A Court Ruling Makes Mortgages Vanish Into Thin Air


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(Bloomberg Opinion) — For generations, budding lawyers have been taught that if the bank forecloses on your mortgage and can’t sell your house for the amount of the loan, the bank can come after you personally for the rest. Apart from a handful of “non-recourse” states (California being the most prominent), this has long been the rule. But a mystifying recent decision by the U.S. Court of Appeals for the 8th Circuit might inadvertently lead to a reevaluation of what had been settled law — and potentially change the way the secondary market values mortgage loans.

The facts of the case are simple but instructive. CitiMortgage, Inc., had purchased hundreds of home loans from Equity Bank, a regional bank doing business in Kansas, Missouri, Arkansas and Oklahoma. The contract stipulated that if CitiMortgage later discovered defects in any of the loans, Equity was required to cure the defects or repurchase the loans. The dispute arose from 12 mortgages that Citigroup found defective and Equity refused to buy back. Six had already been foreclosed.

A disagreement over so small a number of loans would not ordinarily lead to litigation; the parties would settle, or one would write the loans off.  Here, however, there was reason to press on. Six of the 12 loans had been foreclosed, and Equity Bank made the remarkable argument that foreclosure and resale meant that the mortgage loan no longer existed, meaning that there was nothing to repurchase.

The 8th Circuit agreed. Part of the ruling relied on the language of the contract, but the court’s interpretation of the language assumed that Equity was right — that foreclosure extinguished the loan. “CitiMortgage has not explained what, exactly, Equity was supposed to repurchase,” the panel wrote. “Without evidence of what, if anything, remained of the underlying loans, we are left guessing about whether Equity breached by failing to fulfill its repurchase obligation.”

But no guessing should have been necessary. What remained was the right to go after the borrower’s other assets. That’s the point of a recourse loan. That the value of this right might be very small in most cases of foreclosure does not mean the right does not exist. By ruling otherwise, the 8th Circuit in effect transformed recourse loans into non-recourse loans.

The distinction is not trivial. A non-recourse loan means in practice that the lender provides the borrower with a put option — that the borrower can always escape the obligation by selling the asset to the bank at the price of the current loan balance. This structure should lead to higher interest rates and reduce the likelihood of a housing boom. The truth might not be so clear-cut: A 2017 study found that non-recourse states saw higher rates of real estate speculation and larger swings in housing prices. The study noted that a lender who plans to resell the loan to distant investors has a reduced incentive to price the risk correctly.

True, even when the loan allows recourse, the lender will rarely pursue the borrower’s other assets, because their value is likely to be small compared to the cost of chasing them. But the borrower knows that the threat exists. As the dissent in 8th Circuit pointed out, the mortgage borrower signs a promissory note. The note’s enforceability is not affected by the disposition of the underlying property. That’s why the majority is wrong to suggest that the loan has disappeared. The borrower’s obligation to pay survives the foreclosure.

The pricing of a home loan is always imprecise, and the lender always faces risks. The borrower might not have enough cash to repay or the house itself could depreciate to the point where its value is lower than the loan balance. That’s why purchasers in the secondary market include clauses like the one at issue in the dispute between Equity Bank and CitiMortgage. If the loan originator has to repurchase defective loans, it has a greater incentive to price the loan correctly. But if as the 8th Circuit ruled, the clause becomes unenforceable because foreclosure has occurred, the purchaser won’t pay as much for the underlying loans.

To be sure, there’s an argument to be made that all U.S. mortgages should be non-recourse, as they are in most of the world. Activists in other countries — most notably Spain — have argued against recourse loans on the ground that mortgage debt shouldn’t follow a family to the grave. (It doesn’t.) More to the present point, non-recourse loans might reduce inflation in the value of the underlying asset — the home — and so reduce the risk of a bubble. But that’s a policy judgment for legislators, not one that judges ought to make.


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