The New Face of Loan Defaults: Seller Risks

First trust deeds have always offered seller protection for homeowners in the event of foreclosures. In California, banks can’t collect from borrowers for primary, so-called “first-lien,” loans that go unpaid. When a house is foreclosed or sold through a short sale, the lender of the first loan gets the house back or only the proceeds it can collect from another buyer.

But during the “housing bubble”, banks also made thousands of “second-lien” loans, including those used to finance 20% down payments during the housing boom. A separate category of “seconds” includes home equity loans and home equity lines of credit. Nationally, about 3.4% of those loans are currently delinquent.

Homeowners defaulting on mortgages today may be surprised to learn years from now that they still owe thousands of dollars—and a collection agency is coming after them to get it.

That’s because lenders have been quietly selling second mortgages and home equity lines left unpaid after foreclosures and short sales. The buyers: collection agencies, which in some states have years to make a claim. If they win court judgments, these collectors could have years to pursue borrowers with repayment plans, and even garnish their wages.

Most people are so stressed out and exhausted by trying to save their homes today that they are unaware they could face another hit later. And many who are losing homes don’t get the advice necessary to prevent future fallout.

Owners are generally, but not always, on the hook for the second loans left over from a foreclosure or short sale. Most investor mortgages, too, leave the borrower liable for potential unpaid debt. In many short sales, experienced real estate agents or attorneys can negotiate away debt obligations for the second-lien loan. But many inexperienced borrowers don’t know that, and sign final-hour agreements giving lenders the right to pursue them later.

The phenomenon suggests an ominous, looming echo of today’s real estate meltdown. As debt collectors surely seek at least partial repayment of millions of dollars in unpaid home loans, some say renewed financial stresses on tens of thousands of local consumers could dampen economic recovery.

“The only relief a consumer will have is entering into a debt negotiating plan or filing for bankruptcy,” said Sylvia Alayon, a vice president with the New York-based Consumer Mortgage Audit Center. The firm provides mortgage analysis to lenders, advocacy groups and attorneys. “I think there will be a lot of unhappy people when it hits. We saw this in the ’90s. This is not really new. Just when you think you’re back on your feet, you’re making money and the economy’s good, they hit you with this.”

Tens of thousands of people in California who have this hanging over their heads who don’t even know it. The fear is that a new wave of bankruptcies might flatten people just starting to recover from losing their homes.

Many of these are people with 750 or 800 credit scores who made a bad decision, or they’re people who suffered income cuts. These are people, in terms of the economy, whom we need to participate, build and strengthen it.

But an entire industry is gearing up to buy their debt at deep discounts and collect what they can, Alayon said. “It’s a big business and investors are coming out of the woodwork. It’s a very lucrative business,” she said. Real estate insiders and financial players know it as “scratch and dent.”

The best advice? Seek the advice of a mortgage counselor and your legal advisor. Make sure the language of the short sale offer from bothe the senior and junior lien holders is written to protect your interests, now and in the future.

Government forces are already moving to limit potential damage to millions now struggling with home loans. A new Obama administration short sale program aims to prevent banks that hold second-lien loans from pursuing collections from homeowners after the short sale. It goes into effect April 5, 2010 and works this way: Sellers will receive notice that their servicer has steered part of the sales proceeds to secondary lien holders “in exchange for release and full satisfaction of their liens.” This release would apply only to short sales done through the administration’s Home Affordable Foreclosure Alternatives program.

In California, Democratic state Sen. Ellen Corbett recently introduced SB 1178, which would expand California’s protections for some people who refinance and take on a second mortgage. Still in the early stages of consideration, it must clear both houses of the Legislature and be signed by Gov. Arnold Schwarzenegger by Sept. 30 in order to take effect.

People who refinance, but use the funds to improve their homes or to stay in their homes with a better interest rate, would be protected. Lenders could not seek court judgments to collect from these borrowers in the event of foreclosure or short sales. The bill would apply to all foreclosures or short sales that occur after it becomes law, irrespective of when the loan was made.

“If you refinance a property and aren’t using the money for personal reasons, you shouldn’t lose your personal protections,” said California Association of Realtors lobbyist Alex Creel. He said the idea has been around for years but has become more urgent as thousands lose income and fall into mortgage trouble.