This article is Part II in a series examining the history of the U.S. mortgage industry, with a focus on California mortgage lending practices, from the 1980s through today. To learn more, read: A history the mortgage industry history: Part 1.

The stage for deregulation is set

Up until the 1980s, legal battles placed favor on property owners over lenders fairly consistently. This trend began to reverse beginning in 1982 when the United States Supreme Court gave federally chartered savings and loans associations (S&Ls) the ability to automatically enforce their due-on-sale clauses for profit and economic viability on the following actions involving a mortgaged property:

  • a sale;
  • a lease with a term of three years or more; or
  • a further encumbrance of the secured property.

The due-on clause is a trust deed provision which allows a lender to call the debt due and immediately payable on any transfer of legal or equitable ownership (with some exceptions for intra-family transfers). The primary event triggering the lender’s due-on clause and call for immediate payoff of the mortgage debt is the sale of the property liened by the trust deed.

The ruling enabled federal S&Ls to call a mortgage without concern for the impairment of their security or the buyer’s creditworthiness. [12 Code of Federal Regulations §591.2(b); Fidelity Federal Savings and Loan Association v. de la Cuesta (1982) 458 US 141 (Disclosure: the legal editor of this publication was the attorney of record for the property owner in this case)]

This resulted in serious inconsistencies between state and federal due-on practices. The resale differences for property encumbered by a federal S&L mortgage significantly hindered the federally chartered S&Ls’ ability to lend at rates obtainable by other mortgage lenders. To compete, they were lending at rates a quarter of a percent less than market.

The Garn-St. Germain Federal Depository Institutions Act of 1982 (Garn) was intended to settle this due-on imbalance and impending widespread mortgage holder insolvency brought on by the 1980s recession, the worst since the Great Depression (until 2008, of course).

Garn extended the rights which de la Cuesta gave federally chartered S&Ls to all mortgage holders. Signed into law in 1982, Garn brought about blanket preemption of state law limitations on due-on practices. Together, de la Cuesta and Garn created a new body of federal mortgage law, eliminating states’ rights to protect buyers from mortgage holder due-on interference.

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Regulating around the due-on clause

The FHLBB steps in

The Garn legislation, which persists today, provides only general guidelines for due-on enforcement. Garn gave the Federal Home Loan Bank Board (FHLBB) and other regulatory agencies the authority to issue rules, regulations and opinions interpreting Garn. [12 United States Code §1701j-3(e)]

In drawing up these regulations, the FHLBB took care to specifically define what events constitute a sale or transfer under Garn. The FHLBB defined a transfer as the conveyance of any right, title or interest in the mortgaged property, whether equitable or legal, voluntary or involuntary (as in a judgment or tax lien sale).

However, the FHLBB regulations left some significant issues undetermined. Loopholes still exist in the due-on catch-all. Neither the regulations nor Garn itself mention anything about transfers structured:

  • with delayed purchase agreements;
  • with escrow instructions; or
  • between limited partnership and limited liability company (LLC) interests.

These loopholes are exploited as paths to avoid due-on enforcement under Garn. However, in the evolution by lenders of the due-on wording in trust deeds originating after Garn, lenders added wording that prohibited the use of entities for transfers that were to take place off title, by sale of the entity which owned the secured property but not a change in title to the real estate.

The failed financial deregulation experiment

Garn was heralded as an economic catalyst to remedy the cyclical failure of lending institutions in the inflationary 1970s by:

  • allowing S&Ls to venture directly into exotic, highly speculative investments;
  • raising the federal guarantee on individual savings accounts from $40,000 to $100,000;
  • allowing mortgage holders unfettered use of due-on clauses to increase portfolio yields through loan modifications and recast rights; and
  • eliminating loan rate competition between state and federally chartered mortgage lenders by leveling the playing field.

Money market deregulation in the late 1970s and the congressional due-on legislation in 1982’s Garn brought about sanctioned mismanagement in the S&L industry. By the early 1980s, FRMs and dramatically rising short-term interest rates (over 14%) were blamed in part for extensive S&L insolvency. This eventually led to the multi-billion dollar S&L debacle of the late 1980s.

Mismanagement sets the stage for the Millennium Boom

S&L mismanagement through the mid-1980s ran too long without regulatory oversight, causing losses the industry was unwilling to cover itself. The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) was passed in 1989 to relieve the S&L industry of its financial insolvency due to undercapitalization.

Annual foreclosure sales increased nearly eightfold in the early 1990s. The glut of foreclosed properties drove down home prices, which were already declining due to late-1980s interest rate increases and California’s falling employment and per capita income.

In 1998, the Fed started raising short-term interest rates to induce a routine recession to orchestrate an adjustment in economic growth. As planned, the recession took hold in early 2001, one year after the Fed finally pushed short-term rates higher than long-term rates. But this effort to cool the economy was to be short-lived.

The economic reaction of both the Fed and the administration to September 11, 2001 froze the price of homes at their artificially elevated peak before the corrective work of a recession took place. The Fed opened the floodgates controlling the flow of money into mortgages, lending money and purchasing treasuries in the money markets, adding large amounts of fresh cash to the money supply through bankers of all sorts.

The seeds of the Millennium Boom thus were laid, and — unabated by rates or regulations — eventually grew to unsustainable heights.

Deregulated mortgage market leads to the Great Recession

Cheap, short-term federal money provided upwards of $2 trillion to be lent. The availability of this easy unregulated money gave Wall Street bankers the impetus to provide mortgage funds to as many borrowers as possible.

