The DirtLaw Blog

The Federal Reserve Board Amends Reg Z and California Passes SB 1137

The newspapers today were filled with headlines that the Fed was curbing "shady lending" practices.  Of course, these articles were a little vague on what the name of the regulation was and what date these rules would go into effect.

Going straight to the horse's mouth, I learned that the Fed is amending Reg Z to deal with "higher-priced mortgage loans" in the following manner:

"The final rule adds four key protections for a newly defined category of "higher-priced mortgage loans" secured by a consumer's principal dwelling.  For loans in this category, these protections will:

• Prohibit a lender from making a loan without regard to borrowers' ability to repay the loan from income and assets other than the home's value.  A lender complies, in part, by assessing repayment ability based on the highest scheduled payment in the first seven years of the loan. To show that a lender violated this prohibition, a borrower does not need to demonstrate that it is part of a "pattern or practice."
• Require creditors to verify the income and assets they rely upon to determine repayment ability.
• Ban any prepayment penalty if the payment can change in the initial four years.  For other higher-priced loans, a prepayment penalty period cannot last for more than two years. This rule is substantially more restrictive than originally proposed.
• Require creditors to establish escrow accounts for property taxes and homeowner's insurance for all first-lien mortgage loans. "

It goes into effect October of 2009.

And that's just the federal amendment.  California's Senate Bill 1137 passed on July 8, 2008--EFFECTIVE IMMEDIATELY.  The legislation requires lenders and mortgage loan servicers to: 1) contact borrowers about restructuring options before beginning the foreclosure process, 2) requires a 60-day notice to be given to tenants of buildings facing foreclosure before they can be removed from a rental housing unit; and 3) allows fines of up to $1,000 a day for owners of foreclosed properties that fail to adequately maintain them.

And folks...I think there is more legislation to come.  I have been a bit baffled by S.B. 1137 because while it makes a lot of sense to increase communcation with borrowers and work out a loan modification (I often do this for junior lenders) it doesn't make a lot of sense to prolong the f/c process by another 30 days. 

Often if a borrower is trying to walk away--no loan modification would give them an incentive to pay because they do not want to pay a mortgage on a house worth less than the mortgage.  Thirty more days simply delays the inevitable--and prolongs our economic slump. 

Mortgage Pool in Bankruptcy - What Can Investors Do?

For those of monitoring the Cedar Funding implosion, it was not surprising to see that Cedar Funding, Inc. filed for Chapter 11 bankruptcy last week.

Cedar Funding is now a Debtor-in-Possession (DIP), and no doubt David Nilsen will seek to remain in control of the organization, and avoid the receiver recently appointed by a California Superior Court judge. 

What can creditors do?

In cases of fraud or wrongdoing, creditors can seek to appoint a Chapter 11 Trustee.  This would prevent the DIP (in this case Nilsen) from having ongoing control and management of the business.  However, many creditors should recognize that there is a cost associated with this, much the same as having a receiver in place.

Additionally, for unsecured creditors, the US Trustee will circulate a request that a creditor's committee be formed.

All of these steps are to part of evaluating the DIP's ultimate plan for reorganization.  The committee has voting rights, and in addition to the Trustee can object to a plan that is unlikely to be successful or in the best interest of creditors.

More aggressive steps? Creditors can determine if they should bring a motion to convert the bankruptcy to a Chapter 7.  Upon a conversion, the bankruptcy estate is controlled by the Chapter 7 Trustee and the goal of the Chapter 7 is a liquidation of assets rather than an a "re-organization."  While it can seem draconian, in reality, most Chapter 11 bankruptcies fail and the sooner the debtor liquidates, the higher likelihood of some recovery before the estate is eaten away.

How can a creditor decide?  A DIP has the obgliation to prepare operating reports and in this case, the operating reports may be more detailed than the reports that the investors may have sporadically received in the past.  The failure to supply these reports can be an indication that there is something to hide or that the debtor lacks the ability to satisfy the requirements of remaining in a Chpater 11 bankruptcy.

At a bare minimum, creditors will need to prepare their proof of claim and can decide to take a wait and see approach.

Private Money Investors Beware

Here in Northern California, we are all just wrapping up the mess that California Plan, Inc. made.  Michael Schneider was convicted and only recently sentenced.  He stole over $40M from investors, and was sentenced to 28 years.  Schneider's fraud was typical in that all investors claimed Schneider had their trust and was like family to them. 

