It’s fight time in New York. On one side is newly-passed state legislation which sets tough standards for subprime and “high cost” loans and on the other is Freddie Mac, which says it won’t buy such loans in the state after September 1st, the day the new law goes into effect.
This is a big deal because if New York lenders can’t sell mortgages to buyers such as Freddie Mac, they simply won’t make such loans. You can guess what happens next: No subprime loans, no high cost loans, no buyers, no sales. A big chunk of the real estate market will close down.
At the heart of the dispute is newly-enacted legislation which says lenders can’t foreclose subprime or high cost borrowers in the state unless a lengthy list of standards has first been met. Most importantly in the eyes of Freddie Mac and other weary mortgage buyers are provisions in the law which say that mortgage investors — not just loan officers or local lenders — are liable for improperly originated loans.
Holding mortgage investors responsible for the sins of mortgage originators sounds good — at least in theory. After all, if investors have something to lose they will surely insist on stronger lending practices and thus borrowers will get a better deal.
This seems to make a lot of sense until you enter the real world. An investor in Dubai, London or Hong Kong — or in San Diego, Orlando or Cleveland — has no way to oversee lenders in Poughkeepsie, Buffalo or Utica. Such investors are essentially buyers of IOUs secured by real estate, IOUs which hopefully will yield a given level of interest and never require a foreclosure.
In a typical case, local lenders originate mortgages and then sell those loans in the “secondary” market. The loans are then packaged together and used to create mortgage-backed securities. These securities are like stock; they can be sold and re-sold worldwide with electronic speed.
The biggest buyers of local mortgages are Fannie Mae and Freddie Mac. They, in turn, sell securities to pension funds, insurance companies, investors and sovereign funds around the globe.
These loan buyers are generally protected against borrower claims under a legal principle called the “holder-in-due-course” rule.
According to The Language of Real Estate, “a holder-in-due-course enjoys a favored position with respect to the instrument because the maker cannot raise certain ‘personal defenses’ in refusing payment. Personal defenses include lack of consideration, set off and fraud.”
In other words, even a mortgage created by fraud becomes legitimatized if the loan is bought in good faith. Under the holder-in-due-course rule the borrower remains in debt when the mortgage is sold and re-sold and the investor is protected against most borrower claims.
What makes the New York law different is that it effectively sets aside the holder-in-due-course rule by saying that if the original lender or an assignee — someone who has gained ownership of the loan — tries to foreclose then any violation of the new law can be used to stop the foreclosure.
The threat to investors from the new law is plain: If a loan owner cannot readily foreclose then there’s no way to enforce the mortgage if the borrower stops making payments.
Brad German, the chief spokesman for Freddie Mac, said the new law lays out 20 specific requirements that brokers and lenders must adhere to when making new loans.
“If any of the requirements aren’t followed,” says German, “the investor becomes liable and the borrower can use the omission to defend against a foreclosure in court which means our ability to manage risk and legal liability depends on lender/broker actions that we are not in a position to monitor or enforce.”
German points out that the new legislation is not a significant problem for Freddie Mac.
“We don’t generally buy subprime mortgages,” he said. “Had the new law been on the books last year, it would have affected very few of the NY mortgages we purchased.”
Also, German says that under Freddie Mac guidelines the company has not bought “high cost loans” in New York state since 2003.
The real issue, says German, is how the new law might impact the willingness of lenders and investors to finance some of the new rescue mortgage products now being developed. The worry is that they may be captured under the new state definition of “subprime” loans, a worry which German says is shared by many mortgage investors.
While state officials have little or no say in the affairs of national banks, thrifts and credit unions regulated by the federal government, they're the boss when it comes to the foreclosure process. In effect, although states cannot directly regulate loan originations made by national lenders, they can influence the lending process through the back-door, the door that leads to foreclosures.
What does the New York law say? In addition to creating a new liability for investors, the legislation sets out an unusual array of pro-borrower definitions and requirements:
- The bill applies to subprime and high-cost loans. A “subprime loan” is any mortgage that starts with a rate that’s 1.75 percent about the comparable rates published weekly by Freddie Mac.
- Lenders must send a pre-foreclosure notice to borrowers at least 90 days before foreclosure proceedings can be started. In New York state, according to RealtyTrac.com, a typical foreclosure before the new law goes into effect already takes 445 days to complete — that’s almost 15 months. Under the new law the foreclosure process will be extended another three months.
- If lenders foreclose, they must prove in court that they actually hold the mortgage note. This may be a difficult standard to meet given the way mortgage-backed securities are sold and re-sold.
- Before making a subprime loan, lenders must determine that the borrower can reasonably repay the debt. Stated-income loan applications are out. For adjustable-rate products the lenders must qualify the borrower on the basis of the fully indexed rate and not a low-ball teaser rate.
- Mortgage brokers must “act in the borrower’s interest’ when selling a loan. The state has plainly established an “agency” obligation for mortgage brokers, meaning that mortgage brokers who sell borrowers something other than loans with the best available rates and terms may find themselves sued by borrowers.
- All loan officers must register with the state.
“The New York legislation is one of the most comprehensive mortgage reform bills seen to date,” says James J. Saccacio, chief executive officer at RealtyTrac.com, the nation’s largest source or foreclosure data and listings. “The measure has a host of good features, but while the intent of the bill is plainly to bring balance to the lending process, making distant investors responsible for the acts and omissions of local lenders is not workable.
“The better choice is to keep the consumer protections but amend the legislation so that investors are encouraged to bring their money into the state. That’s the surest way to reduce the inventory of unsold homes now holding down property values.”
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.