Real estate law is largely governed by the individual states, and foreclosure processes vary greatly among them – and these processes can have a significant effect on a defaulted loan. The differences depend primarily on whether the state uses mortgages or deeds of trust for the purchase of real property (although the terms are often used interchangeably, they really involve different legal instruments). Generally, states that use mortgages conduct judicial foreclosures; states that use deeds of trust conduct non-judicial, or statutory foreclosures. As one might expect, the judicial procedure requires court action, so the process in judicial foreclosure states is usually lengthier and more expensive.
Non-judicial foreclosures (as in California and many other states) are generally based on deeds of trust that contain a power-of-sale clause. These provisions enabling the trustee (initially the escrow/title agent from the property’s earlier sale, but often foreclosure responsibilities get assigned to another experienced third party) to initiate a trust deed foreclosure sale without having to go to court. The trustee is typically required to record a notice of default at the county recorder’s office and to notify the trustor (borrower) so that he has an opportunity to bring the loan current. After that notice, if the loan is still not brought current, a notice of sale is recorded, and notice of it is given to the borrower. Public notices are regularly published for a certain period, and then a sale is held. The lender can usually bid on the property on a credit basis for the amount of the loan, while other bidders typically need to have ready cash. The length of time needed for the non-judicial foreclosure process varies by state, but a 3-6 month period would not be uncommon.
In judicial foreclosures, on the other hand, a lender must often wait for several mortgage payments to have gone unpaid, and then must pursue court action to prove the validity of its claim and to get the court’s approval to initiate foreclosure or to get a decree of sale. Judicial foreclosures do generally allow for a lender to get deficiency judgments against a borrower, i.e. for any shortfall between the ultimate sale price and the money that was actually owed. The waiting time, though, to get claims through the judicial process can be long, and attorneys’ costs are generally greater.
Also, in judicial foreclosures the defaulting borrower often has the right to redeem the property for as long as a year after the foreclosure sale is completed, i.e. if the defaulted borrower makes full payment of the unpaid loan, plus costs, during the redemption period he can reclaim the property. In non-judicial foreclosure jurisdictions, redemption rights usually only apply to the period leading up to the actual time of sale.
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These “stylistic” differences have real consequences, as has been demonstrated in the aftermath of the recent Great Recession. Although the entire country was affected by that crisis, real estate markets seem to have rebounded much faster where state laws permit foreclosures to move quickly, rather than allowing homes with defaulted loans to sit and deteriorate. By contrast, in states where laws allow large numbers of homes in the process of foreclosure to remain in legal limbo, home-price recoveries seem to have been hindered because lenders are prevented from recovering the units to buyers who will fix them up and add value.
Experts have remarked that the differing rebound patterns of judicial vs. non-judicial foreclosure state have jumped dramatically out of study data. Non-judicial states seem to have bottomed out sooner – and have seen greater appreciation since the bottom, than judicial states. These “concentrated foreclosure effects,” while painful while they’re happening, seem to relatively quickly purge the marketplace by turning over distressed units to new ownership.
Judicial states, on the other hand, tend to still be struggling with homes flowing out of the foreclosure pipeline, prolonging the negative price effects on other houses for sale. The housing market crash so bogged down the systems in New York and New Jersey, for example, that foreclosures there have routinely dragged on for two or three years; their timelines are among the longest in the country.
States other than New York and New Jersey whose foreclosure processes seem particularly slow recently include Connecticut, Florida, Hawaii, Massachusetts, Pennsylvania, and Wisconsin. Each of these states either uses the judicial foreclosure process exclusively or else seems to have gotten bogged down with the judicial system when statutory processes might have better served it.
It’s important that investors take into account the legal environment of the different states when considering debt investments. If a loan were to go into default, the foreclosure regime of a state can greatly affect the ability, length of time, and expense that a lender incurs in order to sell the property securing the loan, and thus to regain the principal amount originally expended in making the loan.