Now the Cedar Funding fiasco in Monterey has surfaced.  Cedar Funding is a $70M+ fund, and the principal, David Nilsen, has been accused of running a giant Ponzi scheme, loaning money to insiders, (ie, himself to purchase his $4.2M posh home).  The DRE has suspended his license.  The Court has appointed a receiver to manage the fund and the DA is investigating.  Again, investors are saying that they trusted Nilsen.  The Montery Herald article says it all:

Nilsen was a member of her church, she said, and he instilled her with a sense of trust.

"I thought, 'This man is a God-fearing individual who would take good care of my money,'" said Abraham-North. "But he did not — he left me penniless."

The schemes fraudsters like Schneider use are not particularly creative.  Schneider was simply cutting and pasting investor names onto a Deed of Trust to make it look like it had been recorded for the investor.  In reality, Schneider photocopied investor names and glued them over the actual secured parties' name.  In this manner, he was able to make it look like the investor was secured when in fact, the Deed of Trust with their name was forged.

Additionally Schneider would not tell investors when their loans had paid off.  Instead, investors received their monthly interest payments for years, never realizing the borrower had re-financed and paid off their loan years ago.  Often, Schneider would tell investors after a payoff to leave their money in his trust account and he would "roll it over" into the next loan to allow them to continue to earn interest on their money.

How does an investor protect his or herself from this? 

Regardless of how trustworthy and conscientious a broker is, the investor must safeguard their financial future and take charge of their loan portfolio. If the investors had simply asked Schneider for the originals of their Deed of Trust, half their problem would have been eliminated. 

Additionally, a random spot check/audit of your Deed of Trust investing portfolio is never a bad idea.  You can search county records to see if your Deed of Trust has been reconveyed.  If it has, but you never received the payoff funds--you've got a problem.

Lastly, complacency puts the investor at risk.  If your loan pays off--take the money.  Wait for your broker to bring you the next investment opportunity and re-invest your money.  Losing out on a month of interest can spare the investor the heartache of losing the whole enchilada.

For investors in mortgage pools or collateralized mortgage obligations--you are entitled to monthly accountings.  If you are uncomfortable about not knowing the percentage loans held by insiders, hire an independent auditor to help you ask the right questions and get the right documentation from the fund manager.

New Foreclosure Related Legislation

DISCLAIMER: THIS IS NOT INTENDED TO BE TAX ADVICE. FOR TAX ADVICE FOR YOUR SPECIFIC SITUATION, CONSULT WITH A TAX PROFESSIONAL. 

Though my work is lender focused, I frequently receive calls and emails from borrowers who want to know if they can just "walk away" from their loans.

From my previous posts, it is obvious that I work for lenders pursuing judicial foreclosures and deficiency judgments.  (See previous blog entries regarding California's One Action Rule and Anti-Deficiency statutes).  That means that while I can quote verbatim from the statute about which loans are recourse, that does not mean that I know anything about the specific tax consequences. 

In addition to the possibility of a deficiency judgment, the borrowers who cannot meet their loan committments could have tax consequences. 

Generally in short sale situations, the debt remaining is treated as a debt forgiveness--which creates income.  The most interesting piece of new legislation I've seen is the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) which snuck in quietly in late 2007.

If the borrower meets certain criteria, the debt cancelled will not be treated as income for federal income tax purposes.  This act applies to income in 2007, 2008 and 2009.  The catch?

That doesn't solve the state tax consequence.  Since California has not passed a companion law yet, the California Franchise Tax Board likely takes a different view of the situation. 

That might change for next year, but in the meantime--borrowers who are paying to sign up for these "homeowner walk away" from their mortgage should beware.  There is no one size fits all solution.  No one can predict how a lender will choose to deal with a bad loan, or the likelihood the lender will pursue a judicial foreclosure and seek a deficiency judgment.

California's Anti-Deficiency Laws - a brief refresher

What is the anti-deficiency statute?  It is California Code of Civil Procedure Section 580(b).

The code states in relevant part:

"No deficiency judgment shall lie in any event after a sale of real property or an estate for years therein for failure of the purchaser to complete his or her contract of sale, or under a deed of trust or mortgage given to the vendor to secure payment of the balance of the purchase price of that real property or estate for years therein, or under a deed of trust or mortgage on a dwelling for
not more than four families given to a lender to secure repayment of a loan which was in fact used to pay all or part of the purchase price of that dwelling occupied, entirely or in part, by the purchaser."

In plain English - the statute addresses 2 types of loans:

1) purchase money loans and

2) seller carryback loans.

Under the statute, seller carryback loans are not entitled to seek a deficiency judgment against the borrower.  However, there is an exception under California's stare decisis (case law) that does permit the seller to recover against the borrower under certain circumstances.

As for the purchase money loans - no deficiency if it is owner-occupied, residential one to four.  What does that exclude? vacation homes, home-equity lines of credit (HELOC), investment properties where the borrower does not reside there, apartment buildings more than 4 units.

