Would you support a California-wide ban on lender due-on enforcement?
- Yes (88%, 37 Votes)
- No (12%, 5 Votes)
Total Voters: 42
Interest rates are bound to rise, which means the due-on clause will come back to haunt California real estate. This is the first installment of an ongoing series tracking the development of due-on issues in the coming era of rising interest rates.
The coming storm
It’s possible that real estate professionals licensed in the past ten years have never even heard of the due-on sale clause standard to all California trust deeds. This is because the clause lost all relevance in the past 30 years of steadily falling interest rates and ever-greater loan amounts.
In contrast to the past decades, rates went on a steady upward march (with peaks and valleys, of course) from around 1947 to 1980. During this 30-year post-war period, structuring deals by assuming the notes with lower interest rates was commonplace.
In addition to making sense for the buyer, these assumptions also squared perfectly with real estate law (and still do). The mortgage runs with the property it encumbers, not at all a personal debt of the individual (unless they sign a continuing guarantee or a recourse note).
California real estate is on the cusp of entering another period of rising interest rates where the assumption of low-interest mortgages will once again become a hot topic. Only now, rather than facilitating deals, the existence of the due-on sale clause promises to squash them . . . unless!
The new regulatory landscape
Beginning in 2014, Fannie Mae and Freddie Mac will only be permitted to purchase qualified mortgages, according to its regulator, the Federal Housing Finance Agency (FHFA). The qualified mortgage was developed under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) to set underwriting standards for lender behavior. Primarily, the qualified mortgage rules:
- prohibit low- and no-doc loans;
- forbid deceitful “teaser” rates for adjustable rate mortgages (ARMs); and
- submit loans to rigorous underwriting standards.
Fannie Mae and Freddie Mac’s loan purchases will be limited to loans that measure up to this rigor. Thus, Fannie Mae and Freddie Mac will not purchase mortgages that:
- are interest-only, unamortized loans;
- have terms in excess of 30 years; or
- include points and fees in excess of three percent of the loan amount.
The qualified mortgage restriction on Fannie Mae and Freddie Mac loan purchases will be instituted in order to gradually shrink their footprints on the mortgage market and protect the American taxpayer, according to an FHFA statement.
The FHFA has linked arms with the Consumer Financial Protection Bureau (CFPB) to stay the hand of Wall Street Bankers. Essentially, a universal regulation has been imposed on all mortgage lenders since they depend on Fannie Mae and Freddie Mac to buy nearly all U.S. home mortgage originations.
Fannie Mae regulator restricts purchases to qualified mortgages” from Bloomberg News
This shows, in part, that the CFPB and the FHFA are doing their job in discouraging the use of predatory loan products associated with the deregulatory policies that led us into the Lesser Depression.
However, Fannie Mae and Freddie Mac still trade in adjustable rate mortgages (ARMs). ARMs, particularly those issued directly to the public by Wall Street this past decade, played an incredibly instrumental role in creating the 2005 market bubble.
As all signs point to a mini-pricing bubble at present, first tuesday is keeping a close watch on the ARMs-to-loan ratio. We have seen a small increase both month-over-month and year-over-year as of March 2013. However, the ratio is tiny and nowhere close to the great disparity of ARMs — near 80% of all mortgage originations — that we saw during the Millennium Boom.
Once only popular among seasoned real estate traders, ARMs began to be marketed to those whose income only covered payments during the intro period — a classic bait and switch perpetrated by buyer’s agents and mortgage brokers during the Millennium Boom. When used by unsophisticated owner-occupants to finance their shelter, ARMs simply allow for price over-reach — a risk taken under the false pretense of perpetually appreciating real estate prices. The buyer and their agent ignore the fact that the interest rate (along with the monthly payment!) will inevitably increase — and this is important — above and beyond any expected wage increases!
Many agents are all too happy to push ARMs use, since they typically result in a buyer purchasing a higher priced home and thus inflated agency fees.
There are several factors that may explain a dampened ARMs ratio during the current era of speculation. (Among them is the high volume of cash buyers who harbor misapplied inflationist theories.) But watch for a spike in ARMs use and tacit agent approval once the currently zero-bounded interest rates increase — it will be the “only way” to close a deal, so some will say.
An increase in ARMs originations is but one of the pitfalls resulting from the inevitable increase in interest rates. Of even greater significance is the coming era of due-on enforcement. As rates move up, buyers will begin looking over their shoulders at the bottomed-out 3.5% interest rates of yesterday.
