Thursday, April 14, 2011

Responsible Borrowing and Defense to Foreclosure

In 1953 my grandmother went through a divorce at a time when very few people living in middle America got divorces. Abandoned by her husband at about thirty years of age, she and her three young children (all under the age of 10) moved back to the tiny town of Parsons, Kansas, where her parents and siblings lived. My grandmother moved in with her mother and father and got a job in town which barely covered the expenses for herself and her children. After a short time, she realized that she needed a loan from the local bank in order to make ends meet.

My grandmother did not have credit or any collateral, but she hoped that her family's long-time presence in the community would help her in securing the small loan she needed. When she talked to the banker, she told him that her father would be willing to co-sign for her for the loan. The banker's only question was, "Who is your father?"

"Harlan Stringer," replied my grandmother.

"In that case, I don't need a co-signer," replied the banker. "I know your father. If you don't pay this money back, he will, whether he co-signed for it or not." She left the bank with the money, which she did pay back in full from her meager wages.

My great-grandparents were fairly typical of Depression-era families. They never had any extra money, but they raised a garden and a cow which allowed them to feed their own six children plus six extra children from town every night. (Each of their children had instructions to bring home one classmate from school each night for dinner, but to rotate the children so that all of the classmates could come out to the farm and eat. Children who lived in town often went hungry, so it was important that the invitations be extended to everyone since the Stringers raised their own food so they always had plenty to eat.) My great-grandfather eventually went to work for the railroad, and after he retired he stayed home and kept the garden, raised and sold chickens and fished. At that point, my great-grandmother got a job in town where she worked until well into her seventies.

They had no expectation of wealth--no concept of winning the lottery or some other contest that would bring a windfall into their lives. They expected to work for whatever they received and to pay for whatever they owned. They did not borrow money carelessly, because their sense of honor required that debts had to be paid--even if the debt were for an adult child who had borrowed the money because of a personal crisis but could not afford to repay the loan.

We hear a lot of comparisons today between our present day crisis, "The Great Recession," and the "The Great Depression" but I really don't think that it is fair to compare our society with the generation from 70 years ago who weathered that storm. The Depression-era generation was not as sophisticated as we are today and not nearly as well educated or well traveled, but they had a sense of values that our generation cannot begin to understand.

Today, we hear a lot about responsible lending but virtually nothing about responsible borrowing. By portraying  the borrower as the perpetual victim who is not responsible for the choices he makes, we are creating a society in which lending is almost impossible.  As an example, the Dodd Frank bill contains defense to foreclosure provisions which will become law in July, 2011.  Section 1413 of the Dodd Frank bill,  "Permits borrower to assert a defense to foreclosure against creditor or assignee or other holder of mortgage loan in judicial or non judicial foreclosure or any other action to collect debt in connection with mortgage loan when there is a violation of anti-steering and ability to repay provisions. Claim can lead to actual damages, statutory damages and enhanced damages including return of finance charges." (Quote taken from a 16 page summary of the mortgage provisions of Dodd-Frank).

Notice, that the claim can be against "creditor or assignee," which means that a current servicer of a closed, sold loan can be forced to pay "enhanced damages" if either the ability to repay or loan officer compensation statutes are violated. Of course, the "qualified residential mortgages" which are now being developed create a "safe harbor" for lenders, but that safe harbor can be rebutted in a legal argument.

Dodd Frank establishes prohibitions on "steering" by prohibiting payments to loan originators based on the terms of the loan and it prohibits the loan originator from receiving compensation from both the consumer and the lender. The "safe harbor" provisions also put a 3% cap on the total of broker and lender fees.

The bill further puts the penalty for violations of the compensation rules and "duty of care" on the shoulders of the loan originators as well as the servicers. Not only can violations be used as "defense to foreclosure" for the life of the loan, but the individual loan originator can be held liable for penalties of the greater of actual damages or an amount equal to 3 times the total amount of compensation or "gain" received by the loan originator plus costs and reasonable attorney fees.

In other words, if a consumer stops paying his mortgage, for whatever reason, and the lender starts the foreclosure process, if the attorney can argue successfully that the loan originator compensation rules were violated in any way or that loan originator did not meet the "duty of care" requirements, the loan originator is required to pay back the greater of whatever damages the court awards to the consumer or 3 times his compensation plus attorney fees and closing costs.

So let's see how this might look: John originates a loan for Sally for a $300,000 home. He knows that the new compensation rules do not allow him to collect money from both Sally and the lender, so he chooses consumer paid compensation of 1% or $3000.00. Sally receives a base salary from the office machines company where she works plus bonus. Since she has been receiving the bonus for the last two years, John uses the bonus as part of her income. Sally gets the loan. One year later, the office equipment company files bankruptcy and Sally loses her job. Since she is not able to find a job right away, she cannot make her payments on the house, and soon her current servicer begins foreclosure proceedings.

Sally gets an attorney who argues that she was not qualified properly with regard to her income because her bonus was used to qualify her and everyone knows that bonuses are discretionary. Without the bonus, she would not have qualified. Under the "defense to foreclosure" rules, Sally's home is now safe and she does not have to worry about making the payments. In the course of the attorney's investigation, he finds out that John's company is structured as a corporation rather than a sole proprietorship. Although he was self- employed, the judge rules that he does not meet the "salaried" requirements of the Federal Reserve interpretation of the loan originator compensation rule. So the judge rules that two violations have occurred.

Because of these violations, Sally's lender cannot foreclose on her even though she is not making the payments and in fact cannot afford to. And since the "defense of foreclosre" applies to the life of the loan, even when she gets a job and is able to make the payment, she can still live in her home without making hte payment and without fear of foreclosure. John, on the other hand, is now liable for $9000.00 plus attorney fees and court costs for originating a loan that he worked hard on and believed was perfectly fine. If he is like most loan originators today, John won't have the money, so the judgment will actually cost him his business.

Sound far fetched? It isn't. We are rapidly creating a world where consumers have no responsibility for their choices or actions. Even though no one coerced Sally to purchase a $300,000 home and in fact when she bought the house she would have been insulted at the implication that she could not afford to live there, as soon as she starts having financial difficulties, the purchase of the home and the loan that made it possible is everyone's fault but her own. Meanwhile, John who has worked hard and survived three years of real estate drought, is out of business because of regulations he did not even understand he was disregarding.

I learned last week that my local bank where I have my personal accounts has closed its residential mortgage department due in part to the defense to foreclosure provisions of Dodd Frank.  So a long-time customer of the bank who has trusted his local community bankers to handle his finances will now have to go elsewhere for mortgage money.  And I believe this is beginning of a trend which is going to lead to most smaller players exiting the mortgage origination market.  That leads to fewer choices for consumers and higher prices.  If we want to create a climate where originators will be able to do their jobs, we have to return to standards of personal responsibility and free enterprise. A basic fact of lending is that the only incentive that lenders have to make large personal loans in the form of residential mortgages is the collateral of the home and the lender's right to foreclose on it. As we make foreclosure impossible, we also make mortgage lending impossible. And by punishing the delivery system for mortgages, which is the loan originator, we create a system where no housing loans exist at all.

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