PLI's Pocket MBA Everything An Attorney Needs To Know About Finance

Term of the Week: Non-Recourse Debt

Secured loan for which the lender may not hold the borrower personally liable upon default.

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NON-RECOURSE DEBT IN THE REAL WORLD:

Really, the definition of this week's term would ordinarily have sufficed for the entire issue—the only reason PMBA is bringing it up is to presage next week's issue on the Term Asset-Backed Securities Loan Facility (TALF), which entails non-recourse loans by the government to all manner of investors. Still, all in all, in reading about non-recourse debt, Pocket MBA learned a couple things that put the continuing mortgage crisis in better perspective and thought to share the info. Like non-recourse debt explains why people in some states would actually just abandon a home when they realize they overpaid for it. That is, in some states, mortgages are non-recourse by operation of laws that prohibit lenders from going after borrowers assets beyond the collateral used to secure a mortgage (i.e., the house). Pocket MBA figures having a house worth less than you paid for it is better than having no house and no credit. But when continuing to pay for that house brings you perilously close to or shoves you into bankruptcy, maybe that assumption, like so many others in today's world, no longer holds.

Non-recourse debt is a simple concept. You borrow money and put up collateral—could be a building; could be toxic assets. If you default, the lender can go only after the collateral. That is, it has no recourse against the borrower personally.

Non-recourse debt went mainstream when the government engineered JPMorgan Chase's takeover of Bear Stearns in March 2008. In exchange for receiving $30 billion from the Federal Reserve—$30 billion with which JP Morgan Chase bought Bear Stearns—JP Morgan Chase pledged to the Fed, as collateral, some of those toxic assets that brought Bear Stearns down in the first place. So long as JP Morgan Chase pays back the $30 billion, all is good. If JP Morgan defaults, the government has a claim on those toxic assets. That could be good or bad, depending on whether the assets have appreciated or depreciated at that time. If they appreciate, the Fed can make the taxpayer whole; if they depreciate, the government takes a loss or continues to hold them and prays. The same prospect occurs in transactions between borrowers and private lenders. If you substituted Joe's Bank for the Federal Reserve, Joe's Bank would carry the $30 billion on its books as a liability and the toxic assets as, well, assets.

The reason non-recourse debt makes sense in a real estate deal is because, historically, the collateral is such that it tends to appreciate in value at a fairly predictable rate. This is especially so in commercial real estate deals where the borrowers tend to be businesses with long-term investment objectives. Whether it's a hotel or office building, values have tended to go up. And lenders apply rigorous standards to the loans and don't loan out the entire amount of a project. With those checks and the collateral in place, the lender is assured of recouping most, if not all, of its money even should the borrower go belly up. For consumers, non-recourse loans are not the norm—you have to pay up handsomely (in interest) to get one, if you can get one at all. Now back to abandoned homes. Why would someone abandon their home? Well, assume you paid $300,000 for a home, plunked down $0 in cash, obtained a variable rate loan and bought mortgage insurance—the whole bit. Then assume the value of the home drops to $200,000 after a year, meaning you have only a few more dollars in equity than when you started. And then the interest rate rises, consuming more and more of your monthly salary, and yet you still own virtually nothing, with interest payments consuming more and more of your income. (PMBA could create interest rates and demonstrate the peril you are in, but the financial press has been demonstrating that for the past two years.) If you have a recourse loan—that is, the lender can come after your assets apart from the collateral—you will do everything in your power to pay your mortgage, even if it means working three jobs and never even looking at a Starbucks again—yeah, you'll even drink instant coffee. Neither selling the house nor going into bankruptcy will pay off the mortgage, cramdown (see PMBA, Vol. 7, No. 10) potentials to the contrary notwithstanding.

But what if you live in one of the following states? Arizona; California; Colorado. These are states with "anti-deficiency" statutes (there are a few other states with them), which is basically a fancy way of saying that a lender may not pursue a borrower after default for deficiencies in the value of the collateral that render the collateral insufficient to pay the remaining principal on the loan. That is they are non-recourse by operation of law, although each state has its peculiar limiting provisions. The interesting thing about that list is that it includes three of the states that are most notorious in the current crisis (from PMBA's non-empirical study of news reports) for abandoned houses. Under these statutes, all you need do is give the keys back to the lender, and you walk away debt free. Sure you're credit is busted for years. But these days, having busted credit is no shame—it's as common as a morning coffee.

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