A Court Ruling Makes Mortgages Vanish Into Thin Air
The decision might change how home loans are valued in the secondary market.
November 11, 2019, 10:00 AM CST
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.”
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.
Loan Sharks Play a Useful Role in the Economy
A new study suggests illicit lenders aren’t all bad.
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— LawsInTexas (@lawsintexasusa) June 4, 2021
Hear the term “loan shark” and what do you think of? Probably a desperate borrower going to Tony Soprano and, later on, having his legs broken for paying late. No doubt that occurs.
But as I press my first-year contracts students to understand, those who lend money to the poor, even at extravagant rates of interest, fill a market niche.
Just like everybody else, people with bad credit want to borrow money. And because capital markets are effectively closed to them, they have to turn to unregulated lenders.
The trouble has long been that we lack good data on whether their typical borrowing experience involves repayment (admittedly at exorbitant rates) or some version of those broken legs.
Happily, that gap has been filled. A new NBER paper by economists Kevin Lang, Kaiwen Leong, Huailu Li and Haibo Xu offers a picture of how the sector works in practice. The authors studied roughly 100,000 loans made to some 1,000 borrowers by unlicensed lenders in Singapore.
The authors find that the typical borrower borrows frequently, and fully understands the structure of the deal. 1 A typical contract involves “six payments, each equal to 20% of the nominal loan amount,” a scheme that yields an interest rate of either 8% a week or 5.5% a week, depending on whether the first payment is credited against the principal. The majority of the loans are not paid on time, a failure for which the usual penalty is additional interest on late payments.
But let’s not jump to the paternalistic assumption that the borrowers are deluding themselves. The authors tell us that the borrowers generally understand what they are getting into. They know the odds are that they will not repay on time; they know that this failure will make the loan more expensive.
Let’s remember why people go to loan sharks in the first place. Regulated lenders won’t serve people with poor credit because usury laws make it impossible to price the risk of default into the loan contract.
The unlicensed lender can charge an interest rate reflecting the actual risk. By agreeing to the interest rate and other onerous terms, the borrower is signaling to the lender a serious intention to repay, so that those onerous terms don’t kick in.
And the borrowers seem to be serious indeed: Although only 14% of the loans are paid in full on time, 92% are eventually paid in full, in an average of 15 weeks.
The study also challenges the assumption that borrowers in the informal market have no bargaining power. After the local government cracked down on illegal lending, interest rates for borrowers in the unregulated market rose sharply, reflecting lenders’ increased risk.
This means that the lender captures more of the surplus, making the loan less attractive to the borrower. But if borrowers have as little bargaining power as many fear, lenders should have been able to charge those higher rates all along. Possibly the lender’s difficulty in doing so reflects competition in the unlicensed market; or it might suggest the willingness of borrowers to walk away from a deal.
What about all those broken legs? The paper takes a close look at what the authors term “harassment” — pressuring a delinquent borrower to repay.
Most of the harassment from unlicensed lenders involves tactics similar to those that exist in the legal lending market: letters, phone calls, visits to home or office.
Legal lenders can also ding to borrower’s credit rating, which the unregulated sector cannot, but unlicensed lenders likely share information about who reliably repays and who doesn’t.
Still, as Hollywood reminds us, the key difference in the unregulated market is the ability of lenders to make (and perhaps carry out) other threats as well. The availability of these other threats — the busted-up car, the broken legs — is a crucial element of the popular picture of how loan sharks work, and why they remain in ill repute.
The paper finds, however, that threats are extremely rare. Even when loans were not repaid on time, the main form of extra-legal punishment was vandalism, which occurred in only about 15% of the cases of delinquency. This makes sense.
As the authors point out, acts that impose high costs on the borrower will be rare, because those acts are also costly to the lender. (If you send someone to break my legs, that person has to be paid; and the resort to violence involves the risk of criminal punishment.)
Still, the threat of the more-costly forms of harassment is always there. If a government crackdown targets the costly sanctions (no more leg-breaking), the lender will shift to less-costly sanctions, but in order to get the same result will harass more frequently. The authors tell us that “suggestive evidence in the data” supports this analysis.
This suggests that the way to deal with loan sharks is to outlaw their worst tactics, not their lending. But the worst tactics are already illegal. If we really believe that leg-breaking is widespread, we can crack down by enforcing more vigorously the laws on the books.
If we believe that loan sharks will always break legs, we could reduce their appeal by softening interest rate caps to allow those with weaker credit access to regulated banking. 2 Some will shiver at the idea, but it was once a goal of those styling themselves progressives.
To be sure, the authors do find some problems in the market for unlicensed loans: Some 47% of delinquent borrowers get the lender off their backs by going to another loan shark. And we can’t be sure how much of a study conducted in Singapore would replicate in other countries.
But if, as the study suggests, those who borrow from loan sharks know what they’re getting into, then the argument against the practice can only be that they have no business borrowing money — in other words, that they should consume less.
But it’s not the job of regulators to dictate to consumers what they ought to want. Paternalism is a disease best cured early.
- The study includes demographic information on borrowers —for example, that they are overwhelmingly male, and tend to fall below the median income but at the bottom of the distribution —but these data, although intriguing, might reflect aspects unique to Singapore.
- This approach might also reduce the number of fraudulent loan sharks, who often will try to collect more than is actually owed.