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Volume 127 Number 2 February 2010
Guest Headnote: FdIC PoIsed to sue Former dIreCtors and oFFICers oF FaIled Banks
Paul r. bessette and Carl Fornaris 97
From one BIG House to anotHer: lessons learned From tHe CommunIty Bank ProseCutIons
William C. athanas 100
sPeCIal lIaBIlIty rIsks For dIreCtor aPPoIntees to BankInG orGanIzatIons
mark V. Nuccio, Paulo J. marnoto, and eugene P. Hwang 120
Borrower suItaBIlIty standards For resIdentIal mortGaGe loans
elizabeth C. yen 138
tHe Brave new world oF reGulated overdraFt Fees: How Can Banks PrePare?
Peter J. Wilder 158
wIll Tousa CHanGe lendInG PraCtICes?
Kerrick e. Seay and Douglas r. urquhart 167
new york HIGH Court deCIsIon, allowInG JudGment CredItors to GarnIsH overseas or out-oF-state ProPerty, sIGnIFICantly ImPaCts InternatIonal Banks and tHeIr ClIents
Sander bak, Felix Weinacht, and matthew latterner 173
Bank FaIlures rIse and D’oench Duhme returns
allan C. Wisk 179
CasH dePosIt deemed a “seCurIty Interest” By tHe suPreme Court oF Canada
Steven A. Meyerowitz
President, Meyerowitz Communications Inc. manaGInG edItor
Adam McNally Board oF edItors Paul Barron
Professor of Law
Tulane Univ. School of Law George Brandon
Partner, Squire, Sanders & Dempsey LLP Barkley Clark
Partner, Stinson Morrison Hecker LLP
John F. Dolan Professor of Law
Wayne State Univ. Law School Stephanie E. Kalahurka Hunton & Williams, LLP Thomas J. Hall
Partner, Chadbourne & Parke LLP
Michael Hogan
Ashelford Management Serv. Ltd.
Mark Alan Kantor Washington, D.C. Satish M. Kini
Partner, Debevoise & Plimpton LLP
Paul L. Lee
Partner, Debevoise & Plimpton LLP
Jonathan R. Macey Professor of Law Yale Law School Martin Mayer The Brookings Institution Julia B. Strickland Partner, Stroock & Stroock &
Lavan LLP Marshall E. Tracht Professor of Law New York Law School
Stephen B. Weissman Partner, Rivkin Radler LLP Elizabeth C. Yen Partner, Hudson Cook, LLP
Bankruptcy for Bankers
Howard Seife
Partner, Chadbourne & Parke LLP
Technology, Law, and Banking
James F. Bauerle
Keevican Weiss Bauerle & Hirsch LLC
Directors’ Perspective
Christopher J. Zinski Partner, Schiff Hardin LLP
Banking Briefs
Donald R. Cassling Partner, Quarles & Brady LLP
Intellectual Property
Stephen T. Schreiner Partner, Goodwin Procter LLP
The Banking Law JournaL (ISSN 0005 5506) is published ten times a year by A.S. Pratt & Sons, 805 Fifteenth Street, NW., Third Floor, Washington, DC 20005-2207. Application to mail at Periodicals postage rates is pending at Washington, D.C. and at additional mailing offices. Copyright © 2010 ALEX eSOLUTIONS, INC. All rights reserved. No part of this journal may be reproduced in any form—by microfilm, xerography, or otherwise—or in-corporated into any information retrieval system without the written permission of the copyright owner. Requests to reproduce material contained in this publication should be addressed to A.S. Pratt & Sons, 805 Fifteenth Street, NW., Third Floor, Washington, DC 20005-2207, fax: 703-528-1736. For subscription information and custom-er scustom-ervice, call 1-800-572-2797. Direct any editorial inquires and send any matcustom-erial for publication to Steven A. Meyerowitz, Editor-in-Chief, Meyerowitz Communications Inc., 10 Crinkle Court, Northport, New York 11768, [email protected], 631-261-9476 (phone), 631-261-3847 (fax). Material for publication is welcomed—ar-ticles, decisions, or other items of interest to bankers, officers of financial institutions, and their attorneys. This pub-lication is designed to be accurate and authoritative, but neither the publisher nor the authors are rendering legal, accounting, or other professional services in this publication. If legal or other expert advice is desired, retain the services of an appropriate professional. The articles and columns reflect only the present considerations and views of
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elizabetH C. yeN
The author discusses the need to educate home buyers and home owners about hidden risks associated with conventional 30 year mortgage loans.
I
ncreasingly, there are more and more new state and federal requirements obligating mortgage lenders and brokers to make borrower suitability determinations before recommending or originating residential mort-gage loans for individual mortmort-gage loan applicants. New and enhanced bor-rower suitability requirements may help slow down the process of obtaining a residential mortgage loan — probably a desirable result, given the large amounts of money typically involved and the significant consequences as-sociated with mortgaging one’s home. The Federal Reserve Board and De-partment of Housing and Urban Development (“HUD”) have also recently used their respective rulemaking powers under the Truth in Lending Act (as recently amended by Congress) and Real Estate Settlement Procedures Act (“RESPA”) to inject a deliberate element of delay in the residential mortgage loan closing process, to give prospective borrowers more time in advance ofelizabeth C. yen, a member of the board of editors of The Banking Law Journal, is a partner in the New Haven, Ct, office of Hudson Cook llP, headquartered in maryland. ms. yen is a past chair of the truth in lending Subcommittee of the Consumer Financial Services Committee of the american bar association’s Sec-tion of business law, a past chair of the Consumer law SecSec-tion of the Connecticut bar association, and a past treasurer of the Connecticut bar association. She is a member of the Conference on Consumer Finance law and a fellow of the ameri-can College of Consumer Financial Services lawyers. ms. yen ameri-can be reached at [email protected].
