Well, if the comments are any indication, Tuesday’s post–where I discussed articles about problems with home equity lenders pulling their lines and errors in bond ratings–seems to have a struck a nerve. Rather than reply to each, I will reply to all in a general way.
First, a number of comments suggested that I was soft on fraudulent borrowers or too hard on the rating agencies. "Jarhead," for example, admonished that we should "start to sue borrowers." "AMC" doesn’t understand why lenders shouldn’t be entitled to the full benefit of their contract rights. "Orville R" claims that "nobody, I repeat nobody, for[e]saw [sic] the unprecedented 20% drop in house values." In any case, he suggests, Moody’s mistakes were a "non-story" because Moody’s ratings simply reflected disagreements among the professionals–in particular the lawyers.
I should be clear that I have no sympathies for any particular type of stakeholder in the mortgage mess. I think no category of participant has a monopoly on cupidity, deceit or incompetence. Thus, I agree that many borrowers who probably knew better (or should have known better) should be held to the bargains they struck. But that’s exactly what we’re doing. Jarhead’s comment that we should sue borrowers ignores the fact that we are: It’s called "foreclosure," and the rates of suit are apparently at historic highs.
Home Equity Lenders–LTV Issues
The problem with banks that pull a home equity line when the loan-to-value ratio (LTV) declines is that it may be compounding one mistake with another (thus the title of the post). If AMC had read the underlying article he or she would see that there is no good reason to believe that the new, reduced valuation is any better than the old, inflated one—and there is some reason to believe that it is excessively low.
Thus, the bigger problem is this: In a world of falling real estate prices, what rational lender would ever choose to throw a paying borrower into default? That, of course, is the likely effect of declaring a loan in default solely on LTV grounds. I have to imagine that the mortgages discussed in the New York Times piece—like every competently drafted mortgage—provide that falling below a certain LTV ratio is a default. I am equally sure that in many (perhaps most) cases, the values really have fallen, and the borrowers are in technical default. (incidentally, Orville, Robert Schiller was telling us for a long time that real estate was way over-valued).
But as anyone who has ever had any involvement with the real world of debt in the United States knows, there is a big difference between a "payment" default and a "technical" default. A payment default is what it sounds like: The borrower was supposed to pay at a certain time, and didn’t. A technical default, by contrast, is a violation of any of the many covenants or obligations or promises a borrower might make in the loan agreement–including the promise that the property will remain above a certain value relative to the amount of the loan (LTV). In a well-crafted loan agreement, breach of any obligation–including the LTV ratio–will be (technical) grounds to declare the loan in default.
In my experience as a lawyer, it was almost always possible for a lender to find some technical violation, big or small, to declare a loan in default–if the lender wanted to do so. But the prudent lenders with whom I worked (and even the not-so-prudent ones) all recognized that declaring technical defaults was a risky business, for both economic and legal reasons. Why default a paying customer? Why risk a claim of bad faith or (*gasp*) lender liability?
Here, if the Times story is to be believed, we have lenders doing just this–creating technical defaults at a time when it is simply irrational to do so. It is irrational for them to upset the payment stream they bargained for, if the borrower is current. It is irrational for them to force yet another house onto the auction block. It is simply compounding one mistake with another.
Now, if there are payment defaults, that’s a different story. But if there’s a payment default, there’s no need to adjust the LTV. Everybody understands that a lender does—and should—act with haste to protect itself in the presence of a payment default.
Nor, I should add, is it always inappropriate to declare a loan in default when the LTV covenant is tripped. It’s there for a good reason–it’s an early warning system to the lender. Thus, lenders in many cases may be well advised to call a loan early for LTV or similar technical defaults, if they think it will head off greater trouble in the future.
But usually, the sensible result of calling the loan (especially for a technical default) is negotiation with the borrower over new terms. Here, however, we have good reason to believe that’s not occuring at nearly the rate that it should. Mortgage servicers are already stuck in a "traffic jam" of existing defaults which they can’t renegotiate. Why on earth should they create new ones?
The Rating Agencies
As for Moody’s mistakes: The problem with Moody’s (and S&P and Fitch)–the three big rating agencies– is that they are subject neither to meaningful market competition nor risk of liability. They had little incentive to get it "right"–and it’s not clear that that’s going to change.
I doubt that liability–as in suing the rating agencies–is likely to produce better ratings in the future. But introducing more competition–something even conservatives should support–could make a big difference. As I understand it–and the evidence is limited–it sounds like the rating agencies suffer from two market failures.
First, and less important, they are effectively an oligopoly. Federal securities laws makes it very difficult for new players to enter the market (although some are trying), yet requires that many bonds have a rating from the big three.
