by Giang Hoang
After years of lush activity, the real estate market has come full circle: agents, brokers, buyers and seller are feeling the crunch of a slowdown in the housing market. This is the flipside of the loose mortgage financing activities brought about since 2001 by Wall Street bankers. Where once housing news was dominated by reports of rising homeownership and the ease of getting a mortgage loan, it is now flush with swiftly rising numbers of foreclosures, a skittish selling and buying population and seized up mortgage markets.
At the heart of the current foreclosure crisis are the adjustable rate mortgages (ARMs), many of which were sub-prime mortgages. ARMs allow a borrower to qualify for a home loan based on an artificially low interest rate. This initial teaser rate adjusts to market rates after a specified number of months, frequently after one month. While rates are low and borrowers’ incomes are stable, ARM loans are ostensibly viable. However, when rates inevitably rise as we move through the economic cycle, ARM loans become disastrous for the borrower, the lender, and the entire economy at large.
In the 1980’s, ARM loans were known as Graduated Payment Adjustable Mortgages (GPAM) loans. The term was abandoned soon after the real estate community began verbally referring to GPAMs as “gyp ‘em” loans because of their negative effects on buyers as payments rose.
In 1982, the US Treasury authorized banks to make ARM loans. During this period, ARMs came to be known as Reverse Interest and Principal for Optimal Fast Foreclosure loans, or RIPOFF loans in
The risk in an ARM loan
A buyer is interested in purchasing a home for his family to live in. However, due to his low gross annual income of $29,000 from all sources, he is looking for a loan program that will give him the highest loan amount for the monthly payment he can afford. A representative from a federally insured institutional lender informs him the best choice for his situation is an option payment adjustable rate mortgage (OpARM).
An OpARM allows a borrower to make payments on either:
- a 1% interest rate;
- an interest only rate;
- a 15-year amortization; or
- a 30-year amortization.
Out of these four payment plan options, the only one that is financially viable to the buyer is the loan payment program at a 1% interest rate, the initial teaser rate. The terms of the loan provide for:
- a loan term of 360 months (30 years);
- first year’s amortized payment schedule based on a 1% interest rate;
- annual monthly payment increases for the first five years of no more than 7.5% of the previous year’s monthly payment;
- after the first five years, monthly payments increases to fully amortize the balance due on the loan over the remaining life of the original 30 year loan;
- interest is adjustable monthly, based on an index figure plus a margin of 2.75%;
- maximum deferred interest (negative amortization) is 115% of the original principal balance at which point the payment schedule is reset to amortize the loan;
- no ceiling exists limiting the monthly interest rate increases; and
- the lifetime ceiling on the interest rate is 9.95%.
The buyer qualifies for a $300,000 loan based on the 1% interest rate OpARM payment option. He applies for the loan and purchases a new home with the funds. Based on the same 40% payment-to-income ratio, the buyer’s $965 maximum monthly payment would have only qualified him for a $174,000 fixed rate loan at the current rate of 5.30% with a 30 year amortization – standard financing for a long-term ownership of real estate. A $300,000 fixed-rate loan on the same terms would require a monthly payment of $1,666, and amount representing 69% of the buyer’s gross pay.
Although the selling agent handling his purchase of the home is fully aware terms of the OpARM, he does not advise the buyer in any way about the financial consequences of the loan or the buyer’s anticipated period of ownership. The sale closes and the buyer begins payments of $965 a month on the loan.
Since interest accruing on the loan is adjustable monthly, the loan does not keep the initial rate which only applies during the first month. The interest rate adjusts monthly, limited in amount to 9.95%. Thus, the OpARM begins to negatively amortize, the accruing unpaid interest being added to the principal. For the second month, the interest rate increases to 8.00%. This is calculated by adding the ARM index figure of 5.25% and the 2.75% margin. After the first year, the principal balance has increased to $311,773.
For the second year of the loan, the amount of the monthly payment is also adjusted upward by 7.5% over the first year payments. The buyer begins paying $1,038 monthly during the second year. By the end of the third year, when he made payments of $1,199 every month, the principal balance has ballooned to $338,775.
