A great many of the homes for sale today have more than one loan but there will not be enough sale proceeds to pay them both. That’s a short sale. To bridge this gap, a negotiation takes place whereby the first lender may agree to give some of the sale proceeds to a junior lender, such as a home equity loan, to get them to agree to release their lien. The typical amount given by first lenders to junior lenders is $3,000. But often that is not enough and the junior lenders demand that the Seller contribute more money to them. If they can do this, the seller avoids foreclosure. While this has been a common practice, the rules are now changing with very negative consequences for sellers, lenders, and the real estate community.

Understandably, a first lender wants to get paid in full before any money goes to a junior lender. If the seller has money that they could contribute to share in the loss, the first lender wants that money too. But often, sellers are giving money directly to junior lenders with or without the first lender’s consent or knowledge. And that’s where the problem comes in. Today, nearly 90% of home loans are owned by FNMA, Freddie Mac, and other government sponsored enterprises (GSE’s). These are now demanding that there can be no seller contribution to a junior lender. The only money a junior lender can get in a short sale is what the first lender offers them. Recently, Freddie Mac rejected 3,000 Bank of America short sales where BofA had allowed the sellers to make payments to junior lenders or even to the sale closing costs!

This has now spread throughout the real estate market. Short sales with multiple loans are being killed by first lenders refusing to allow any seller contribution to anyone other than the first lender. And this has led some junior lenders to push sellers to commit mortgage fraud.

A real estate transaction is supposed to be “transparent”. All parts of the deal are to show up on the escrow company’s Closing Statement, the HUD1. However, some junior lenders and some agents have urged sellers to make contributions to junior lenders “outside” of the escrow so they would not show up on the HUD1. While this may get the deal done and avoid foreclosure, participants are committing mortgage fraud by knowingly closing the sale with misrepresentations or omissions on the HUD1. If caught, this is both a Federal and a State crime. While the impacted first lender could invalidate the short sale, the particpants, ie: sellers, buyers, agents, and junior lenders, could all face criminal prosecution.

If you are being pushed to commit mortgage fraud, don’t give in. Contact your lawyer for advice and consider reporting the second lenders to the FBI or your State’s Attorney General. There are alternatives that might still get the deal done. But mortgage fraud is not the solution.

Effective July 15, 2011, California has prohibited Junior Lenders (2nds, HELOCs, etc) from having any deficiency recourse claims against the borrower if the lender agrees to take part in a short sale. Gov. Jerry Brown signed SB 458 (Corbett) into law and it took effect immediately. In January, 2011, SB 931 (2010) was put into effect requiring that any First lender that agrees to a short sale must accept the agreed upon short sale payment as payment in full of the outstanding balance of all loans. But unfortunately, the rule did not apply to junior lien holders. SB 458 extends the protections of SB 931 to junior liens. Both laws only apply to one to four unit residential properties.

Whether this is a victory for sellers and the real estate industry remains to be seen.

California Association of Realtors President Beth L. Peerce stated: “SB 458 brings closure and certainty to the short sale process and ensures that once a lender has agreed to accept a short sale payment on a property, all lienholders – those in first position and in junior positions – will consider the outstanding balance as paid in full and the homeowner will not be held responsible for any additional payments on the property.”

But the real question is whether this will in fact make short sales harder to get done.  For any lender being asked to take the loss of the deficiency in a short sale, their only obligation is to determine whether a short sale will get more money back for their investors than a foreclosure. For first lenders on one to four unit residential properties, short sales are almost always better because: 1) Buyers pay more at a short sale than at a foreclosure sale; and 2) almost all foreclosures of these type of properties in California are done using a Trustee Sale from which there is no deficiency recourse. So for the foreclosing first lender, the short sale will generally bring them more money than a foreclosure. That is not necessarily the case with junior lenders.

In most short sale situations, there is not enough value in the sale proceeds to pay anything to junior lenders. Unless the junior lender made a “purchase money loan” (acquire personal residence), the junior lender has recourse against the borrower if not paid in full. However, unlike the first lender, the junior lender will not foreclose. They will wait for the first lender to foreclose which will wipe-out the security for the junior loan. Once that happens the junior lender can file a lawsuit against the borrower for whatever is owed them and, unless the borrower files Bankruptcy, the lender can collect everything owed to them. This is very different from what pre-existed this law when at least borrowers had some legal defenses against junior lender collections after a short sale. There are few if any defenses to post-foreclosure junior lender collection lawsuits.

One of Murphy’s Laws is called “The Doctrine of Unintended Consequences”. We got into this market collapse as a result of a government policy to promote expansion of home ownership. But this required making loans to people who were less qualified to repay them. This noble Policy drove up demand for homes and that drove up prices…. until borrowers could no longer afford to pay their debts. SB 458 is a similarly good sounding Policy. As much as I hope it does not occur, I fear that the unintended consequence of the passage of this law will be that junior lenders will reject short sales, more homes will go into foreclosure, and the real estate industry will further decline (except for those handling post-foreclosure REO properties). Time will tell whether this is a victory or a disaster.

The information presented in this Article is not to be taken as legal advice. Every person’s situation is different. If you are a real estate professional involved with short sales or in anyway providing communication or advice to upside-down owners, be sure to get competent legal advice in your State immediately before giving any advice.

If you have specific questions about dealing with upside down loans or real estate, feel free to contact us at sjbeede@bpelaw.com. We offer a $200 flat fee attorney consultation to review your situation and help you evaluate and choose the best opportunities. This can be done in person or by phone. If interested, please call us at 916-966-2260.