This article analyzes the unspoken stifling effect the due-on-sale clause has on the California real estate market and the opportunity brokers and agents now have to abolish these negative impacts and forge long-term stability in the real estate market.
A provisional wall limits sales volume
Consider the California real estate market of the future: the year is 2016, and the real estate recovery is finally picking up appreciable speed. Real estate sales volume and prices are on a stable rise as Generation Y (Gen-Y) enters the California housing market, buoyed by plentiful well-paying job opportunities. Enter our first-time homebuyer, a member of Gen Y lured by reports of the ripe housing market and looking to move out of his rented housing and become a homeowner in the community.
With the help of a real estate broker, the homebuyer begins his search for a suitable single family residence (SFR) to purchase. While the homebuyer searches, the burgeoning housing boom is spurring on the economy, but inflation hovers above the Federal Reserve’s (the Fed’s) 2% target. Thus prompted, the Fed raises short-term interest rates to slow the accelerating pace of the economy and correct for the artificially low interest rates it injected to stimulate growth following the Great Recession. [For more information about Gen Y’s involvement in the real estate recovery, see the October 2010 first tuesday article, The demographics forging California’s real estate market: a study of forthcoming trends and opportunities, Parts I and II.]
An SFR suitable for the homebuyer is finally located and a purchase agreement is entered into with the seller, contingent on the homebuyer obtaining financing to fund and close the transaction. The homebuyer’s broker advises him to shop two or more competitive lenders for a mortgage, and gives the homebuyer a checklist of questions to ask to get the information he needs to make an informed decision about the type of loan to apply for. As advised, the homebuyer visits several lenders, armed with the broker’s checklist. [For more the list of questions a homebuyer shopping for a mortgage needs to ask lenders, see the June 2010 first tuesday article, A borrower’s mortgage worksheet: who has the most advantageous financing?]
What the homebuyer finds when he goes shopping for a mortgage is that lenders have, in response to rising inflation and the Fed’s actions, raised the long-term interest rates and the miscellaneous fees they charge on fixed-rate mortgages (FRMs). Higher interest rates alone mean the homebuyer cannot borrow as much money as he was able to just a few months earlier.
During his lender consultations, the homebuyer is told he no longer qualifies for the amount of financing he needs to close escrow at the price and the down payment he agreed to paysince FRM interest rates are higher — a common scenario in a rising interest rate environment.
Editor’s note — Initially, rising mortgage rates tend to reduce the volume of home sales, but eventually, they drive down prices so buyers can again buy. As a result of lower prices, the volume of sales picks up. [For more information about the interplay between interest rates, seller pricing and the amount of financing a homebuyer is able to qualify for, see the February 2011 first tuesday Market Chart, Buyer purchasing power.]
The lender representatives do, however, tell him they can lend the amount of funds he needs and do so at lower interest rates if he chooses to go with an adjustable rate mortgage (ARM). The homebuyer, eager to purchase, discusses the use of a non-conventional loan (i.e., the ARM) with his broker.
The broker goes over the financial risks involved in financing real estate ownership with a short-term interest rate provided by an ARM. Together, they weigh these risks against the ARM benefit of borrowing more money than permitted by the financing fundamentals of a long-term FRM. [For more information about what the ratio of ARMs to total mortgage originations means for the real estate recovery, see the February 2011 first tuesday article, The ARMs threat: monitoring a sustainable recovery.]
As an alternative method for financing the purchase price to be paid for the property, the broker suggests they negotiate with the seller to either:
- cash out the seller’s equity in the property and agree to take over the payments on the seller’s existing mortgage since it has a lower interest rate than can be found in the current market, an arrangement called an assumption; or
- arrange for the seller to carry back a note and trust deed for a portion of his equity and assume the existing loan to finance payment of the price.
The homebuyer concurs, and the broker contacts the seller about the homebuyer taking over the existing mortgage on the property. The seller agrees, and will also carry back a note for part of his equity. The purchase agreement is modified to state the homebuyer is to take title to the property subject to the existing FRM loan, conditioned on the lender’s consent to the seller’s carryback arrangement, the buyer’s assumption of the loan without modification and an assumption fee not to exceed one-half point.
