This article is part one is 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 series concludes with part three in May 2005.
Ownership objectives were paramount
The demands for survival made by owners who have invested in real estate for income and profit and mortgage lenders who also invest based on the security value in the real estate collide when an owner encumbers real estate with financing.
Owners and lenders are always competing for a higher return on their investment. Their investment positions generally are in conflict with one another, since the return to both the owner and the lender must ultimately come out of the property’s value and income flow.
Capital growth and a return of equity are the owner’s objectives. Lenders seek an interest income yield, payable either out of the property’s income or for the owner’s use of the property. Pursuit of these conflicting goals often involves economic violence.
Owners risk their invested money in the expectation of a return and to hedge against the constantly diminishing purchasing power of the dollar.
The return is based on an owner’s projection of the effect the general and local economy will have on the value of the property.
If the owner’s choice of location is correct, his invested capital will increase in value due to inflation and appreciation. The owner has a useful hedge against this deterioration of the dollar’s purchasing power.
Owners also risk the time and effort they have invested in locating suitable real estate and properly managing the maintenance and enhancement of their investment. Owners generally take an active role in maintenance. They look after their property on a daily basis. Thus, while the owner is protecting his investment, the lender’s security interest and investment return is automatically protected.
Lenders avoid the ownership risks and liability exposure accompanying property management. Mortgage lenders are portfolio investors, uninvolved in the activities of real estate management.
Mortgage lenders seek out lending opportunities on properties in locations which they feel will hold their values. When lending, they try to avoid exposure to the risks inherent in real estate investments, such as the depreciation of property due to a depressed or recessionary local economy.
However, the value movement in real estate is precisely what an ownership investor is gambling on.
A lender takes care to avoid becoming the owner of the secured property as a result of making a loan. While the owner’s investment risk is 100% of the property’s value, a mortgage lender takes an invested risk of only 70% or 75%.
The mortgage lender’s margin, a loan-to-value (LTV) ratio, indicates quite clearly the lender is not in the business of owning real estate.
Lenders simply select desirable investment locations, lend amounts below the current market value of the property, and lend only to borrowers/owners who have other substantial assets.
Lenders look for owners with other assets to cover the risk of the secured property value falling below the loan balance. A deficiency in the value of the secured property as against their loan amount is always foremost in their mind.
Lenders want a return on their investment based on the current rate at which they can “rent” their money. No mortgage lender formulates its entire return on the annual income the secured property will yield. To do so would be to base its earnings and wealth on both the property’s current market value and on the future strength or weakness in the general and local economies.
Only when stuck with foreclosed properties do lenders succumb to the pressures of the sales market.
Lenders vs. owners
Thus, the positions, goals and anticipations of the lender and the owner of real estate are diametrically opposed. This adversarial relationship stems partly from greed – which, after all, is what brought both parties to the property in the first place.
California Supreme Court decisions in the 1960s and 1970s brought the confrontation between lenders and owners into sharp focus.
Challenging the right of lenders to flex their “due-on-sale” muscles and raise interest rates almost at will, or take insurance proceeds and apply them to the loan balance at will, property owners took one case of lender injustice after another to the courts.
Before litigation slowed in mid-1980, two decades and the tide of judicial favor had come and gone for owners of real estate. To understand the cause of the ongoing lender-owner battle, a review of the events in the 1960s and the 1970s is necessary.
Important factors included the shifting control of the marketplace from lender to owner, and again to lender, the often conflicting national and California economies, and the development of case law up to the early 1980s.
The early ’60s: a stable market
No shocking economic events occurred between 1960 and 1965. General prosperity reigned, and relative satisfaction with real estate interests existed among owners and lenders. However, the recurring cycle of tight money contributed to the real estate recession of 1965.
In between the 1958 and 1965 recessionary dips in the economy, the savings and loan associations (S&Ls) in Southern California fell into what became for them the disastrous period of the 1963-64 economic boom.
A massive inflow of funds to be lent on real estate forced the S&Ls, who were staffed only for a steady flow of funds and investment lending, to rely on the brokerage industry to place the funds.
The lenders paid commissions and points to real estate brokers who procured or referred borrowers to them. The construction industry was verging on hysteria at this abundance of funds. Anyone, it was then said, could use the back of an old envelope to sketch a building plan and obtain a lender’s “horseback” appraisal and commitment for a construction loan – and close on it!
