The Legal Fallout Of The Subprime Market Collapse Has Begun
Real Estate Realities
The legal fallout of the subprime market collapse has begun
The Valley’s residential real estate market continues to reel from the effects of the subprime market collapse. Home foreclosures are on the rise and banks are tightening lending standards. Arizona Business Magazine has assembled a roundtable featuring some of the top lawyers in the real estate field to discuss the current unrest in the housing market.
Taking part in the roundtable were:
With the collapse of the subprime market, Congress has been talking about reform legislation. Is it needed or are there already laws in place to handle this situation?
The (federal) legislation that I am most aware of is Senate Bill 2136 … That is aimed at trying to modify the bankruptcy code to make it permissible for debtors to modify their home mortgage loans, something they cannot do currently because of the protections afforded mortgage lenders. That particular legislation would permit … borrowers to reduce the amount of the loan value to the amount of the collateral in cases where the loan value is in excess of the collateral, and it would also allow them to modify the interest rate to a court-determined rate.
One of the things that I wonder about legislation like that is whether by the time — if it makes its way into law — whether we’ll still have this crisis in front of us or whether it will be a crisis in a different shape.
… (T)he subprime collapse and the issues that surround it have a much broader implication in a number of different markets from the lenders’ perspective too. And there has been talk about trying to regulate more closely lending practices and create some standards, particularly for the larger financial institutions … so that they don’t make those decisions themselves. But I tend to think that Brian is right. By the time that legislation winds its way through the process, it’s likely not to be needed in quite the way it’s perhaps perceived as being needed right now. So who knows what kind of backlash and other unanticipated problems could arise out of that.
… From my perspective, I think the market is going to deal with this problem. It’s not going to be pleasant, of course, because we are so far down this road there really is no way of stopping it. I’ve heard some statistics … that a large number of these subprime loans are having as high as 60 percent default rates right now. If you look at the amount of dollars that are at issue with any of these subprime portfolios, it’s just a staggering amount of money that was lost by these lending institutions. I think it’s important to keep in mind that this problem touches a whole bunch of constituents.
… You have developers and builders that have gotten caught up in the rampant speculation that came with the easy availability of credit in the soaring real estate market. We also have the trading markets themselves because a lot of commercial properties are in real estate investment trusts, which have been securitized and are being traded right now. But a lot of the subprime portfolios have been securitized and they are being traded. We have mutual funds and other retirement vehicles, as well as the broader securities markets, that are feeling a real significant effect from this.
In the framing of the issue, it’s very important that we don’t just focus on subprime and how we define subprime. It’s not just the subprime that created this. There is also the secondary market. … Coming from Tucson, there is a big financial institution that is in Chapter 11 bankruptcy right now. It’s clear it didn’t have subprime paper, but it did have Alt A paper and A paper …
It might be helpful for us to define or at least characterize what we mean when we say subprime loans. … I think it’s intended to refer to higher-risk residential loans. And particularly those that are characterized by higher loan-value ratios or higher interest rates or both; some of which come with adjustable rates.
… Going back to what Dan said, what we have here is we ran into a period where getting credit was much too easy to obtain and I think it was because mortgage lenders wanted to get into this boom. Everybody saw real estate values going up, a lot of people wanted to speculate in residential real estate and other kinds of real estate and so lenders asked, “How can we offer these very attractive packages that minimize the amount of scratch somebody actually has to put into real estate investment?”
… And they came up with all kinds of different variations. Some of which may not have been well disclosed to the borrowers. And that’s where you get into the point about the lending practices and were they appropriate…
But I think, prospectively, market forces are going to be at work and credit is going to tighten, just like it did the last time we were in this boom-bust scenario … I think part of the problem that Congress is currently dealing with is what do we do with the folks that are caught up in these. But what I’m seeing is a lot of folks that are affected by these subprime mortgages are folks that were doing this as investment properties.
… When you look at this, the reason for this is if you have a subprime loan that has a very high loan-to-value ratio, it doesn’t take a very deep drop in the real estate market for that property to go underwater, for the loan to exceed the value of the property. At which point, they don’t have a great incentive to want to try to keep that property. So, that’s obviously one of the big reasons for the high rate of default on these types of loans.
… There have been rules of thumb in the lending industry about how much should be paid down or paid up front by a borrower, and consequently went below what the value ratio should be and what kind of return lenders needed to get on their loans for it to be a profitable business. And the down payment structure had two points to it. One was to make sure that a homeowner was truly invested, literally and metaphorically, in the property that they were buying. But it was also to create a cushion in case there were market fluctuations; the borrower might still have some skin in the game, so to speak, and the lender wouldn’t be completely underwater. Arizona has what we call the anti-deficiency statute, which basically says that on a single-family residency, a mortgage lender can only look to the value of the property to satisfy the loan. It is essentially a non-recourse loan for a traditional mortgage or a trustee-secured loan. So those parameters for borrowing become very important because, unless the person who is borrowing against that house perceives that they still have value there, there is very little disincentive for them, other than a negative credit report rating, to walk away from the property. … it’s created a landslide of defaults and foreclosures.
