BILL ANALYSIS
SENATE JUDICIARY COMMITTEE
Senator Ellen M. Corbett, Chair
2009-2010 Regular Session
SB 1178 (Corbett)
As Introduced
Hearing Date: March 23, 2010
Fiscal: No
Urgency: No
ADM:jd
SUBJECT
Real Property: Deficiency Judgments
DESCRIPTION
This bill would preserve a borrower's protection from a
deficiency judgment when loans are refinanced, but only to the
extent that the refinance is used to pay debt incurred to
acquire, construct, or substantially improve the real property.
BACKGROUND
California has several anti-deficiency statutes to protect
borrowers in real estate transactions. Those statutes protect
borrowers when their home is sold in foreclosure for an amount
that is less than what they owe on their loan. "A 'deficiency'
is the liability of a borrower to the lender for the amount of
the loan in excess of the value of the real property, as
determined by a judicial foreclosure." (Insolvency Law
Committee, State Bar of California Business Law Section.)
Current law protects residential borrowers against deficiency
liability on their original loan for the purchase of a home,
regardless of the method of foreclosure the lender uses,
judicial or non-judicial. However, under current case law, this
anti-deficiency protection is lost if the original loan is
refinanced. (See Comment 2.) In other words, refinancing
causes a loan to change from "non-recourse" - meaning the
borrower is not liable for any deficiency - to a "recourse" loan
- meaning the borrower may be liable for a deficiency.
Moreover, borrowers are generally unaware that refinancing
eliminates their anti-deficiency protection.
(more)
SB 1178 (Corbett)
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This bill would protect residential borrowers by preserving
existing law's anti-deficiency protection when loans are
refinanced, but only to the extent that the refinance is used to
pay debt incurred to acquire, construct, or substantially
improve the real property.
CHANGES TO EXISTING LAW
Existing law provides, in part, that a secured lender under a
deed of trust or mortgage is prevented, following a judicial
foreclosure, from obtaining a deficiency judgment against the
borrower, but only to the extent that the loan is a purchase
money loan, i.e., the financing is used to acquire the property.
(Code Civ. Proc. Sec. 580b.)
This bill would provide that a loan used to pay all or part of
the purchase price of real property or an estate for years
includes subsequent loans, mortgages, or deeds of trust that
refinance or modify the original loan, but only to the extent
that the subsequent loan was used to pay debt incurred to
acquire, construct, or substantially improve the real property.
COMMENT
1. Stated need for the bill
The author writes:
Most borrowers are generally unaware that refinancing their
home mortgage causes them to lose the anti-deficiency
protection of existing law. That anti-deficiency protection
is important because it protects the borrower under certain
circumstances if the lender forecloses on them. Senate Bill
1178 seeks to narrowly address that issue by preserving the
anti-deficiency protection for borrowers if they choose to
refinance their home for purposes of improvement. Borrowers
who refinance for personal reasons, such as buying a car,
would not be protected.
The sponsor, California Association of Realtors (CAR), also
writes:
It is unfair to subject homeowners to new personal liability
merely because they refinanced the original mortgage.
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Similarly, additional acquisition or improvement debt that
would have had the same treatment in the first note should be
similarly protected. The unfairness is particularly acute in
that almost no borrowers understood the new liability that was
being acquired along with the refinance.
2. This bill would create an exception to the rule set forth in
Wendland that a homeowner who refinances an original loan
loses Section 580b protection against deficiency liability
Code of Civil Procedure Section 580b was originally enacted in
the 1930s, during the Great Depression, as part of a package of
bills intended to protect borrowers in financial transactions
secured by real property. The original bill provided that
vendors holding purchase money trust deeds were barred from
obtaining deficiency judgments. In 1963, the statute was
amended to provide that lenders holding purchase money trust
deeds on owner-occupied residential property were also barred
from obtaining deficiency judgments. As noted above, "purchase
money" is generally understood in the real estate market to mean
any of the financing used to acquire residential property.
In 1976, in Union Bank v. Wendland (1976)54 Cal.App.3d 393,
defendant borrowers executed three promissory notes and deeds of
trust related to their residential property. The defendants
defaulted on the first note and their home was sold. According
to the case, the second deed of trust was executed for purposes
of remodeling the residence. Also according to the case, the
proceeds of the second deed of trust were used to pay and
discharge payments on the second note and the payments were
applied to payments due under the terms of the first note. (54
Cal.App.3d at 397.) Union Bank filed a complaint on the third
note seeking a money judgment.
