Libor – How rate-setting works

Those of us who deal with real estate realize some loans have interest rates that vary or change. But did you ever wonder how and why the changes take place?

In the early 2000s adjustable rate mortgages were common in residential transactions. Interest rates were fixed usually for 1, 3 or 5 years then could change based on so many percentage points above an index, which often was the going rate for certain types of U.S. Treasury securities. In the commercial world, interest rates often varied as often as daily, based on fluctuations in the price of similar U.S. Government debt instruments.

The good news in both instances is interest rates followed the market.

But as the residential and commercial lending arenas expanded, new loan products were developed to appeal to different tastes. Or, said another way, to take advantage of different appetites for risk.

Enter Libor – London Interbank Offered Rates – the rates lending institutions charge when lending to each other. Although Libor got its start in 1986, it didn’t catch on in residential transactions until a couple of decades later. But as an index for residential mortgages, use of Libor – a bank-to-bank lending product – was probably misplaced. Still, variable rate mortgages began to appear using Libor as an index because bank-to-bank lending rates tended to be low.

How does Libor work? Each day, the British Bankers’ Association publishes rates in 10 currencies for loans between banks for terms ranging from overnight to one year. The rates are set in the London time zone, so don’t account for market conditions developing later in, say, New York and Asia.

A cynic might say Libor emanates from a smoke-filled room, because it’s calculated by a daily morning survey of 20 big banks (the number used to be 16) to determine the rate each bank thinks it would have to pay to borrow money from the others. The BBA throws out the 5 highest and 5 lowest rates and averages the remaining 10 to come up with its rates.

According to the Financial Times, more than $350 trillion in financial products are based on Libor. The FT also reported recently that UBS, the Swiss bank, has been subpoenaed by U.S. regulators “…over whether it had made ‘improper attempts’ to manipulate those rates.” If, for example, during the 2008 economic meltdown, a weakened bank predicted a high rate for borrowing, would a competing bank resist lending to it, worried about a Lehman Brothers-style default? Possibly. Which might tempt the weakened bank to misstate its borrowing rate, thereby skewing the Libor rate-setting process.

There’s no question the meltdown caused sharp bank-to-bank interest rate spikes as stronger banks grew suspicious of their sister institutions, which meant Libor-based variable rates in turn elevated dramatically. As a result, monthly installments of Libor-indexed residential mortgages shot off the charts, sometimes quadrupling the initial monthly payment. Not only were borrowers shocked; many began to default.

Yet another instance of borrowers having no inkling of what they were getting into.

- Morrie Erickson

Judgment Liens – Does bankruptcy wipe them out?

Suppose you’ve been sued for unpaid medical bills. The court enters judgment against you for $5,000. You own your house but because you’ve lost your job, as more and more bills pile up you throw up your hands and file for bankruptcy relief. The bankruptcy court orders an automatic stay, meaning the judgment creditor, your mortgage holder, and any other lien creditor can’t sue you to take away your property – at least, not until your bankruptcy case is over.

So you breathe a sigh of relief because, now, you’re protected and the $5,000 debt will be history, right? Well, not quite.

Most people think a bankruptcy discharge wipes the debtor's slate clean. While a bankruptcy discharge DOES cancel the debtor’s personal obligation to pay it, the discharge doesn’t terminate the judgment lien which attached to the house when the judgment was entered – unless the lien is removed by the bankruptcy court.

Until the bankruptcy court actually removes the lien (and it’s been my experience that in most cases it doesn’t), the lien sticks to the house like flypaper, regardless of the debtor not being personally responsible for paying it. As a result, the holder of the judgment can foreclose its lien against the house as soon as the bankruptcy case is closed and the automatic stay lifted.

When that happens, the creditor is free to enforce its lien through a court-enforced sale of the property. While on the one hand, the debtor has no obligation to pay, if the debtor doesn’t, the property will be auctioned off, the creditor being paid from the proceeds. It’s a case of the creditor forcing the debtor to cough up the money…or else.

The lesson? Debtors should ask their bankruptcy attorneys (during the bankruptcy, not afterwards) to petition the bankruptcy court to have the liens released. Whether they can be depends on several factors, but high loan-to-value personal residences are likely to qualify.

What about property acquired AFTER bankruptcy? In Indiana, debts which become judgment liens BEFORE bankruptcy do not attach to property acquired AFTER bankruptcy. Why? The rationale is the old debt ceased to exist before it could attach to the new property. Title underwriters refer to this doctrine as the “fresh start” rule.

- Morrie Erickson

Residential Mortgages – A lesson from Canada

Thanks to the recent economic meltdown, the U.S. mortgage industry – and its lax standards in residential lending – has been the subject of intense scrutiny. The debate has led to the question: where do we go from here?

It might be helpful to look north, given that our Canadian neighbor’s residential mortgage lending industry didn’t get out of whack like ours did here in the U.S.