I am seeing a lot of banks that are taking more property into their real estate owned departments than ever before. I think Michael’s point is important; this really isn’t just about subprime. Really, the whole subprime industry was driven by the fact that we’ve seen an almost unrequited period of appreciation in real estate for almost the last two decades. … There are a whole bunch of collateral effects that have been going on that really have to do with this, to use Alan Greenspan’s term, irrational exuberance in the real estate market. … It’s a more far-reaching problem, to Michael’s earlier point, than just the subprime issue.
We touched on the lending practices part of this, and certainly if there are problems with lending practices, those need to be addressed. This is not the first time we’ve had this. In fact, the Truth in Lending regulations and laws came from the time, similar to this, where there were problems with borrowers understanding what the terms of their loans were. We need to … see if somebody’s practices violate those Truth in Lending laws.
… So if we need to do something to enforce or tighten those laws up, maybe that’s the way we should address that. But I tend to believe that a lot of this stuff is driven by market forces and can ultimately be corrected by market forces.
I’m actually seeing less in terms of bankruptcy filings than you might expect. I tend to think that’s driven by one thing in particular and that’s the lenders are reticent to force the issue on a lot of properties that are distressed … Because they have taken huge losses, they are taking enormous amounts of property … that is not moving. For example, I have one case that to this day surprises me. Back last July, my client, who is the owner and developer of the property, told the bank that they simply weren’t going to … be making payments anymore. They’d keep the For Sale sign up front and if the lender wanted the property back, here were the keys. And it wasn’t a bluff.
… And lo these six, seven months later, the lender hasn’t even noted the default. There hasn’t been a penny paid on the loan and the lender hasn’t noted the default or started the foreclosure process or anything like that. I think that’s very telling of the market that we are in right now.
There’s going to reach a point, either because the lending community will require them to force the issues or because we get to a tipping point where nothing else can happen, where I think you are going to see more bankruptcies. …
… (Lenders) also have strict rules they have to abide by in certain situations that don’t necessarily make sense for the borrowers. That sometimes prevents reasonable resolution of these problems and it ends up causing the borrowers to look at other sources of relief like bankruptcy relief.
Garrison: It strikes me too that there is a difference between a lender who has a real significant presence in the market … and a lender who is primarily headquartered someplace else and is perhaps just coming into this market because of the perception that it was such a vibrant market to be involved with and doesn’t really understand what’s going on here. … I can’t imagine a tougher time to try to appraise a property than right now.
For the last several months, it’s been such a moving target … no one is quite sure what property is worth. And since property isn’t selling very much right now, the more subjective appraisal kind of process that we’ve relied on for a long time becomes difficult to trust. I do suppose that it’s changing, but I do know that over the past few months I’ve certainly talked to a lot more bargain hunters — investors coming from the outside that I think are harbingers of the fact that the market is starting to bottom out because it’s smart money coming in now and looking for deals … and those folks know their business very well and they have the wherewithal to sit on the property for a couple of years if they need to or as much as five years if they need to. …
The fallout out too is going to be the regulatory stuff. You’re going to see DFI (Department of Financial Institutions) trying to regulate all the forces of the market, including, like you were talking about, the appraisers. A lot of people think some of the appraisers have contributed to this problem by inflating prices and there was really no ways of going back on the appraisals, for example. They really don’t have bonds and things like that, and licensee enforcement of them really hasn’t been as stringent as some would like to see. If they have a bad appraisal, they don’t have insurance to go after them.
There’s really nothing they can do to hold them accountable, so there are a lot of appraisers coming in and out of the market. Same thing holds true for the loan officers. … I think there has even been a bill introduced to try to license loan officers, and that goes back to whether or not loan officers had incongruent opportunities to try to get more people in the market. … I think you’ll see a lot of regulatory things at the state and federal level.
I have no doubt that there is going to be legislative reaction to this. And the thing that concerns me is that it will be reactionary. … I tend to think that the licensing and the regulation of those different vocations within the industry may not accomplish much of anything … The fact that the real estate market had gone up for so long and so continuously and so precipitously that people got lazy, and people who shouldn’t have been speculating, shouldn’t have been investing, shouldn’t have been lending on the terms that they were and were willing to ignore what would ordinarily have been cautionary practices because everybody was making out.
Everybody was in a frenzy because there was so much money to be made. … I think now, obviously, that people have felt the results of the excess and those that were affected are going to be a lot more prudent about how they go about their business in the future.