Deficient in Deficiencies: The Potential Effects of the Refusal to Uphold Full-Recourse, Residential Real Estate Loans

I. Introduction

Foreclosures have taken on a new significance in the last few years as a result of the financial crisis. This has the led the finer points of the foreclosure proceedings to become extremely important for many lenders, and for many borrowers in default. One potentially important practice is the oft-rumored, but rarely documented routine of certain judges to simply refuse to grant any deficiency judgments in personal foreclosures. Cases have been brought before higher courts across the country, leading to judges being rebuked for ill-advised activism in refusing to properly entertain requests for deficiency judgments. [1] In light of the record number of foreclosures taking place in the last two years [2], a lack of deficiency judgments may prove to have a significant effect on banks and may lead to a change in the practices of many banks. The purpose of this article is to question what effects such a practice is having, and could further have on the residential real estate loan market.

II. Background

Traditional real-estate loans, also known as recourse loans or full-recourse loans, have allowed the lender and mortgagee to seek the enforcement of a deficiency judgment against the borrower. This would be the case where the foreclosure sale was not sufficient to cover the debt. [3] These types of loans afforded the banks a strong probability that the full debt would eventually be collected even if foreclosure were to take place.

Recourse loans exist alongside non-recourse loans which, as the name implies, offer the lender no recourse against the borrower beyond foreclosure of the mortgage instrument. [4] Typically, non-recourse loans offer a higher degree of risk, and therefore carry a higher interest rate to match. [5] The banks run the risk that owners will abandon properties which they can no longer afford in a poor state of upkeep, reducing the value of the home, and therefore the amount the bank will receive out of a foreclosure sale.

III. Analysis

A. How prevalent is the practice of refusing deficiency judgments?

It is unclear how many of judges and courts have been routinely and categorically refusing to grant deficiency judgments, though rumors of such are often heard from those attorneys working in the foreclosure industry. [6] In the past, the need to know and understand the residential foreclosure and deficiency realms was limited due to the relatively low importance of deficiency judgments. This lowered importance was not only due to a smaller number of overall foreclosures. It was also in part because the expenses involved, the insolvent nature of the average defendant, and the low chance of success combine to make seeking deficiency judgments less than cost-effective for the banks. [7] As such, they were low importance considerations. Even more importantly, deficiency judgments are left within the discretion of the judges; this means that the appellate standard would be an abuse of discretion standard. [8] This is a difficult to burden to meet. Due to this burden, it is possible that such cases have never been brought to light in an appellate forum.

In addition to judge activism, there are some compelling legal reasons for why a judge may choose not to grant deficiency judgments in the great majority of cases. [9] Such reasons include the fact that lay persons interpret mortgage loans as being non-recourse and that the lay approach should be the one accepted by the courts. [10] Furthermore, some argue that a mortgage and loan transaction constitutes a contract, which should be interpreted against the drafter, ergo the lender; as such, even the slightest ambiguity with regard to recourse should create a non-recourse loan. [11] Such a result is therefore not necessarily judicial activism, but it is nevertheless counter to the expectations and intuitions of the lenders who loaned money to borrowers under full-recourse conditions. At this time, it is unclear to what extent these practices exist, but the effects can nevertheless be considered.

B. What are the potential effects of this practice?

If a lender believes that a loan once considered to be full recourse is not going to be recoverable beyond foreclosure, they may choose not to offer the loan product anymore. They may also offer an interest rate closer to that of non-recourse loans, since interest rates are determined largely by risk. [12] As such, if the risks of full-recourse and non-recourse loans become near equal, so will their interest rates. This would practically limit the borrower's selection when considering loan products even if full-recourse loan products are not eliminated.

Another alternative that the banks may choose to exercise is to extend non-recourse, “carved-out” loans, often found in the commercial sphere, to the residential real estate world. In recent years, the non-recourse concept has changed significantly from its first iteration, especially in the commercial sector. Specifically, commercial real estate loans now have a growing number of exceptions, often known as “carve outs,” created by the loan documents, giving rise to deficiency judgments. [13] The carve outs therefore allow the lender to minimize the risk it accrues through moral hazard. [14]

For example, in a traditional non-recourse loan, the lender runs the risk that the borrower will abandon or undermaintain an unprofitable property. [15] This would serve to reduce its value and the lender would therefore stand to recover less of the debt. Carve outs solve this problem by delineating situations that render a loan partial- or full-recourse. [16] Such situations include subsequent encumbrances, bankruptcy, or certain types of waste. [17]

This same concept, typically reserved for commercial loans, may well soon be applied to residential loans. If full-recourse loans never lead to deficiency judgments, they amount to little more than non-recourse loans. Non-recourse loans with carve-outs may allow lenders to more easily recover deficiency judgments because they all require a showing of borrower bad behavior. This may lead reluctant judges to become more likely to rule against borrowers who have willingly and intentionally interfered with the lender's ability to recover on the note.

The practice of applying carve-outs to non-recourse, or partial-recourse residential loans is not new per se. Carve-outs have existed in many residential loans for some time but are generally very rare. [18] If full-recourse loans have lost their teeth, it may very well be that these carved loans will become much more common in the coming years.

