Historically the process and consequences of HECM foreclosure (and its cousins: short sale, short pay, trustee sale, etc.) have not been taught to reverse mortgage originators. As a result, many in our industry have given it a kind of “Shangri-la” twist. It is as if nothing negative comes of it.
HUD pays off any balance due at termination and all is well. What could go wrong?
This article will look at the harsh realities of HECM foreclosure some HECM originators have been discovering. HECM foreclosure is a process with which far too many are becoming familiar.
The article is not legal advice. As to questions about short pay, foreclosure, short sale, deed in lieu of foreclosure, and similar transactions, originators should advise borrowers to seek the counsel of a competent attorney specializing in such matters and practicing law in the state where the property is located.
No Need to Worry? In mid-2004 the widow of a friend who had passed away a few years before made it known she needed more monthly cash flow. Several mutual friends asked me to help. An acquaintance, who was a well-respected managing partner of the second-largest law firm in Los Angeles County, suggested looking at reverse mortgages even though she knew very little about them.
With little to go on, my inquiries about reverse mortgages began. Months later, despite speaking with several originators and the regional manager of a large lender, HECMs remained as mysterious and exotic as the 10,000 Immortals of Xerxes must have been to the Spartans just before the Battle of Thermopylae. It was as if the products (monthly and annually adjusting) were so novel and distinct, there was literally nothing to compare them with. While HECMs may be mortgages, it sounded as if their special nonrecourse nature (through FHA insurance) and their “tax-free” income proceeds made HECMs unique and incomparable to all other mortgages. HECMs were allegedly both “equity release” and “equity conversion.” By late 2004, they were indeed still very mysterious.
When discussing nonrecourse, most HECM originators were surprised to hear that very few “foreclosures” on recourse mortgages in California result in deficiency judgments. Due to the high costs and the time required to obtain a deficiency judgment when a California recourse mortgage is in default, most note holders forgo their right to a deficiency judgment and elect to have the trustee exercise its power of sale found in the deed of trust. Judicial foreclosure is so rare in California that most real estate attorneys there broadly classify it as a nonrecourse state. Despite explaining that foreclosure of any kind in California generally results in credit dings and income tax consequences, most HECM originators declared that the nonrecourse afforded by FHA insurance eliminated all those concerns.
It was odd how the answers, definitions, and explanations from HECM originators were so consistent. It must be true, right? After emphasizing real estate taxation and real estate finance in grad school and holding a real estate broker license for more than 12 years, HECMs seemed far too good to be true. That is because, as explained, they were.
Despite not getting all questions answered, with a home appraised at more than $800,000, it was hard to imagine how a mortgage with such low available proceeds would result in a situation where the balance due would end up in excess of the value of the home at termination, even years down the road. So with few other acceptable alternatives, the widow got a HECM.
Around the Office In early 2005, the sheer boredom of retirement from a CPA firm made the idea of helping seniors and learning more about this “equity release” product very intriguing. So I joined a HECM lender. Training consisted of a half-day on a Saturday and on-the-job training from a mentor for a minimum of three closings; unfortunately, the mentor canceled every meeting with borrowers. Instead the originator who provided the HECM for the widow took me on one of his appointments. Although the topic of foreclosure was mentioned, aside from no deficiency judgment no other consequences were mentioned.
To most originators it was a distraction to learn such tangential and theoretical information when home values were rising and the number of seniors waiting for information on reverse mortgages was growing. When questions came up at the office about the consequences of HECM termination when the balance due was in excess of the then value of the home, the question was generally met with: “Don’t worry about it. The chances of the balance due being greater than the value of the home at termination are so remote it is not worth discussing. Even if that occurs, the FHA insurance will take care of all of that. So let’s get out there and originate more HECMs.” In the years that followed it was amazing to hear the misinformation originators gave to seniors on this topic. It was as if some originators were originating one kind of HECM, and others, another.
A recent thread of comments on LinkedIn, which was eventually deleted, shed considerable light on the surprise many originators felt as a five-year industry veteran explained what he recently discovered about HECM foreclosure at termination. By his first comment one could tell he was still confused and reeling from what he learned.
The comment shows he was trying to reconcile what he knew before about HECM foreclosure with what he was being told by the servicer and – perhaps even worse – his knowledge regarding recourse. To a large degree, combining that comment with his second comment clarifies what the servicer told him.
Surprised and Appalled (All quotations were copied and only edited to remove superfluous content. All typos were left intact.) The industry veteran researched the credit report ramifications of HECM foreclosure with the servicer for a couple who had a HECM and wrote the following: “ … if they move out (to go to a nursing home or move in with their adult children), and the value is less than the mortgage balance, they cannot just walk away without a foreclosure or a short sale – still owing on the remaining debt. If they short sell it, they are in default on the remainder and have to use other assets, if any and if the bank requires it as a condition, as many often do, to mitigate the shortfall. Worse, it is a federal debt default since it's FHA. It's a lot more complicated when the owner is alive than if the owner passes away.”
In his second comment the industry veteran goes on to say: “I can only say that Generation Mortgage's servicing department told me that if the owner is still alive, there is either a foreclosure or short sale on the borrower's record, plus the credit shows a short sale or foreclosure, and the only way to clear it is to pay the difference. I was appalled.”
