Are Arizona’s anti-deficiency statutes feeding the bubble?

Jack and Jill were living the American dream. They bought their dream house in 2006. Then, the economy spiraled downward. Jack lost his job. Housing values dropped, and the amount remaining on Jack and Jill’s mortgage exceeded the value of the property — commonly known as having a house that is “under water.”

Jack and Jill didn’t want to pay the mortgage any more, so they walked away, leaving the bank to clean up the mess from their financial misstep.

They were able to do that because of Arizona’s anti-deficiency statute, which says that if a person or corporation owns a residential property on 2.5 acres or less that is used as a dwelling, the owner is not responsible for any deficiency occurring after a foreclosure, according to Lynne B. Herndon, city president for BBVA Compass.

“The difference between the fair market value of the home — or the amount that the foreclosure sale brings — and the loan balance is known as a deficiency,” said Paul Hickman, president and CEO of the Arizona Bankers Association. “In Arizona, the bank suffers that loss, not the homeowner who walks away from the home.”

But it’s not only the homeowners — whom the statutes were intended to protect — who are catching the breaks.

“Unfortunately, the statute has been interpreted more broadly than originally intended such that properties used for investment are also covered,” Herndon said.
Arizona is one of only 12 states that has some form of anti-deficiency protection. Of the 12, Herndon said Arizona has the most liberal statute.

“This statute absolutely contributed to the housing bubble as investors both in this state and outside of the state knew they could buy residential real estate in Arizona and walk away if the investment became negative,” Herndon said. “Homeowners in this state have experienced larger declines in home value due to this statute allowing investors to speculate and walk away.”

The incidence of homeowners like Jack and Jill walking away from their home, avoiding hundreds of thousands of dollars of negative equity in their home, and legally sticking their lenders with a loss and became an all-too-common move during the Recession, experts said.

“In my view, the average borrower was not likely aware of the finer points of the anti-deficiency statutes when determining whether to purchase a home,” said Jennifer Hadley Dioguardi, a partner in Snell & Wilmer’s Phoenix office. “However, once the housing market crashed, the anti-deficiency statutes likely caused some homeowners who had the means to make their mortgage payments to decide to simply walk away from the residence given the fact that the lender had no recourse against them other than to foreclose upon the residence once the residence was under water. The borrower was not responsible for the deficiency. This likely contributed to some homeowners who could pay their mortgage simply walking away from the property and leaving the lender on the hook.”

Experts believe that homeowners and investors who seized the opportunity to take advantage of Arizona’s anti-deficiency statutes to protect their own financial futures, might be stifling the state’s chance at an economic recovery and exacerbating the economic collapse.

“The broadness of the deficiency statute has had an overall negative impact not just on the banking industry, but more importantly, Arizona’s long-term economy,” said Keith Maio, president and chief executive officer of National Bank of Arizona. “Arizona’s statute is the most liberally interpreted of the 12 non-recourse/deficiency states, the majority of which limit the protection to primary residences or some other means that limit its contribution to speculation. In Arizona, it allows investors to finance their speculation in housing, risk-free. If their investment does not work out, they don’t have to pay back the difference between what they sold the home for and what they owe. This statute was intended to protect homeowners, but what it has really done is hurt traditional homeowners by opening them up to large swings in housing values. I believe the impact, while negatively effecting banks earnings, is greater on the homeowners in the community at large.”

Despite the impact on the overall economy, it’s still been the banks who take the initial and biggest hit because they are often precluded from recovering the balance of the loan deficiency from the foreclosed borrower. While short sales are not protected by the Arizona’s anti-deficiency statutes, lenders have often been willing to agree to short sales and reduce or otherwise waive deficiency claims, because lenders know they could not otherwise recover loan deficiencies, should the borrower elect to foreclose.

“The deficiency statute has led to greater losses for residential lenders in Arizona because they cannot obtain a judgment against the borrower who may have the ability to repay the deficiency,” Kevin Sellers, executive vice president of First Fidelity Bank. “Lenders’ inability to pursue the borrower for the deficiency creates an environment that results in a higher incidence of strategic defaults.”

The biggest problem for lenders may be that it doesn’t appear that they will get any relief from lawmakers. Dioguardi said properties initially covered by the anti-deficiency statutes had to be two and one-half acres or less and utilized either for a single one-family or a single two-family dwelling. This language was interpreted by the Arizona Supreme Court to require that the dwelling be built and at least occasionally occupied.

“However, a recent decision by the Arizona Court of Appeals has extended the anti-deficiency protection to cover a residence that was not yet constructed and in which the borrowers had never resided,” Dioguardi said. “The Court found that even though the home was never utilized for a residence as required by the statute, because the borrowers intended to live in the single-family home upon its completion, they were subject to the protections of the anti-deficiency statute.”

The court decision, Dioguardi said, needs to be refined to protect both lenders and borrowers.

“Given that the Arizona Supreme Court declined the petition for review of the decision, the legislature should amend the statute to make it even clearer that the borrower must physically inhabit the property to claim the protection of the anti-deficiency statute,” she said. “The current risk to lenders created by the decision as it currently stands will likely drive up the cost of construction loans.”

Bank executives also believe that amending — not necessarily getting rid of — the state anti-deficiency statutes is what the banking industry needs to continue on the road to post-Recession economic recovery.

“A very reasonable solution proposed by the Arizona banking community is to simply require that a property protected from a deficiency judgment be the primary residence of you or a member of your family as already defined in Arizona’s property tax statues,” Maio said. “This will have the effect of limiting this protection for homeowners, which is what was intended. Those in our Arizona business community that oppose this type of change are motivated by their own special interests. Those whose real motivation is to profit on speculative investment or from the fees and commissions that come from buying and selling speculative homes for profit, you will oppose this type of change. But for the rest of us that want to protect Arizonans from future bubbles and encourage a long-term and sustainable economy, we should support this simple change, as it is in our best long-term interest.”