Credit was somewhat secondary. The lender’s objective was to get the funds out. Interest earnings were the major concern. Short-term profits, called “points” and “dutch interest” were of lesser concern.
Frankly, the lenders viewed the excess money as lettuce, about to rot on the shelf. It had to be moved, and they chased deals to place it – a classic prelude to investment error.
Broker control during the early ’60s
In an environment of excess investment and loan funds, brokers and owners usually control the market.
In the early 1960s, builders and buyers picked and chose projects and properties with little concern over the availability of loan funds. Funds were advanced for the asking. The interest rate was below 7%, with inflation lower.
Builders overbuilt and vacancy rates and foreclosures soared. Lenders lent and sellers sold to unqualified borrowers and buyers, and default and foreclosure rates increased. Brokers did their job of rendering the services needed to bring the different parties together.
Suddenly, the real estate industry, having grown too fast without financial safeguards, became mired in its own excesses. Lenders started looking for ways to protect themselves and regain control of their investments by the mid-1960s.
Lenders begin massing forces
At the time, a case handed down by the California Supreme Court went generally unnoticed. [Coast Bank v. Minderhout (1964) 61 C2d 311]
In the first decision in a continuing series of cases relating to the lender’s use of the due-on clause contained in some trust deeds, the Coast Bank court modified common law’s harsh interpretation of the due-on clause.
Common law had rendered due-on clauses absolutely void and unenforceable. The clause was simply a restraint on the free use of any ownership interest. In Coast Bank, reasonable enforcement (use) of the due-on clause was injected into the law of restraints on alienation.
As a result of the reasonable enforcement test, the lower courts and the lender’s attorneys easily carved out purposes for a lender’s use of the clause which could be considered “commercially reasonable” under the circumstances surrounding the note and trust deed.
If reasonable circumstances were found to exist to justify the lender’s calling the loan, then the clause could be enforced by a demand for payoff, and foreclosure if the demand was not met.
Coast Bank had no immediate influence on the real estate market of the early 1960s. Most lenders were not using the due-on-clause to improve their profits and maintain their portfolio yields.
Real estate professionals in the early 1960s paid little attention to the presence of the due-on clause in trust deeds.
The late ’60s: Marketplace instability
By late 1965, when the money supply had tightened, interest rates increased, the availability of funds decreased and inflation started to soar.
What occurred was entirely due to governmental expenditures unrelated to the general economy; the prime culprit being the Vietnam conflict and the related buildup of the war effort.
Portfolio lenders did not foresee the massive inflation which would adversely affect their fixed-rate portfolios of 30-year loans.
Almost a quarter of all the S&Ls in California were in serious financial difficulties. The S&Ls had lent on anything and everything, and had done so everywhere.
The result was foreclosures by the thousands – and by entire tracts.
Real estate owned (REO) became common jargon of the real estate broker. Lenders acquired property in foreclosure which had to be sold and their insolvency was rampant. Thus, merger upon merger occurred.
Most often, these mergers were induced by government pressure to keep the weak lenders from going under or being taken over.
The result: the big got bigger.
Add to this marketplace dilemma the fact that agents who had been making good (and comparatively easy) money in the early 1960s now were unable to remain in real estate as a source of livelihood. The industry and dwindling sales no longer could support the huge number of agents which had amassed.
As weak lenders merged into bigger, stronger lenders, the ranks of the brokerage business and the real estate trade organizations were decimated.
Thus, lenders were the first to regroup and adjust to the changing economy, getting a head start in gaining control of the real estate marketplace. And, by 1968, lenders had pulled themselves together. Lenders were organized and prepared for the times ahead.
Not so for the brokers. Each broker had pretty much been reduced to operating as a lone wolf. Little cooperation existed between brokers, and their fear of losing what control remained over lenders and owners literally drove them apart.
Sympathy for lenders shown by some courts
To top off the bad economics of the late 1960s for the non-lending portion of the real estate industry, California appellate courts decided two due-on-sale cases in favor of the lender.
It was now reasonable for the real estate lenders to use the due-on clause for profit and to adjust their portfolios yields to reflect current (higher) yields in the marketplace. [Cherry v. Home Savings & Loan Association (1969) 276 CA2d 574; Hellbaum v. Lytton Savings and Loan Association of Northern California (1969) 274 CA2d 456]
The reasoning of Cherry was repudiated by the Supreme Court two years later. [La Sala v. American Savings & Loan Association (1971) 5 C3d 864]
However, it took almost another decade for the confusion caused by these cases and the earlier Coast Bank case to be put to rest in Wellenkamp v. Bank of America (1978) 21 C3d 943.
