Debtor Friendly Legislation and Unintended Consequences
The 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.