstances of debtors improves. California Ponzis are going to be drained for years by these old debts.

Much-Needed Relief

A bill, sponsored by the California Association of Realtors, would offer some protection to borrowers.

The New York Times reports:

The bill that passed the Senate by a lopsided vote of 30 to 4 would protect former homeowners up to the amount of their original loan. For instance, a family that took out a $500,000 mortgage to buy a house and then refinanced and took cash out, swelling their loan to $600,000, would be released from claims on the original sum but remain vulnerable on the $100,000.

Ellen M. Corbett, the Democratic state senator from San Leandro, Calif., east of San Francisco, who introduced the measure, said it is a matter of fairness.

During the Depression, she said, California legislators decided that losing your house was punishment enough. They did not want lenders endlessly hounding borrowers for the difference between what they owed and what their former house was worth, an amount called the deficiency.

Seventy-five years later, because of that law, anyone who has an original loan and wants to get rid of the house because it has fallen in value can simply walk away without further legal jeopardy. But a homeowner who refinanced, even for the straightforward reason of getting a lower interest rate, could in theory lose the house and be pursued for the deficiency.

“I don’t believe the original intent was to have a two-tier system, where some were protected and some were not,” Ms. Corbett said.

Bankers, of course, are lobbying hard to fight this bill:

“We’re concerned this could adversely accelerate strategic defaults,” said Rodney K. Brown, chief executive of the California Bankers Association, referring to instances in which borrowers leave their properties without settling with the lender.

Support This Bill

I am in favor of this bill for a three of reasons:

1. It only applies to the purchase money amount. Money borrowed beyond that will still be at risk of collections. This satisfies my moral hazard concerns.

2. Many California homeowners refinanced during last decade, taking advantage of ever-lower interest rates. Advertising was everywhere. In a sick-and-twisted kinda way, refinancing became part of our culture during the boom. And I suspect that very few homeowners understood that refinancing would put them personally at risk in case of default

3. This bill will help with California’s economic recovery. Saddling hundreds of thousands of us will unexpected debt in 3-5 years will only drag out our misery. And for whose benefit? The banks? They are the ones who encouraged everyone to refinance in the first place.

Will It Encourage Defaults?

The Bankers’ claims that this legislation would encourage more defaults are exaggerated. First, most would-be defaulters have no choice. Second, most would-be defaulters aren’t even aware of recourse possibilities anyway. Third, most would-be defaulters who have been holding on, concerned about recourse, will eventually default anyway.

Sure, there will be some who are considering strategic default…and this might nudge them to take action.  But, short-term, I don’t believe this would lead to more defaults then there otherwise would be. And, long-term, less debt means an earlier, stronger, more stable recovery.