So far, he has been able to maintain the monthly payments despite their increase due to 5% annual increases in his gross pay from his employment. However, during the fourth year (at approximately 42 months), the maximum negative amortization amount of $345,328 in principal loan balance is reached. Once this maximum negative amortization amount is reached, the terms for payment are reset, a process called a Negative Amortization Limit Recast. Based on the outstanding principal balance, the remaining term and the fully indexed current interest rate the payment schedule is reset to ensure that the loan is paid off within the scheduled amortization period. Now the buyer must start making monthly payments in an amount sufficient to amortize the principal over the remaining 26 ½ year life of the loan.
This pushes the buyer’s monthly payment to a staggering $2,619, an increase of $1,420, equal to 93% of his current gross income and far more than the buyer’s income has increased in the same period.
As the interest rate increases, the buyer begins to struggle with his payments. When the interest rate reaches the cap of 9.95%, the buyer must pay $3,063 per month. He is now paying more than three times as much as his original payment of $965 and more than his entire gross income.
The buyer can no longer make his monthly payments and the lender forecloses on his home. The buyer then seeks to recover damages from his broker for not disclosing the details of the ARM and explaining the consequences of the 1% interest rate payment option ARM. The broker claims he had no duty to advise the buyer on his loan choice since the buyer’s loan broker had a duty to explain the consequences of the loan to the buyer, not the broker.
Did the buyer’s broker have a duty to advise the buyer on his loan choice and explain the negative consequences of a 1% interest rate payment option ARM?
Yes! Even if the buyer retained a loan broker, the broker’s selling agent still owed a duty to the buyer to protect and care for the buyer in the transaction, including providing an explanation of the consequences of the purchase-assist loan which facilitated the acquisition negotiated by the agent.
It is entirely up to the selling agent and the borrower to determine the consequences of the loan terms over several years of ownership of the property encumbered by the ARM. Mortgage lenders have no duty owed to the buyer to explain the consequences of the terms of a loan, regardless of the obtuseness of the language used in the note. Their only responsibility is to disclose the terms and meet the minimum state and federal disclosure requirements.
A principal may hold his agent liable for the recovery of money losses arising from the agent’s failure of the fiduciary duty owed the principal, in this case the buyer.
Consider a seller who hires both an attorney and a broker to assist in the credit sale of a property. The buyer makes timely payments to the seller, but neglects to make property tax payments. The attorney and broker are contacted regarding the default in the property taxes, but they do not advise the seller about his rights to foreclose upon the buyer.
The buyer ultimately defaults on the carryback note and the seller forecloses, acquiring the property at the trustee’s sale. It’s then that he discovers he could have earlier foreclosed due to the default in payment of the property taxes. He sues the broker for his money losses caused by the broker’s failure to properly advise him of his foreclosure rights.
Can the seller recover his losses from his broker for failure to advise on the seller’s legal right to foreclose when contacted regarding the default in payment of property taxes?
Yes! The seller had the right to recover losses from his broker caused by the broker’s failure to fully advise the seller of his rights, a breach of fiduciary duty, even though the seller also retained an attorney for advice. [Brown v. Critchfield (1980) 100 CA3rd 858)]
To avoid being pursued for recovery of the buyer’s losses, the buyer’s broker and selling agent must concern themselves with the nature of the loan their buyer chooses as financing to fund the purchase his selling agent has negotiated. The selling agent must inquire about the terms and determine the effects of the purchase-assist loan. The terms should be analyzed by preparing an ARM Disclosure Worksheet and reviewing it with his client. The buyer’s agent must ensure that his buyer fully understands the consequences the loan could impose on the buyer. The agent must then advise the buyer on the financial consequences of that choice to the best of his ability, using all information readily available to him.
