Short Sale Game Changer – For Better or for Worse

Last Friday, California Governor Jerry Brown signed SB 458 into law, requiring any lender that accepts a short sale – in a senior or subordinate lien position – release the borrower from any liability for the deficiency.

Simply put, SB 458 means that the acceptance of a short sale by the senior lien holder and any subordinate liens on the property, will waive whatever balance remained between what was owed on the mortgage and what the property actually sold for.

Often, lenders will request that the borrower contribute towards the deficiency in order for the short sale to be approved. Even in non-deficiency states (such as California) where the senior lien holder typically doesn’t have the right to pursue of the deficiency, the subordinate liens usually do.

Let’s say you have two mortgages – the first for $150k and the second for $20k – and the property sells for $125k. The first lien would get the bulk of the proceeds from the sale, leaving much of the balance paid-off, minus $25k or so (not factoring in costs). They could accept the short sale and agree to release you from the deficiency for the $25k, they can request you pay back a portion of the deficiency or they can request that you pay back all of it.

In non-deficiency states, the first lien usually has two choices – take the home back via foreclosure, or sue for the full amount owed. They can’t typically foreclose AND pursue you. The overwhelming majority of the time, they choose the former.

With second liens, it’s a different story and in most instances, they can pursue for the deficiency – regardless of which state you’re in. Even worse, the sale of the home will only provide a limited amount of cash to the subordinate lien holder(s). Based on the example above, a lender owed $25k might only receive a $3k payoff from the first lien.

Some second liens will agree to “release the lien” only, meaning they’ll take the small payoff, allow the sale to go through, but reserve the right to pursue for the balance down the road.

Others might agree to accept the payoff and request additional funds at closing, however the senior lien can block that – as they often do. A senior lien has little concern for subordinate liens, so it’s not uncommon for them to request that any additional funds that are available go them, not the subordinate liens.

With this legislation, regardless of what’s owed or if the lender has the right to pursue for it, if they accept the short sale, the amount they receive from the transaction will be all that they’re able to collect.

In a deficiency state where both senior AND subordinate liens can usually pursue for the balance, legislation like this could have an even more profound impact.

On the surface, this is a good move. A large number of strategic defaulters – people who can afford their mortgage payment but have decided it’s a bad investment and would rather walk – might re-consider a short sale now, knowing that they won’t be forced to contribute more money in the form of cash payment or promissory note, which are often requirements of lenders.

Further, many people who can barely afford their payment but don’t have the funds to contribute cash at closing (or via a promissory note), could now consider a short sale as well.

Prior to this legislation, we found that many people would take their chances with the lender pursuing them down the road, rather than do a short sale where there is a better than average chance of the lender seeking additional funds from the borrower at closing.

The thinking for many goes: there is no way lenders will be able to pursue everyone that owes money from short sales, so they’d rather run the risk of possibly being pursued for the full amount of the deficiency in the future, over having to almost certainly pay a reduced portion of it today.

A reduced deficiency is nice, but when you don’t have the money to put towards it (as is the case for a lot of people considering a short sale), it really doesn’t help much.

It’s like being offered a Ferrari for $125k, when it usually sells for $250k. Great deal? You bet, but only if you have $125k. Most don’t.

Nevertheless, this legislation is far from perfect and begs the question; does this mean lenders will stop doing short sales? Or, will they cut back on the amount they’re willing to do?

A lender has no legal obligation to consider a short sale – they do it, because it’s in their best business interest to do so. The cost of a foreclosure can cost them tens of thousands of dollars, so a short sale is often the most cost-effective route… if they can pursue for the balance.

If the only proceeds they can now receive are from the sale of the home, especially for subordinate liens, the incentive to consider a short sale is considerably reduced.

Consider the following: If someone has a $10k second mortgage and the first lien offers a pay-off of $2k, that’s not a bad deal when factoring the costs of pursuing the balance. However, if $100k is owed on a second mortgage and the first lien is only offering $2k, I don’t know how quick they’ll be to approve the short sale and walk away from the balance. Remember, the first lien receives the bulk of the funds from the transaction, but subordinate liens receive crumbs.

I like the intention of this legislation, but I’ll be watching with great interest to see how lenders respond…