closing to review certain loan-related disclosures and to carefully consider the advisability of the pending loan transaction.1
Requiring mortgage lenders and brokers to pay more attention to bor-rower suitability also will inevitably constrict the availability of mortgage financing — again probably a desirable result, to help balance other gov-ernmental incentives to both borrowers and lenders to enter into residential mortgage transactions (including government-sponsored tax and secondary market incentives, Federal Housing Administration (“FHA”) and Veterans Administration (“VA”) mortgage insurance and guaranty programs, federal preemption of state first mortgage loan usury ceilings and state restrictions on alternative mortgage transactions, and various other laws giving residential mortgage transactions preferential treatment).2
suItaBIlIty requIrements
Interestingly, there are no generally prevailing borrower suitability re-quirements or mandates outside the realm of residential mortgage lending. For instance, there is no prevailing legal requirement that automobile finance contracts only be offered after they have been determined to be “suitable” for individual retail buyers. This may be partly because automobiles typically de-preciate significantly in value after a relatively short period of use — one does not expect the underwriting of automobile finance contracts to incorporate intentionally rosy and optimistic assumptions about the future fair market value of the automobile serving as collateral. The anticipated depreciation of an automobile’s value over time may explain the shorter maturities available for automobile finance contracts (particularly when compared to mortgage loan maturities), relative absence of interest-only payment options, and more conservative underwriting requirements. Depreciation of an automobile’s value also may explain the relative lack of refinancing options for purchase money vehicle finance contracts, in contrast to available mortgage loan refi-nancing options. In addition, consumers who finance the purchase of auto-mobiles could be both significantly and rapidly inconvenienced by the loss of a vehicle through repossession, and may have significantly fewer options to stave off repossession, when compared to the threat of losing mortgaged resi-dential real property through foreclosure. The immediate day-to-day need
to be able to drive a car to and from work and errands, combined with the relative lack of refinancing options, may provide consumers with significant motivation to avoid defaults on their automobile-secured consumer credit contracts, and corresponding indirect motivation to avoid entering into au-tomobile financing arrangements with unrealistic or unaffordable payment requirements.
For unsecured consumer credit, where the creditor has no ready access to the borrower’s property in the event of default, prevailing underwriting standards also may be more conservative as a matter of sheer business neces-sity, and may therefore effectively incorporate certain elements of a borrower suitability or affordability analysis. In addition, as a matter of common law, the consideration for continuing to make an “evergreen” or demand line of credit available to a borrower could include prospective changes in terms — if the borrower did not agree to those changes in terms the creditor could dis-continue the line of credit. Open-end creditors could therefore reassess their risk of loss and periodically reprice their lines of credit, increase or decrease available credit limits, and so forth, unless applicable federal or state law spe-cifically curtails the common law in this regard. Interestingly, rather than focus on borrower suitability in the area of open-end consumer credit, federal regulators and Congress have instead focused on substantive regulation of consumer home equity credit lines and credit card accounts.
Consequently, when considering how best to regulate residential mort-gage loan borrower suitability, and when contemplating potential unintended consequences of mortgage loan borrower suitability standards, there may not be any useful existing analogies in the consumer credit world. One may in-stead need to look at pre-existing suitability standards in the areas of securities and insurance investments by way of rough analogy.
seCurItIes and InsuranCe ProduCts
Securities broker-dealers are generally required to first determine an in-dividual customer’s financial and tax circumstances, investment objectives, and ability or willingness to handle investment risk (including the risk of possible future significant decline in the investment’s value and liquidity), before making securities-related recommendations. Securities customers are
classified into categories based on factors such as primary and secondary in-vestment objectives (for example, long-term gain, tax-free income) and tol-erance for investment risk. Securities broker-dealers also may evaluate an individual customer’s securities-related experience and sophistication before deciding how much latitude to accord a customer with respect to customer-requested securities transactions. The process of determining an individual customer’s risk tolerance, investment sophistication, and investment objec-tives takes time, and may ultimately result in a stock brokerage declining to execute certain customer-requested transactions. Investors wishing to bypass this suitability determination may choose to open self-directed brokerage ac-counts, or invest directly in mutual funds and other securities investments that are made available directly to the investing public.
Securities investments clearly require a certain degree of crystal ball gaz-ing and speculation with respect to the future value and liquidity of the vestment, future cash dividends associated with the investment, and the in-vestor’s best guess as to whether the investment will be held for the long- or short-term. Regardless of whether the investor purchased with the assistance of a broker-dealer or on a self-directed basis, the average investor probably understands that trading and market losses, illiquidity, and other investment risks will be 100 percent borne by the investor (although some investors may try to recover a portion of their losses through litigation).