As soon as an agent becomes aware of his buyer’s choice to take out an ARM loan, he should disclose all aspects and option of the ARM using the ARM Disclosure Worksheet to inform his buyer of his future payment consequences, such as <B>first tuesday<D> Form 320. To avoid claims on the broker after closing, this form should be treated as a mandatory disclosure by the agent’s broker, and discussed with the buyer at the outset of negotiations to purchase a property. A signed acknowledgement of receipt should be obtained, and retained in the broker’s file.
The ARM disclosure is equivalent to the disclosure mandated for seller carryback financing. Since a buyer is subject to the consequences of the financing arrangement which facilitates the purchase, the wise agent will consider it his fiduciary duty to fully disclose the loan alternatives available to his buyer, rather than waiting for his buyer to come to him demanding answers when an unexplained consequence arises.
Disclosing is especially pertinent to ARM loans since there is always the impending payment reset at the end of a fixed period if the payments do not initially include principal reduction. Second to this is the risk of having an insufficient increased value in the property to support the increase in loan amount due to negative amortization. When interest rates rise as the market place moves through the economic cycle, values tend to stabilize and eventually decline. Selling agents need to explain to their buyers the consequences of not being able to pay when payments on the loan are recast.
Doing an internet search for “Payment Option ARM Calculator” will give agents access to websites with calculators that will help an agent put together the ARM disclosure for his buyer.
Options after a loan recast
Once the buyer’s loan goes through a Negative Amortization Limit Recast, the buyer has several options:
- borrow funds to supplement gross income;
- use personal savings fund to make house payments;
- file for bankruptcy;
- default on the loan;
- negotiate a pre-foreclosure with the lender; or
- sell the property.
Borrowing funds is a temporary solution. The funds are usually from relatives or credit cards and do not provide a permanent fix while pushing the buyer further into debt.
Some borrowers may choose to use their personal savings to avoid the social stigma of losing the home to foreclosure. Like borrowing funds, this only provides temporary relief until the funds are exhausted.
Filing for bankruptcy is of little or no practical help to a borrower since the current bankruptcy laws require extensive counseling and education before bankruptcy may be declared. Additionally, the current laws encourage deferred payment plans rather than allowing a mortgage balance to be “crammed-down” or greatly reduced to match the value of the property which is security for the loan.
Another option is to default on the loan. The borrower would continue to reside on the property, but no longer pay the mortgage, property taxes, assessments, or insurance premiums. Only when the trustees’ sale occurs at the conclusion of the foreclosure process does the borrower move, since the borrower would owe rent for his continued occupancy since he no longer owns the property.
In a pre-foreclosure workout, the borrower first defaults on the loan and then contacts the lender to accomplish one of two goals:
- negotiate with the lender to “cram-down” the principal balance of the loan to an amount equal to or below the property’s current value and set up a payment schedule with a fixed interest rate manageable for the borrower; or
- agree with the lender to declare a moratorium period on loan payments allowing the borrower to replenish savings and reduce credit card debt incurred to make loan payments before defaulting.
The pre-foreclosure agreement should be a modification of the loan note to reflect new terms rather than a refinance with refinance fees, and should not have a due date. While entering into negotiations for a pre-foreclosure agreement is not difficult, many lenders are slow to agree to one, especially during the first few years of a housing recession.
The final option available to a borrower is to sell the property in a short sale with all the proceeds going to the lender. During a real estate recession, lenders are more likely to agree to a short sale since they would rather have the proceeds of the sale than a property with declining market value. While there is tax relief for the discount on a tax sale, the relief doesn’t continue into 2010 when it will still be needed.
A real estate recession is defined as a period beginning with a decline in monthly sales volume as compared with the preceding months, which continues for several years until the sales volume increases over the prior months and maintains that trend for nearly a year.
In California, the real estate recession began with August 2005, the month the sales volume and loan origination commenced the current deceleration. The trend of reduced sales volume and loan origination will most probably continue until volume bottoms out around 2010-2011. In 2011-2012, volume will most likely begin to increase with prices inching up to peak in 2015-2018. The environment in which lenders will be willing to accept a short sale will run well into 2010.
