Monday, October 6, 2008

Does Recourse Matter on Income Property Loans?

One of the ideas that occasionally pops up in discussions about the mortgage crisis is that mortgage loan losses are exacerbated by the fact that most mortgage loans are non-recourse (see, for example, The Hidden Put via Over the Counter). Is there any truth to this idea? I don't think so.

Actually, the best answer is, we don't know. To prove the argument we would need to match a pool of non-recourse loans to a similar pool of recourse loans and see how they perform. If anyone has done that for income property loans I'm not aware of it, and if it has I seriously doubt if the pools were matched correctly (for reasons discussed below). Absent actual data, we're left with theories. The theory that recourse matters is compelling, but in my experience does not conform to actual borrower behavior.

To start at the beginning - a nonrecourse loan is a loan secured by collateral under which the lender's ability to collect is limited to the collateral. For example; a lender makes a loan for $1,000,000, the borrower defaults, the lender forecloses on the property and sells it for $800,000. If the loan is nonrecourse, the borrower has no further obligation to the lender. If the loan is recourse, the borrower is still liable to the lender for the deficiency. Typically, the lender obtains a judgment for the deficiency and executes it against the borrower's other assets.

The theory that recourse matters is straightforward. With a nonrecourse mortgage, the borrower has a simple put to the lender; any time the property value drops below the mortgage amount the borrower can walk away. With a recourse loan there is no put, and the borrower has an incentive to pay the whole debt. What's there to argue about?

The first problem with the theory is it does not accurately describe borrower behavior. Many, many borrowers continue to pay their mortgage even when there is no equity in the property. Many, many income property borrowers come out of pocket to pay debt service on properties with no equity and which don't generate enough income to cover expenses. In my experience, the actual norm is, "Borrower's pay their mortgage regardless of property equity and cash flow until it becomes apparent they are going to run out of money (and sometimes longer)."

Why would a borrower continue to spend money on an investment which has no value?

  • The borrower is not fully rational. There are whole sets of cognitive biases which predispose people to overvalue what they own (endowment effect, post-purchase rationalization), continue to do what they've done in the past (status quo bias, sunk cost effects, loss aversion), and expect a positive outcome to their choices (optimism bias, and valence effects). We know these biases exist, and their existence helps explain seemingly irrational borrower behavior.
  • The borrower believes in honoring his or her obligations. That approach may be irrational for an isolated nonrecourse loan, or it might be rational if the borrower is thinking about ability to borrow in the future.
  • The borrower is rational and believes (incorrectly or correctly) that the property still has equity or will have equity in the future. Historically values have always recovered, and it's difficult to predict how long the recovery will take. Anyone who was around during the last significant income property downturn (1990-94) remembers the incredible fortunes that were made by the people who bought distressed real estate at the bottom, and no one wants to be the chump who lost his or her property right before the recovery. Most real estate investors are optimists willing to bet a recovery is just around the corner.

If a borrower will pay his or her mortgage until he or she runs out of resources (and I believe that's the vast majority of borrowers), it doesn't matter if a loan is recourse or nonrecourse. The time of default is the same (when the borrower runs out of resources), and even if the loan is recourse there are no resources for the lender to go after once the borrower exhausts them.

Of course, there are some borrowers who will default before they run out of resources; even if 90% pay until their resources are exhausted, 10% of all defaulting borrowers these days is a big number. What about them? For a variety of reasons, it usually does not make a lot of sense for lenders to go after such borrowers:

  • By definition, these borrowers are not "do the right thing" people (those people pay until they can't). Google "asset protection" and you will get 3.1 million hits, most of which seem to be law firms happy to help debtors avoid their creditors. The set of borrowers who are vulnerable to deficiency judgments are those with assets who are too stupid to protect them. This is a very small subset of all income property borrowers.
  • Lenders rarely get a clean shot at assets which are easy to execute upon. Defaulting borrowers tend to have encumbered assets and fractional ownership interests. Sure, you can execute your judgment against that 3% general partnership interest in that mortgaged strip center, but do you really want it?
  • The deficiency judgment process is usually unpleasant. Historically, mortgage foreclosures were time-consuming judicial proceedings that could take a year or more. Mortgage lenders lobbied, and almost all jurisdictions now provide a relatively quick non-judicial foreclosure mechanism for lenders to get their collateral (New York notably excepted, and there are others). However, if you want a deficiency judgment, you usually still need to go the slow judicial route. Often, part of this proceeding is a determination of collateral value. The borrower gets his appraisal, the lender gets theirs, the judge usually sets the value in the middle.
  • An almost guaranteed effect of seriously pursuing a deficiency judgment is a set of counterclaims from the borrower (lender liability, document deficiencies, etc.). On the one hand, these claims rarely have merit; on the other hand, responding takes time and money, and the downside is substantial.

Back when I was chasing borrowers, our rule of thumb was to subtract our loan amount from what we thought the property was worth, divide by two (on the theory the judge would set the value in the middle), subtract $100K for legal fees, add a year to the process, and weigh that number against the assets the borrower is likely to have which we could execute on. The only times this equation made sense for us was when the loss was severe and the borrower had a non-real estate source of recurring income we could go after (for example, a doctor or dentist). There's some irony there; the default risk for borrowers not fully engaged in real estate is much higher, but they're the best candidates for deficiency judgments.

To bring this full circle, to definitively answer this question you would need to match a pool of similar non-recourse and recourse mortgages and look at default rates and loss recoveries over the life of the pools. If recourse doesn't matter, the recourse pool will have a similar default rate and similar recoveries compared to the non-recourse pool. Given all the factors outlined above, I think that's what a well-designed study would show. But, I don't expect to see such a study, because income property lenders don't have the data to create similar pools. It would not be difficult to create similar pools based on collateral location, type, initial LTV and DSC, etc. However, if you accept the premise that borrower financial capacity is relevant to this question, there's a problem; income property lenders don't capture that data up front, so someone would need to go back through the original underwriting files for each loan. That's not likely to happen.