Our Authors’ Lack Of Understanding Of Home Mortgages

[Pat]

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There is a shocking lack of understanding of home mortgages exhibited by our authors on pp. 42-45!!!

Shocking because our authors are not only holding themselves out to be experts on the banking system but also, at least in pp. 42-45, experts on home mortgages!!!

What don’t they understand???

The difference between recourse and non-recourse loans!!!

And the fact that California is one of the few states in the U.S. in which home mortgages are non-recourse.

[Presumably home mortgages are non-recourse loans in Germany as well or Prof. Admati’s gaffe would have been caught by her co-author!!!]

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EXPLANATION

There are at least two different ways to classify loans = secured vs. unsecured and recourse vs. non-recourse.

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Secured vs. Unsecured

Examples of secured loans are home mortgages, car loans, pawn agreements, etc., etc.

Lenders who/which require collateral (the home, the car or the item pawned), accomplish two objectives. First, they have the additional safety that the value of the collateral is available to insure repayment. Second, if the debtor becomes bankrupt, the secured lender has First Call on the value of the security and only any excess value of the collateral over the amount of the loan (plus, usually, expenses & penalties) goes into the general pool in which unsecured creditors share.

We could even digress, momentarily, on title-theory vs. lien-theory jurisdictions because many of our general readership may be unclear about this issue.

In a lien-theory jurisdiction, the debtor retains title to the property but the loan comprises a lien or call upon that ownership. Usually the lien is recorded so that subsequent lenders or purchasers have notice of the lien and take subject to it.

For example, in Salt Lake County, home mortgages and trust deeds (more about trust deeds in the final paragraph of this secured-vs-unsecured section) are recorded together with deeds and other legal documents affecting the title to real property, with the Salt Lake County Recorder.

Similarly, most states in the U.S. provide that car loans are recorded with the Department of Motor Vehicles. Accordingly, any purchaser of the automobile will be unable to register it without at least knowing that there is a lien that will result in re-possession of the automobile if the loan secured by the automobile goes into default. And most states will not even permit the new owner to register the automobile without the loan being repaid first.

However, some types of assets do not have a registry for liens when they are used for collateral for loans. In such cases, the lender usually requires two things = (1) possession of the asset until the loan is repaid, and (2) a bill of sale so that title to the asset has been transferred to the lender with a clause that requires title to be transferred back to the borrower if the loan is repaid.

[For example, the second and third sections of http://www.ReadingLiberally-SaltLake.org addressing “Inner-City Holocaust and America’s Apartheid ‘Justice’System” (In Honor of Jonathan Kozol and In Memory of John Howard Griffin), which describe the $84 Billion of lawsuits against 15 of the largest international financial institutions for the admitted theft of a trade secret whose value had been pledged in legally-binding fashion to provide for tutoring/mentoring 10 million California inner-city children as they progressed from kindergarten through high school graduation and to guarantee their college tuition, do not mention that for the final appeal to the U.S. Supreme Court in which the “Question Presented For Review” was “Can state court judges order their decisions which they know are diametrically-opposed to well-settled law, not to be published or cited (a strategy labeled ‘the segregated toilet’ in correspondence with 51 inner-city clergy who represent the 10 million inner-city children who have been disclosed from the outset as the ‘real parties at interest’ in this law suit) in order to flush away the rights of the 10 million inner-city children without disturbing the rights of first-class American citizens -- without violating the ‘Equal Protection of the Law’ requirement of the Fourteenth Amendment of the U.S. Constitution?”, John Karls was forced to pawn his Rolex watch to pay for printing the “Petition for Certiorari” (request to accept an appeal) as required by The Rules of the U.S. Supreme Court. [Full disclosure = the Supreme Court Rules require that all documents including Cert Petitions be printed, not that the petitioner pawn a Rolex watch in order to pay for the printing.]

[For the curious, the pawn agreement for John Karls’ Rolex watch required interest at the rate of 10%/month, or 213.8%/year with compounding if the loan can’t be repaid for that length of time.]

Segueing into the next issue, John Karls’ pawn agreement technically comprised a Bill of Sale transferring title to the Rolex to the pawnbroker, subject to John’s Right of Redemption by repaying principal and accumulated interest. However, one day late for any scheduled payment extinguished the Right of Redemption. And each month, the pawnbroker had the option whether to extend the agreement for another month or to require complete repayment with the Right of Redemption extinguished if complete repayment was not made. [For the curious, John made two monthly interest payments and redeemed the watch at the end of the third month.] Accordingly, John Karls’ pawn agreement was non-recourse because he could have “walked away” from the agreement and forfeited the considerable excess of value over the re-purchase price.

But before segueing to the next issue of recourse vs. non-recourse, it is worthwhile noting that the pawn agreement provided for a transfer of title with a clause requiring title to be transferred back if the repurchase price (and interest) were timely paid. The reason for pausing to note this is that about half of the states of the U.S. also have similar provisions for home mortgages and automobiles = “title theory” states provide for a transfer of title subject to a clause requiring re-transfer of title if the loan is repaid while “lien theory” states provide that the “owner” of the property retains title and the security comprises only a lien which can be recorded as such. For the curious, Utah is a mish-mash with respect to real estate, permitting mortgage/liens to be recorded even though most home loans are secured by Trust Deeds (the transfer of title to a trustee for the mortgage lender subject to an obligation to re-convey title upon satisfaction of the loan) because Trust Deeds by-pass the delays & expense of the judicial system when it comes to foreclosure (but that is another story).

