Conventional wisdom among California homeowners has been that if they go through foreclosure, they will lose their homes, yet be freed from the remaining debt on the mortgage. But that silver lining, distressed borrowers are learning, applies only if they did not previously refinance their loan.
The state Legislature created laws during the Great Depression intended to allow people who lost their homes to get back on their feet. They protected borrowers from being pursued for the difference between what they owed on their mortgage and the decreased value of their former home. But, at a time when refinancing was less common, those laws did not include loans that refinanced the original purchase mortgage - even if it was done only to obtain a lower interest rate.
Now, proposed legislation would extend protections to those foreclosed owners who refinanced their loans. The state Senate approved the new law in June and it was passed by a state Assembly committee Tuesday, but its future is unknown.
State bankers' groups are trying to alter the bill, which was sponsored by the California Association of Realtors, before its final vote this summer. The bankers do not want changes to apply to existing loans, but rather only to future mortgages.
We do not wish for the California Legislature to go in and amend contracts," said Rodney Brown, chief executive of the California Bankers Association. "The banking industry is very supportive of extending these kind of protections, but the idea of breaking a contract between the borrower and the lender is not really consistent with contract law in the U.S. or the way to do business."
The gap between what is owed on a mortgage and the value of a home is known as a deficiency.
As it stands, homeowners who only have an original purchase loan can walk away from their debt obligation and not worry about bill collectors. Their credit might suffer, but their future earnings will not be threatened by debts from their current crisis.
Not so strategic
That has led some owners to pursue so-called strategic defaults, where they have the means to continue paying their mortgage, but choose not to.
In contrast, an owner who refinanced the original loan - whether a strategic defaulter or someone who lost his job and could not pay the monthly mortgage - could be chased down for debts almost indefinitely.
For homeowners in default, the concern is not academic. Real estate lawyers say they increasingly are getting calls from distressed owners who are trying to work with lenders. Many owners are discovering that even if they pursue a short sale - where the bank allows the home to be sold for less than what is owed on the mortgage and ostensibly forgives any remaining debt - they still could be on the hook for the unpaid balance at a later date.
"I'm seeing a significant increase in situations where the lender reserves the right to collect on any shortfalls," said Shannon Jones, a Danville real estate attorney who said she receives several calls a day from people concerned about their liabilities post-foreclosure. "I'm also seeing lenders turn over the outstanding loans to collection companies, who send letters demanding payment."
If the state legislation goes the way the bankers want it to, it could hamper former owners' ability to ever buy a house again and would violate fundamental principles of fairness, according to Alex Creel, senior vice president and chief lobbyist for the California Association of Realtors.
"Our thinking is why should refinancing the loan, and nothing more, result in a loss of protections that you had when you made the loan at the outset," Creel said. "But in California, you lose that protection, and it's not as if the lender tells you about it. But you lose it nonetheless."
Creel points out that the proposed legislation does not protect those who refinanced their loans to get cash, in the form of home equity lines of credit and other second loans. And it shields former homeowners only up to the amount of their original mortgage.
Raising the debt
If an owner obtained a mortgage of $400,000, but then boosted the loan to $500,000 by refinancing for cash, the law would allow him to be billed for the $100,000 difference, he said.
Creel noted that pursuing loan deficiency payments requires going to court and is cumbersome, and therefore not favored by banks. But that does not stop lenders from using the threat of court action as leverage in negotiations over the fate of a property verging on foreclosure.
"We've heard of lenders saying, we're not going to agree to a short sale unless you sign a contract to pay all or some of the deficiency," Creel said. "And it's not a hollow threat because currently, they are entitled to do it."
Creel said lenders have four to six years to obtain a judgment against a borrower, but the judgment is good for 10 years and can be extended another 10 years.
Paul Leonard, director of the California office for the Center for Responsible Lending in Oakland, said the law needs to be changed because there is no express reason for the distinction between those who refinance and those who don't, but the difference has enormous financial implications.
"We feel like it's a fairly arbitrary distinction that is applied to refinanced loans and purchase loans, and we believe that many people did not fully appreciate the potential danger," Leonard said.
