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Loan Modifications: Old Fiascos and New Hopes

A recent California appellate decision, Aceves v. U.S. Bank (January 27, 2011) has stirred new hopes amongst struggling borrowers and their advisers that lenders can be held liable for their refusal to grant loan modifications. In reality, that is an overstatement of what the court actually said, but I will get to that later. First, I need to set the scene.

For almost four years now lending institutions have offered, at least superficially, loan modifications to strapped borrowers. There are any number of reasons why a borrower might want a modification. A teaser interest rate may have re-set to a brutal, long-term rate; the borrower may have lost his job; or the loan may have been unaffordable in the first place and reality has taken hold. So lenders beefed up their "loss mitigation" departments to handle the deluge of loan- modification applications. The Obama administration created its "making homes affordable" program designed to permanently modify some 3 to 4,000,000 loans. Only about three or four percent of those resulted in permanent loan modifications; and about a year ago the administration declared the program a failure and introduced a new and improved version.

It is not clear that all lenders welcomed the new program. Some openly stated they wanted no part of it. Others continued taking applications, but any improved success rate remains unknown (at least to me). What I do know is that no lender is anxious to reduce principal on the loan because of the negative impact on the lender's balance sheet. The interest rate may be reduced; delinquent amounts may be deferred until near the end of a 30-year term; and monthly payments may be reduced, at least somewhat. This is the most that the lucky few who receive a permanent modification may expect.

In my experience, most borrowers do not. I have seen borrowers put on a so-called "trial program," only to be denied a permanent modification some three or nine months later. In the meanwhile, the lender has captured some additional monthly payments. I have seen borrowers who, at the lender's request, continue sending in additional and new financial statements and other requested documentation, only to find that the process has become endless, lasting a year or more. In the end the denial letter arrives. I have seen denials based upon inadequate income. I have also seen denials based upon too much income or a bank account holding too much cash. I have seen foreclosures occur even while an application for modification remains pending. I have seen great frustration repeatedly. As a result, over the past two years I have refused to work on loan modifications for any client. I don't like the odds, and I don't like taking money from someone facing such long odds.

Back to the case decision in Aceves. The court held that a lender who had promised orally to "work with" the buyer on a loan reinstatement and a loan modification became bound by that promise, because the borrower gave up, in exchange, her opportunity to convert her bankruptcy case to chapter 13 and thereby obtain a payment plan through the Bankruptcy Court. That is the court's holding in a nutshell. To be clear, the court did not rule that the lender had an obligation to grant any loan modification. A court cannot make agreements for the parties; and by the same token it cannot force parties to modify an existing agreement. The court in Aceves simply held the lender to its promise to negotiate over the terms of a potential modification.

The facts of the case were aggravated, not to mention aggravating for the borrower. She was already in chapter 7 bankruptcy. By converting to chapter 13, she might have received a workable payment plan while keeping the lender from foreclosing on her home. After promising to work with her, the lender went on preparing for a foreclosure anyway and filed a motion for relief from automatic stay in the Bankruptcy Court. In reliance on the lender's promise, the borrower did not oppose that motion. Consequently, the Bankruptcy Court gave the lender permission to foreclose. And, sure enough, it did foreclose.

Strangely, the day before the foreclosure sale the lender made a proposal for modification to the borrower's attorney by telephone. The terms were pretty heavy. The lender asked for an immediate payment of $6500 plus a new monthly payment of $7200. The borrower had almost no time to raise the cash even if she had the ability to do so (which is doubtful). At any rate, the court did not consider this 11th hour proposal (or should I say midnight?) as meaningful negotiation with the borrower.

The decision raises several fascinating questions not yet answered by any other court. Because the court correctly refused to reverse the foreclosure sale on the ground that the borrower had not tendered payment of the amount in default, the borrower lost her home irretrievably. The borrower was relegated to a lawsuit for money damages. It is hard for me to figure out what those damages might turn out to be. (The case came to the appellate court on a pre-trial motion to dismiss; and therefore we do not know how the case may ultimately end after a trial.) What are the damages against a lender for its refusal to negotiate? Are the damages equal to the borrower's equity in the property (if any)? If there was no equity, then there was no economic loss. Since negotiating, even in good faith, does not guarantee an eventual agreement, it is impossible to figure out the value of any future modified loan to the borrower. I would guess that the appellate court had absolutely no idea what legal damages the borrower could eventually recover. So I see the real significance of the decision to be a rebuke to the entire lending industry for its high-handed treatment of borrowers in distress. And with the rebuke comes the warning: Lender, you will see a raft of new lawsuits from motivated lawyers after this one.

The threat is a serious one. Creative lawyers can now argue that, based on the legal theory of "promissory estoppel" invoked by the Aceves court, a borrower who detrimentally relies on the lender's promise in any fashion can file a viable lawsuit. The reliance might take the form of making trial payments to the lender. The reliance might also take the form of wasting time on the loan modification as opposed to engaging in a short sale or simply walking away from the property. There are other possible variations on this theme. We will see. Until the proverbial boom times return to the national economy and to the real estate sector in particular, we will still see millions of borrowers needing some form of loan modification and predictably not getting it in time or at all.

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