Debtor Friendly Legislation and Unintended Consequences

house_for_sale.jpgThe rate of home foreclosures in the current mortgage crisis has not been evenly distributed. Some states — such as Nevada, California, and Florida — have seen many more foreclosures than others, and not simply because some of them are big states. Take California, where in some localities the foreclosure rate has been as high as 25 percent. What gives here? Are California home buyers and mortgage brokers just much more irresponsible than the rest of the nation? Is there some California specific economic shock that accounts for this? I don’t pretend to know the ultimate answers to these questions, but I think that at least part of the blame for California’s high foreclosure rates needs to be laid at the feet of California’s debtor friendly home mortgage law.

According to California Civil Code section 580b:

No deficiency judgment shall lie in any event after a sale of real property or an estate for years therein for failure of the purchaser to complete his or her contract of sale, or under a deed of trust or mortgage given to the vendor to secure payment of the balance of the purchase price of that real property or estate for years therein, or under a deed of trust or mortgage on a dwelling for not more than four families given to a lender to secure repayment of a loan which was in fact used to pay all or part of the purchase price of that dwelling occupied, entirely or in part, by the purchaser.

What this means is that virtually all purchase-money home mortgages in California are non-recourse. In other words, in the event of default the bank can foreclose on the house but cannot come after the debtor personally for repayment of any debts left unsatisfied by the foreclosure sale. The result is that if buyers are left underwater on a loan, owing more than the house is worth, they can walk away from the house without any debt.

Obviously, this means that mortgage lenders in California necessarily bear more of the downside risk for home price fluctuations, and they ought to lend accordingly, demanding larger equity cushions to limit their exposure. (The homeowner, of course, is still left with the upside if prices rise.) Hence, we needn’t shed too many tears for the banks and secondary investors who lost money on the homeowners who left the keys on the kitchen counter and walked away. Likewise, the borrowers have gotten a pretty good deal in that they received large amounts of money that they will not have to repay. Rather the down side of this law, its seems to me, comes from the costs that it imposes on neighbors keep their homes.

A natural effect of the law will be to increase foreclosure rates at the margin. There is less incentives for homeowners to hunkerdown, hang on to their homes and hope for a brighter future. Easier to simply cut your losses and walk away from the house and any future risk associated with it. There is also less of an incentive for homeowners who are leaving to spruce up the house, maximize its value, and sell it themselves. It doesn’t matter — except perhaps to your future credit rating — how far underwater you are on the loan because your personal liability once you leave the house will still be zero. The result will be lots of foreclosure sales in which lenders — who are poorly positioned to transform themselves into real estate brokers — sell off a lot of foreclosed homes for less than they would otherwise realize.

The problem is that the appraised value of a home hinges in large part on the comps. If all of the homes that have sold recently in your neighborhood had been selling cheap, you will have a hard time demanding more if you sell your house. Hence, all of the homeowners who remain on the street with three foreclosure sales take a hit because of those sales. In a neighborhood where the non-recourse law is helping to fuel foreclosure rates as high as 25 percent that can be a very big hit.

There is also the question of foreclosures’ communal costs. I tend to think that foreclosure is providing homeowners with a very important signal, namely that they borrowed too much money and bought too much house. The best thing to do is to heed that signal and get yourself into housing that you can afford. On the other hand, there is real value in having communities with rooted residents, and that is something that home ownership at least potentially can provide. Hence, while I am against the notion that we always need to keep homeowners in their homes and keep the big bad banks from foreclosing, I don’t think that we want a policy that affirmatively encourages foreclosure in the marginal case. Yet that is exactly what California and other non-recourse states are doing.

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10 Responses

  1. In this model, are there costs to home-selling neighbors not offset by the corresponding benefits to home-buyers?

  2. Nate Oman says:

    Good question. It seems to me that it would boil down to whether the costs associated with a bad credit score are sufficiently high to internalize the costs thrown out on neighbors when borrowers make the decision to walk. I doubt that it does. These are going to be borrowers who already have pretty crappy credit scores, scores that no doubt completely went down the toilet in the period immediately prior to their walking away from the house. Accordingly, I doubt that the hit they take on their credit scores is a huge marginal cost for them. (Remember also, that in brute welfare terms most of the gains to the borrowers in unpaid debts are offset by the lenders’ losses.)

  3. This sort of theoretical commentary is agonizingly frustrating. While we have heard all about “jingle mail” in recent months, I have yet to see or hear about one scintilla of empirical evidence that this happens. The hit to one’s credit score from walking away is not at all insignificant in our credit-based economy, so while I don’t doubt that some small subset of mortgage borrowers have just walked away from underwater mortgages, I doubt the impact is anything like your observations (and many less responsible ones elsewhere) imply. At least you put it in terms of “at the margins,” but I suspect the effect is extremely marginal at best.

    Are you aware of any empirical evidence (not unsubstantiated anecdote) that jingle mail is a real phenomenon that occurs in more than a fraction of a percent of all cases in California and other non-recourse states (like AZ)?