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Recourse vs. Non-Recourse

Under English-American Common Law, providing security for a loan does not make the loan non-recourse.

In other words, the borrower has an obligation to repay the loan and the lender has the additional safety that the value of the property IN ADDITION TO THE EARNING POWER AND OTHER ASSETS OF THE BORROWER is available to insure the loan is repaid.

If the borrower becomes bankrupt and the value of the property is insufficient to repay the loan, the borrower becomes an unsecured creditor for the balance and receives the same “cents on the dollar” for the balance that other unsecured creditors receive with respect to their loans.

However, English-American Common Law does NOT prohibit borrowers and lenders from providing in their contract that the loans is non-recourse. In other words, if the value of the property is insufficient to repay the loan, the lender has agreed to forego any further recourse against the borrower.

For the curious, non-recourse loans typically command a sizable interest-rate premium over what would be charged for a recourse loan. And non-recourse loans are typically made for only a much smaller fraction of the value of the collateral than would be available with a recourse loan.

In addition, English-American Common Law can be changed by statute. And, for example, most states have made extensive revisions to English-American Common Law with regard to crimes. Most of us have forgotten, if we ever knew, that at Common Law a “felony” was any crime punishable by death. And a “misdemeanor” was simply a crime for which the maximum punishment did not include death. And most of us never new the meaning of the term “beyond the pale” = it derives from the concept of “The King’s Pale” which was the area comprising a radius of several miles around the person of the English King and moved whenever the King moved -- EVERY misdemeanor automatically became a felony if committed within the King’s Pale in order to provide extra safety for the English King and “Beyond The Pale” became an expression for the concept that “anything goes” outside The Pale, at least in terms of misdemeanors because the miscreant does not have to pay with her/his life.

Why is this important???

Because a handful of states have enacted statutes which provide that home mortgages are non-recourse.

Digressing again momentarily, California and Louisiana are famous for their legal systems which are based on the Napoleonic Code rather than English-American Common Law -- due to the colonial history of California and Louisiana. Most of us are aware of this difference, at least when it comes to the concept of “community property” in divorce actions.

It would be interesting to know whether the provision in California law that home mortgage loans are non-recourse, comes from the Napoleonic Code, or whether it was enacted by the California legislature. [Perhaps someone else has time to “chase that rabbit”!!!]

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Utah Law -- For The Curious

Utah law is based on English/American Common Law.

Utah has NOT modified English/American Common Law to provide that home mortgages or, more commonly, trust deeds are non-recourse.

However, the Statute of Limitations for a lender to institute a lawsuit against a homeowner for any deficiency of value of the home when compared to the balance that was due on the mortgage (or, more commonly in Utah, the trust deed) is 90 days following the foreclosure auction.

As a practical matter, lenders do not “throw good money after bad” by pursuing the former homeowner if it is obvious that it is unlikely to be able to squeeze “blood from a stone” -- that the foreclosed homeowner probably can’t be bled for any more money, at least not enough to justify the expense of such a lawsuit.

Accordingly, it is common practice for the lender to enter a bid at the foreclosure auction equal to the unpaid balance on the loan plus penalties and interest -- this extinguishes any additional exposure for the foreclosed homeowner. Occasionally but rarely, investors will bid more than that amount, in which case the excess is paid over to the foreclosed homeowner.

And for the really curious, the minuet becomes quite involved when there is both a first and second mortgage (or, more commonly in Utah, a first and second trust deed).

If the trust deed in second position is foreclosing, the auction will typically proceed as described in the second-preceding paragraph. Though, of course, the first mortgage or trust deed is not affected so the bidders are only vying for the net equity and take title subject to the first mortgage or trust deed.

But if the trust deed in first position is foreclosing, the owner of the trust deed in second position has the unhappy decision of whether to “throw good money after bad” by bidding after the typical starting bid by the first-position trust-deed owner of an amount equal to its unpaid balance plus penalties and interest.

When a second-position mortgage/trust deed owner decides not to bid, there is a much greater probability that it will simply sue the foreclosed homeowner within the 90-day statute of limitations.

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CONCLUSION

There is no excuse for Professors Admati and Hellwig to exhibit such gross ignorance in such a short book (only 228 pages excluding index & footnotes) which has been “dummied down” for the general public.

[Indeed, any book “dummied down” for the general public should have a higher requirement for accuracy.]

AND THE PRINCETON UNIVERSITY PRESS EDITORS ARE EVEN MORE GUILTY IN FAILING TO CATCH THESE GROSS ERRORS!!! AFTER ALL, THE RAISON D’ÊTRE OF EDITORS IS TO INSURE THAT THE ERRORS OF AUTHORS DO NOT REACH PRINT!!!