Who got there first?

Banks' New Foe: Homeowners Associations

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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No one looks forward to a bank foreclosure. It's miserable for the people being kicked out of their homes, it's miserable for the law enforcement folks who have to do it, and it's expensive as hell for the banks.

Nevada bankers have discovered something even worse than foreclosure: not being able to foreclose themselves because the homeowners association got there first:

Like lenders, homeowners associations can foreclose on homes to recoup delinquent payments, an option that many have taken after waiting years for lenders themselves to foreclose, a scenario that has left homes without dues-paying owners and some HOAs strapped for cash. Nevada and about 20 other states have laws that allow HOA liens to get priority over first mortgages.

The result, according to a recent state court decision, is that homes can be put up for auction by HOAs -- without the blessing of the mortgage lender -- and sold, extinguishing the first mortgage and allowing the investor to get title to the home. Such sales often are for an amount equal to or slightly above the HOA dues in arrears.

This doesn't seem to make a huge amount of sense: If a homeowner pays their mortgage but not their homeowners association dues, can the association really seize the house that secures the mortgage and auction it off without regard to the outstanding loan?

Historically, this wasn't a problem, because the first lien was usually the mortgage, senior to everything except the tax bill. Happily, this was usually also the largest lien, so the bank's incentives were broadly aligned with getting the highest possible price for the house.

The rise of homeowners associations, however, has changed that calculation, at least in states where their dues get priority over the mortgage. Now they can take a house, sell it for just enough to cover the dues and make some investor very happy. In Nevada, they don't even have to go through the courts; they can just take the property straight to auction.

In theory, there's an obvious answer: The banks should keep the dues current in order to protect their interests. If your servicer screws up and fails to pay it, well, you had your chance. However, the bankers claim in court filings that they are not always able to ascertain how much is owed, and in some cases the homeowners associations refuse to allow them to pay it off.

In the short term, this will hand a windfall to investors, if the court allows it to stand: Make friends on the homeowners association's board and you can have them gift you a house for a trivial sum. The Journal cites one house that was worth $180,000 and sold for $11,000, which has got to be a very nice profit, even after legal fees and rehab. In the long run, banks will eventually plan for this contingency. The best way would probably be to collect homeowners association fees as part of the mortgage payment and refuse to lend into developments that won't let them do so.

But a vast regulatory thicket surrounds mortgage lending, and those changes may be slow to come. In the meantime, I wouldn't be too eager to buy Nevada mortgages.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Megan McArdle at mmcardle3@bloomberg.net

To contact the editor on this story:
Brooke Sample at bsample1@bloomberg.net