BILL ANALYSIS SENATE COMMITTEE ON BANKING, FINANCE, AND INSURANCE Senator Ronald Calderon, Chair SB 931 (Ducheny) Hearing Date: April 7, 2010 As March 25, 2010 Fiscal: No Urgency: No SUMMARY Would require the holder of a first mortgage or deed of trust that is secured by residential real property to accept, as full payment, the proceeds of a short sale to which it agrees in writing, and would obligate that note holder to fully discharge the remaining amount of the borrower's indebtedness on the deed of trust or mortgage following the sale. DIGEST Existing law 1. Prohibits a lender from using pursuing a borrower for a deficiency judgment on a purchase money mortgage or deed of trust that is secured by single-family residential real property (Code of Civil Procedure 580b). Note: There is some disagreement among legal professionals about the circumstances under which the purchase money protection provided by CCP 580b applies. However, it is generally believed to provide protection to a purchase money note that becomes the subject of a judicial or nonjudicial foreclosure action or a short sale; 2. Prohibits a lender from pursuing a borrower for a deficiency judgment on a note on which that lender exercised its power of sale through the nonjudicial foreclosure process (Code of Civil Procedure 580d). Note: There is some disagreement among legal professionals about whether this statute additionally applies to notes that become the subject of a judicial foreclosure; 3. Defines a deficiency judgment as a personal judgment against a debtor for a recovery of secured debt, measured by the difference between the debt and the net proceeds received from a foreclosure sale (case law); 4. Defines waste, in the context in which it is used in this bill, SB 931 (Ducheny), Page 2 as any unlawful act or omission, by the tenant or other person in possession of land, that causes a permanent injury to the inheritance, by injuriously affecting the market value of the property. There must be a permanent diminishment or depreciation in the value of the property for waste to have occurred (case law); 5. Prohibits any person whose interest is subject to the lien of a mortgage from performing any act that will substantially impair the mortgagee's security (Civil Code Section 2929). This bill 1. Would provide that no judgment shall be rendered for any deficiency under a note secured by a first deed of trust or first mortgage for a dwelling of not more than four units, in any case in which the trustor or mortgagor (i.e., the borrower) sells the dwelling for less than the remaining amount of the indebtedness due at the time of sale, with the written consent of the holder of the first deed of trust or first mortgage; 2. Would provide that written consent of the holder of the first deed of trust or first mortgage to that short sale would obligate that holder to accept the sale proceeds as full payment, and to fully discharge the remaining amount of the indebtedness on the first mortgage or deed of trust; 3. Would expressly not limit the ability of the holder of a first deed of trust or first mortgage to seek damages or use existing rights and remedies against the trustor or mortgagor or a third party, if the trustor or mortgagor commits fraud, with respect to the sale of, or waste, with respect to, the real property that secures the first deed of trust or first mortgage. COMMENTS 1. Purpose of the bill To ensure that a borrower is no worse off financially after a short sale than after a foreclosure. 2. Background A short sale is a real estate transaction in which a lender allows a borrower to sell his or her home for SB 931 (Ducheny), Page 3 less than the full amount the borrower owes on their mortgage. For example: John owes his mortgage lender $275,000. John's mortgage lender agrees to let John sell his house for $225,000, with the understanding that the lender receives all of the proceeds from the house sale. John avoids foreclosure. John's lender loses out on $50,000 in principal to which it was entitled under the provisions of John's mortgage, but the lender avoids the costs of foreclosure, and has one less bank-owned property on its hands. It is also likely, given the current housing environment, that John's lender nets a greater return through a short sale of the property than the lender would have received, if it had taken back the property through nonjudicial foreclosure and subsequently sold it to a third party. Short sales have begun to increase in popularity among both lenders and borrowers, since California's mortgage troubles first became apparent in early 2007. According to the California Association of Realtors, there were approximately 90,000 short sales in California during 2009, up from only a few thousand in 2008, and a negligible amount in 2007. Some of the advantages of short sales are summarized above. One of the other key advantages: negative equity is wiped out. The new property owner is not saddled with a mortgage worth far more than the house; if the new owner even holds a mortgage (some short sales are paid fully in cash), the size of that mortgage is in line with the fair market value of the property. However, as short sales have become more popular, lenders have become more creative in what they require from borrowers, as a condition of agreeing to the short sale. Several lenders are now requiring borrowers to agree that the lender may pursue them for the difference between the sales price of their home and their unpaid mortgage balance (to agree, in other words, to a sort of hybrid short sale, where the lender temporarily agrees to accept less than the amount they are owed on the mortgage, but reserves the right to pursue that borrower for the full amount at some point in the future). These types of agreements are morally repugnant to some, and are legally questionable in cases where the property being sold secures a purchase-money mortgage. They can also place SB 931 (Ducheny), Page 4 certain borrowers in the unexpected position of being worse off financially, following a short sale, than they would have been if they had simply walked away from their home and let their lender foreclose. An explanation of the logic and mathematics behind these unexpected scenarios is provided below. 