The result was an aggressive mortgage lending environment on Wall Street which eventually evolved into a proliferation of subprime lending. Mortgage standards were further relaxed, luring unprepared or underqualified tenants into homeownership.

While certainly not the first instance of mortgage discrimination, the largest proven act of racial discrimination in the mortgage industry occurred during the Millennium Boom. Countrywide charged minority families higher fees and steered them into subprime mortgages, even though minority homebuyers’ credit histories were similar to the credit histories of white applicants. As a result, many of these homebuyers eventually defaulted and lost their homes to foreclosure following the 2008 recession.

In 2012, Bank of America and Countrywide agreed to pay $335 million in response to their discriminatory and predatory lending practices.

During the same post-2001 period, the U.S. Treasury and Congress continued deregulating mortgage lenders and Wall Street bankers. Deregulation, encouraged by the Fed, removed most of the previously established fundamental parameters for safe mortgage lending. At the same time, Wall Street also began buying up established mortgage banking operators around the nation.

By 2005, Wall Street bankers dominated all aspects of mortgage management nationwide, with the exception of broker-packaged mortgage originations.

Deregulation allowed increasingly risky mortgage lending up until 2007. That year, mortgage borrowers began defaulting in exponential numbers. Lenders and mortgage holders were inundated with foreclosures due to the imprudent lending practices permitted by a deregulated and out-of-control financial sector.

The foreclosure crisis pushes reform

Almost overnight during 2007, the cash-engorged hey-day of the Millennium Boom boiled over into what became the Great Recession, which eliminated trillions of dollars in asset wealth across the nation.

It left nearly 40% of California’s 6.5 million homeowners in a negative equity condition, with their houses worth far less than the remaining amounts owed on their mortgages. As a result, the vast majority of homeowners who bought during the Boom became prisoners in their own homes, with no ability to sell and relocate.

To compound matters, adjustable rate mortgages (ARMs) began to reset at higher rates, causing their monthly payments to swell. Homeowners who bought after 2001 had lost too much of the equity necessary to refinance. California was thus faced with a foreclosure crisis of unprecedented proportions.

Lawmakers moved swiftly to ensure such a fiasco is not soon repeated. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) was born from calls for sweeping re-regulation of the financial system aimed at ensuring Millennium Boom conditions will not again threaten our economic stability.

Dodd-Frank, passed into law in 2010, rolled out in the form of regulatory pieces over the following five years, establishing numerous new mortgage regulations, the most critical being:

  • minimum standards for consumer mortgages;
  • integrated consumer mortgage disclosures;
  • loan originator compensation rules; and
  • more stringent servicing rules.

Regulators, including the newly-formed Consumer Financial Protection Bureau (CFPB), introduced a host of new protections intended to produce financial stability and the safety of the consumer. The CFPB was made in charge of the:

  • Truth in Lending Act (TILA)’s Regulation Z (Reg Z);
  • Real Estate Settlement Procedures Act (RESPA)’s Regulation X (Reg X); and
  • appraisal rules in FIRREA, which is regulated by other entities with guidance from the CFPB. [15 USC §§1601 et seq.; 12 CFR §1026.43]

Reg Z set ability-to-repay (ATR) rules to require residential mortgage lenders to make a “reasonable and good faith effort to verify that the applicant is able to repay the loan.” [12 CFR §§1026.43 et seq.]

Lawmakers also introduced the Secure and Fair Enforcement for Mortgage Licensing Act (SAFE Act), which created a uniform national licensing scheme for mortgage loan originators (MLOs) and the Nationwide Mortgage Licensing System and Registry (NMLS) for registering MLOs. [See Real Estate Finance: Chapter 2: Consumer mortgage re-regulation]

California adopted its version of the SAFE Act in 2010. To implement the SAFE Act, the California Department of Real Estate (DRE) and the NMLS work together.

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Mortgage Concepts: California MLO licensing laws

Mortgage lending in the future

Following the elimination of California’s due-on protection in 1982’s Garn, interest rates began their 30-year cyclical downward trend. Since then, rates have not risen for long enough periods to permit brokers to gain practical experience handling the due-on issue of mortgage holder interference. But that luxury is quickly coming to an end.

During periods of rising interest rates — as in the coming years — lenders seize on any event triggering the due-on clause to increase the interest yield on their portfolio. Thus, mortgages become increasingly difficult to be taken over by buyers as interest rates rise. This imprisons homeowners unable to sell and relocate without accepting a lower price for cash-out sales, ultimately stifling home sales volume.

The only beneficiaries of Garn are the lenders, who use the threat of the due-on clause to exact additional profits from homebuyers by requiring a new mortgage to be originated with each transfer.

Repealing Garn would return the right to alienate property (sell, lease or further encumber) to the property owners. State law, which is currently superseded by Garn, only allows lenders to interfere when buyers are not creditworthy or would put their security at risk.

But is a repeal of Garn likely?

Not currently. But as more interest is expressed in seller carrybacks during the future decades of rising interest rates, future state legislation that would go around the federal law is possible.

California can legislatively bar the use of trustee’s and judicial foreclosure proceedings as a remedy for due-on enforcement. This would limit the lender’s recourse to judicial foreclosure proceedings in federal courts, which are time-consuming and costly for the lender to simply get the property back when demanding extra profits on an assumption.

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The due-on threat prevents seller carrybacks