Foreclosure, even if you are current? Welcome to the world of technical default

It was not that long ago, in the late 80′s, when the FDIC closed approximately three hundred banks in New England and the “orphan” loans, those without a bank to service them were being foreclosed on because of technical default.

A technical default can be for many reasons other then payment default and frequently based on the decrease of value of the underlying collateral, the real estate usually. Real state was severely depressed for that time period and thus could no longer be deemed adequate collateral for most loans loan.

This gave RECOLL or the Resolution Trust or any of the surviving banks the excuse to clean up their portfolio and rid themselves of risky loans before the loans went bust on their own. At least that was the excuse we heard.

Could it happen again? It’s possible, as we see banks folding under the pressure of non performing loans, loans legitimately in default for failure to pay the monthly debt service, but what we are also seeing is a slow but steady erosion of the real estate market with values being depressed daily.

It varies area by area even neighborhood by neighborhood, but I see some values down as much as 50% or more while so called good areas are depressed 5-10%. Could this continue and get worse? We are told that we should expect continued decline in real estate values through 2009-10 when those that know expect a turnaround.

Will real estate decrease in value enough to trigger a repeat of what happened in the 80′s? Its possible. As values decrease below the loan amounts and with  required equity  being at least 20%, which is being severely challenged, it is entirely possible many loans may fall into this technical default zone of no return and be foreclosed on.

I have not heard it happening yet, but it could and that’s the point. Technical default is a dangerous one way street were the borrower can do little to change the reality of the situation other then to refinance out of the bank. This is another challenge as the same real estate value will again yield a lower value refinance and thus leave shortfall for the payoff of the technically defaulted loan.

The original bank could take a short payoff and release the  borrower from the shortfall loss, but only if the borrower is without additional assets and liquidity.

If the borrower has other assets or liquidity he is in for a tough ride, facing the possibility that other assets may be forced into liquidation to cover the shortfall liability from the offending loan.

Believe me this happened, I played a large role in defending borrowers in this situation in the 80′s writing books, articles and presenting seminars on how to deal with this issue as well as negotiating many workouts on behalf of my clients with the banks on this exact problem. It did happen, it can happen again, and the situation is ripe and getting riper.

What should you do to deflect this issue, the following are a few suggestions:

1. Fix your credit scores, so if you have to refinance you will be able to and at the best rates available.

2. Do your debt workouts to reduce debt…now! It takes time and the sooner it gets done the better you are.

3. Refinance after you have repaired your credit and done your workouts so you can afford the debt and the refinance should put you into a relatively safe harbor as the risk is freshly appraised thus should remain acceptable for a few years as this storm passes.

4. Reduce debt if possible.

5. Build cash to reduce debt or just to increase reserves for liquidity purposes.

6.Refinance into local small banks, credit unions or any institution other then the large regional banks. They are far less likely to default borrowers for technical reasons.They will treat you much better if you do fall into real default as well.

7. Repair your credit if necessary.

8. Sell assets, reduce inventories, downsize, move to less expensive space,  to gain liquidity and remove debt if necessary.

9. Retain assets with significant equity.

10. Lease instead of own especially depreciating assets.

11. Move as much debt as possible to an entity other then yourself so you are personally debt free or have less debt. You can accomplish this by establishing an LLC for this purpose or using a business entity to hold your debt ridden assets. This will help you refinance if required.

Be prepared for a battle, be flexible and keep your wits, this problem can be navigated safely.

Call me if you need some help 413-549-2966.