During the late 1960s and until the late 1970s, the due-on uncertainty strengthened the lender’s control over the real estate industry. Without the agent first discussing an impending deal with the existing lender, no deal was allowed by a lender to be consummated.
Vocabulary development: geared to profit lenders
With the advent of greater-than-expected inflation and the failure of money market interest rates to return to normal within a year or so, lenders were forced to look for extra profits from less traditional sources.
Lenders developed a new vocabulary. “Non-assumable loans” and “conventional loans” became the parlance of the day. In contrast, “assumable loans” were loans insured by the Federal Housing Administration (FHA) and the Veterans Administration (VA).
The “non-assumable loans” were required to be formally assumed and modified if taken over by a buyer of the secured property. “Assumable loans” were not required to be assumed or modified. All misnomers at best!
The interest rate on non-assumable loans would be increased on assumption by the buyer to the current rate charged by the lender. Points and fees would be charged as though the loan was newly originated. Simply put, terms of the loan were recast, or adjusted, under the due-on clause on the takeover of the loan by the buyer.
Conventional lenders were now able to obtain more than the originally bargained-for fixed rate of return. Upon any ownership use, such as a transfer or further encumbrance, lenders would interfere and exact additional profits. This shift in wealth to the lenders diminished the market value of the real estate that carried the loan.
The conventional lenders had achieved a dual profit role with no downside risk – a floor rate, the original fixed rate of interest, and an upward-only adjusted rate on the sale of the real estate under the due-on clause.
The 1970s! What a decade for the lenders!
The “Medovoi” syndrome: non-disclosure to the lenders
But brokers and owners fought back. They developed methods to avoid the due-on clause.
Games were played to avoid disclosure and to covertly transfer ownership.
For example, brokers would have the owner transfer the secured property into a trust or family partnership for the owner’s benefit. The lender would be advised of the action. Explanations were made, but these were hardly the reasons for the establishment of the trust or partnership vesting.
Then, and of course without detection by the lender, the beneficial use of the trust’s property would be transferred, or the ownership of the partnership would be assigned. Both events were “off-record” transfers.
Even with recorded transfers by grant deed, lenders would not be advised. All-inclusive trust deeds (AITDs) came into vogue, and lenders were none the wiser, as long as sellers continued to make payments and the insurance policies were not transferred.
If the lender chanced to discover the transfer through tax rolls, insurance policies or inspection of the record for transfers, buyers would attempt to avoid full disclosure. [Medovoi v. American Savings and Loan Association (1979) 89 CA3d 244 (decertified)]
Some transfer methods had built-in hazards for the owners. Many transfers occurred unrecorded. Grant deeds piled up in escrow and brokerage offices.
This failure to record caused as many – or more – problems for owners and lenders on the average, than had the recording and disclosure to the lender occurred in the first place.
The ’70s: adjusting to staged inflation
It was clear inflation would run high during the 1970s. An investor needed a “hard” or real rate of return in the region of 3%, after inflation and taxes on the inflation were accounted for.
Depository lenders (banks, S&Ls and thrifts) looked for a 2% to 3% spread over their cost of money. They were willing to net 1% on total capital assets (which included all liability to depositors).
The lenders’ risk existed in projecting a profitable annual rate of return over a 30-year period on fixed-rate loans. Lenders did not relish the idea of making mistakes they would have to live with.
Mortgage lenders seized on the due-on clause in their trust deeds to cure their miscalculations on the long-term cost of doing business.
Any mistake which had an ongoing effect could be remedied by calling the loan due when the property changed hands. This was often, given California’s typical short-term turnover of property.
But right at the decade’s outset, the lenders began to see the judicial handwriting on the wall. They knew they could not rely on their due-on clauses as a long-term tool to correct their erroneous business decisions.
So lenders lobbied for legislation to shift the burden of the changing economy onto owners, a shift in the benefit of real estate as a hedge against inflation from the owner to the lender.
The variable interest rate loan (VIR) was lobbied into legislation as a way to pass on the cost of inflation to be paid by the owner of real estate encumbered by a VIR loan. [Calif. Civil Code §1916.5]
Mortgage lenders believed this would help them rectify any misjudgment of forthcoming rates, while giving them constant earnings of 2-1/2% to 3% on their loan balances.
Lenders preferred for owners, not themselves, to live with economic uncertainty.