Not all carve-outs currently used for commercial properties would necessarily be applicable to, or useful for, residential purchase-money mortgages. Of the typical carve-outs identified by authors Portia Morrison and Mark Senn, environmental risk is the particular stand out in this category. [19] Whereas commercial lenders need to be protected from any costs associated with environmental contamination, this need is nearly nonexistant with residential owners because they are not taking part in industrial activities. On the other hand, many other identified carve-outs, such as fraud and sale are very relevant to residential properties. [20] Several questions arise as to some of the carve-outs that would still be possible, but arise out of situations that are not typically default conditions on a residential loan. For example, commercial loans often have a carve-out creating a loss of exculpation for subsequent encumbrances, which can be a default on a commercial loan but is typically not so on a residential loan. [21] Another typical commercial carve-out is bankruptcy. [22] It seems questionable that individuals should be 'punished' in this way for a bankruptcy the way a corporation would be.

This leads to the question as to whether this approach is desirable. Given the recent economic situation, many feel that deficiency judgments against individuals on foreclosures are neither necessary nor desirable but it becomes questionable as to whether a world where recourse is no longer widely available to lenders would be beneficial to homeowners present and future. The availability of certain types of loans could decrease. Furthermore, the interest rates could generally increase on full-recourse loans. Therefore, the needs of today's foreclosed homeowners and the needs of tomorrow's borrowers will need to be balanced carefully.

C. Will the effects necessarily come about?

Many lenders do not pursue deficiency judgments because the borrower is simply unlikely to have any funds from which judgment could be recovered. [23][24] As such, it seems possible that the interest rates and general costs of full-recourse fully encompass this fact. It is possible that, despite the growing importance of foreclosure in loan considerations, deficiency judgments will not have any effect on the behavior of lenders because they have already sufficiently covered for these potential losses by the interest rate schemes present in their current loan products.

IV. Recommendation

The number of mortgage loans in default and of residential foreclosures is increasing significantly as a result of the subprime crisis; for example, 342,038 residential properties were in default or in a foreclosure proceeding in April 2009, for an overall rate of 1 in 374 households, showing a significant increase over 2005 rates. [25] The results are twofold. First, some judges may prove themselves more reluctant to impose deficiency judgments, either through pity or through activism against the banks, thereby increasing the prevalence of this practice. Second, the great amount of foreclosures as a percentage of all home loans means that the amounts lost by lack of deficiency judgments is much more significant to the lenders' bottom line than it used to be. As such, the lenders's practices and product offerings may prove much more sensitive. These factors combine to mean that now is the time to both seek to understand whether this practice is a significant part of the foreclosure world or simply a real estate lawyer's myth, and whether this is having any effect on lending practices. The lack of deficiency judgments may serve to increase interest rates and reduce the variety of loan products available to future borrowers. This fact must be balanced against the interests of homeowners in foreclosure due to subprime loans. The data at this time is simply insufficient to fully understand the situation, and therefore makes it impossible to determine what the exact effects may be. As such, we must study this problem further in order to ascertain the effects of this practice on the residential lending market. We must further question whether these effects are desired or not, and whether it is wise to leave such a practice to the discretion of the individual judges and courts rather than fully deciding the issue through legislation.

V. Conclusion

Given the presence of foreclosures at the forefront of the banking and real estate landscapes, the potential declawing of full-recourse loans is an important consideration. Any systematic refusal to grant deficiency judgments against residential borrowers could have a significant effect on lenders and their practices. In order to proper regulate residential lending practices, it is critical to gain a clear understanding of the extent to which this practice exists. It would also be important to more fully question to what extent lender behavior would be modified by the prevalence of such a practice, and whether this change in lending practices is one that should be welcomed or rebuffed.



[1] See e.g. Am. Gen. Fin. Servs. v. Brown, 658 S.E.2d 99 (S.C. 2008) (confronting a lower court judge who refused to grant any deficiency judgments).

[2] See e.g. Les Christie, August foreclosures hit another high, CNN, (last visited Oct. 27, 2009).

[3] Portia Owen Morrison and Mark A. Senn, Carving up the 'Carve-Outs' in Non-Recourse Loans, 9 Probate & Property 8, 9 (1995).

[4] Id.
[5] Steven W. Bender, Celeste M. Hammond, Michael T. Madison & Robert M. Zinman, Modern Real Esate Finance and Land Transfer, 252 (2008).

[6] Ilyce Glink, Foreclosure Affects Credit But Homeowner May Avoid Deficiency Judgment, (last visited Nov 2, 2009).

[7] Ron Lieber, Thoughts on Walking Away From Your Home Loan, N.Y. Times, Mar. 13 2009, available at .

[8] See e.g. FDIC v. Hy Kom Dev. Co., 603 So. 2d 59, 59-60 (Fla. Dist. Ct. App. 2nd Dist. 1992).

[9] John Mixon, Fannie Mae/Freddie Mac Home Mortgage Documents Interpreted as Nonrecourse Debt, 45 Cal. W. L. Rev. 35 (2008).

[10] Id. at 51.

[11] Id.

[12] Morrison, supra note 3, at 9.

[13] Id.

[14] Id.

[15] Id.

[16] Id.

[17] Id.

[18] Harris Ominsky, Real Estate Lore: Modern Techniques and Everyday Tips for the Practitioner, 93 (2006).

[19] Morrison, supra note 3, at 10-11.

[20] Id.

[21] Id.

[22] Id.

[23] Ilyce R. Glink , Failure to Repay Home-Equity Lines Can Result in Foreclosure, Wall St. J., Oct 17, 2009 available at .

[24] Mixon, supra note 8, at fn 21 (quoting Texas attorneys Michael C. Barrett and Tommy Bastian).

[25] Dan Levy, U.S. Foreclosure Filings Hit Record for Second Month, BLOOMBERG, (Updated May 13, 2009).