Life insurance agents are also generally required to make suitability deter-minations before selling life insurance or annuities to their customers. Suit-ability factors include such things as the proposed insured’s Suit-ability to continue paying required insurance or annuity premiums, the amount of pre-existing insurance already in force, the amount of new insurance that will be in force and the time period during which insurance will be in force, the insured’s ability to borrow against the cash value of the policy, tax consequences or benefits arising from the policy, and other factors. As is the case with a secu-rities investment, the purchaser of a life insurance policy or annuity needs to consider the likely duration of the policy, its future value, liquidity, dividends, and other factors. However, unlike securities that may be purchased on a self-directed basis, insurance policies could be more difficult to purchase on a self-directed basis, since insurers generally want to underwrite and review an applicant’s eligibility and insurability before quoting a premium or
agree-ing to coverage terms. Additionally, unlike most publicly traded securities investments, a life insurance policy or annuity’s terms are generally governed by the four corners of the relevant contract document — the insurer “designs” the terms of the policy or annuity, as it were, and thereby dictates the terms that govern the relationship of the annuitant or insured with the insurer. (An insured may be given various insurance coverage and deductible options or choices, and thus may participate in the “design” of the final policy.) In con-trast, investors in publicly traded securities are generally offered securities on a “take it or leave it” basis, and do not typically need to refer to the certificate of incorporation, bylaws, or similar documents of the securities issuer before making their investment decisions. Investors in publicly traded bonds and other securities do not typically read the prospectus before investing in such securities.
The suitability determinations that generally must be made by securi-ties broker-dealers and insurance agents cause certain types of products to be recommended only to certain consumers and not to other consumers. These suitability determinations raise the same types of conflict of interest issues found in residential mortgage lending transactions, where borrower suitabil-ity determinations by mortgage lenders and brokers may directly affect the compensation earned by the lenders and brokers. Securities broker-dealers and insurance agents earn transaction fees or commissions when they sell investments, and their compensation may increase if they sell more expensive investments or facilitate more frequent investments by their customers. The securities and insurance industries have addressed these conflict of interest issues and the excessive “churning” of investments or unnecessary replace-ment of pre-existing investreplace-ments with new investreplace-ments. The securities and insurance industries have also attempted to regulate the total compensation that may be earned by a broker-dealer or agent in connection with a single transaction. To this extent, the securities and insurance models may provide useful analogies to those seeking to impose enhanced borrower suitability requirements on residential mortgage lenders and brokers.
The sale of securities and insurance products is extensively regulated at the federal and/or state levels. Agents typically need to be registered or li-censed, for example. Continuing education requirements typically need to be met periodically in order to renew registrations or licenses. State law also
regulates the permissible coverage, terms, and exclusions of insurance poli-cies, insurers’ loss ratios and liquidity. The highly regulated nature of both securities and insurance products, and the regulatory regimes generally ap-plicable to the individuals who sell such products, indicate that reasonable analogies could be made to residential mortgage lending and brokering.
mortGaGe loans
Mortgage loans carry certain consumer risks analogous to securities or insurance investments — the value of the underlying mortgaged real property can fluctuate significantly, and the market (and liquidity) for the real property can rise and fall. If the borrower stops making required loan payments, the borrower risks losing the mortgaged property — similarly, if an insured stops paying premiums, the policy may be cancelled. Lenders “design” the terms of their loans, and borrowers’ contractual rights and obligations are generally contained within the four corners of the relevant contract documents. There is, however, one critical difference between a consumer’s loan-related risk, and a consumer’s securities or insurance investment risk: For loans, the party that initially pays out significant funds with the hope of receiving a return on those funds is the lender, not the consumer (borrower). Furthermore, the lender’s return is generally capped at the contractual interest rate set forth in the loan agreement. Any increase to the underlying value of the mortgaged property generally benefits the consumer (through an increase to the con-sumer’s unencumbered equity). Conversely, the risk of decrease to the value of the mortgaged property is borne by both the consumer (homeowner) and the mortgage lender.
The homeowner we seek to protect through borrower suitability require-ments has typically obtained the contractual right to use a lender’s funds for a relatively long period of time, with repayment secured by property in which the homeowner typically only owns a relatively small percentage free and clear of liens. On average, mortgage holders may effectively own a signifi-cantly higher percentage of the fair market value of residential real property than the so-called “homeowners” or mortgagors.3 Based on recent statistics,
the average U.S. homeowner does not own his or her home free and clear of consensual mortgage liens. It might therefore be more accurate to consider
the mortgage lender as the party investing funds into the mortgaged real property, with the homeowner being the beneficiary and recipient of that investment.4
Mortgage loans combine real estate market risk (a risk largely beyond the control of lenders and borrowers) with credit risk (including the risk that the borrower’s future available income may remain unchanged or decline). There is some evidence that national average household income reached a plateau and has been in decline since approximately the year 2000. During that same time period, the ratio of national median home price to national median household income generally increased (after having remained relatively con-stant for many decades).5 Under these circumstances, it is not surprising that
homebuyers and mortgage lenders alike have been willing to decrease down-payment requirements and increase the risk of down-payment default by increasing the percentage of income devoted to home ownership costs.
