Magazine article Business Credit

What Every Credit Manager Needs to Know about Default and Foreclosure of Real Estate

Magazine article Business Credit

What Every Credit Manager Needs to Know about Default and Foreclosure of Real Estate

Article excerpt

What Every Credit Manager Needs to Know About Default and Foreclosure of Real Estate

By Robert J. Aalberts and Stephen J. White

Foreclosures on real property have soared in the 1980s creating great financial pressures on creditors and debtors alike. Foreclosures became particularly apparent in the oil patch and agricultural regions of the United States in the mid-1980s. More recently, the Northeastern U.S. has seen real estate values stagnate or fall, and is perhaps the toughest region in which to sell a house. Thus, it is not surprising that the Northeast now has the dubious distinction of being the area in which bankruptcies are growing the fastest.

Indeed, bankruptcies, so finely intertwined with foreclosures on real property, are becoming much more common and have exhibited a conspicuous upward historical trend. For example, in the Depression of the 1930s, 4.65 filings per 1,000 people occurred. In the 1960s, that figure advanced to 8.34 per 1,000, and in the 1970s increased further to 9.21 per 1,000. But then in the 1980s, the rate ballooned to 18.16 per 1,000. Furthermore, bankruptcies are expected to rise 10 percent above 1989 levels by 1992. That translates into an anticipated 890,000 debtors who will file.

Correlation Between Bankruptcies and Foreclosures

Bankruptcies and foreclosures generally coexist due to both the economics and legalities which govern real estate. Tnere are generally two economic situations in which people default on their mortgage note. One is obviously an inability to pay. The other that may arise depends on the amount of equity in the property.

Both the borrower and the creditor are forced to make some often complex economic and legal decisions when confronted by one of these situations. For example, if it is appropriate and possible, the two parties may renegotiate the loan at a different interest rate or maturity or accept a moratorium on interest payments.

More likely though, due to the borrowers diminished financial status and uncertain future, the parties may agree to a deed-in-lieu-of-foreclosure. A creditor, however, may be loath to elect this option especially when there is negative equity. This is due to the fact that after the deed-in-lieu-of-foreclosure alternative is chosen, the borrower(s) can no longer be pursued for a deficiency judgment. If the borrower has other assets to seize, if there are other parties for which the deficiency could be sought, or if there are junior liens on the property, executing a deed-in-lieu-of-foreclosure also may not be acceptable alternatives for the creditor.

Another option for a creditor might be to foreclose on the property in order to recoup some of its losses. The decision to foreclose can be influenced by the economic implications of the varying laws.

Tax implications can further complicate and influence how the borrower and creditor interact in the default/foreclosure processes. For example, if the creditor and borrower do agree to a deed-in-lieu-of-foreclosure, the debt represented by the mortgage note is now forgiven. This can give rise to a substantial amount of taxable income and might not be an economically feasible option.

On the other hand, if the property is subjected to a foreclosure sale, the borrower will likely be pursued for a deficiency judgment. Deficiency judgments can often be very onerous.

If the borrower does elect bankruptcy, he may likely choose Chapter 7, or total liquidation bankruptcy. This is because the other bankruptcy options for individuals who are not farmers, a Chapter 13 or 11, consist of a restructuring of the debt and require some payment over a period of time. Under Chapter 7, however, almost all of the bankrupt's debts will be discharged, including the deficiency judgment. Moreover, under Chapter 7, state or federal law permits the bankrupt individual to keep some of his property and the tax implications can be similarly attractive. …

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