The new deficiency market

With many foreclosures producing considerable deficiencies–the amount the home sells for at foreclosure being far less than the amount owed—more lenders are suing the foreclosed upon borrowers seeking money toward those deficiencies.

In past years, it hasn’t been worth the trouble, as the legal costs would outweigh the deficiency amounts. “Before, it didn’t make sense [for banks] to expend the resources to go after borrowers; now it doesn’t make sense not to,” Michael Cramer, president and chief executive of Dyck O’Neal Inc., an Arlington, Texas, firm that invests in debt, tells the Wall Street Journal.

It turns out, “$100,000 was roughly the average amount by which foreclosure sales fell short of loan balances in hundreds of foreclosures in seven states reviewed by The Wall Street Journal,” writes Jessica Silver-Greenberg. “And 64% of the 4.5 million foreclosures since the start of 2007 have taken place in states that allow deficiency judgments.”

There are 41 states and the District of Columbia that allow lenders to chase borrowers for deficiencies.

But Silver-Greenberg points out that only in a small percentage of cases do lenders pursue borrowers. She writes,

Public relations is a limiting factor, some debt-buyers believe. Banks are reluctant to discuss their strategies, but some lenders say they are more likely to seek a deficiency judgment if they perceive the borrower to be a “strategic defaulter” who chose to stop paying because the property lost so much value.

As deficiency judgments are considered assets, there is now a secondary market in these judgments, and the judgments may eventually be bundled into packages resembling mortgage-backed securities. Ironic, don’t you think?

However, busted homeowners don’t have much, so the judgments trade for two cents on the dollar writes Silver-Greenberg, a fraction of what credit-card debt trades for.

Some believe this secondary market will unleash a flood of deficiency judgments. Sharon Bock, clerk and comptroller of Palm Beach County, Fla., expects “a massive wave of these cases as banks start selling the judgments to debt collectors.”

Investors are reportedly “ravenous for this debt and ramping up their purchases,” says Jeffrey Shachat, a managing director at Arca Capital Partners LLC, a Palo Alto, Calif., firm that finances distressed-debt deals.

But should they be? State legislators, a few who have likely lost their own homes, can create laws to keep aggressive deficiency pursuers at bay. In hard-hit Nevada, that state’s legislature passed AB 273 this past legislative session. Before this bill passed, like most places, someone buying a debt could collect: a deficiency after foreclosure in the amount of the debt, minus either (i) the fair market value of the property at the time of sale or (ii) the amount of the successful bid at the foreclosure sale (whichever results in the smaller deficiency).

The new legislation changes the rule for,

an assignee which purchased the secured loan from the original lender or an intermediary. It provides that the deficiency which may be recovered by an assignee is limited to the amount of consideration paid by the assignee, minus the fair market value or bid amount. The legislation provides that this change is effective June 10, 2011.

For assignees buying junior loans “its recovery will be limited to the amount of consideration paid for the loan.”

Also, lenders pursuing junior loans that are “sold-out” in the foreclosure process must take action within six months, instead of six years, the previous statute of limitations.

Nevada’s AB 273 addresses loans, not deficiency judgments. But the same logic applies.

Two cents on the dollar may not be such a bargain after all.