The current U.S. system of residential mortgage finance encourages home buyers to limit their initial cash investment in their homes to the minimum downpayment amount acceptable to mortgage lenders. For example, residen-tial mortgage interest may be deductible for income tax purposes, unlike other types of interest payable in connection with consumer credit transactions (and unlike residential rent payments), turning the residential mortgage into a po-tential tax shelter for some borrowers. Mortgage interest and real property tax deductions may allow some homeowners to declare additional itemized de-ductions (such as charitable dede-ductions), in excess of the so-called standard deduction that would otherwise be available — since the tax benefits associated with the mortgage interest deduction increase with higher mortgage interest payments, the Internal Revenue Code encourages higher outstanding mort-gage balances and lower downpayments, and the purchase of more expensive homes. Certain “points” and mortgage insurance premiums paid in connec-tion with purchase money residential mortgage loans may also be deductible for income tax purposes, creating additional tax incentives to minimize downpay-ments when purchasing homes. One should also consider the message that the Federal Housing Administration implicitly gives all prospective homebuyers and mortgage borrowers through its first-time homebuyer 3.5 percent down payment program (a recently increased downpayment requirement, effective January 1, 2009) — Congress and the FHA evidently continue to regard a
96.5 percent loan-to-value ratio as safe and appropriately insurable with tax-payer funds. Capital gains on the sale of a primary residence are also sheltered from federal income tax, and homeowners do not have to declare as “imputed income” the dollar amount of rent payments they save by owning their homes. With governmentally-created tax and other benefits, the average consumer might understandably have considered mortgage financing to be, on the whole (subject to recent highly publicized subprime and adjustable rate mortgage ex-ceptions), relatively benign. Many consumers may have considered a mortgage or deed of trust as a mainstream financial planning tool, not significantly more dangerous than a credit card (and almost as readily obtainable and replaceable as a credit card account).6
an alternatIve vIew
Here is an alternative view of residential mortgage lending: A home- owner who has (for example) mortgage liens encumbering 60 percent or 70 percent of the fair market value of the home is effectively a minority co-owner of the home, sharing homeownership with the holders of the mortgages on the home. Our residential mortgage market assumes that lenders are willing to hold (through their mortgages or deeds of trust) a super-majority multi-year ownership interest in residential real property. Mortgage lienholders could therefore be thought of as analogous to landlords, with a borrower’s mortgage payments analogous to lease payments. Mortgage loans are argu-ably analogous in some respects to “rent to own” contracts. Consumer advo-cates often discourage use of “rent to own” contracts as a means of acquiring personal property, such as computers, televisions, furniture, and other house-hold items, because the total price paid through a “rent to own” contract is usually significantly higher than the price payable through more conventional personal property financing, a layaway plan, or accumulated cash savings. Eighty percent loan-to-value 30 year fully amortizing purchase money mort-gage financing is not typically considered an unreasonable or anti-consumer way to finance a home, even if less expensive housing alternatives (including rental options) might be available.
Perhaps only relatively sophisticated borrowers have understood that purchase money mortgages and refinancings, combined with second
mort-gages, are analogous to margin lending in the securities world, or insurance premium financing in the insurance world. A securities investor who does not repay a margin loan on time should expect to lose the cash and securities that collateralize the margin loan. An insured who does not make insurance premium finance payments on time should expect that the related insurance policy will be cancelled. Similarly, a homeowner who stops making required payments to a mortgage lender should reasonably anticipate the eventual loss of the mortgaged property (just as a tenant who falls behind on paying rent to the landlord should anticipate eventually being evicted from the property).
mortGaGe rIsk dIsClosure
Another mortgage loan risk should be clearly disclosed to mortgage loan applicants and any prospective purchaser of real property who intends to pur-chase with loan proceeds: Our present system of homeownership financing is based on the underlying premise that the mortgaged property is a fairly liquid, marketable investment that will generally increase in value over time — oth-erwise, if the prevailing common wisdom were that real property values are at high risk of remaining flat or decreasing over time, one would expect avail-able mortgage financing options to more closely resemble availavail-able automobile, securities or insurance financing options. Government-sponsored secondary market and FHA/VA mortgage programs have made 30 year fully amortizing first mortgage maturities commonplace, clearly evidencing a widespread belief that the mortgaged property will at least maintain its value, if not increase in value, over the long term.7 The current national attention on “short sales”
and press reports about certain homeowners deliberately stopping their mort-gage payments because their homes are worth less than their mortmort-gage bal-ances provide further evidence that homeowners (and mortgage lenders) have not expected mortgaged property to depreciate significantly. (In contrast, one does not typically see press reports about car owners deliberately stopping their car loan payments simply because the value of their financed automobile has fallen below the outstanding balance of the car loan. Instead, one reads about consumers’ “negative equity” in traded-in used cars being added to the amount financed in connection with the purchase of another car.) However, although it may be true that over a 30 year period real property values will generally
increase (just as it is also true that over a 30 year period an investment in pub-licly traded stocks will generally reflect a positive return), recent events remind us that all markets have downturns, and the timing and extent of a downturn could be, to put it mildly, extremely inconvenient to an investor confronting imminent retirement, layoff, job relocation, or other financial stress.8
Mortgage loan maturities would not significantly exceed the median or average number of years a person can be expected to remain in residence at the same address, if the mortgaged property were not generally thought of as an appreciating investment that can be bought and sold (and refinanced) at will even if the property is encumbered by one or two mortgages. For example, the HUD-1 settlement statement includes two preprinted lines in the column summarizing the seller’s transaction, to show the payoff of first and second mortgage loan balances — this suggests that we generally presume homes will be marketed and sold while they remain encumbered by mortgages, and that such mortgages will generally be repayable from the property’s sale proceeds (net of real estate commissions and other seller-paid closing costs).
