Recourse and Judicial versus Non-Judicial Foreclosure

Many are firmly fixed on the idea that making a loan recourse reduces default risk. Here is Greg Mankiw, for example:

How might the feds ensure repayment of these mortgages? One possibility is to make them recourse mortgages (that is, the lender would have recourse to the borrower's other assets, if the borrower defaults and the house value falls below the mortgage principal).

In my experience this is not the case; I've talked about why here. In a nutshell, there are factors far more influential than potential loss of other assets that drive borrower behavior (for example, ability to pay).

Another reason recourse is rarely pursued by lenders is because it is invariably a judicial process. Non-judicial foreclosures through trustee sales are just that – non-judicial, with a fixed time frames, no hearings, and precisely known fees. Once you get attorneys, judges, and even juries involved in a process, both costs and uncertainty escalate dramatically.

This is especially true when judges are on unfamiliar territory. Back in the early 1990’s while working for an income property lender we were in court many times every week getting receivers appointed. Ordinarily this kind of work is allocated within a county to one or two judges, and given any kind of volume the attorneys and judge quickly get on the same page as to what’s expected and what the results would be. However, when the judge normally handling receiverships was on vacation, results were all over the map, because the substitute judge was not familiar with receiverships.

Processes and results also vary wildly between jurisdictions. Receiverships were routine in California, but almost impossible to obtain in Florida. A bankruptcy case which would have been resolved in 6 months in San Diego took 4 years and an appeal to the U.S. Supreme Court to resolve because it started out in Shreveport, Louisiana.

Finally, it is often the case that a lender’s effort to strip the borrower of their assets in addition to seizing the collateral gets a cool reception from judges and juries. From a recent MBA Newslink article:

Terry Hutchens, president of Hutchens, Senter & Britton, Fayetteville, N.C., told participants yesterday at the Mortgage Bankers Association's National Mortgage Servicing Conference and Expo that while lenders or mortgage servicing firms in the past might be given the benefit of the doubt in the event a home foreclosure case went to court, juries and judges in the current unfriendly judicial environment do not feel as inclined to cut mortgage firms or their attorneys any slack whatsoever.

"There has been a climate change," Hutchens said. "The pendulum has swung too far and we are not being treated fairly."

Recourse lending is not a panacea.

“We’re Going to Make a Fortune!” – Why CRE Borrowers Hang On

A reoccurring theme here is that borrowers tend to hang on even though the economics of the deal suggest it would be better to walk away (see, for example, this post). Via Deal Junkie, a MarketWatch interview with a real estate investor explains why better than I could. The money quote is at 2:18 in the interview:

People that take a long term perspective and have a reasonable expectation on their capital are going to make a fortune. Simply, it’s historical. They did it the last time, and they did the last time, and they did it the time before that.

It’s true, the investors who bought distressed assets during previous real estate recessions have ended up making a lot of money. Borrowers hang on until they can’t because the market has come back from previous downturns, and if they can ride out the storm they will be the ones with the fortune. The idea of someone else making money on an asset you used to own is a powerful motivator to persevere.

Single Asset CRE Borrowers: Not a Stupid Idea

The decision by the sponsor of Baywalk, a large retail complex in St. Petersburg, FL, to offer a deed in lieu of foreclosure has attracted some commentary from Traffic Court and Calculated Risk. Here is the full post from CR:

CRE Owner "Walking Away"

by CalculatedRisk on 12/20/2008 10:16:00 AM

From the St. Petersburg Times: BayWalk owner proposes deal to surrender deed, walk away (hat tip Terry)

Hoping to avoid drawn-out foreclosure proceedings, BayWalk owner Fred Bullard said Friday he is negotiating a deal to simply surrender the deed to the downtown entertainment complex and walk away.
Under the proposal, a bank would take control of the retail and restaurant portion of BayWalk and appoint a trustee to run the complex until a suitable buyer is found.

And good luck pursuing him for any penalities:

The technical owner of BayWalk, STP Redevelopment, has no other assets and was created solely to own BayWalk.

As I've noted before, CRE owners are much more willing to just walk away than residential owners.

The fact that STP Redevelopment has no other assets and was created solely to own BayWalk has no bearing on whether or not Mr. Bullard can be pursued. Standard procedure for CRE loans is to have the asset held by a single asset entity (SAE) to ensure the deal is isolated from problems with other assets controlled by the sponsor. For example, if the sponsor controls two projects each held by SAEs, and one becomes insolvent while the other is still solvent, the insolvent SAE files bankruptcy but the lender on the solvent project is not affected. If both assets were held in the same entity, both projects and lenders would be involved in the bankruptcy and the lender on the solvent project risks having it’s debt reorganized as part of the plan to save the insolvent project.

This structure does not necessarily put Mr. Bullard in the clear; the lender may have required guarantees from him or others in connection with the loan. The fact the asset was held in an SAE says nothing about the existence or absence of such obligations.

Whether or not CRE owners are much more willing to walk away than residential owners is a big, juicy topic. At this point, let’s just say I’ve not seen any evidence to support the assertion.

Will Adding Recourse Provisions Improve Loan Performance?

There’s a very thoughtful criticism of Martin Feldman’s proposal to tie recourse provisions to loan modifications at Credit Slips. I think the post's criticism of Feldman's proposal is right on. I would add, I don't think there is any evidence to support the contention recourse loans perform better than non-recourse loans. One place to look for such evidence is loans which have subordinate home equity lines. Those lines are invariably recourse and in theory should perform better, but in fact they don't. The reality is that borrowers tend to pay until they can't, and at that point it doesn't matter if the loan is recourse or not, because there is nothing left to go after. I've written about why that's the case in the income property context here, and I think the logic is the same for home loans.

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.