Together, the payments under the assumed loan (with its lower-than-current market interest rate) and the carryback financing arrangement with the seller amount to 31% of the homebuyer’s income — the typical allowable debt-to-income (DTI) ratio on a conventional FRM. [See first tuesday Form 150 §5 and 6; for more information on the debt-to-income ratio, see the February 2011 first tuesday Market Chart, Buyer purchasing power.]
The lender, upon receiving a request for a beneficiary statement and consent to the sale, informs the seller that the seller’s trust deed contains a due-on sale clause, allowing the lender to call the loan due upon the sale of the property to the homebuyer.
The lender also informs escrow (and thus the homebuyer and the seller) it will consent to the sale and proceed without calling the loan if the terms of the loan are recast to current market interest rates — interest rates under which the homebuyer cannot qualify, except by use of the perfidious ARM. And, yes, the extraction of an assumption fee of 1.5 points.
Ultimately, the sale falls through since the homebuyer is unable to arrange any suitable financing for the purchase of the home at the price demanded by the seller. To sell the property he no longer wishes to own, the seller must either drop his price, hold out for someone who will use an ARM or withdraw the property from the market since his lender will not permit a sale subject to the existing mortgage financing encumbrancing the property since it has a due-on-sale clause in its trust deed.
On a large scale, repeated thousands of times over in the real estate market, the lenders’ Congressionally-approved use of due-on-sale clauses shifts wealth from sellers to lenders. This quickly undermines the recovery’s vigor, wasting years of recuperative effort and financial stimulus on the part of the government. The inhibited sales volume comes at a great expense to the economy, the government and the people desiring to sell and buy using the mortgage financing already in place on the property (by taking advantage of the existing lower mortgage interest rates and no loan fees/charges).
On a more prosaic level, brokers and agents interested in seeing the recovery of their real estate practices under the new real estate paradigm must take steps to protect their clients, and their brokerage businesses, from the stifled sales volume caused by the due-on-sale clause. This profitable interference was engineered by mortgage lenders and has been permitted by Congress since 1982. [For more information about California’s new real estate paradigm, see the May 2010 first tuesday article, Looking through the window towards recovery: a real estate paradigm shift — Parts I and II.]
The due-on-sale clause comes due
Prior to 1982, under California law and our state’s Supreme Court ruling in Wellenkamp v. Bank of America, homebuyers and sellers had protection from lender interference. Wellenkamp barred lenders from exacting additional interest earnings and profits when prospective homebuyers enter into any type of real estate transaction, be it a cash-to-loan (CTL) sale, seller financing arrangement, a subject-to transfer (the Wellenkamp assumption) or a formal assumption agreement with the lender — no loan modification allowed. Wellenkamp prohibited any lender interference with a sale, except when it was reasonably necessary to protect the lender’s security interest in the transferred real estate from impairment — the failed credit situation of the insolvent arsonist homebuyer. [Wellenkamp v. Bank of America (1978) 21 C3d 943]
However, in 1982, Wellenkamp was superseded by new federal law. The due-on-sale codes and regulations were crafted and government-stamped under the Garn-St.Germain Federal Depository Institutions Act of 1982 (Garn) to give the then-failing savings-and-loans (S&L) outfits the ability to exact extra earnings from borrowers for simply clearing the homebuyer’s credit in assumptions. S&Ls were now able to charge points and fees, adjust interest rates to current market (always upwards) to increase lender income and remain solvent as though a new loan origination took place. All this was an attempt to supplement the shrinking profits of these mortgage lenders by allowing them to take a share of the monies a buyer was willing to pay a seller for a property — money the seller had been entitled to receive.
At the time, Garn was the financial equivalent of using a bucket to bail out a sinking cruise ship: the S&Ls eventually failed en masse despite the government-sanctioned windfall they received from sellers (and buyers) via new rates and fees on either assumptions or new loans (plus the now-restricted prepayment penalties). Yet, the due-on-sale clause remained after the closing down of the S&L mortgage financing and banking structure in the late ‘80s. The few S&Ls which did not fail simply became Federal Deposit Insurance Corporation (FDIC) banks (which are now failing) to avoid restrictions placed on S&L conduct.