The 30 and 40 year first mortgage loan maturities that continue to be widely available have essentially become yet another way (in addition to lower interest rates) for a borrower to reduce the amount of the required installment payment.9 Notably, the Obama administration’s “Making Home Affordable”
modification program allows mortgage servicers to enter into 40 year modifi-cation terms if an interest rate reduction by itself will not result in affordable monthly payments (generally defined to mean first mortgage payments not greater than 31 percent of the borrower’s gross pre-tax monthly income, in-clusive of property taxes and homeowner’s insurance premiums) — a maneu-ver to help mortgagors avoid payment defaults and foreclosure by lowering the dollar amount of the required periodic payment. The extended term of the modification leaves mortgagors subject to the risk of not being able to pay off the full unpaid balance of the modified loan when the mortgaged property is ultimately put up for sale (in all likelihood before the maturity date of the modification). The extended term of the “Making Home Affordable” modi-fication does, however, help give the homeowner more control over when the mortgaged property ultimately will be sold and when the homeowner will move out of the property.
confidence about taking on larger dollar mortgage loans, since, over the long term, it may be reasonable to expect the borrower’s income and the mort-gaged property’s value to gradually increase (at least in absolute dollars, if not relative to the rate of inflation), while the unpaid principal balance of the mortgage loan gradually decreases. If, however, the average or median num-ber of years a homeowner can be expected to stay in residence at the mort-gaged property is significantly less than the scheduled maturity of a mortgage loan, assumptions about the time period in which the borrower’s income and property value will increase, and the time period in which the princi-pal balance will gradually decrease, should be carefully reconsidered, and the risk of finding oneself in a temporary economic downturn at the time the homeowner wants to either refinance or sell should not be overlooked.10 For
example, the amount of principal reduction in the first eight years of a 30 year fully amortizing mortgage loan is approximately 12 percent. Principal would be reduced by approximately 16 percent after the first 10 years post-closing.11
If the original mortgage amount was 80 percent of the property’s fair market value, a 12 percent principal reduction would equate to an equity increase of approximately 9.8 percent of the property’s original fair market value, and a 16 percent principal reduction would equate to an equity increase of ap-proximately 13 percent of the property’s original fair market value. A market downturn of 10 percent in the first 10 years of the loan could therefore largely counterbalance the scheduled principal reduction and corresponding equity increase on a 30 year fully amortizing loan. The consequences of a flat real estate market or a market downturn on a loan with a loan-to-value ratio at closing of 90 percent or more, or with a term longer than 30 years (and/or with interest-only payments), would be magnified.12 Closing costs (such as
the selling homeowner’s real estate broker commission or a refinancing home-owner’s loan origination fees) may further erode available equity.
Prospective home buyers (not just mortgage loan applicants) should be cautioned that any attempt to refinance a mortgage loan at a later date (for example, to take advantage of lower prevailing interest rates and/or to bor-row additional funds against the property’s appreciated value) is economically equivalent to finding a third party willing to invest significant sums into the property and become a co-owner of the property. Cash-out refinancings ar-guably are even more like a sale of the homeowner’s interest in the mortgaged
property, by allowing the homeowner to turn accumulated equity into cash. The cost and availability of mortgage refinancing will of necessity depend on the property’s then-current market value, as well as the borrower’s credit, income, and other financial circumstances. Refinancing requests made when property values locally appear to be softening or in a downturn, or when the longer-term prospects for the borrower’s employer or employment sector ap-pear to be in transition, may not receive hoped-for underwriting treatment. Conversely, if a homeowner successfully refinances during a real estate market upswing, and converts accumulated equity into cash at that time, the fact that the property may subsequently fall in value before the refinancing loan is repaid in full should not in principle take the homeowner by surprise or cause the homeowner to think the property is no longer worth keeping.
Home PurCHase dIsClosures
Protection of the “homeowner” or of “homeownership” through new borrower suitability, disclosure, and substantive residential mortgage lend-ing requirements should be carefully considered, when the interest of the “owner” sought to be protected is initially limited to the cash downpayment (in the case of a purchase money mortgage loan) or the unencumbered equity in the mortgaged property (in the case of a non-purchase money mortgage loan). Mortgage lenders and brokers clearly should not be encouraged to make mortgage loans to borrowers who appear to be incapable of repaying as contractually required. But by the time a borrower approaches a lender or broker for mortgage financing, the borrower typically has already either entered into a purchase contract for the real property (and may risk losing a significant deposit if the contract is breached), or already holds legal title to the real property. Mortgage loan disclosures under RESPA and the federal Truth in Lending Act understandably are not required to be provided until after a loan application has been received — recent revisions to the federal Truth in Lending Act and Federal Reserve Board Regulation Z require esti-mated disclosures to be provided to mortgage loan applicants within 3 busi-ness days after receipt of the mortgage loan application, and prohibit the loan applicant from being charged any fees (apart from bona fide credit report fees) before the applicant receives such estimated disclosures.13 Similarly, the
RESPA-required good faith estimate generally must be provided within three business days after a mortgage lender or mortgage broker receives a mortgage loan application, and the applicant may not be charged any fees (apart from fees to cover the cost of obtaining a credit report) before the applicant receives the good faith estimate.14
The nonrefundable good faith “earnest money” deposit that has typically already been paid by a prospective homebuyer towards the purchase of a new home will be significantly more than the cost to a mortgage lender or mort-gage broker of obtaining a credit report. Thus, the financial consequence to a prospective homebuyer of deciding against buying a house because the con-sumer is unwilling to accept purchase money mortgage financing on terms available from willing mortgage lenders could be significant. Certain generic non-loan specific RESPA disclosures that must be provided by mortgage bro-kers or lenders may be more useful if provided earlier to homebuyers, includ-ing in particular the HUD booklet about settlement costs.15 Since most
home purchases will include some type of purchase money financing, some precautionary disclosures to prospective homebuyers at or before the time a binding offer is made to buy a house, about the financial risks inherent with owning and financing (leveraging) real property, would be appropriate.
