How Can a Second Lender Keep a Deficiency Right in a Short Sale?

Question: How Can a Second Lender Keep a Deficiency Right in a Short Sale?

A reader asks: "The first has agreed to the short sale and is forgiving the deficiency. The second is being the stickler by requiring 10% of their original loan to approve the short sale. The first is paying $3000, and I'm on the hook for the rest due at closing. By the way, the second is not forgiving deficiency. I live in a recourse state. I've talked to others who suggest foreclosure, why be out more money if they are still going to come after me? Is there a "best choice" for me in this situation? What happens when the second lender reserves a deficiency right in a short sale?"

Answer: You bring up an interesting yet far too common scenario. It is the second lender in a short sale that can blow the transaction. The worst thing a second lender can do is reject the short sale. The second worst thing a short sale lender can do is to refuse to release the seller from personal liability and reserve the right to pursue a deficiency judgment. In the latter, it almost, but not quite, removes the incentive for a seller to do a short sale.

Why Second Lenders Play Short Sale Hardball

When housing prices fall, many second lenders find they hold a loan without security. Why people continue to pay second lenders under these circumstances is beyond me. It generally makes little sense, apart from adverse credit. If your loan has no equity to serve as security, and your home is underwater with the first mortgage as well, paying down the second doesn't put you ahead.

This is what second lenders don't want you to know. That if you stop paying them, they won't do anything. They won't file foreclosure. The reason they won't file foreclosure is because they have nothing to gain from it. Second lenders don't want your upside-down house. They don't want to make payments on your first loan because paying down the mortgage does not give them equity. There is no incentive for these guys to pursue foreclosure.

It's better for many second lenders to let the first lender foreclose. Then, the first lender has the house and the headaches of property ownership. The second lender has a worthless loan that it can sell or perhaps pursue for collection. Believe it or not, there is a market where worthless loans are sold after a charge-off.

As long as these options exist for a second lender, the second lender is unlikely to fully cooperate in a short sale. That's because the second lender can probably make more money through a foreclosure.

Obviously, in states such as California, with the passage of SB 458, now second lenders have even more reason to want to do a foreclosure over a short sale, providing that second loan is a hard-money loan. Second lenders who hold a purchase money loan in California are often very willing to do a short sale for the opposite reason.

Negotiating with Second Lenders

Since your second lender has indicated how much it will accept to grant the short sale, one of the questions is whether you want to pay it. The amount the second lender wants is not unusual. What is unusual is the fact the lender won't release you. The way I see it, there are only two logical answers to this dilemma:

• Obtain a deficiency release and pay for the release or
• Pay nothing for the release and allow the lender to reserve the right of deficiency

However, the lender is not offering either of those alternatives. The lender wants to have its cake and eat it too. The lender wants you to pay toward its 10% demand and yet refuses to release you after the seller contribution. This does not make sense. The second lender might expect a higher payoff.

Here are a few more options to try:

• It is possible the second lender might agree to the short sale but still reserve the right of deficiency with a lower payoff. Ask the second lender to accept $3,000 from the first and then reserve the right to pursue. Then, you could negotiate with the second lender after the short sale, when they might more agreeable to a steeper discount. Or, you could wait until the lender sells its worthless loan and negotiate with that investor.

• Ask the first lender to pay 6% of the unpaid balance of $6,000 to the second lender. Sometimes the investor guidelines for the first lender will allow this type of payment. Ask the lender to release you from personal liability. If the lender refuses, consider raising your seller contribution so the total amount to the second lender exceeds its 10% demand. There is a point where it becomes profitable for the second lender to release you.

• If the first lender is not contributing toward the buyer's closing costs, ask for a revised short sale approval letter with the first lender paying the buyer 3% toward closing costs. Then ask the buyer to contribute to the second lender. Be sure to confirm with the buyer's lender first that underwriting will accept this type of payment, and get HUD approval from the first lender.

If none of this works, then you might have to consider foreclosure. It does not make sense to pay the second lender and not obtain a release of liability. Either the lender releases you and you pay for the privilege or the lender does not yet you do not pay on the front end. You reserve that money for negotiations on the back end or you don't do the short sale. But everybody needs to make their own decisions.

Please do not construe this to be legal advice and, if you have legal questions, you need to ask a lawyer.

_{At the time of writing, Elizabeth Weintraub, DRE # 00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.}