Dollars and Sense: Deficiency in a Short Sale

The news remains ugly.  Foreclosures are still the topic of the day, although now we're focused on "short sales."  But the underlying question is the same: The house is worth less than the debt.  What should we do?

There are two main paths that most people are able to choose from: foreclosure or short sale.

"Foreclosure" has two paths within it as well: judicial and non-judicial. A "judicial foreclosure" is simply a breach of contract case brought in the court system (thus the "judicial" in "judicial foreclosure").  The bank sues a borrower for breach (the failure to pay) and gets a judgment.  The judgment is collectible by first selling the house through a Sheriff's sale, and then going after the balance (presuming the house sale isn't enough to pay off the judgment amount) by attaching and selling everything else the borrower owns that the bank can get a hold on.  This balance is what everyone refers to as the "deficiency judgment."

The good news for the bank is that it can seek other assets beyond the property to satisfy the debt.  The bad news is that it costs a LOT to get that benefit.  

A judicial foreclosure can take 18-24 months, and cost $75,000 in attorney fees.  Oh, and after the house is sold by the Sheriff, the borrower has up to one year to buy it back from the bank.  Yup, one year. So, a bank has to know it will be holding onto that property for 2.5-3 years before it can sell it as an REO asset.  The deficiency amount better be worth it.

A "non-judicial" foreclosure is just what it sounds like, a foreclosure that does not include the courts (thus the "non-" in "non-judicial"). The California Legislature set up a system to make the recapture of the loan collateral (i.e., the house) a more simple, faster, and less expensive process.   In a non-judicial foreclosure, the bank issues a Notice of Default; then three months later, a Notice of Sale, then one month later, holds a Trustee's sale.

The Trustee's sale is what we all think of, and call, a foreclosure sale.  At the end of the day, either the bank or some bidder is now the proud owner of the property.  No deficiency is allowed on a Trustee's sale (at least on the note foreclosed upon).The wrinkle in a non-judicial foreclosure is what happens if there are two loans.   If the first position loan (the one recorded first in time) forecloses, the second (or third, or fourth or tenth...) is "wiped out." Well, almost.

Remember that there are two parts to a loan (generally): a note and a deed of trust.  Think of the note as an IOU.  Think of the deed of trust as collateral.

A non-judicial foreclosure wipes out the collateral, but not the underlying note.  So, in some circumstances, the bank holding that second, or third loan, can still come after a borrower for the balance of the loan.  But, since the first lender has already sold the property, that second (or third) can't go after the collateral.  That bank is called a "sold out junior creditor" and can bring a lawsuit for breach of contract.  The bank can get a judgment and collect on whatever other assets it can find.  (In some cases, a junior creditor is better off being "sold out" - that way it is not limited to the shrinking value of the real estate!)

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If the first lender doesn't get enough from the non-judicial foreclosure sale to pay off the entire debt, that's just too bad.  Unlike the second (or third) lender, the foreclosing lender doesn't get to both non-judicially foreclose and sue for breach of contract for the unpaid remainder.  That's called California's 'one action' rule.

But wait, there's more!

We live in the Great State of California.  And California has passed certain laws that benefit homeowner/borrowers.

If the loans being foreclosed on were the ones obtained to purchase the property, and the property was a 1-4 unit building, occupied by the buyer/owner/borrower - then the banks are limited to ONLY the property as collateral.  A sold out "purchase money" junior creditor cannot bring that breach of contract claim.  That's California's 'purchase-money, anti-deficiency' rule.

You just gotta love California.

(Don't confuse 'purchase money' with a re-finance loan.  Even if no 'extra' money was taken out of the property when a purchase money loan was re-financed a refi is NOT purchase money.)

Is a short sale the same?  Oh, hell no!

At its most basic, a 'short-sale' is just a modification of the loan contract.  Actually, it is the negotiation of the release of the collateral.  It is NOT a release of the note.

Hmmm.  Sound like a problem brewing?  You betcha!

Most people (i.e., those sub-prime borrowers who probably should have never gotten into those loans in the first place) think that the lender's agreement to a short sale is also the lender's agreement to waive any short fall in loan proceeds.  Not so.