The Liar’s Loan
If you are not in the mortgage business, chances are you are not that familiar with how the mortgage business really works. Most lawyers I know -even real estate lawyers – are not familiar with the underwriting guidelines for mortgages, the way mortgage interest rates are priced, and how banks and mortgage brokers get paid.
The A Paper Mortgage
It used to be that a potential borrower would walk into their local bank and fill out a mortgage application form, called a 1003 (pronounced Ten Oh Three). On this application would be numerous questions, including questions about employment, income, and assets and debts. The bank would then take the 1003 and verify the contents of it. Sometimes this would be done with the borrower’s help, such as having the borrower provide paystubs, bank statements, letters from employers.
Often the bank would check up themselves, calling an employer (called a VOE – verification of employment) or a VOD (verification of deposit), both of which would require the employer to provide proof of income, or a bank to provide proof of a certain sum of money the borrower had in an account. The bank would also make sure that your loan to value ratio was appropriate – meaning you still had some equity in your house, or they would require you to purchase mortgage insurance. Finally, the bank would confirm that your debt to income ratio was also appropriate – that your debts (credit cards, car loans) were not so high that the mortgage payment was going to push you over the edge.
Mortgages were very low risk investments for lenders. The default rate was very low. And so began the beginning of the mortgage crisis – it all started in a benign way. Investors decided that it would be great to take a large group of mortgages, bundle them together, and sell shares of them as investments. These were called ‘mortgage backed securities”. The “collateral” was the mortgage – ultimately it was your house. Since most people did not want to lose their homes, they would pretty much do everything to prevent foreclosure – hence the attractiveness of these loans.
Banks would then sell their notes and mortgages to a third party – who bunlded them and sold them on the open market. The investment market loved these loans – but soon they ran out of them to sell. So the lending institutions – the banks – started coming up with “better” loans – for the people who would not qualify for an A paper loan. Such as people who had good credit scores, but no assets, or perhaps no set income, such as people who were self employed. These loans were called Alt-A loans.
The Beginning of the End: Alt-A
Now, don’t get me wrong. Not all Alt-A loans were bad loans. They were just riskier loans. They were riskier because they were not based on the same criteria as the A paper loans. There were several different kinds of Alt-A loans, such as the Negative Amortization Loan, the NINA Loan, the Stated Income Loan, also known as the “liar’s loan”, and the No Ratio Loan. The NINA Loan, a/k/a No Income/No Asset was the ulitmate no-doc loan. If your FICO score was high enough, and you had a certain amount of equity in your house (usually 30%), you could get a loan for 70% of the value of your house, wihtout providing the bank with a single shred of documentation and you did not have even have to tell them how much income you made.
The Stated Income Loan, also known as the Liar’s Loan, allowed you to tell the bank that you made a certain amount of money, but they did not actually check it to make sure. In fact, they used an outside CPA to verify that the kind of job you had (not that the bank actually verified that you had that job) it was reasonable for you to make a certain amount of money. So perhaps you were a car mechanic, and you really made $39,000, technically you could state you made $90,000 a year and get a loan based on that amount. Now, you were not supposed to lie but you can guess what happened . . . yeah a lot of people lied. Shocking.
So now people are defaulting on these loans because, well, a lot of them could not afford them in the first place. For the people who could afford them, well they are probably the people buying up all the property everyone else is losing to foreclosure.
The Liar’s Loan and Bankruptcy
In bankruptcy, normally a debtor’s ultimate goal is to have all of his or her debts discharged. Some debts are not discharged because they are backed by collateral, such as a house or car, and the debtor wants to keep that house or car. But if the debtor did not want to keep the collateral, the debt could theoretically be discharged. Sometimes, in rare circumstances, a wholly unsecured second mortgage could be discharged and you could still keep the house. The key would be whether the equity in the house was so low that none of the second mortgage – not even $1 – would have any equity (Example: House worth $150,000, first mortgage balance $160,000; Second Mortgage Balance: $50,000). The second mortgage can sometimes get “stripped” in a bankruptcy and you can walk away from it and keep your house.
Sometimes however, there are reasons that a creditor will object to a discharge of a certain debt, or of every debt. Usually the allegation is fraud. So what if you lied to a bank when you got a “stated income” alt-a loan and now you want to discharge or strip that mortgage? Good question.
Recently, the bankruptcy court in California ruled in In Re: Hill that even thought debtors did in fact lie to the bank on there Stated Income Alt-A loan, they were not barred from discharging that debt because the bank failed to prove that it had in fact relied on the information provided by the debtors on their loan application. Reliance on the lie is one of the factors in determining whether a debtor’s fraud will prevent a discharge. Basically, the bank’s lax underwriting guidelines were its own demise.
A note of caution. The conservative bankruptcy courts in the Middle District of Pennsylvania where I practice would be, I think, hard pressed to rule the same way.
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