But there is almost certainly competition among the three, so the second and bigger question is: Competition on what? Here, it appears to have been competition to provide ratings–not to provide accurate ones.
That crucial distinction appears to have been driven by the way ratings were purchased. Ordinarily, in any significant transaction, the buyer and seller will do their own analysis of the value of the thing being purchased. A rating is not a valuation, of course, but it sounds like it was important to the buyers, who claim to have been misled into purchasing highly rated, mortgage-backed securities that were "toxic", or at least riskier than their ratings would indicate.
Here, the problem appears to be that the issuers–the sellers of the bonds–were paying for the ratings, even though it was the buyers who relied on them. This appears to have distorted incentives, since the rating agencies all wanted to be paid to give the rating, and so would tend to give high ratings because that was what their customers–the sellers–wanted. In U.S. corporate law, it would be a little like the acquiror of a corporation relying solely on a fairness opinion prepared by the target. It would never happen, because the buyer and seller–and their information professionals (whether rating agencies or appraisers)– have competing incentives.
The rating agencies now have a pretty bad track record. We know they made serious mistakes in their Enron and Worldcom ratings. They even acknowledge their current mistakes–although they are quick to point the finger at the issuers who packaged the transactions in the first place. They may be right to do so. But that does not excuse their own mistakes.
I should add that, in the same way that I have little sympathy for borrowers who knew or should have known better, I have even less sympathy for hedge fund managers who bought bonds in blithe reliance on (mistaken) ratings. Many of these guys (and perhaps women) apparently pulled down enormous salaries, even as they were using other people’s money (the hedge fund investors’) to purchase bonds that they may not have properly scrutinized because they relied on–you guessed it–mistaken ratings. Being somewhat cynical, I wouldn’t be surprised to learn that in some cases these hedge fund managers knew, or should have known, that the bonds they were purchasing were not properly rated. All will come out in the fullness of litigation.
Andrew Cuomo has tried to fix some of this. But until there is meaningful competition and a realignment of price with risk, I have my doubts about the success of these efforts.
In short, I think there is plenty of blame to go around. I generally support contract and markets as institutions. Contract has been the linchpin of the deregulatory experiment commenced in the 1970s. In some cases it has worked; in some cases, it hasn’t. Increasingly, it appears that in the case of the mortgage crisis, contract has not done its job, and by itself is unlikely to solve it.
Comments
8 responses to “Paying for Mistakes–Redux”
On the LTV issue: I’m puzzled by your use of the word “call”. I read the NYT article, and I did not see any claim that homeowners were being asked to repay borrowed funds ahead of schedule.
A borrower who owes 25k on a line of credit that’s been reduced to 10k doesn’t have to pay back 15k tomorrow; they repay the loan according to the original terms, and thereafter may borrow up to the lender’s allowable LTV, using the lender’s new estimate of the property value. This may be a hardship, but I don’t think it’s what most people would understand by “call”.
I don’t see how these actions would lead to additional defaults, unless the borrower is borrowing money to make the payments on their existing balance.
The AVM is certainly not perfect. But a traditional appraisal isn’t either, and I’m not sure that anyone is willing to pay for one, given the small size of the loans. And particular cases may be arguable, but the AVM’s overall trend should indeed be down, so these cases ought to be happening somewhere.
If you think this is unacceptable, then under what conditions would you consider it appropriate for the lender to reduce the credit limit? As AMC asked, if the uninsured house burns down, then must they lend against the smoking hole?
Must the lender lend against an uninsured, smoking hole? Sure, if that’s what the contract says. But it probably doesn’t.
I agree that reducing an undrawn line of credit creates less harm than putting a borrower into default. But I don’t think reducing undrawn lines is the only thing that’s happening here. If the borrower has drawn $15K under the original LTV, but the new LTV caps the line at $13K, then the borrower is $2k over the limit–and that’s a default under the contract. If that’s what’s going on, then whether or not it’s permitted by contract, it seems a mistake to me, for the reasons previously stated.
Professor, I’ll again point to Mortgage Servicing Fraud as to reasons that entities create foreclosure situations. Servicers, much like the credit industry, make more money when borrowers are in default – any kind of default whether legitimate default or manufactured default.
Again, I’ll point to evidence that I have in my own case of Fairbanks/SPS holding payment until past due thereby creating a default situation. http://www.getdshirtz.com/paymenthold.htm
Fairbanks/SPS local legal counsel, Harmon Law Offices, attempted to have me testify under oath that the 04/24/02 date on the back of that check was the date that the check was received despite the front of the check being clearly stamped “received April 12”.
