Strategic Defaults

What Happens If You Just Walk Away From Your Mortgage

By Robert J. Mintz

The Scope of the Problem

It’s not surprising that many of the “help” calls to our office deal with the liability issues associated with a potential default on a mortgage loan. Typically, the value of the property is worth substantially less than the loan amount and the issue is what happens if he or she simply stops making the payments. Often, the caller has some savings or other properties with equity and the questions are posed:

• What are the legal consequences if I default on my loan?
• Will I lose all my other assets?”
• Is there any way to protect my savings from a loan default?

According to real estate website Zillow, approximately 11 million homeowners, representing 28% of all mortgaged properties, have negative equity in their home.  While this is particularly true for those who live in Florida, the Southwest and California, where underwater properties account for 40-70% of the total, the problem is only slightly less severe in almost every region of the country.

Many of those with negative equity eventually default on their loan as a result of economic necessity because of a job loss or unexpected medical bills. Increasingly, however, the decision not to pay the mortgage is based on a rational financial strategy. When a comparable property can be purchased or leased at a substantially lower monthly cost, it’s reasonable to expect that many or most property owners will choose to default on their loans and “walk away.” This is known as a “strategic default.”

According to RealtyTrac, about 250,000 homeowners per month are now defaulting on their mortgages and as defaults and foreclosures continue or accelerate, many properties which still have equity will decline in value, moving to or near the underwater point and the cycle of strategic defaults and related price declines are likely to continue unabated.

What Happens If You Default on Your Loan

Foreclosures and Deficiencies

• Although the law differs by state, the general rules are that if there is a default on a mortgage loan, the lender has the right to retake possession through a foreclosure or a trustee sale.
• The amount by which the loan exceeds the value is known as a deficiency and generally the borrower is responsible for this amount plus costs of collection including legal fees and penalties.
• The lender will generally obtain a court judgment for the amount of the deficiency and once the judgment is recorded it acts as a lien against any property or other assets in the name of the defendant.

Collection Against Other Assets

• The lender generally relies on previous financial statements or a procedure known as a Debtor’s Examination, to determine assets available for collection and the location of the assets.
• The lender can use the judgment in a collection action against available (non-exempt) assets of the borrower and can enter this judgment in any other state in order to enforce a collection action. For example, if you live in California and default on a property in Florida, the judgment will initially be entered in Florida. If the lender decides to pursue a collection action in California, to reach existing or future assets there, the Florida judgment will be entered in California and will act as a lien on any California property or assets in your name currently at any point in the future. The length of time that a judgment is valid differs by state.  In California, for example, judgments are enforceable for ten years and can be renewed for an additional ten years.
• Some states do not allow a lender to pursue your personal assets in particular situations. Using California again as an example, for loans made to purchase a residence, the lender’s only remedy is to foreclose on the house. Whatever it’s worth, that’s all the lender gets. But if the original loan was replaced in a refinancing or the loan was used to buy an investment property, rather than a home, then the lender has full access to all available assets to cover any shortfall in the value of the property. These restrictions on collection are known as anti-deficiency statutes.
• In our experience, foreclosure litigation differs substantially from other types of lawsuits because the banks in these cases rarely accept a negotiated settlement.  Although settlements appear to make sense for both parties, in reality, the bank pursuing the foreclosure may have little economic incentive to settle. In most home mortgage cases, the bank is merely the loan servicing agent (LSA) on behalf of the investors who purchased the original mortgage. The bank may have initiated the mortgage but, as you’ve probably heard by now, in most cases the loan was sold, soon after origination, into a mortgage pool and purchased by various investors. The LSA, who is retained to service the loan, is generally permitted to add servicing fees and legal costs to the loan amount and to collect these fees before amounts are returned to the investors. As a result, the LSA is free to drag out the case and run up its’ costs, at the expense of the homeowner and the investors, and often has no interest or incentive to reach a settlement.

Asset Protection Planning

Asset Protection planning to minimize risk associated with a potential deficiency judgment involves consideration of state collection laws and the rules on Fraudulent Transfers. Sound planning should be undertaken at the earliest time if the goal is to shield or insulate assets from a future potential liability risk.

Asset protection planning is often accomplished by holding and shielding valuable properties or other assets from the judgment lien arising from a foreclosure.  Common strategies employ entities such as a variety of trusts or special purpose vehicles with a capital structure appropriate for the particular circumstances of the case. The most basic tenet of litigation is that having substantial and reachable assets, available to satisfy a claim, will encourage aggressive collection and provide the plaintiff’s lawyer with the strongest negotiating leverage. When your personal assets are “in play” as the defendant in a case, and you face the threat of loss, the plaintiff’s bargaining position is very strong.

Conversely, protecting your personal assets from a future liability claim clearly changes the relative bargaining power of each side in the litigation. When your assets are protected from a claim, the plaintiff effectively loses his principal bargaining chip and the case can and should then be settled (or not) based on the true merits of the claim.

As a note of caution, any planning strategy must be discussed with your attorney who is familiar with your particular situation and again, after a thorough consideration of state and federal laws pertaining to Fraudulent Transfers as those laws apply to your circumstances. An understanding of how the law is applied and the practical application of the foreclosure and collection procedures should be useful in developing a sound legal plan for debt payments on properties with little or no equity for the foreseeable future.