Further encumbrancing: who is to benefit
A due-on clause is triggered in several ways:
- on sale – the conveyance of the remaining ownership;
- on lease – a conveyance of the right to possession; and
- on further encumbrance – a lien establishing a security interest in the property owned.
A 1971 California case dealt with an owner who used his equity to obtain funds while still retaining ownership. The owner further encumbered his property with a second trust deed to secure the loan of funds.
The first trust deed holder called the loan, claiming the further encumbrances breached the due-on clause.
The trust deed gave the holder the right to prematurely call the loan due and payable on the unconsented-to further encumbering of the property.
However, the California Supreme Court held a mortgage lender could not use the due-on clause as protection against an increased risk of loss brought about by the further encumbering of the property without reasonable justification.
The mere placing of a second trust deed on the property gave the lender no legitimate cause for concern over the loss of the loan balance or the loss of the trust deed position held in the property.
In truth, the lender now had two individuals with vested interests in keeping the property well maintained and the first trust deed note current. These two were the original trustor/owner (still the owner) and the new second trust deed holder.
The interests of both individuals were junior to the lender’s prior claim against the property’s value. Hence, there was no impairment of the lender’s security interest in the property due to the further encumbrance. [La Sala, supra]
In effect, trust deeds are intended to protect the lender from loss of the loan, not to interfere with the exercise of ownership rights.
As a result, the market for second trust deeds promptly opened up. Now a private lender could make a second trust deed loan without the concern the first trust deed holder would call the loan. Loan escrows could once more close on receipt of the existing lender’s beneficiary statement.
La Sala permitted owners to obtain additional financing based on their equity in the property. Authority to make second loans was all most brokers saw in the case. The rule of reasonableness between lenders and owners was mostly overlooked by lenders, agents and owners.
Misdirected attention to carryback security devices
In 1974, the California Supreme Court again looked into lenders’ use of the due-on clause. This time, a sale of the secured real estate triggered the lender to call the loan due prematurely. [Tucker v. Lassen Savings and Loan Association (1974) 12 C3d 629]
The Tucker court rejected the lender’s need for additional profits as a legal justification to interfere with the change of ownership.
“Good faith” interference on the part of the lender was now injected by the court. “Good faith” meant a genuine belief, supported by facts, that the lender was either impaired in its security interest under the trust deed or the transfer created a substantial risk of default on the loan obligation.
The legal noose was tightening around the economic necks of the lenders.
The need for impairment struck home so clearly that the lender in the Tucker case later filed only judicial foreclosures when seeking to use the due-on clause.
Lenders were made aware of the potentially expensive threat of punitive damages for tortious conduct, due to lack of good faith use of the due-on clause.
Also, a later case further imposed attorney fees on a lender who improperly used the due-on clause against a non-assuming buyer. [Saucedo v. Mercury Savings and Loan Association (1980) 111 CA3d 309]
Now the owners of property encumbered by a due-on trust deed had some economic clout. Lenders, for the first time, had something to lose when they sought to interfere with the ownership of the secured property for the purpose of increasing their portfolio yield.
Still some agents used deceit when conveying property for clients. More and more “contract escrows” were opened to hold documents off the record until the legal issues about due-on clauses were more settled.
Reverse trust deeds became the rage. A buyer would be given a note and trust deed from the seller as a lien held by the buyer on the property purchased by the buyer.
The phony “loan” amount actually would be for the amount of the down payment. The seller’s grant deed and any carryback trust deed would remain unrecorded. The official record would reflect the seller was still the owner and the buyer merely a lender to the seller.
Yet the change of ownership occurred and possession was transferred.
Time for Wellenkamp
The La Sala case specifically dealt with further encumbrances. It contained a footnote indicating a further review and application would be made of the reasonableness standard when a case involving a sale came along.
Tucker became the footnote. But the carryback sale was structured as a land sales contract.
However, the facts of Tucker regarding the carryback financing device used in the sale distracted nearly everyone from the legal concepts controlling lender conduct.
The brokerage community focused on the wrap around security device, called a land sales contract, used by the seller to document the installment sale of the property.
The transaction’s form of sale (land sales contract) overshadowed the rule which the court applied to sales. It caused uncertainty as to whether the same rule would apply to other forms of sale – such as a grant deed conveyance.
Thus, the question lingered. Was there justification for calling a loan when the borrower/owner no longer owned any interest whatsoever in the property which secured his loan from the lender?
Wellenkamp answered this question without equivocation.