In the thirty years since Garn, the government has had no measurable basis for taking the due-on-sale clause exactions away from lenders; interest rates were already dropping by the time Garn was passed, and they have been decreasing ever since. Lenders have had little reason to call a loan due on an unconsented-to transfer when interest rates are lower in the market than they are on the mortgage paper taken over by the homebuyer. If a lender called a loan, it could not re-lend the pre-paid funds and obtain a great yield. This is about to change, dear reader.
With no impetus to change, Congress has simply let the due-on-sale clause lay coiled like a somnolent rattlesnake, dormant but ready to strike at the slightest provocation — such as a rise in interest rates triggered by a battle against inflations led by the Fed and driven by the bond market. This clash will occur sometime later this decade during the recovery, just as brokers and agents least need it.
Just how economically damaging can one clause be?
California’s real estate market is in recovery, currently bumping along on the recovery plateau. Its frequent small steps forward (and occasional small steps back) show not only the recovery’s resilience, but also its sensitivity to economic shocks. When jobs return to the state, as they will in sufficient annual numbers beginning in 2013, the newly-employed potential homebuyers will be called upon to take up the mantle of homeownership. This will jump-start the next virtuous cycle of real estate sales (and at some point, prices). But their numbers and enthusiasm will not be enough to mitigate the negative effects of the due-on-sale clause on sales volume when we find ourselves in a rising FRM interest rate environment with prices accelerating. [For more information about the shape of California’s recovery, see the November 2009 first tuesday article, Divining the future: the letters game.]
Firstly, the due-on-sale clause guarantees homebuyers who enter the market during a period of rising mortgage rates that they will be unable to negotiate deals with amenable sellers for seller financing or assumptions without having lenders off a piece of the action through new loan fees, increased interest rates or prepayment penalties. Since the investors who actually own the mortgage-backed bonds (MBBs) only collect the interest income on the mortgages they own, anything exacted above the interest income (namely, the extra fees granted lenders by the due-on-sale clause) are profit collected solely by the servicer-lender — for doing a negligible amount of paperwork beyond getting the buyer’s credit score.
By limiting homebuyers’ options in a rising interest rate environment — replete with ARMs and loan takeovers — the due-on-sale clause directly tampers with the pace of the real estate market. Homeowners who cannot quickly sell and move to new job opportunities (or simply retire and relocate) will be unable to buy, reducing home sales volume.
Alternatively, emotionally-charged homebuyers who cannot afford the higher FRM interest rates and who are not permitted to take title subject-to the existing mortgage will run straight into the ARMs of lenders, trapping themselves in volatile financing arrangements too quickly leading to financial ruin. Sellers will be hit with prepayment penalties. We need look no further than the current economy to witness the chaotic negative equity disaster precipitated solely by the excessive use of ARMs during the Millennium Boom. [For more information on carryback financing arrangements, see the February 2011 first tuesday article, Carryback arrangements facilitate a sale, Parts Iand II; see first tuesday Form 410]
The impact of the due-on-sale clause resulting from increasing FRM interest rates is only part of the resale and purchase picture. Sellers, restricted by the due-on-sale clause from structuring deals to more effectively find willing homebuyers, will be forced to either lower their sales price to allow the homebuyer to qualify to finance their purchase of the property under rising interest rates, or hold out for that unqualified homebuyer who is either ill-informed or foolhardy enough to take out an ARM. This lowering of the price, while it may mimic the rational seller’s propensity to price his property to sell, is as disruptive to the market as an overinflated price and for the same reason: it is not the result of the property’s fundamentals or the unavailability of Congressionally-disapproved financing arrangement.
Rather, it is a function of lender dominance (and thus, intuitively, interference with the sale). If the seller and homebuyer will not pay fees and increased interest rates to the lender to grease the wheels for the assumption of an existing mortgage, the lender will simply threaten to call the loan and put fetters on the transaction. Or, the lender may “graciously” accept additional fees and increased interest income under a modification agreement, which basically represents the costs and rates to originate a new loan. Due to its delivery of “double-ended” profits, the due-on-sale clause is an effective deterrent to the seller’s use of the property’s existing 30-year mortgage to effectively sell the property during the loan’s 30-year term.