The inevitable rise of the 10-year T-note will set the whole drama in motion. Since mortgage rates are benchmarked to the T-note (with a 1.5% spread), purchase-assist financing will gradually become more expensive in tandem with the improving economy.
At the same time, we can expect the Federal Reserve (the Fed) to begin winding down their bond purchases to keep inflation under control. A job-creating economy, showing signs of increased demand both for consumer goods and purchase-assist financing, is all the Fed needs to back off.
Despite news of a recovering economy espoused by the media, this has yet to actually happen. We at first tuesday have made it abundantly clear on numerous occasions, the current real estate “recovery” is a mirage.
So, as the economy truly recovers, there will be a perfect storm for interest rate increases and real estate pricing. Increased employment will drive the dynamic cycle of organic buyer-occupant demand. Greater employment will in turn inspire the Fed to withdraw from the market. However, it will also fuel investor belief that a full-blown recovery is underway, sending rates even higher and prices flat to down.
As rates increase, we will once again see an initial turn to ARMs. For a time, buyers expecting to finance their purchase with mortgage funds at 3.5% will make it happen, if only nominally. They will buy, jumping into an ARM boasting “the low rates of yesterday”. All this will be made irresistible by soaring rates on FRMs.
Eventually, even ARMs will inflate beyond the 3.5% teaser rate, placing them out of reach for the buyer addicted to the notion that financing a home ought to never cost more than 3.5%. Then, as in the 1960 rising interest rate market, buyers will once again be asking, how can I assume the seller’s 3.5% loan?
Due-on and market decline
Unfortunately, the answer to this question will be, you can’t avoid a call. This is due to improper federal regulations enacted in 1982 to favor lenders by using the due on clause to force new loan originations. Technically you may be able to “assume the note” but only at current rates and with an abundance of points and fees tacked on, to render the deal essentially the same as if a new loan was originated.
As will soon become all too clear, the harder it is for a buyer to “take title subject to” the existing 3.5% loan, buyers and sellers will resort to desperate measures, as they have done before. As lenders do not presently permit assumptions without modification to current rates and points at the time of the assumption, sellers will collectively have to lower their prices to be able to sell. This is, of course, after the aforementioned period of sellers being unwilling to lower prices as buyers jump into ARMs, which, as we all now know, is a recipe for disaster.
Oh yes, and beware unrecorded land sales contracts, purchase-lease-option sales, dirty transfers, along with the totally failed property disclosures and illegal prop 13 reassessment avoidance these off-record arrangements create. All because Congress got into bed with lenders in the ‘80s – and they are still much too cozy.
California’s state of exception
Dodd-Frank did not, but should and could have corrected this initial congressional misstep. Garn-St. Germain was enacted in 1982 solely so lenders could make more money on the sale of the encumbered property and remain solvent. Thus, Congress avoided the true cure needed to correct the reasons for lender insolvency way back then.
Fortunately, California real estate agents, buyers and sellers have recourse to resolve the due-on dilemma without having to lobby Congress. That’s right. The problem of due-on enforcement, which stifles deals, lowers prices and leads to duplicitous market activity, can be ethically and legally skirted if California can get its act together.
Garn-St. Germain is federal law. Lenders looking to “enforce” the due-on clause, when the time comes, will necessarily rely on state-supported instrumentalities to foreclose when they call the loan and it is not paid off. California can choose, under the banner of state’s rights, to legislatively bar the use of trustee’s and judicial foreclosure proceedings as a “remedy” for due-on enforcement.
This move is completely within the power of the California state legislature and, if enacted, would end due-on enforcement through state-sponsored foreclosure proceedings, as we know them.
If mortgage lenders wish to call a loan pursuant to their federally sanctioned due-on clause, their recourse would be limited to judicial foreclosure proceedings in federal court — as it ought to be!
Editor’s note — first tuesday will remain at the forefront of due-on developments in the California real estate market. Expect careful reporting and analysis of the California real estate market, as it becomes complicated by rising interest rates and due-on enforcement.
Disclosure: Fred Crane, first tuesday’s Legal Editor, was the attorney of record on the two leading due-on enforcement cases, [Wellenkamp v. Bank of America (1978) 21 C3d 943] and [Fidelity Federal Savings & Loan Assoc. v. de la Cuesta (1982) 458 US 141].