Servicers make more money when borrowers are in default – at least when they’re in default according to the servicer’s books. Period.
No LTV defaults on Equity lines here in Texas (for homesteads). Plus you cannot get an equity loan for more than 80% of the value of the home. I don’t believe a consumer can get an “open-line” secured by a homestead here in Texas either. Before we let “Equity” lines of credit in here in Texas, I had people asking “why” all the time. When we first let “Home Equities” in here in Texas people were then griping because they could only do 80%. It all seems like genius now. The 80% helped hedge against the ups and downs of the market and the other “bells and whistles” basically protected us from ourselves. If people down here knew what was going on in the rest of the country on these types of home loans, I am sure I would hear less of “Let the free market decide”. So in short, LTV is a non-issue for homeowners as it pertains to foreclosure here in Texas. We are also a non-judicial foreclosure State……except when it comes to “Home Equity” loans on “Homesteads”. Mortgage creditors have to jump thru some extra hoops when it comes to “Home equity” loans here in Texas. Those “hitches” in the lending laws here in Texas did not seem to slow the Home Equity Lending very much. I am sure though that if we are looking at volume and comparing the different states, there may well be a big difference in Home Equity originations.
You misstate my comments.
I made two points – one, I didn’t think there was anything wrong with HELOC lenders having a right to terminate the right to borrow additional monies based on declining home values.
And two, you equated several different concepts in a misleading way. Specifically, not being able to borrow is not the same as “having to pay”. And, in my view, declining home values does not mean that the lender necessarily made a “mistake” in allowing a borrower to make a HELOC loan.
I also loved this: “If AMC had read the underlying article he or she would see that there is no good reason to believe that the new, reduced valuation is any better than the old, inflated one—and there is some reason to believe that it is excessively low.” Is CreditSlips goal to engage in discussion at the “let’s make up something ad hominem to disparage those who disagree” level? Shall I respond with a “Mr. Lipson could understand my points if he hadn’t been dropped on his head as a child?” Or shall I just wait for you to drop a Nazi analogy and go full Godwin on your little melt?
The NYT article is just an article. Even if you like what it says, it’s not some rigorous study. It has various opinions in it, and some statements by individuals that you seem ready to extend beyond what is actually stated.
For example – the article does seem to support the idea that the loss of home equity line of credit financing is actually based on real home value declines. From the article: “Analysts say the cuts have mostly come in regions where real estate values have dropped” – that comports with the idea that home value decreases are the main factor in the ability to borrow on these loans being reduced.
Your assumption that the valuations are unfair are based – from my reading of the article, solely on this: “Lenders have automated systems that can estimate a home’s value without a formal appraisal, Mr. Findlay said, but they are now most likely underestimating that value “because they’re hedging their bets a little bit.” The statement is that they HAVE an automated system that CAN estimate values, not that it is actually being used. You may have additional information re: what percentage of HELOC loans that are suspended for loan to value deficiencies are based on some Zillow-like system, but it isn’t stated in the article. Instead, you assume it, and apparently believe I have to make the same assumption “if I had read the article”.
Further, you assert that there are reasons to believe that the values are excessively low – again, because of one comment that second mortgage lenders going conservative on their value estimates. But, home values are plunging, and forced sale values are, if anything plunging quicker. In addition, more and more circuits are permitting wholly unsecured junior mortgages to be stripped off and treated as unsecured claims.
My view of the statement in the NYT article is influenced by my own experiences. When I talk to people about the value of their real estate, they’ll say something like: “The property is worth $200,000.” And when I follow up with – “So, that’s what you could sell it for if you put it on the market?” they respond with – “Oh, you mean in today’s market? Maybe $160,000.” It is my understanding, from talking to Chapter 7 trustees, that they are very reluctant to try to liquidate real estate in today’s market – the auction values don’t have a stable floor, and they are getting stuck with expenses on properties that don’t sell.
And, I think you are just wrong in equating a loan-to-value deficiency with a technical default. Yes, in sophisticated commercial lending situations, where a loan is tied to some combination of inventory, work-in-process, and accounts receivables, a loan-to-value ratio problem is a technical default. But there is NOTHING in the article, or in my experience reading HELOC loan docs for other purposes, that lead me to believe that a loan-to-value deficiency is a default under most HELOC’s, permitting a second mortgage holder to commence a foreclosure action. The big problem (other than an inability to borrow) highlighted in the article is the effect on HELOC borrower’s credit scores for a very technical reason – the loss of the ability borrow additional funds, NOT the existence of a loan default. Why do you think that was the article’s focus if second mortgage holders were actually reporting defaults based on LTV problems?