Sellers looking to relocate to greener pastures in search of employment opportunities which match their skills will find their inability to offer flexible seller financing arrangements or CTL arrangements (as suppressed by the due-on-sale clause) a hindrance to their re-entry into the job market where jobs are available. For the new generation of homebuyers who will, in large part, prefer to live where they work, the barriers introduced by the lender’s due-on-sale clause throw up an unwelcome systemic mismatch of homebuyers to sellers whose property is already financed, and by extension, employees to employers. This continues in a vicious cycle of failed opportunities, all due to the presence of due-on-sale clauses in existing mortgages during periods of rising interest rates. [For more information about the changing housing tastes and increasing urbanization of homebuyers, see the February 2011 first tuesday article, The generations have spoken, who will listen?]
On behalf of California’s real estate users
The due-on-sale clause is one of many of the inconsistent federal government’s policies which lead back to now-weakened, but still-powerful anti-consumer lobbies.Federal housing and lending policy favors lender interests while peddling the illusion of helping the common man fulfill the “American Dream” with feel-good placebo programs (one of which is the tragically ineffective Home Affordable Modification Program (HAMP)).
Editor’s note — The federal government’s lender bias can be seen at the core of its housing policy. The federal government pushes homeownership as a sort of social stabilizer (which it may not be), but finds no irony in counting people who overreach to finance their home purchases with ARMs as part of that “stable” society. The federal government also continues to allow people to write off their mortgage interest as a tax deduction – but if the tax deduction were meant to stimulate homeownership, one wonders why the write-off is based solely on indebtedness, not homeownership… [For more information about the proposed restructuring of the homeownership tax subsidies, see the March 2011 first tuesday article, The home mortgage tax deduction: inducing debt and stifling mobility.]
Fortunately for the homebuyers, sellers, brokers and agents of this state, for decades California’s legislative and judicial history has championed the right of California property owners and the real estate market to freely sell, encumber or transfer real estate, also known as the right of alienation. This California real estate history provides precedence for lender noninterference. Under California law, limited use of the due-on-sale clause allows automatic assumptions, giving brokers the ability to structure competitive seller financing and CTL transactions once again. Equally important, the need for ARM financing as a bridge for funding sales during recessions and periods of rising interest rates, with the accompanying tight money conditions, would disappear and sales volume would remain stable.
While time still remains in this recovery period to shape the future of the recovery ahead, brokers and agents must push for change lest they let this crisis go to waste. State legislators must, on behalf California property owners and the California economy, put pressure on the federal government to change the lender double-dipping allowed under the due-on-sale clause with a state resolution, signed by the governor, kindly requesting that Congress repeal federal due-on-sale legislation. Garn, and all the backhanding regulations issued in its name allowing continuous lender interference, must be reversed.
The recent establishment of the first-ever Consumer Financial Protection Bureau to be created by Congress, in face of massive lender resistance, indicates an important shift in the nation’s overall economic mindset. Instead of turning a blind eye to profligate lender abuses implemented by 30 years of deregulation, the government has finally taken steps to again, as in the 1930s, hold lenders accountable for their policies and actions. Congress has gone even so far as to tell lenders what they cannot do so societal institutions, and the nation’s economic welfare, are not placed in jeopardy again as in our recent past. Even so, it will be an uphill battle for Congress to pry from lenders what they have come to believe is their right to exact additional fees and earnings on someone else’s unrelated property transaction.
While the recovery is still nascent and homebuyers can still be protected from the effects of the due-on-sale clause, and while the market is still relatively free of the rising mortgage rates and the taint of widespread ARMs financing, brokers and agents have a window of opportunity to do something. They can write their state and congressional representatives and voice their concerns on behalf of their sellers, buyers and themselves. In leading the charge to protect their livelihoods against the improper restraint on sales posed by the present authorized lender use of the due-on-sale clause to exact further profits on an owner’s use of his property (by selling, leasing or further encumbrancing), real estate licensees will begin paving the way for a stronger, more successful and long-lived real estate recovery.