Many states now impose so-called homeownership or housing counsel-ing requirements on certain first-time homebuyers and/or on certain appli-cants for higher-cost mortgage loans, but only as a condition of obtaining mortgage financing.16 Counseling requirements also may be imposed as a
condition of qualifying for state or federal loan guaranties, loan insurance, or similar types of governmental mortgage loan assistance or subsidies. Certain governmentally-assisted homeownership programs may also require home-ownership counseling as a condition of being eligible for such assistance.17 In
most instances, the party required to enforce the homeownership or housing counseling requirement is the mortgage lender, not the private sector seller of the property or the real estate agent. Practically speaking, homeowner-ship counseling may be too late to be useful once the nonrefundable “earnest money” deposit has been paid on a home purchase contract.
Existing federal and state borrower suitability standards that focus on borrower debt-to-income ratios and ability to make contractually required loan payments ignore the fact that the borrower may have already decided
to purchase a home in a certain price bracket with a certain downpayment — the smaller the downpayment, the more the borrower will be subject to market risks associated with home ownership.
Requiring a mortgage lender or broker to verify the borrower’s ability to repay a 30 year fully amortizing mortgage loan “as required” by the terms of the loan also overlooks the strong probability that the homeowner will not remain in residence at the mortgaged property for the full maturity of the mortgage loan. Some disclosure to prospective homebuyers (not just mortgage loan applicants) about the disconnect between the median or aver-age expected years in residence at the property18 and typical mortgage loan
maturities would be useful. The homeowner’s decision (whether voluntary or forced by economic circumstances) to sell and move out of the property can effectively transform a seemingly benign 30 year fully amortizing loan to a type of balloon loan. Although the timing of this balloon final payment may be largely under the borrower’s control, the borrower cannot control whether the prevailing real estate market (and/or the prevailing mortgage market) is experiencing a downturn at the time the borrower is trying to sell and move out of the mortgaged property.
“Buyer beware” and “Borrower beware” are equally important warnings for consumers thinking about entering into credit transactions to be secured by real property. Putting more emphasis on homebuyer education would be consistent with existing securities and insurance suitability requirements, which focus on the prospective investor or insured, before the consumer has paid for the security or the insurance policy. Homebuyer education is espe-cially important in a system that presumes a third party (the mortgage lender) will be the primary source of funds for the purchase transaction, and that also presumes the home may be refinanced, releveraged and sold without impedi-ment. Some consideration could also be given to imposing buyer suitability requirements on real estate agents, to supplement the borrower suitability requirements imposed on mortgage lenders and mortgage brokers.
non-PurCHase money mortGaGe rIsk dIsClosures
Mortgage loan applicants also should be cautioned against additional risks associated with borrowing against the home for non-home related reasons
(in-cluding credit card, student loan or automobile-related reasons). If mortgage debt were limited to financing the purchase price of the home net of the buy-er’s downpayment, the risk of having to repay the mortgage in full at a time when real property values are flat or declining would be partly cushioned by the downpayment and any mortgage principal reduction that has been achieved with mortgage payments. If additional mortgage debt is incurred for other unrelated reasons, having nothing to do with the real property itself, the cush-ion against the risk of flat or declining market values may be eroded, and the homeowner may be more vulnerable to property devaluation risk.
retHInkInG tHe status quo
Recent market disruptions provide a useful opportunity to rethink the status quo. While we undoubtedly do not want to turn back the clock to 1933 (a time when five year interest-only balloon first mortgages were commonplace in the U.S.), it is interesting to look north to Canada for a completely different approach to residential mortgage lending: Canadian mortgage borrowers are typically asked to choose upfront what amortization period they would like, what interest rate structure and loan term they would like, and so forth. “[M]ost mortgage payments are at a level that would amortize the mortgage over a period of 25-30 years. The loans, however, typically have maturities of from six months to five years. At maturity, the borrower may refinance the loan at current interest rates, or pay off the mort-gage note.”19 The borrower’s loan origination fee may depend on the exact
loan program selected by the borrower. The borrower must make important decisions about the loan term (which also may translate to an interest rate lock decision as well as a decision concerning prepayment, since prepayment penalties typically apply if loans are prepaid before their scheduled maturity), amortization period, and so forth in advance of loan closing. By giving the borrower significant choices and decisions upfront, and allowing the bor-rower to collaborate with the lender in designing the terms of the borbor-rower’s mortgage loan, a Canadian borrower arguably enters into a residential mort-gage loan with greater understanding about and acceptance of the terms of the mortgage loan, not unlike a U.S. securities investor who has to make a specific selection of a security, or a U.S. purchaser of an insurance policy or
annuity, who has to make specific decisions about coverage amount, term, and so forth. In addition, the shorter-maturity Canadian mortgage loans arguably force prospective mortgage borrowers to consider mortgage loans more as cash management or financial planning tools, and may help borrow-ers more clearly distinguish between the separate (although related) concepts of home ownership and home financing.
The current U.S. system of highly leveraged homeownership, in place for the last 75 years, raises significant public policy issues with important eco-nomic and social consequences. Higher loan-to-value and debt-to-income ratios (as have been encouraged under the current U.S. residential mortgage finance system) are closely correlated with higher default and foreclosure risk.20 Government and policy makers should carefully consider the extent to
which borrowers and lenders should continue to be systemically encouraged to enter into residential mortgage transactions with maturities that signifi-cantly exceed the homeowner’s expected period of residency and ownership, where the only significant and viable source of repayment in the event of a default or loan acceleration (including voluntary acceleration by the bor-rower) is the mortgaged property, and where the homebuyer’s investment in the home is significantly less than the financing mortgage lenders’ investment in the same property.
notes
1 See, e.g., Federal Reserve Board Regulation Z revisions published at 74 Fed. Reg.
23289 (May 19, 2009) and RESPA Regulation X revisions published at 73 Fed. Reg. 68204 (November 17, 2008). See also the Mortgage Disclosure Improvement Act of 2008, Sections 2501 through 2503 of the Housing and Economic Recovery Act of 2008 (Pub. L. 110–289), as amended by the Emergency Economic Stabilization Act of 2008 (Pub. L. 110–343) and Federal Reserve Board pending proposed revisions to the closed-end and open-end mortgage loan disclosure requirements of Regulation Z (including proposed addition of new 12 CFR Sections 226.37 and 226.38), published at 74 Fed. Reg. 43232 and 43428 (August 26, 2009).
