Complications can arise when there are multiple mortgage loans against a borrower’s property. A senior lien is one which has priority over the claim of a junior lien. Regarding real property, a first mortgage loan creates a senior lien, while a second mortgage loan “goes behind” the first mortgage as a second mortgage. The lien of the second mortgage is junior to the lien of the first mortgage.
If the first lender’s foreclosure process is completed, the result is a trustee’s sale. This is an auction of the property, usually conducted at the courthouse of the county in which the land is located. If the amount generated at the trustee’s sale exceeds the amount owed to the first lender, then the surplus belongs to the borrower. However, if there is a second mortgage, the second lender will receive the surplus to the extent of the amount of the borrower’s second mortgage debt.
Frequently the value of the property is less than the amount of the first mortgage. If that is the case, no third party will show up to bid on the property at the trustee’s sale. Under such circumstances, the lender winds up owning the property by virtue of “bidding in” at the trustee’s sale.
This sets the stage for the sold-out junior lender problem. In the scenario above, where the second lender receives nothing from the trustee’s sale, its second mortgage is “wiped out.” The lender therefore becomes an unsecured creditor. Under California law, the foreclosing first lender may not be able to seek recovery of any “deficiency” from the trustee’s sale. In other words, if the sale generates less than the amount owed to the foreclosing lender, the lender can’t go after the borrower for the difference.
The second lender is treated differently, assuming that it received nothing from the trustee’s sale. All mortgage loans in California are governed by antideficiency rules and the one-action rule. The antideficiency protection of California law doesn’t apply to a sold-out junior lender whose lien has been wiped out by the foreclosure of a senior lien. Ordinarily, the one-action rule forces the lender to foreclose on its collateral before proceeding against the borrower under any circumstances. Once the lender becomes a sold-out junior lender, the one-action rule no longer governs. This means that the lender may immediately bring a case in court seeking recovery of the full amount of its debt.
As a result of all this, homeowners frequently find themselves in a position where a relatively large first mortgage is less of a problem in the long run than is a relatively small second mortgage. Some debtors opt for bankruptcy under such circumstances, in order to discharge their obligations with respect to both loans, and walk away from the problem. Filing bankruptcy also can help if a foreclosure would create income tax obligations. Under many circumstances, discharging the debts in bankruptcy will not result in any income taxation, whereas foreclosure or cancellation of all or some of the debts may result in cancellation-of-debt income.