These loans are commonly referred to as "non-recourse" loans because lenders on these types of loan know their only recourse is the security (collateral).

DISCLAIMER: THIS IS NOT INTENDED TO BE A PRIMER ON HOW TO AVOID YOUR DEBTS AND LOAN LIABILITY.  CONSULT WITH A BANKRUPTCY SPECIALIST AND TAX ADVISER.  Please do not email or call me for tax advice.  I am not an accountant or tax professional. 

The Partial Reconveyance

Often in a construction context, the Deed of Partial Reconveyance is required.  The most common scenario is when an owner wants to subdivide their parcel and the parcel is encumbered by a Deed of Trust.

The second most common scenario is when a neighbor wants to buy some additional portion of the adjacent property, usually to comply with setback requirements of their remodel or to preserve their view.

In both circumstances, the Lender made a loan against the entire property.  For ease of reference, assume Lender's Deed of Trust encumbers all of Property A, which totals 1 acre.

California is a Trust Deed state, which means there are 3 parties involved in the loan-- the lender is the Beneficiary, the borrower is the Trustor and the lender designates a Trustee (usually a title company).  The beneficiary has the power to tell the Trustee to reconvey title to the property back to the Trustor (borrower) if the loan is paid off.

However, when Owner A wants to sell 1/2 an acre to Owner B, the lender has to approve it and agree to instruct the Trustee to issue the Partial Reconveyance of the original Trust Deed.

The Lender will want an appraisal because it wants to make sure that if Owner A is shrinking the land (security or collateral for the loan) that the Trust Deed encumbers, that the borrower (Trustor) still meets the Lender's underwriting guidelines for the loan.   

The appraisal report will need to show the value before and after the proposed sale of the land to the neighbor.  If Owner A has owned the acre for a while, she or he may have experienced an increase in value and accordingly, even with the loss of the square footage, the value of the 1/2 acre may still be enough to meet the loan-to-value ratio the Lender requires.

After the Lender reassures themselves (with appraisal reports) that they are still adequately secured, they will instruct the Trustee to execute the partial release.  The Trustee is sometimes a title company and so they can usually prepare the Partial reconveyance in house.

In additional to the hurdles with the bank, the City or County will need to be involved for a lot line adjustment.

While the lender’s decision is not related to city or county approval, the city approval gives the appraiser a firm idea of what the boundaries are, square footage etc. on which to base his or her appraisal. 

Additionally, a civil engineer or surveyor will need to be involved in order to confirm those findings and describe the newly changed property boundaries.

In sum, it is not a particularly easy process to navigate as it requires the coordination of so many parties.  However, working with seasoned professionals will speed up this process.

The Deed of Reconveyance

And today, a guest blog from Eric Hartnett, Esq.  For those of us who have refinanced our loans, we have seen the Deed of Reconveyance before.  However, given the flurry of refinance loans in for the last 10 years, it became common that lenders, trustees and title companies would fail to request and record the Deed of Reconyance.

Eric writes:

Your Loan Secured by a Deed of Trust has been Paid Off - What Now?

You can finally see the light at the end of the tunnel and you've paid off your loan.  CONGRATULATIONS!

When you took out a loan and as security for the loan (evidenced by the Promissory Note or Loan Agreement), you agreed to have a Deed of Trust recorded against your home. California is a "trust deed" state rather than a "mortgage" state but in common parlance, most folks refer to their loan as a "mortgage."

Whether the loan is a 30 year mortgage or a 3 month loan, if you have made all of your loan payments, then you will want the lien (Deed of Trust) removed from your property (one does not actually have the Deed of Trust "removed," rather it is reconveyed to you, the borrower). What are the necessary steps under California law to accomplish this?

A reconveyance for a Deed of Trust upon satisfaction of any loan obligations is addressed in California Civil Code § 2941. §2941(b)(1) provides that if you have satisfied your loan obligations, then the lender (beneficiary under a Deed of Trust) or its assignee shall within 30 calendar days execute and deliver to the Trustee of the Deed of Trust several documents. These documents include the original note (i.e. the Promissory Note), Deed of Trust, and a request for a full reconveyance. The Trustee shall then execute the full reconveyance and shall record the full reconveyance with the county recorder within 21 days after receipt by the Trustee of the original note.

Of course, the above-described situation is the ideal scenario. What if the Trustee or the lender (beneficiary) do not fulfill their duties? You, as the trustor/borrower, have options. First, if the full reconveyance has not been recorded within 60 days of your last required loan payment, then you can make a written request to the beneficiary/lender to issue a full reconveyance under Civil Code §2941 (b)(2). Second, if the full reconveyance has not been executed and recorded despite you making all the payments and writing the aforementioned request to the lender, then 75 days after the last required loan payment was made you may have a title insurance company record a release of the obligation. Civil Code §2941(c).

