Homeowner Bankruptcy: When Lenders Hope for it

by | BiggerPockets.com

Desperately business man - or just monday morning. by sandnes[tag]Bankruptcy[/tag], or the “B” word, is one of the few words that [tag]lenders[/tag] fear. It usually means that it will take several months before they will begin to see any money from a homeowner. When a [tag]homeowner[/tag] is in foreclosure and they file for Chapter 13 Bankruptcy, it effectively freezes the foreclosure and costs continue to climb for the lender.

In order for a lender to foreclose on a property after a homeowner has filed for Bankruptcy protection, it can take several months for all the paperwork to be sorted out and then the homeowner has to miss payments to either the Bankruptcy court or the lender who holds the mortgage. Even then, the lender must re-file the foreclosure notice and all that represents to the lender is increased costs and a longer wait until they get the property.

That sounds like something no lender would want to face. Why would a lender actually hope that a homeowner would file for Bankruptcy? Let me tell you about a time when a lender did just that.

I will change the numbers a little for explanation purposes:
A few years ago I found a homeowner who was in foreclosure and they had agreed to sell. The house had an after repair value of about $100,000. The owner had a first mortgage with a payoff of $60,000 and a second mortgage with a payoff of $25,000. The total payoff amounted to $85,000 and that meant the property only had 15% equity in it. That is hardly a deal in the real estate investment world.

I got the homeowners authorization and contacted the 2nd lien holder. It turned out that they did not know the 1st lien holder had filed to foreclose. With just under one week to go until the foreclosure auction, I faxed over an offer of $2,500 for a Short Sale to the 2nd lien holder.

Of course they laughed at my offer of $0.10 on the dollar but I quickly reminded them that their lien would be wiped out entirely at the auction. They told me they had to look into it and get authorization and would let me know.

I called them every day after that and during that time I had all the arrangements made with the title company to close on the first lien while waiting for the answer on the short sale offer.
The auction was scheduled to start at 10:00 am on the first Tuesday of that month and I still had not been given any answer by the 2nd lien holder.

It was 9:30 am and I was in the car on the way to the auction when the lender called me. They were very brief and told me they have accepted my offer of $2,500 and gave me seven days to fund it. They gave me drafting instructions and that was it.

I called my attorney at the title company and turned the car around and headed to the title company to close on the deal.
The short sale on the 2nd had taken the total payoff from $85,000 down to $62,500 and now the deal was $0.625 cents on the dollar or 37.5% equity. That is a good deal and it was only possible because I had waited for the 2nd lien holder to accept the offer.

At the closing, I commented to the lawyer that they sure took their time and let it go down to the wire. She then told me that this is one of the rare times a lender actually hopes that the homeowner files for Bankruptcy because if they do, the lender has a fair chance to recover what is still owed on the mortgage. They waited until the last possible moment to accept the short sale offer because they were holding out hope that the owner would file a last minute Bankruptcy.

For all of you that might pass on a possible deal because there is a 2nd mortgage, I hope this experience might be useful to you in one of your deals.

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  1. I just stumbled upon this – hope you’re still reading your comments because I want to pass along my compliments. Really interesting post, and a smart solution!

    Also, one question: how did the second lien holder finally become convinced that a bankruptcy wasn’t going to happen? Also, once you removed the second lien, did that open the door for other offers on the property (with higher equity)?

  2. @Laurie_ I understood the original post to indicate that the second lien holder waited until the morning of the auction in hopes that the borrower would declare bankruptcy (avoiding foreclosure, allowing the second lien holder to possibly recover some money via Chapter 13). Since the borrower did not declare bankruptcy the foreclosure auction was going to proceed, and since the auction was for the 1st position loan the 2nd lien holder would get ZERO. So they called the investor and took $0.10/dollar instead of zero.

    At that point the 1st loan is still scheduled to proceed to foreclosure in an hour or so. Note the original poster said he had the title company all lined up to pay off the first loan. So basically the poster had a purchase agreement with the homeowner (who was going to lose via foreclosure anyway) and that loan closed/funded/paid-off the first lien before the foreclosure proceeding that same morning. The closing at the title company was on-hold and would never have proceeded unless the investor got his discount from the second position lender. The homeowner got the house sold before foreclosure, so though their credit report will show late payments, the loan was paid in full by the investor. The second lien holder got 10% instead of zero, and the investor got himself a home at 62.5% market value instead of 85% market value.

    So he got a 37.5% discount instead of only a 15% discount. If he’d gone to auction, he MIGHT have gotten in for just the amount of the first line, thus a 40% discount, but would have had to face any other bidders.

    At least that’s how I understood the original post.

  3. Austin Bankruptcy Attorney on

    Great story. As a bankruptcy attorney, I see this all the time. If you have equity in your home and face a foreclosure, some second lienholders will actually advise you to speak with a bankruptcy attorney. Of course, in this market homes are often underwater and second lienholders face the risk that their liens will be stripped from homes through a chapter 13 bankruptcy. In that case, they fight bankruptcy tooth and nail. This has not been as big of an issue in the State of Texas, but it sure has caused problems in states like Arizona and Florida.

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