What Happens When You Default on a Mortgage: Strategic Default from the Bank’s Perspective?

Aug 23, 2012 in Vital Information

Most people who are considering strategic default, think about it from their perspective.  However, it is helpful to also understand how lenders view strategic default.

First: Understand Loss Reserves & the Bank’s Pain

Because deposit accounts in banks and thrifts are partially guaranteed by the Federal Deposit Insurance Corporation (“FDIC”) or the Office of Thrift Supervision (“OTS”), the minimum capital requirements of banks and thrifts are strictly regulated by the FDIC or OTS.  Minimum capital requirements are used by FDIC and OTS regulators to reduce the risk of bank  failure as a result of becoming over-leveraged.  Therefore, where the lender is a bank, or where the bank is the “owner” of the loan, the bank is typically required to set aside a portion of its equity capital to account for, or to make up for, losses the bank expects to occur is association with upside-down property or a non-performing loans.  The equity capital that is set aside is commonly known as loss reserves.  Minimum loss reserves are dictated by the FDIC or the OTS.

For banks and thrifts, when a borrower stops making payments on a mortgage loan, the bank or thrift must set aside some of its equity capital to account for the additional risk that the bank or thrift will not recover the full loan amount.  For banks and thrifts, setting aside capital is a financially painful operation.  This is also the reason that lenders are unwilling to work with most borrowers unless or until the borrower ceases making payments. Having loss reserves set aside is also a reason why lenders typically will not work with you until you’re delinquent. Following a payment default, the bank usually becomes more willing to work with you to resolve the account.

From the bank’s perspective, they don’t care that you may be struggling to make the payments.  They do care about their balance sheet and having to set aside their equity capital into a loss reserve account.

How the Banks Respond to Defaults

Historically, after a homeowner has gone three months delinquent, the bank or thrift would initiate a foreclosure lawsuit.  In this market however, where banks engage in active balance sheet management, we have seen clients go as many as 2+ years before the lender even files a lawsuit.  We have also seen many banks refrain from filing a foreclosure suit where there is an active short sale or loan modification application pending because it may have less of an effect, at least temporarily, on the banks balance sheet.  However, on average, we are seeing lenders wait about six months or so after the first missed payment to file a foreclosure suit.

Your Response

The filing of the lawsuit by the bank is the beginning of the “foreclosure”. Borrowers typically have 20-days from date they are served with the foreclosure suit to respond. Whatever the time frame dictated by the summons, it is during this window of opportunity that it is critical to retain a competent foreclosure defense lawyer if you have not already done so prior to initiating a strategic default.

Once you have been served, if you do not submit a timely response to the clerk of court, the lender may ask for a “Clerk’s Default.”  Where service of process was properly perfected and a clerks default properly entered, it is very difficult to set aside the default in order to make any challenge whatsoever to the lawsuit.  At this point, absent only the most extreme circumstances, you lose your rights to defend or otherwise challenge the lawsuit. The lawsuit then proceeds at the bank’s pace and discretion.

This doesn’t mean that something cannot be worked out with the bank – but it will help if you are working with a competent foreclosure defense attorney. It does however mean that you have lost your opportunity to gain potentially huge legal leverage to use to accomplish a particular outcome, like avoiding deficiency judgment.

Why Banks Historically Do Not Favor Loan Modifications

Because loss reserves on an upside-down loan could be very damaging to a lender’s balance sheet, one of a lenders central goals of resolving an upside-down loan is to recover the equity capital which was placed in the loss reserve account. In many cases, recovering the equity capital can only be accomplished by resolving the loan.

From the lender’s perspective, some resolutions are better than others.

In most cases, foreclosure, short sale or a deed-in-lieu of foreclosure is preferable to loan modification. This is because when a loan is modified it is still on the lender’s books – meaning the lender still may not be able to recover all of the equity capital it has had to set aside in association with the non-performing loan. This is one aspect of the lender’s balance sheet management.

Where We Are At Now

With the inception of the financial and banking crisis, the FDIC and OTS has relaxed the minimum standards for loss reserves to give banks and thrifts more flexibility.  This likely helps borrowers who are seeking loan modification, and hurts borrowers who are seeking to simply get out from under an upside-down property.

The post What Happens When You Default on a Mortgage: Strategic Default from the Bank’s Perspective? appeared first on Castle Law Group.

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