Defendants asserted that the complaint was barred by the
provisions of Section 580b because it wrongly sought a
deficiency judgment. The court held that a homeowner who
refinances his or her original loan loses Section 580b
protection against deficiency liability. It should be noted
that the court's discussion of Section 580b focused on the
pre-1963 language, which barred vendors, but not lenders, from
obtaining deficiency judgments. The court stated:
Section 580b was drafted to protect purchasers under the
standard purchase money mortgage transactions in which the
vendor of real property retains an interest in the land sold
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to secure payment of part of the purchase price ?.
"Variations on the standard are subject to section 580b only
if they come within the purpose of that section." ?. The loan
transactions with [the refinancing lender] are variations from
the standard that do not come within the purpose of section
580b. Accordingly, when [the homeowner] refinanced the
property ? he lost the purchase money protection afforded by
section 580b. (54 Cal.App.3d at 399-400, citations omitted
and emphasis added.)
This bill would create an exception to the holding in Wendland
by providing that a refinance of an original loan retains the
character of the original loan and is protected under Section
580b against deficiency judgments, but only to the extent that
the refinance is used to pay debt incurred to acquire,
construct, or substantially improve the real property.
3. This bill would preserve a homeowner's protection against a
deficiency judgment when a homeowner refinances a purchase
money loan in order to improve the property and thereby the
value to the lender
Existing law bars a lender from getting a deficiency judgment
against a borrower following a judicial foreclosure if the loan
was a purchase money loan for an owner-occupied dwelling for one
to four families. This bill would preserve that borrower's
protection from a deficiency judgment when the borrower
refinances the original loan, and that refinance is used to pay
debt incurred to acquire, construct, or substantially improve
the home.
The author posits the following reason for enacting SB 1178. As
interest rates dropped many homeowners chose to refinance their
home loans at a lower rate. However, at the same time that
homeowners were refinancing, they were not aware or made aware
that the refinancing would cause them to lose the
anti-deficiency protection on the original loan. This bill
would alleviate that problem by preserving the anti-deficiency
protection to refinancing for purposes of home improvement.
4. Additionally, the sponsor, CAR, asserts three reasons for
preserving a borrower's protection from a deficiency judgment
when a loan is refinanced for purposes of improving the
property
CAR asserts that the same good public policy considerations
underlying Section 580b should apply to the protection of
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refinancing the same debt. Those are that it is a matter of
fairness; anti-deficiency rules help ensure the quality of loan
underwriting; and so-called "cash out" refinances deserve
limited protection.
a. The fairness issue
When a home buyer and a lender enter into a contract for the
purchase of residential property it is with the idea that the
mortgage is a non-recourse loan, and that the lender would
look to the security - the house itself - to make good on the
debt if the borrower cannot. Preserving that protection on
refinances meets the legitimate expectation of borrowers who
likely have no idea they are losing that protection when they
refinance. CAR states that home owners are unaware that a
refinance has exposed them to personal liability and new tax
liability on the note. CAR states, "It would be unfair to
allow a lender, or someone who has purchased a note from a
lender, to pursue the borrower beyond the value of the agreed
upon security."
b. Anti-deficiency rules help ensure the quality of loan
underwriting
CAR asserts that the anti-deficiency rule will give lenders
the incentive to underwrite a refinance loan at least as
carefully as an original purchase money mortgage. According
to CAR, "If lenders are allowed to look beyond the property
actually being taken as security, and make the decision to
lend based upon the borrower's other assets such as other real
estate or personal assets, it erodes their incentive to make
sure that the loan 'pencils out' and has adequate security."
The real estate meltdown, foreclosures, and mortgage defaults
demonstrate the extent of inadequate underwriting. And, as
overextended lenders become desperate to salvage loan
portfolios, those lenders may begin pursuing borrowers through
judicial foreclosures seeking deficiency judgments and through
debt collectors. As noted above, a recent article in the
Sacramento Bee discusses this looming problem of debt
collectors going after defaulting homeowners years after the
default occurred. Senate Bill 1178 is intended to alleviate
this problem to some extent by providing protection to
homeowners who refinance for purposes of home improvement.
c. "Cash Out" refinances deserve limited protection
CAR observes that over the last few years, many refinance
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loans were aggressively marketed with additional "cash out,"
over and above the original loan balance, for home improvement
or consumer expenses. A "cash out" loan takes equity out of
the property, unless it is reinvested in the property. As CAR
notes, "a bona fide home improvement loan actually increases
the borrower's basis in the property and the value securing
the loan." Thus, as a matter of good public policy, a cash
out loan used to improve the property should be protected from
deficiency judgments.