The article talks about suspensions of lines of credit, or an inability to make additional draws, not declaring a default on the loan – not that it is going to be economical for a second mortgage holder to put a property through foreclosure in most cases anyway. Foreclosure is primarily a first mortgage holder’s remedy, not a second (or third) position lender.
Finally, if you are wrong about a loan to value deficiency triggering a default on the loan (and I think you are wrong on that), my question about the ability to borrow additional amounts on HELOCs is: who cares? Yes, there will be some hardship situations, but while HELOCs lack the aspect of pure evil you find in pay day lenders, it makes up for it in the damage these loans have done to consumer finances in this country. People turning the equity in their home into debt is not a good thing on a macro level for this county and its citizens.
Unless I am mistaken, federal consumer protection laws (based on a 1988 Amendment) prohibit a change in the loan-to-value ratio being a grounds for default.
Unfortunately, this comment section does not appear to like html coding for bolding and underlining – so here is a link and the raw language:
http://www.fdic.gov/regulations/laws/rules/6500-1600.html#6500226.5b
(f) Limitations on home equity plans. No creditor may, by contract or otherwise:
(1) Change the annual percentage rate unless:
(i) Such change is based on an index that is not under the creditor’s control; and
(ii) Such index is available to the general public.
(2) Terminate a plan and demand repayment of the entire outstanding balance in advance of the original term (except for reverse mortgage transactions that are subject to paragraph (f)(4) of this section) unless:
(i) There is fraud or material misrepresentation by the consumer in connection with the plan;
(ii) The consumer fails to meet the repayment terms of the agreement for any outstanding balance;
(iii) Any action or inaction by the consumer adversely affects the creditor’s security for the plan, or any right of the creditor in such security; or
(iv) Federal law dealing with credit extended by a depository institution to its executive officers specifically requires that as a condition of the plan the credit shall become due and payable on demand, provided that the creditor includes such a provision in the initial agreement.
(3) Change any term, except that a creditor may:
(i) Provide in the initial agreement that it may prohibit additional extension of credit or reduce the credit limit during any period in which the maximum annual percentage rate is reached. A creditor also may provide in the initial agreement that specified changes will occur if a specified event takes place (for example, that the annual percentage rate will increase a specified amount if the consumer leaves the creditor’s employment).
(ii) Change the index and margin used under the plan if the original index is no longer available, the new index has an historical movement substantially similar to that of the original index, and the new index and margin would have resulted in an annual percentage rate substantially similar to the rate in effect at the time the original index became unavailable.
(iii) Make a specified change if the consumer specifically agrees to it in writing at that time.
(iv) Make a change that will unequivocally benefit the consumer throughout the remainder of the plan.
{{12-31-07 p.6652.03}}
(v) Make an insignificant change to terms.
(vi) Prohibit additional extensions of credit or reduce the credit limit applicable to an agreement during any period in which:
(A) The value of the dwelling that secures the plan declines significantly below the dwelling’s appraised value for purposes of the plan;
(B) The creditor reasonably believes that the consumer will be unable to fulfill the repayment obligations under the plan because of a material change in the consumer’s financial circumstances;
(C) The consumer is in default of any material obligation under the agreement;
(D) The creditor is precluded by government action from imposing the annual percentage rate provided for in the agreement;
(E) The priority of the creditor’s security interest is adversely affected by government action to the extent that the value of the security interest is less than 120 percent of the credit line; or
(F) The creditor is notified by its regulatory agency that continued advances constitute an unsafe and unsound practice.
I suspect this regulation is one of the reasons why loan-to-value defaults are never (to my knowledge) included in HELOCs. The home equity mortgage holder can stop further lending on that basis, but they can’t call the loan (or any part of the loan) based on a loan-to-value default.
The grounds for declaring a default appear to be limited to: 1) fraud on the part of the borrower, 2) a payment default, 3) action or inaction by the borrower that is harmful to the security of the loan, or 4) if federal law requires the loan to be due on demand.
In contrast (iv) specifically allows a termination of the extension of additional credit if (A): “The value of the dwelling that secures the plan declines significantly below the dwelling’s appraised value for purposes of the plan”
To amplify on a comment of Professor Lipson’s:
Bob Zadek–a well-known West Coast practitioner–says that if the loan closes and the borrower isn’t in default, he isn’t doing his job. Lenders always want the power the control the debtor. This is a very different thing than always wanting to exercise this power.
Happy to be your foil, but give me a break. “The borrowers” are my clients, and I’m tired of them buying into the hype that exposes them to this mess. I thought I made that clear.
As far a technical defaults go, the HELOCs getting pulled is just the lender’s way of not throwing good money after bad. It’s a smart move for debtor and creditor.