2 See, e.g., C. Garriga, W. Gavin & D. Schlagenhauf, “Recent Trends in
Homeownership,” Federal Reserve Bank of St. Louis Review (September/October 2006) at 397, 401-403 (discussing inter alia additional federal government support of homeownership “by authorizing state and local governments to issue tax-exempt
mortgage revenue bonds” and several HUD affordable housing programs) (copy available at http://research.stlouisfed.org/publications/review/06/09/Garriga.pdf).
3 For example, based on 2000 U.S. Census data, over 71 percent of Connecticut
homeowners reported that they had one or more mortgages on their homes. The median value of an owner-occupied home was approximately $191,471, according to the 2007 American Housing Survey. (U.S. Census Bureau data indicates that the median value of an owner-occupied home was approximately $119,600 in the year 2000.) Various Federal Reserve Board publications indicate that the national average first mortgage balance is upwards of $110,000. As of the close of 2007, the average “AltA” first mortgage loan balance may have been as high as $300,000, and the average “subprime” first mortgage loan balance may have been as high as $180,000. (See http://www.newyorkfed.org/regional/techappendix_spreadsheets.html.)
4 Treating the mortgage lender as an owner of the property is also consistent with
certain states’ laws treating mortgage deeds as the transfer of legal title from the mortgagor to the mortgagee. For example, in Connecticut, a mortgage deed is considered the conveyance of legal title from the mortgagor to the mortgagee, with the mortgagor retaining equitable title and the right to redeem legal title from the mortgagee upon payment in full of the mortgage debt and fulfillment of the other terms and conditions of the mortgage. See, e.g., State v. Hahn, 207 Conn. 555, 541 A.2d 499 (1988); Conference Center Ltd. v. TRC, 189 Conn. 212, 455 A.2d 857 (1983). For similar Massachusetts case law, see Cooperstein v. Bogas, 317 Mass. 341, 58 N.E.2d 131 (1944).
5 See, e.g., “Household Incomes and Housing Costs: A New Squeeze for American
Families,” by Barry Bluestone (April 4, 2007 testimony before the U.S. House of Representatives Committee on Financial Services), copy available at http:// financialservices.house.gov/hearing110/htbluestone040407.pdf. See also testimony of Kathleen E. Keest before the U.S. House of Representatives Subcommittee on Commerce, Trade and Consumer Protection (Committee on Energy and Commerce) regarding H.R. 2309, “The Consumer Credit and Debt Protection Act” (May 12, 2009), copy available at http://energycommerce.house.gov/Press_111/20090512/ testimony_keest.pdf (noting a slowdown in average household income growth between 1976-2007, a decrease in median household income, adjusted for inflation, from 2000-2006, and an increase in real housing prices of 22 percent between 2000-2005). U.S. Census Bureau information indicates that median household income in 2007 was approximately $50,740. (See http://quickfacts.census.gov/qfd/ states/00000.html.)
6 See, e.g., the link on HUD’s web site to a “Buying versus Renting” online calculator,
designed to help a renter decide whether buying a home might be financially more advantageous than continuing to rent. The calculator defaults to a 10 percent
downpayment, a one percent per year property tax rate, and a two percent per year home value increase, although these variables may be modified by the individual who uses the calculator. (However, the calculator does not allow the user to enter a negative number for the annual change to the property’s value.) The calculator also presumes a mortgage interest “tax savings” at the 28 percent income tax bracket (which in turn presumes, among other things, that the homeowner will have aggregate mortgage interest and other deductions greater than the standard deduction). (See http://www. ginniemae.gov/rent_vs_buy/rent_vs_buy_calc.asp?Section=YPTH.)
7 Prior to 1934, most U.S. residential first mortgages were shorter-term (as short
as three to five years), non-fully amortizing (including interest-only) balloon loans, requiring the typical homeowner to negotiate renewals or refinance. 1933 federal legislation creating the Home Owners’ Loan Corporation, and the 1934 creation of the Federal Housing Administration, combined to encourage use of longer-term (including 15 year to 20 year) fully amortizing first mortgage loan terms. (See, e.g., F. Wright, “The Effect of New Deal Real Estate Residential Finance and Foreclosure Policies Made in Response to the Real Estate Conditions of the Great Depression,” 57 Ala. L. Rev. 231 (Fall 2005) and S. Ramirez, “The Law and Macroeconomics of the New Deal at 70,” 62 Md. L. Rev. 515 (2003).) We have now shifted from mortgage maturities that were significantly shorter than the homeowner’s expected number of years in residence, to maturities that are significantly longer than the homeowner’s expected number of years in residence, and from loans requiring larger downpayments to loans requiring significantly smaller downpayments.
8 For example, based on the S&P/Case-Shiller Home Price Indices, by the end of
the first quarter of 2009 national average home prices in the United States were at approximately the same level as in the fourth quarter of 2002 (down from a record high reached in the second quarter of 2006). Nonetheless, recent stock market declines may have caused the average stock market investor to incur significantly greater losses for the 10-year period 03/31/1999-03/31/2009 than a real estate investor for that same 10 year period (with the caveat that stock market and home price indices do not accurately reflect the performance of an investment in a specific stock or parcel of real estate).