CAR also notes that the federal law exempting mortgage debt
forgiveness from treatment as ordinary income recognizes this
distinction, that is between using cash out funds for a new
roof or room addition, which increases the borrower's tax
basis, versus cash that is taken out for an unrelated reason
such as the purchase of a car. Consistent with that
distinction, SB 1178 would protect additional home equity debt
only if it contributed to the equity by investing in the
property in some manner.
5. Opponents' arguments
Opponents make a number of arguments in opposition to SB 1178.
First, they state that the bill would perpetuate the same
over-leveraging by borrowers that contributed to the existing
mortgage "melt down." CAR argues that over-leveraging was by
lenders, not borrowers, and notes that lenders control the
quality of the loans they make, not borrowers. Problems arise
when lenders market home loans to less than credit worthy
borrowers, and at the same time do an inadequate job of
underwriting those loans. "If a lender can only look to the
value of the home being financed, the lender will be more
careful about the value of the asset." CAR goes on to say that
this same reasoning should apply to refinancing a home loan.
Second, opponents assert that the bill would extend
anti-deficiency protection to refinancing that exceeds the
original loan amount, which would "encourage borrowers to strip
equity from their homes possibly leaving them with debt
exceeding the value of their homes should property values
decline." The sponsor argues that this is incorrect because the
bill would only protect from a deficiency judgment refinancing
used to improve the property and thus its value, which would in
turn enhance the lender's security interest. Under the bill,
lenders will still be making the underwriting decisions as to
whether the creditworthiness of the borrower and the value of
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the property, the security, support the loan.
Third, opponents argue that the bill would encourage borrowers
to strategically default on a loan they have the capacity to pay
because the property has lost value. It is important to note
the reason borrowers are "upside down." It is because everyone,
lenders and borrowers, miscalculated how the real estate market
was going to move, and not because borrowers wanted to take
advantage of anti-deficiency protections and had planned to lose
their homes. And, as between the borrower and the lender, the
lender is in a better position to judge and guard against
potential losses.
CAR responds that "[b]y all accounts, strategic defaults are
relatively rare; judicial foreclosure actions seeking a
deficiency are even rarer. While the threat of a judicial
deficiency action is common, the reality is that almost all
foreclosures still proceed non-judicially." CAR also notes that
it is now common for a lender to require a "reservation of
right" for a deficiency in a short sale, which "creates a
perverse incentive for the borrower to abandon the short sale or
modification in favor of a non-judicial foreclosure."
Fourth, opponents state that it is unclear whether the bill
extends anti-deficiency protection to all proceeds of a
refinance or just the funds used to improve the property. This
argument appears to be directed at the question of "cash out"
financing. The bill is intended to give limited protection to
cash out refinancing, that is to the extent that the money is
used to improve the home and thus its value. To the extent
there is a question as to how to calculate the amount, that
would be a matter of proof in a judicial proceeding.
Fifth, opponents assert that the bill may negatively impact
short sales. This bill does not speak to short sales; it is
intended to protect borrowers from deficiency judgments when
they refinance their loans. CAR notes that, "If the refinance
included additional debt for purposes of improving the home,
that portion of additional debt would be protected" under this
bill. Additionally, CAR notes that it is unclear how many fewer
proposed short sales would be approved or not after this bill.
As has been noted, borrowers are unaware that at the time they
refinance they lose the anti-deficiency protection afforded the
original loan. The bill is intended to bring fairness to
borrowers experiencing judicial foreclosure.
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Support : Center for Responsible Lending
Opposition : California Bankers Association; California Credit
Union League; California Financial Services Association;
California Independent Bankers; California Mortgage Association;
California Mortgage Bankers Association; Securities Industry and
Financial Markets Association
HISTORY
Source : California Association of Realtors
Related Pending Legislation : SB 931 (Ducheny, 2010) would,
among other things, prohibit a deficiency judgment under a note
secured by a first deed of trust or first mortgage in any case
in which the trustor or mortgagor sells the home for less than
the remaining amount of the indebtedness due at the time of the
sale. This bill is currently set for hearing in the Senate
Banking, Finance and Insurance Committee on April 7.
Prior Legislation : None Known
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