3. How Can A Short Sale Be Worse For A Borrower Than A Foreclosure? A quick primer on recourse loans, nonrecourse loans, and deficiency judgments is necessary to answer this question. Four different scenarios then follow, to demonstrate the operation of existing law and the way in which this bill would interact with existing law. California Code of Civil Procedure Section 580b and case law provide that original, purchase money loans are non-recourse . A non-recourse loan is one on which the borrower is not personally liable. If the borrower defaults on a non-recourse loan, the lender can seize the collateral securing the note, but the lender's recovery is limited to the collateral. If the value of the collateral is insufficient to cover the outstanding loan balance, the difference between the value of the collateral and the unpaid principal balance of the loan becomes a loss for the lender. Some borrowers (particularly those who purchased homes during the boom years of the early to mid 2000s) took out both a first mortgage and a second mortgage when they purchased their homes. If both loans were taken out at the time of purchase, both are purchase money loans, and both are considered non-recourse. Refinanced loans are typically recourse in nature (the one exception is a scenario in which the borrower refinances a purchase money loan with the same lender and takes out no additional money, other than money to pay closing costs). Thus, in most cases, if a borrower refinances one or more of their purchase money loans, the refinanced mortgage(s) are considered recourse loans. Recourse loans give the lender the right to pursue a debtor's personal assets, to collect the unpaid principal balance of the loan. California also has what is known as the "one form of action rule," which is found in Section 726(a) of the Code of Civil Procedure. The one form of action rule is complex and SB 931 (Ducheny), Page 5 embodies a variety of related, but distinct rules and principals, all of which have been litigated. However, for purposes of explaining the impact of this bill, the one form of action rule may generally (and simply) be described as follows. Under the one form of action rule, a lender may take only one action to collect on a mortgage or deed of trust. Thus, if a lender chooses to foreclose, that lender may not pursue the borrower in court to collect the difference between the foreclosure price and the loan amount; the lender's "one form of action" was foreclosure. ----------------------------------------------------------------- |Scenario 1 (the problem this bill is attempting to fix): | |Borrower has first deed of trust for $300,000 and second deed of | |trust for $90,000. Both loans are recourse loans, due to a | |refinancing. | ----------------------------------------------------------------- |--------------------------------+--------------------------------| |Foreclosure Scenario: |Short Sale Scenario: Holder of | |Holder of first deed of trust |first deed of trust agrees to a | |forecloses; holder of second |short sale for fair market | |deed of trust takes no action |value of $250,000, but states | |and becomes a sold-out junior |in its approval letter that it | |lienholder. |reserves the right to pursue | | |the borrower for the difference | | |between what the property | | |fetches at sale and the | | |outstanding, unpaid principal | | |balance of the loan. Holder of | | |second deed of trust agrees to | | |the short sale (Note: the | | |holder of the second deed of | | |trust must agree to the short | | |sale, before it may go | | |forward). | |--------------------------------+--------------------------------| |Impact on the borrower: When |Impact on the borrower: The | |the holder of the first deed of |holder of the first deed of | |trust forecloses, it has no |trust may pursue the borrower | |further ability to pursue any |for $50,000 (the difference | |deficiency under the one form |between the $300,000 the | |of action rule. Because the |borrower owes on the note and | |second deed of trust is a |the $250,000 the sale | |recourse loan, the sold out |generates). Because the second | |junior lienholder may pursue |deed of trust is a recourse | SB 931 (Ducheny), Page 6 |the borrower for a deficiency |loan, the sold-out junior | |judgment of $90,000. |lienholder may pursue the | | |borrower for a deficiency | | |judgment of $90,000 | |--------------------------------+--------------------------------| | |Net result: Borrower has | |Net result: Borrower has |$140,000 in personal liability | |$90,000 in personal liability. |and is worse off financially | | |under a short sale. | ----------------------------------------------------------------- ----------------------------------------------------------------- |Scenario 2 (another example of the problem this bill is trying | |to fix): Borrower has first deed of trust for $300,000 and | |second deed of trust for $90,000. Both loans are purchase money | |loans and thus non-recourse. | ----------------------------------------------------------------- |--------------------------------+--------------------------------| |Foreclosure Scenario: |Short Sale Scenario: Holder of | |Holder of first deed of trust |first deed of trust agrees to a | |forecloses. |short sale for fair market | | |value of $250,000, but states | | |in its approval letter that it | | |reserves the right to pursue | | |the borrower for the difference | | |between what the property | | |fetches at sale and the | | |outstanding, unpaid principal | | |balance of the loan. | |--------------------------------+--------------------------------| |Impact on the borrower: When |Impact on the borrower: The | |the holder of the first deed of |holder of the first deed of | |trust forecloses, it has no |trust may attempt to pursue the | |further ability to pursue any |borrower for $50,000 (the | |deficiency under the one form |difference between the $300,000 | |of action rule. The holder of |the borrower owes on the note | |the second deed of trust |and the $250,000 the sale | |becomes a sold-out junior |generates). The question of | |lienholder but lacks any |whether such an action is | |recourse against the borrower, |prohibited by CCP 580b has not | |because the loan is |yet been litigated, and is thus | |non-recourse. |unresolved. The holder of the | | |second deed of trust agrees to | | |the short sale and becomes a | | |sold-out junior lienholder, but | | |lacks any recourse against the | SB 931 (Ducheny), Page 7 | |borrower, because the loan is | | |non-recourse | |--------------------------------+--------------------------------| |Net result: Borrower has $0 in |Net result: Borrower may have | |personal liability. |$50,000 in personal liability | | |and could be worse off under a | | |short sale. | | | | ----------------------------------------------------------------- ----------------------------------------------------------------- |Scenario 3 (how this bill would work, if enacted): Borrower has | |first deed of trust for $300,000 and second deed of trust for | |$90,000. Both loans are recourse loans, due to a refinancing. | ----------------------------------------------------------------- |--------------------------------+--------------------------------| |Foreclosure Scenario: |Short Sale Scenario: Holder of | |Holder of first deed of trust |first deed of trust agrees to a | |forecloses. |short sale for fair market | | |value of $250,000 and must | | |accept that value as full | | |payment. | |--------------------------------+--------------------------------| |Impact on the borrower: When |Impact on the borrower: When | |the holder of the first deed of |the holder of the first deed of | |trust forecloses, it has no |trust agrees in writing to the | |further ability to pursue any |short sale, it has no further | |deficiency under the one form |recourse to pursue any | |of action rule. The holder of |deficiency against the | |the second deed of trust |borrower. The holder of the | |becomes a sold-out junior |second deed of trust becomes a | |lienholder. Because the second |sold-out junior lienholder. | |deed of trust is a recourse |Because the second deed of | |loan, the sold out junior |trust is a recourse loan, the | |lienholder may pursue the |sold-out junior lienholder may | |borrower for a deficiency |pursue the borrower for a | |judgment of $90,000. |deficiency judgment of $90,000 | |--------------------------------+--------------------------------| |Net result: Borrower has |Net result: Borrower has | |$90,000 in personal liability |$90,000 in personal liability | | |and is not worse off after a | | |short sale. | | | | ----------------------------------------------------------------- ----------------------------------------------------------------- SB 931 (Ducheny), Page 8 |Scenario 4 (another example of how this bill would work, if | |enacted): Borrower has first deed of trust for $300,000. The | |loan is a recourse loan, due to a refinancing. | ----------------------------------------------------------------- |--------------------------------+--------------------------------| |Foreclosure Scenario: |Short Sale Scenario: Holder of | |Holder of first deed of trust |first deed of trust agrees to a | |forecloses. |short sale for fair market | | |value of $250,000 and must | | |accept that value as full | | |payment. | |--------------------------------+--------------------------------| |Impact on the borrower: When |Impact on the borrower: When | |the holder of the first deed of |the holder of the first deed of | |trust forecloses, it has no |trust agrees in writing to the | |further ability to pursue any |short sale, it has no further | |deficiency under the one form |recourse to pursue any | |of action rule and CCP 580d. |deficiency against the | | |borrower. | |--------------------------------+--------------------------------| |Net result: Borrower has $0 in |Net result: Borrower has $0 in | |personal liability. |personal liability and is not | | |worse off under a short sale. | | | | ----------------------------------------------------------------- 4. Support The Housing Opportunities Collaborative is supporting this bill, for the reasons stated above. The Collaborative notes that a short sale appears as "settled debt" on a borrower's credit report and helps a homeowner feel like they took responsibility for their mortgage obligation, rather than simply walking away. Yet, for many homeowners (see scenarios above), a short sale can result in greater personal liability than a foreclosure. According to the Housing Opportunities Collaborative, many real estate licensees who assist homeowners with short sales are not fully aware of how the various scenarios work, and some short sellers are likely to be surprised in years to come, when collection agencies and attorneys attempt to collect or obtain judgments corresponding to the personal liability the short sellers incurred. The Housing Opportunities Collaborative asserts that short sales prevent the vacancies that often follow foreclosures, keep the real estate market moving, and save banks millions in foreclosure costs and SB 931 (Ducheny), Page 9 costs associated with REO properties. They also observe that on several occasions, homeowners with non-purchase money loans have been surprised and torn by the financial outcomes that can result from a short sale. After learning of these outcomes, "many decide that a short sale just isn't the smart decision." 5. Opposition None received. 6. Prior and Related Legislation a. SB 1178 (Corbett): Would give certain refinanced loans non-recourse status. Pending on the Senate Floor. POSITIONS Support Housing Opportunities Collaborative Oppose None received Consultant: Eileen Newhall (916) 651-4102