It seemed the industry veteran did not expect any negative consequences for the borrower when a HECM goes through foreclosure. While there can be no deficiency judgment obtained through the courts because of the nonrecourse nature of the HECM note, it seems the industry veteran was surprised to find that FHA insurance provides no more additional protections to borrowers than any other nonrecourse mortgage.
The industry veteran was not alone in his dismay. Others in that same thread were appalled as well but it was very surprising to read what they wrote.
Some of the HECM Nonrecourse Myths Now the real confusion starts. One commenter stated: “A forward is not non-recourse. A reverse is NON recourse. The loans are FHA insured … But, the borrwr, or heirs, are not subject to the penalties of a foreclosure or short sale.”
The individual posting the now long forgotten original topic stated: “Based upon … his conversation with an individual at Generation's Servicing claiming a deficiency balance would be reclaimed by the lender may be correct if it is a non-recourse (private product) reverse mortgage loan that they foreclosed upon. I think there is plenty of agreement if it is a HECM, non-recourse loan, the deficiency balance is not reclaimed from the borrower after foreclosure as it is not permitted within the program.” Later the same commenter stated: “In the message above, strike (non) if is a recourse reverse mortgage, non-governmental.” When questioned about how a reverse mortgage could ever be recourse, the poster then stated: “…however I was thinking about HELOC's, which in many states have a recourse provision….”
A different commenter wrote (or rather “shouted”): “THIS IS NOT A TYPICAL RESIDENTIAL CREDIT TRANSACTION.” The original poster replied: “I think there is a mixed message herein with the comments. A lost translation of the ‘typical residential credit process to property disposition’, foreclosure process.”
The foregoing quotations demonstrate the confusion so many originators have regarding HECMs, nonrecourse, and foreclosure. It is time to shed a little light on the subject.
Are the Consequences of a HECM Foreclosure Different? Many claim that FHA insurance makes a HECM nonrecourse. Under this theory, FHA steps in and simply pays the difference between the balance due and the amount that is considered or actually paid in foreclosure. This theory is based on the concept that, since the borrower is paying for the insurance, FHA comes to the rescue of the borrower so that the payment from FHA is treated for all purposes as if it came directly from the borrower resulting in no negative ramifications, and somehow, since it is insurance, there are no income tax consequences. Everyone likes the results of this theory, even those who know it is a myth.
First, as to the borrower there is no difference between HECM insurance and lender title insurance. Both are for the primary benefit of the lender with some benefits for the borrower as well. In neither case is the borrower the policy beneficiary. The borrower does not participate in any part of the claim, if any. None of the legal documents make reference to the FHA insurance as the cause for nonrecourse because it is not.
The truth is a HECM is not nonrecourse because of the FHA insurance. Lenders are willing to make the mortgage nonrecourse due to the protection FHA provides them. One of the FHA stipulations is that a HECM is nonrecourse. By federal law a reverse mortgage is nonrecourse [15 USC 1602(bb)] and, of course, HUD does in fact classify HECMs as reverse mortgages. The terms of the note make it clear that the note itself is nonrecourse; this means that if for some reason FHA cannot honor the insurance because of fraud or an unknown material defect, the mortgage is still nonrecourse.
Since a HECM is a nonrecourse mortgage, its consequences are no different than any other nonrecourse debt in the state where the collateral (home) is located when it comes to foreclosure, etc. Despite what one commenter wrote, forward mortgages can be recourse or nonrecourse. All mortgages including commercial mortgages can be recourse or nonrecourse; it all depends on the terms in the note.
Generally there is no way to avoid negative credit reporting from a foreclosure (or short sale, etc.) on a nonrecourse mortgage unless the mortgage is paid in full as a result of sale plus the borrower making up any shortfall. The FHA payoff does not count for this purpose since FHA is insuring the mortgagee in foreclosure, not the mortgagor.
Some Nonrecourse Facts In California the security for a mortgage is generally recorded through a deed of trust. The lending process transfers literal legal or “bare title” in the property to the trust; equitable (the legal concept of equity) title remains in the hands of the property owner/borrower. (Yes, in California title technically does change in a HECM transaction, but except for the trustee’s power to sell, the borrower generally retains all property rights.) With a trust deed, the trust holds legal title, the borrower is the trustor, the lender is the beneficiary, and the trustee is normally a paid third party. Elizabeth Weintraub has a fairly good explanation at ask.com. So it is false to say in states with trust deeds that legal title does not transfer; it does but no differently than any other mortgage recorded in the same way in those same states.
Conclusion There is no special category for HECMs in California, Arizona, and most likely all other states, other than nonrecourse. As previously stated, when foreclosure occurs on a HECM, the results for the borrower are no different than for any other nonrecourse mortgage in the state where the home is located. Credit suffers, income tax consequences result, etc. Of course the borrower can avoid all of that negativity if the borrower (including sales proceeds, if any) simply pays off any remaining balance due before FHA reimbursement. What is true is what is stated in the terms of the HECM note; lenders cannot obtain a deficiency judgment against the borrower.
As to the borrower in termination, there is nothing extraordinary, unusual, special, or favorable about a HECM over any other nonrecourse mortgage. Nonrecourse is nonrecourse.
As to income tax consequences, the benefits of the income tax deduction of accrued interest can exceed the detriments of gain recognition for borrowers but planning in this regard can be crucial. The income tax detriments for estates, and possibly heirs, can be much different and far worse.
Next month the series on nonrecourse will conclude with some income tax aspects on HECM foreclosure and some answers on servicer compliance.