  4. Nate Oman says:


    You apparently have a very low agony threshold ;p->

    The empirical point is a a fair one, but even so I think that you would expect the non-recourse provision to increase lender instigated foreclosures as well. Without the ability to get a deficiency judgment the bank’s incentive on marginal loans in a falling market is to call them and foreclose as soon as possible, and lender with a deficiency judgement is exposed to slightly less risk and so many wait on foreclosure a bit longer. Obviously, this too is just an effect at the margin. Still, the non-recourse provisions may well boost foreclosures that are not “jingle mail.” There have been quite a few press reports of folks walking away from houses in California, however, although I have no idea how prevalent the practice is. What we really need is not a big empirical study of jingle mail (although that would be cool), but something that looks at differing regional foreclosure rates, controls for stuff like demographics and local economic trends and to see what effect legal rules have on foreclosure rates. At this point, everything I’ve seen suggests that causation is just too muddy for anyone to be super confident about the impact of any particular cause. That said, I would quite suprised if the non-recourse laws were shown to have no effect on foreclosure rates.

  5. Nate Oman says:

    For one such study suggesting the link between high foreclosure rates and the absence of deficiency judgments see Lawrence D. Jones, “Deficiency Judgments and the Exercise of the Default Option in Home Mortgage Loans, 36 J.L. & Econ. 115 (1993)

  6. Nate Oman says:

    One other point: “Walking away from a house” needn’t literally mean that I send the keys to the bank and move off, i.e. “jingle mail.” I may decide to stop making mortgage payments and live in the house rent free until I get evicted in a foreclosure proceeding. A de jure involuntary mortgage doesn’t mean that there hasn’t been some voluntary exercise of an embedded option by the borrower.

  7. A.J. Sutter says:

    At the risk of being theoretical, let’s consider Chief Judge Traynor’s explanation of the policy of the “one-action rule,” which was originally enacted in the 1930s: “Section 580b places the risk of inadequate security on the purchase money mortgagee. A vendor is thus discouraged from overvaluing the security. Precarious land promotion schemes are discouraged, for the security value of the land gives purchasers a clue as to its true market value. [Citations Omitted.] If inadequacy of the security results, not from overvaluing, but from a decline in property values during a general or local depression, section 580b prevents the aggravation of the downturn that would result if defaulting purchasers were burdened with large personal liability. Section 580b thus serves as a stabilizing factor in land sales.” Roseleaf v. Chierighino, 59 Cal. 2d 35 (Cal. 1963).

    A couple points here: one is that in a bubble, land prices are likely to be overvalued. Second, Traynor, J.’s focus is on the signal to the purchaser at the time of the purchase. The shift, then, to “foreclosure is providing homeowners with a very important signal, namely that they borrowed too much money and bought too much house,” is an interesting one. This shifts the blame onto the victim. (Nate’s advice is also interesting: “The best thing to do is to heed that signal and get yourself into housing that you can afford” — as if this is so easy when the house you’re in is underwater, and credit is tight?)

    The idea that California is wrong to allow non-recourse loans ignores the forces that create bubbles to begin with. It’s not 75-year-old laws like this that create them.

    Nate’s post seems to say that not only should purchasers be victimized by bubbles, overpaying for their homes, but also they should be blamed for “buying too much house” when the market reverses. There’s no doubt that many buyers were stupid. But if I have to choose between buyers and lenders bearing the risks the one-action rule was meant to address, I think it’s appropriate that lenders bear them. They didn’t have to grant the loan to begin with.

    The bigger problem is lenders’ greed, and the ease with which they could package and sell off the loans. If you really want to keep communities together, why not make it more difficult to sell off loans to “arrangers” and others in the securitization food chain? Require lenders to bear the consequences of their decisions more directly, as they used to.

  8. amused says:

    Jason Kilborn has his argument backwards. If someone comes up with a theory, there are two ways to defeat it. First, to show that the theory is internally inconsistent, logically deficient, etc. Second is to show that the theory is rejected by empirical evidence.

    Kilborn does not offer any empirical evidence that rejects Oman’s theory. And he also does not offer any theoretical reasons to think Oman’s theory is wrong. Making some very vague comment about the hit to a credit score is vastly insufficient to defect Oman on theoretical level.

    Since Kilborn specializes in bankruptcy law, and fails to present anything damaging to Oman, I take it, Oman is in a great shape here!

  9. fortknox says:

    Loose credit is sinking the banking ship.

    No longer theory, is it.

    US govt will have to take over loans here for at least a year.

    US govt uses complex transaction reporting systems in some procurement agencies.

    Similar ratings systems are being designed and need implementation to properly assess credit risk.

    Present credit/loan formulas are lacking proper employment/income risk.

    I believe very strongly in statistical surveys and analysis.

  10. Robert F. Salvin says:

    This is purely anecdotal, but in my experience as a bankruptcy lawyer in Pennsylvania, a state where it is difficult for a residential lender to obtain a deficiency judgment (and I’ve never seen one), people find themselves in foreclosure because they are unable to pay their mortgages. I have never seen anyone with the ability to pay decide to turnover the keys just because the house ended up to be a bad investment. The full social, psychological and emotional cost of moving is totally discounted by Omans hypothesis. Oman also makes the unlikely assumption of knowledge on the part of consumers that their financial obligation is non-recourse. My experience says that most consumers assume the opposite.

    Since the holder-in-due-course rule provides immunity to lenders from the fraud in the front end of the transaction that led a consumer to sign on for a loan beyond his means, it is fair to limit the lender to the value of the house without allowing the lender to pile it on when the transaction inevitably goes south.