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Homes Under Water with No Surface in Reach

Over the past three years I have seen many homeowners who are, to use the popular phrase, "under water" with their properties. Some have lost their jobs and cannot afford to pay the loan; others never had jobs enabling them to pay in the first place; still others have reached the obvious conclusion that it is not worth their while to continue paying on an interest-only loan secured by a property that has lost one third or more of its original value. These last homeowners typically commit what is called, to use another popular phrase, a "strategic default."

Strategic defaults have received attention in the press of late. I was struck by a front-page article in the New York Times (July 8, 2010) describing a class of "rich" homeowners who simply treat a bad investment in a home as a bad investment: They dump it. The article chose Los Altos, CA as its example -- very close to home for me. The article pointed out that, among all groups of homeowners, those in an affluent community are more likely to commit strategic defaults than their less well-off counterparts. Call it callous. Call it shrewd. Several descriptions may apply.

A loan modification represents an alternative. But apparently few loan modifications have been granted since 2007; and those that are granted usually do not give the borrower a large enough financial break to enable (or to persuade) the borrower to continue making payments. The federal government, while adept at bailing out failing lending institutions, has fumbled in its effort to reduce the number of foreclosures. Having finally acknowledged that the first loan modification program (aka 'Making Homes Affordable') was a flop, the Obama administration floated a new and improved version in April calling for, in addition to the usual brew of reduced interest, lower monthly installments and deferred make-up payments, a measure of principal reduction. Some lenders still resist. But foreclosure followed by resale as well as the now-familiar 'short sale' brings the lender to the same loss position anyway - and usually a bigger one. We will see if a new program fares any better.

In the meanwhile, the appellate decisions have begun to arrive from the California courts after the usual lag time. (A normal case may spend a year or two in the trial court and another year on appeal before it results in a published opinion from a court of appeal.) The trends are noteworthy.

In 2008 the California legislature adopted a series of statutes designed to slow the foreclosure process and to encourage voluntary arrangements between distressed borrowers and their lenders. One of the statutes, section 2923.5 of the Civil Code, requires the lender to contact the borrower and to explore options before initiating a foreclosure. In a case of first impression, the court in Mabry v. Aurora Loan Services (June 2, 2010) held that a borrower may file a lawsuit to enforce the statute directly. That part of the decision represents good news for borrowers. But the decision also delivered some bad news. First, the court cannot order the lender not to foreclose; at most the court can order a postponement of the foreclosure sale until the lender complies with the statute. Next, if the foreclosure sale has already occurred, the court cannot reverse the sale and restore title to the borrower. Finally, attorneys for the borrower cannot use a class action in order to enforce the statute on behalf of a large group of borrowers against, in effect, the entire lending industry.

Traditionally, it has been virtually impossible for a borrower to undo a foreclosure sale, absent some serious defect in the procedures for noticing and conducting the sale. Nothing in the recent decisions indicates that the traditional rule will change. In Garcia v. World Savings (April 9, 2010), the borrowers alleged that the lender had agreed to postpone the sale in order to give them time to arrange a new loan and thereby to pay off the default amount. In reliance upon the lender's promise to postpone, the borrowers undertook a refinancing of other property they owned. The refinancing went through. When the borrowers sent the money from their new loan to the original lender, the lender informed them that the foreclosure sale had already occurred.

The appellate court allowed the case to continue on the theory of "promissory estoppel" (breach of contract) for money damages. The court did not, however, overturn the foreclosure sale.

Creative borrowers' attorneys have come up with some novel arguments designed to invalidate the original loan and thereby to prevent the lender from foreclosing. The traditional arguments - such as "I never read the loan papers" or "no one told me what I was signing" or "the loan agent lied to me about the terms" - remain doomed to failure. The courts tend to enforce written agreements against the persons who signed them. The novel arguments, however, spring from the bad lending practices that prevailed in the years before 2007.

A prime (or should I say sub-prime?) example is a loan made based upon "stated income." Instead of verifying the borrower's actual income through financial records and checking references with employers and banks, loan agents treated many applicants as though they were entrepreneurs who knew the income from their own business and could give a figure as their "stated income." In reality, the enterprise did not exist and neither did the income. Now, as foreclosure time arrives, the borrower accuses the lender of lying about the borrower's ability to repay the loan, exaggerating the borrower's income, or engaging in "predatory" practices designed to saddle the borrower with a loan he could never pay off.

The decision in Perlas v. GMAC Mortgage (August 11, 2010) rejected that line of attack.

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