9 See, e.g., Fannie Mae’s April 2005 Consumer Fact Sheet about 40 year
mortgages (copy available at https://www.efanniemae.com/sf/mortgageproducts/ pdf/40yearconsumer.pdf): “With a 40-year term mortgage, you get lower, more affordable monthly payments, making it easier for you to achieve the dream of homeownership. This product may be right for you if you are a first-time or trade-up borrower living in an area where high home prices and affordability are issues. In addition, this mortgage may help you achieve your overall financial management goals. For example, you can use the difference in monthly payment to pay off
higher-cost debt, or save for investments.” See also Conn. Gen. Stat. Section 36a-261(h), generally permitting Connecticut-chartered banks to invest their assets in mortgage loans not to exceed 90 percent of the value of the mortgaged real estate, if the loans require (inter alia) at least consecutive semiannual installments of principal and interest “sufficient to pay the loan in full not later than forty-two years from the date of the first payment….”
10 The HUD booklet about settlement costs (version in effect during 2009) includes
the following discussion of mortgage loan maturities: “Most loans can be repaid over a term of 30 years or less. Most loans have equal monthly payments. The amounts can change from time to time on an ARM depending on changes in the interest rate. Some loans have short terms and a large final payment called a ‘balloon.’ ” There is no mention of the fact that a property sale or mortgage loan refinancing before the maturity of the initial purchase money mortgage loan will effectively transform the purchase money loan into the equivalent of a “balloon” loan.
11 Using a 30 year fixed rate fully amortizing mortgage as an example, and assuming
$100,000 of principal at six percent per year interest, with a monthly payment of $599.55: After 96 monthly payments (eight years post-closing), the unpaid principal would be approximately $87,772.35 (principal reduction of approximately $12,227.65). After another 24 monthly payments (10 years post-closing) the unpaid principal balance would be approximately $83,685.72 (total principal reduction of approximately $16,314.28 after the first 10 years of the loan). If the original $100,000 loan was equal to 80 percent of the property’s fair market value, the fair market value at closing would have been $125,000 (and the homeowner would have started out with $25,000 worth of equity, assuming no secondary financing). A 10 percent drop in the property’s market value in the first 10 years of the loan would equate to a loss of one-half of the homeowner’s downpayment or equity (measured as of loan closing) in this 80 percent loan-to-value example, with a resulting loan-to-value ratio at the end of the first 10 years of the loan of approximately 74 percent.
12 If, for example, the example in endnote 11 above were based on a 40 year
amortization term instead of a 30 year amortization term, principal reduction after the first eight years of the loan would be approximately six percent of the original principal, and approximately another two percent of original principal would be repaid after another two years (for a total principal reduction in the first 10 years of approximately eight percent of original principal). If the original $100,000 loan was equal to 90 percent of the property’s fair market value, the fair market value at closing would have been approximately $111,111 (and the homeowner would have started out with approximately $11,100 worth of equity, assuming no secondary financing). A 10 percent drop in the property’s market value in the first 10 years of the loan would effectively erase the homeowner’s downpayment or equity (measured as of
loan closing) in this 90 percent loan-to-value example, with a resulting loan-to-value ratio at the end of the first 10 years of the loan of approximately 92 percent (higher than the original loan-to-value ratio measured as of loan closing).
13 See, e.g., Federal Reserve Board Regulation Z revisions published at 74 Fed. Reg.
23289 (May 19, 2009).
14 See 24 CFR Section 3500.7.
15 RESPA does not apply to residential real property transactions that are not
secured by a mortgage or deed of trust, and therefore focuses on residential mortgage transactions, not purchase-sale transactions or buyer-seller interactions.
16 See, e.g., Mass. Gen. Laws ch. 184 Section 17B½ and ch. 183C Section 3. 17 See, e.g., 24 CFR Parts 572, 904 and 906. The Obama administration’s
“Making Home Affordable” modification program requires housing counseling if the borrower’s estimated total debt-to-income ratio (including the modified first mortgage payments) equals or exceeds 55 percent of the borrower’s gross monthly income.
18 Information about the median number of years in residence for a specific state,
census tract or metropolitan statistical area is available from the U.S. Census. For example, based on the 2000 Census, for the State of Connecticut, 13.4 percent of householders reported that they had moved into their current homes in 1969 or earlier. 16.9 percent of Connecticut householders reported that they had moved into their current homes within one year of the 2000 census. 27.3 percent reported moving into their current home between 1995 and 1998. Overall, 58.90 percent of Connecticut householders reported moving into their current homes within 10 years of the 2000 census (1990-2000).
19 E. Pittman, “Economic and Regulatory Developments Affecting Mortgage
Related Securities,” 64 Notre Dame L. Rev. 497, 501 n.21 (1989).
20 See, e.g., Mayer, Pence and Sherlund, “The Rise in Mortgage Defaults”
(November 2008), Federal Reserve Board Finance and Economics Discussion Series working paper 2008-59, copy available at http://www.federalreserve.gov/pubs/ feds/2008/200859/200859pap.pdf (“When borrowers with positive equity in their homes experience financial difficulties, they are likely to respond by refinancing or selling their homes. Even if a borrower cannot afford the current mortgage, it is more profitable for a borrower to sell the house than to have the bank sell it through a foreclosure. Borrowers with negative equity, however, face no such incentive, and are more likely to default on their loans…”) (citations intentionally omitted)).