Wider effects of the ARM meltdown
Real estate brokers, agents, buyers and sellers are not the only people affected by a collapsing real estate market fuelled by ARM loan foreclosures. High profile financiers on Wall Street and investment bankers of all sorts who invested in securities backed by the ARM loans found themselves in a bad liquidity position when defaults started to rise on these loans. They could no longer find buyers for all the mortgage-backed bonds they held. With time, only more bad news is to come as more and more ARMs start to recast. As belts tighten among Wall Street bankers, the money available for any kind of borrower – be it credit cards or even prime mortgages – becomes scarcer. Cash has become king again.
Current steps to ease the foreclosure crisis
In December of 2007, the federal government stepped forward to help with the foreclosure crisis. Three key steps were outlined in this aid:
- HOPE NOW Alliance; and
- Regulatory action on the mortgage industry.
The Federal Housing Administration (FHA) has launched FHASecure, a program offering refinances to homeowners with good credit histories, but are having troubles making their current mortgage payments. FHASecure applies to borrowers who are looking to move from a non-FHA-insured loan to an FHA loan. Qualifying for the program depends on the individual circumstances of the loan. A borrower need not be in foreclosure, or even danger of foreclosure, in order to receive aid under FHASecure, however either case may also be eligible for aid. Lender cooperation is also necessary in many cases where the value in the home is less than what is owed on the mortgage.
The FHASecure program is projected to help around 300,000 families by the end of 2008.
For more information on FHASecure, or to find a participating lender, visit //www.fha.gov/about/fhasfact.cfm.
HOPE NOW Alliance
The HOPE NOW Alliance, encouraged by the federal government and consisting of servicers, counselors, investors and other mortgage industry professionals, is a means of streamlining help to the borrower in distress. HOPE NOW is a concerted effort by its members to:
- expand the existing network of mortgage professionals available to aid borrowers in distress;
- contact at-risk borrowers to encourage calling their lender or a credit counselor to discuss their situation; and
- create a standardized process to refer and connect at-risk borrowers to credit counseling to ease their mortgage situation.
HOPE NOW offers a toll-free hotline at 1-888-995-HOPE (4673) for borrowers, available 24-hours a day in multiple languages. For more information and a list of participating mortgage companies, please visit //www.hopenow.com/.
Proposed regulatory action
On December 18, 2007, the Federal Reserve issued a press release detailing a proposal to amend Regulation Z and tighten lending practices on “higher-priced mortgage loans” secured by a borrower’s principal residence by:
- prohibiting creditors from extending credit without considering a borrower’s ability to repay the loan;
- requiring verification of a borrower’s income and assets before making a loan;
- restricting prepayment penalties, except in very specific circumstances; and
- mandating the establishment of escrow accounts by creditors for taxes and insurance.
A “higher-priced mortgage loan” would be defined as either a:
- first-lien mortgage with an annual percentage rate (APR) three percentage points or more greater than the yield on the comparable Treasury note; or
- subordinate-lien mortgage with an APR five percentage points or more greater than the yield on the comparable Treasury note.
Additionally, the following recommended protections would apply to all loans secured by a borrower’s principal dwelling, regardless of APR:
- A mortgage broker must enter into a written agreement with his borrower prior to the borrower applying for a loan or the broker collecting any fees;
- Mortgage brokers cannot collect any fee paid by a lender to a broker for a higher rate loan, called yield-spread premium, from lenders without giving to his borrower a written disclosure of the broker’s total compensation;
- Mortgage brokers would be prohibited from coercing an appraiser to misstate the value of a property;
- Servicing companies are prohibited from failing to credit a mortgage payment upon receipt of the payment or taking inordinately long to provide a payoff statement, among other practices harmful to the borrower;
- The term “fixed” may not be used to advertise any product that is actually adjustable;
- Actual rates must be disclosed along with any introductory “teaser” rates;
- Truth-in-lending disclosures must be provided to borrowers in a timely manner to aid the borrower in a search for a mortgage; and
- A mortgage broker may not charge any fees except a credit report fee prior to disclosure.