Additionally, should you encounter an uncooperative Trustee or lender after you have satisfied your loan obligations, please note that there are civil and criminal penalties for some violations of Civil Code §2941.

What We Learned about Subprime Lending in 2007

Back in March of 2007, I noted on here at The DirtLaw blog that a domino effect was occurring, with local Californian company Central Pacific Mortgage getting little press.

Well, when Countrywide began imploding, it seems that national papers began to pay attention.

Things We Learned in 2007:

-  the bad underwriting practices of 2005 are coming back to haunt the industry.  Time to revert to tighter underwriting policies.

- when lenders are under water, likely scenarios include

1. the short sale,
2. the deed-in-lieu
3. the judicial foreclosure plus deficience judgment and
4. debtors surrendering collateral in bankruptcy
5. debtors walking away from the property and not bothering to file bankruptcy

All in all, we've had a busy year at the firm, and I expect to see an increase in the number of judicial foreclosure lawsuits and deficiency judgment activity as well as more loan modifications.

Let's see if my other predictions come to pass about legislation trying to:

a) craft stricter penalties for "predatory lending" (only now vaguely defined by the California Finance Code)

b) modify the anti-deficiency statutes to include re-finance and HELOC loans as well as purchase money loans (possibly with a sunset provision)

c) abridge or abolish the availability of the stated-income loan (think this is already happening, so score 1 for the DirtLaw Blog.)

Mortgage Law Blogging

I started this blog as a way of adding value for my clients, and for people who were referred to me or the firm to get a flavor for my subject area expertise.  How very nice to see over a year later the nice emails and comments from readers that they find my articles on California Real Estate Law and private money lending (or "hard money" lending) to be informative and relevant.

At the California Mortgage Association's (CMA) October gathering in Las Vegas, I was seated next to a mortgage broker from the San Diego area of California.  At one point, he turned to me and said, "I've read your blog."  I was pretty tickled since he was not a client of mine. 

Recently, Tony Gallegos of The Mortgage Cicerone posted his list of top 20 bloggers of 2007 on mortgage related topics and included me.  Thanks for the vote of confidence. 

Here's to 2008, and the continuing saga of the SubPrime wild ride.

Judicial Foreclosures in California Part I - Code of Civil Procedure Section 580(a)

The Dreaded Deficiency Judgment

Most people are familiar with the non-judicial foreclosure.  This is a private Trustee's Sale that follows the statutory guidelines of California Civil Code Section 2924 et seq.  California is a trust deed state instead of a "mortgage" state so we generally do not use terms like "mortgagor", "mortgagee" etc. and instead the parties are the Trustor (borrower), the Beneficiary (lender) and the Trustee.

When the borrower seeks out a loan, the borrower executes a promissory note and deed of trust.  The deed of trust contains the power of sale.  The borrower give the Trustee the power to sell the borrower's house (the collateral) if the borrower fails to make loan payments to the beneficiaries (bank/lender).

The non-judicial foreclosure is the quickest way for the bank to take the collateral once the borrowers have stopped paying.  For years, the Bay Area experienced soaring house prices and lenders did not need to worry about any deficiency on their loan if the lender had to take a property back at sale.

These days, the house prices are less rosy and lenders are facing a market where the value of the home is LESS than the loan.  That is the dreaded deficiency.

If the borrowers are still working age, or have other assets, lenders may choose to pursue a judicial foreclosure and seek a deficiency judgment.  What does that mean? It means that the bank will file the Complaint in Superior Court and the sale will not be a private remedy.  Instead, the foreclosure would be conducted by a sheriff--a public sale.  After the sale, the difference in the "fair market value" and debt amount will be the deficiency judgment against the borrowers.

Example - Borrower owes $500k.  The house is worth $400k (as determined by the court appointed independent appraiser "referee") at the time of the sheriff's sale.  The actual sale price may be higher or lower than $400k and Court may issue a deficiency judgment for $100k.

This means the bank has taken the house, sold it, evicted the borrower and the borrower has a judgment against them for $100k.  The bank can then enforce that judgment in a number of ways, such as wage garnishment or if the judgment debtors owns other property, levy against it.

Borrowers may have thought they were safe to walk away from their homes that were in foreclosure because they thought that California's anti-deficiency laws protected them.  What is the anti-deficiency statute?  That is California Code of Civil Procedure Section 580(b) and this applies to purchase money loans and purchase money loans on residential 1-4 units owner-occupied.