We're Still in Distress - Foreclosures and Short Sales

According to a recent MPR news story (MPR Story), about half the home sales in Minnesota during 2011 involved short sales or foreclosures. These distressed real estate transactions, which often involve bargain-basement prices, likely were a large component of the market forces that drove down median home prices last year. As of December, home prices were down 12 percent as compared to prices in 2010. Another factor which likely led to this decline is a continuing reluctance of banks to refinance mortgages – which is partly due to increased scrutiny of bank examiners on bank holdings, as well as a general recoiling of lending in general due to unwillingness to accept risks of lending to all but top-tier debtors. Because distressed real estate transactions have become such a major player in the Minnesota real estate market, and in the daily lives of some of our clients, it is critical for the public to be well informed about these real estate transactions. This post will discuss the ABCs of these types of transactions.

Foreclosures & Deficiency Judgments

Minnesota law provides for two routes for a bank to get their money back – foreclose on the property or sue the debtor for money based upon the promissory note. A bank can elect one of these routes, and once completed, the bank cannot further pursue the homeowner.

Foreclosures in Minnesota come in two varieties: 1) foreclosure by action, where the bank starts a lawsuit against the homeowner, and 2) foreclosure by advertisement, where the bank gives notice of the foreclosure in the newspaper. The most common type of foreclosure is through advertisement because it is much cheaper for the bank, and is usually less time consuming. However, foreclosure by advertisement has also drawn the ire of many critics because there have been instances of banks foreclosing on houses when they lack the proper documentation supporting their loans - something that would be more obvious in a court setting. Advertisement actions, though, do have a major benefits to homeowners - the bank holding the first mortgage cannot pursue the homeowner for the deficiency balance - the amount of money remaining on the loan after deducting the market value of the house.

In foreclosure by action, however, the bank can pursue the homeowner for right to possess the house, as well as for any deficiency balance on the loan. For example, if the homeowner owed $200,000 on the mortgage, and the house was only worth $160,000, the bank could seek the right to the property, as well as a judgment of $40,000 against the homeowner.

The final wrinkle in the legal puzzle is the ability of mortgage holders (mortgagees), like banks, to seek a money judgment against the homeowner (mortgagor), based upon the promissory note. This is less common than a foreclosure, but often occurs with second mortgages. That is because a second mortgage holder only gets paid on the mortgage note in a foreclosure once the first mortgage is fully paid. In an underwater home situation – where the value of the house is less than the amount remaining on the loan – the second mortgage holder wouldn't get $1 in the foreclosure sale. Therefore they elect to sue on the promissory note instead of going into the foreclosure process.

Short Sales

Short sales are essentially an agreement between a distressed homeowner and their mortgage lender where the homeowner sells the house to a buyer for less than the amount remaining on their loan, and the bank agrees not to seek the remainder (deficiency) from the homeowner. If a homeowner gets overextended and can't continue to pay their mortgage, but otherwise has good credit, a short sale may be a good way to get back into a sound economic position. The key to the short sale is securing the agreement of the bank. Often a bank will not consider a short sale until a homeowner is behind on their payments and the homeowner shows they lack the ability to make ongoing payments. A bank often requests a hardship letter where the debtor explains their dire financial circumstances. Because of the multiple parties involved, and the degree of scrutiny placed on the homeowner, short sales often take many months as well as an experienced realtor and lawyer to help put the whole deal together.

Many Minnesotans are hoping that foreclosures and short sales draw down this year and home prices start to rebound. However, the wake of the economic meltdown will surely continue so hopefully a little knowledge will go a long way.

Written by: Jim Conway, (952) 445-2817