This article analyzes the economic impact of due-on interference on real estate transactions. This article is part three in a three-part series examining the history of the lender-borrower relationship. Part one presents the background for the legal and legislative resolutions to the ancient conflicts between real estate owners and their lenders. Part two follows the history of due-on enforcement in “Wellenkamp to Garn.”

The great Garn experiment

The Garn St. Germain Federal Depostiory Institutions Act of 1982 (Garn) provided an economically defective regulatory mixture by:

  • allowing savings and loan associations (S&Ls) to venture into exotic and highly speculative investments;
  • lifting to $100,000 the previous $40,000 federal guarantee on individual accounts with S&Ls;
  • allowing portfolio yield to be increased through loan modification and recast rights under the due-on clause; and
  • eliminating loan rate competition between lenders by awarding them a “level playing field.”

All these conditions, speculation being a given ingredient, were granted on the premise they would create an environment which would increase S&L earnings. The S&Ls needed to cover the losses on fixed-rate loans made in the late 1970s prior to the “hot money” rules of money market discounts.

By the early 1980s, fixed-rate loans were purported to have contributed to extensive insolvency throughout the S&L industry. Instead, money market deregulation of S&Ls caused the billion dollar S&L debacle of the early 1980s.

By the mid-1980s, S&L mismanagement, which was allowed to run on too long without regulation or oversight, caused losses that the industry itself could no longer cover.

To bailout the S&L industry, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) was passed.

The Financial Institutions Reform, Recovery and Enforcement Act of 1989 was passed to prevent the S&L industry, considered the historically stable source of financing for homeownership, from collapsing. It renamed the S&Ls as thrifts (which they had proved not to be) and re-regulated the S&L industry to:

  • promote through regulation, a safe and stable system for affordable financing for housing;
  • provide better supervision of S&Ls; and
  • limit investments by S&Ls in risky ventures. [12 United States Code §1811]

However, the due-on clause was allowed to remain as an S&L profit-making device, continuing the Garn Act’s shift of the inflationary hedge in real estate from owners to lenders.

Lenders see $ signs in due-on clause

In California, the due-on clause has not been an issue for buyers and sellers since the early 1980s. The reason: after 1982, the year of the Garn enactment, interest rates generally declined until 1994.

However, whenever inflationary conditions in our national economy develop, interest rates, both long-term and short-term, will rise in initial response.

Gradually, rising short-term interest rates cripple purchasers’ demand and temporarily paralyze the related real estate industry of brokers, lenders, credit agencies, title companies and escrow officers.

The ability to buy and sell real estate is adversely affected by an expectation of increased inflation in the future – affected by the resulting economic slowdown induced by the efforts of the Federal Reserve Bank to increase short-term interest rates to stifle inflation.

Ultimately, short-term interest rates must increase faster than the rate of inflation in order to control the rate of inflation at a level acceptable to the long-term bond market. Then, mortgage rates will remain fairly constant or decline.

Up swinging rates

Lenders are in the profit-making game. They do not call notes due or seek rate modification on a sale of real estate when market interest rates fall below their note rate. Lenders should simply permit assumptions of high rate loans, rather than calling loans due.

Since the 1982 rule changes, interest rates continued on a downward trend until early 1994, and then not high enough or long enough to cause brokers to address how to handle the due-on issue. As a result, no practical due-on experience has been attained by new brokers since the 1982 elimination of California “free transferability” rules by federal law.

However, the mid-1990s experienced a nearly eightfold increase in foreclosure sales as part of the downward adjustment in home prices, brought about by a 6% decline in California employment and a per capita income reduction.

The inability of a buyer to take over financing in a subject-to sales transaction without fear of a call only added to the decline in values. Fewer buyers – including speculators and displaced homeowners – who were able to buy could meet institutional standards for assumptions.

However, the tables will again turn against owners whenever interest rates begin to rise.

An owner attempting to sell when current rates rise above his existing loan rate has a difficult time getting a loan assumption approved – except on a modification at current rates, including the exaction of an assumption fee. These difficulties with lenders will only be exasperated by the fast-growing tendency of brokers to avoid involvement in a transaction after the seller and buyer have entered into a purchase agreement.

Thus, the lender increases its portfolio yield without organized resistance, literally originating a refinancing by modification of the terms of the existing trust deed note.

California brokers will feel the effects of due-on clauses whenever long-term mortgage rates increase for an extended period of time – more than 18 months.

With a steady rate increase, brokers will suffer the shock of discovering due-on clauses permit lenders to call a note due (or modify its rate/payments) when an owner seeks its permission to sell, lease or further encumber the property financed by the lender.

This severe restraint on all types of real estate transactions was last felt during the 1974-75 recession, and was then largely avoided by use of all-inclusive trust deeds (AITDs) in the form of land sales contracts with power-of-sale provisions – California documentation which no longer avoids federal due-on enforcement.

At the turn of the century

Consider a seller of real estate who enters into a mutually acceptable purchase agreement with a creditworthy buyer which calls for title to be acquired subject to the loan of record and the lender’s consent.

The lender informs the broker the sale will trigger the due-on clause in the trust deed on the property if the transaction is closed. The lender, however, will allow the buyer to assume the loan – but at current market rates and for a fee.

The sale falls through since the buyer refuses to agree to current rates. The seller cannot get his price as interest rates are unpalatably high. The broker is unable to move the property as buyers resist payments at increased interest rates.

As demand for housing drops, so ultimately do real estate prices received by sellers. In turn, property values drop, and loan-to-value (LTV) ratios increase. All this leads to more foreclosures, a sort of economic poetic justice for lender interference in resales.

For California lenders in the mid-1990s, particularly those with adjustable rate mortgages (ARMs), the increase in pre-foreclosure workouts, short sales and foreclosures came at a time when foreclosures were at their highest rate since the Great Depression of the 1930s.

The number of Californians employed (and the pay they were receiving) was the lowest in a decade. Interest rates on ARMs rose for the first time since ARMs were federally authorized in 1982. These factors produced a damaging market for mortgage lenders, highly leveraged owners and those brokers who did not adjust by temporarily shifting to foreclosure-related sales.

By 1999, mortgage rates on 30-year fixed-rate loans rose, ending the last of three great refinancing runs for lenders during the decade. Originations dropped as sales slowed from their peak in early 1999. The resale marketplace had all the elements for negotiating real estate sales subject to the existing loan – no formal assumptions at new rates – but one. The real estate brokerage industry had lost the knowledge and confidence to suggest and carryout subject-to transactions on behalf of buyers. Worse yet, the buyers were too flush with the money to care about an alternative to “cash to new loan.”

During the early 21st century, the stock market will fail to maintain the excessive prices mounted at the end of the 1990’s. As a result, real estate values will fall shortly thereafter – six to eight months later based on the experience of the Japanese economy in 1990.

Lenders will then most likely face the foreclosure episode they did in the mid-1990s, further aggravated by the reduced downpayment requirements of the 1990s which were driven by the competitive secondary money market and government encouragement of homeownership.