According to an article in the Financial Times on January 19, 2011, Canada’s home-finance system is more conservative than the one in the U.S. For starters, most residential mortgage lending is handled by large domestic banks. When loans are made in purchase and sale transactions, the banks are required to buy government insurance if less than 20% of the purchase price is put down. The result? Subprime and other high-risk mortgages amounted to a small part of the Canadian housing market.

Also, the impetus for Canadian homeowners to borrow as much as possible isn’t as great as in the U.S. because interest paid on residential mortgages in Canada is not tax deductible. Although suggesting that kind of revamp in the U.S. might cause an outcry in several quarters, some members of the U.S. Congress have suggested taking away the interest deduction would be a welcome double-whammy by curbing U.S. borrowers’ appetite for debt and reducing the U.S. deficit.

Because during the downturn Canada’s economy remained much more robust than the U.S.’s, housing prices have continued to rise despite Canada’s mortgage lending controls. But as of January 17, 2011, the controls were deemed not tight enough. So the Canadian government imposed even stricter lending standards, reducing the maximum amortization term to 30 years.

As a further protection to homeowners, home equity loans (which typically have variable interest rates that can spiral upwards) are now capped at 85% of loan-to-value (down from 90%). What’s more, the Canadian government will no longer insure home equity loans, meaning banks are now on their own if they expect to be repaid by borrowers.

And that lack of insurance protection, according to the Canadian finance minister, will place risk evaluation squarely on the shoulders of lenders instead of taxpayers.

Food for thought.

- Morrie Erickson

RREAL IN – The form only title agents see

As most people involved in real estate are aware, the past few years have seen the State of Indiana and the federal government focus on mortgage fraud.

As a part of those efforts, since January 1, 2010, Indiana has required closing agents to fill out an electronic form for every closing involving single-family residential first lien mortgage loans whether purchases or refinances (practically all mortgages). The form was developed through the Indiana Department of Insurance (IDOI) which regulates and licenses title insurance and closing agents and is known as RREAL IN, which stands for Residential Real Estate Acquisition of Licensee Information and Numbers Database for Indiana, and is mandated by Indiana Code 27-7-3-15.5. The purpose is to develop an electronic system for collection and storage of information about persons participating in or assisting with applicable transactions.

Some of the information the RREAL IN form calls for must be provided by persons or companies closing agents don’t deal with, which makes filling out the form problematic. For example, closers rarely see appraisals but must report the appraiser’s name and license number, the appraisal company’s name and license number, the amount the property appraised for, and the appraisal completion date.

Here’s a list of other information the closer must enter:

1. Name & license number of each:
a. salesperson or broker;
b. principal broker;
c. mortgage loan originator;
d. mortgage brokerage company;
e. mortgage loan originator company;
f. title agent (closer); and,
g. title agency;
2. Name of each seller;
3. Name of each buyer;
4. Purchase price;
5. Property description by tax parcel number & street address;
6. Date closing instructions received; and
7. Date of closing.

As mentioned previously, the RREAL IN form is electronic. It’s accessible only online. Unfortunately, it can’t be filled out partially and saved. Long pauses between entries void the form, meaning closers have to start over again if, say, they take a phone call during data entry. Closers chuckle when IDOI says it takes only 2 or 3 minutes to fill out the form; in reality 20 minutes is more likely. Much of the information on RREAL IN is already on the Sales Disclosure Form (another “simple” form title agents have been required to fill out for years), which leads me to wonder whether anyone at state-level considered combining the forms into one. My cynical side says probably not. Of course, double entry adds to the workload and drives up costs. Maybe no one thought of that either.

While we title agents and closers are doing our part in exposing mortgage fraud (we have strict rules on funding, disbursing, anti-flipping, etc.), we hope agencies tasked with combating the problem are looking at data we’re submitting. But if the targets of RREAL IN are fraudsters, why is House Bill 1273 making its way through the 2011 Indiana General Assembly? Curiously, HB 1273 makes RREAL IN applicable to cash transactions. Which raises the question: What is the actual purpose of RREAL IN?

- Morrie Erickson

Buying Foreclosed Property – Risky or not?

Foreclosures can be treacherous these days.

We’ve all read the news about lenders doing a shoddy job handling foreclosures. But what does that mean for buyers of foreclosed property? Can their transactions be set aside? Can they lose the properties they’ve just bought?

At this point, it's not clear who bears liability for a bungled foreclosure, but it may depend in part on where the time line is in the process. Certainly, the foreclosing lender should be responsible for not handling it correctly, but what if the sheriff's sale and a subsequent sale have already taken place? In that case, a title company will be involved which is why most title companies have received instructions from their underwriters about how to handle insuring foreclosed property.

The risk most lenders and title companies see is a lawsuit being filed after the property has already been transferred to a new buyer. While it’s likely most buyers wouldn't want the house back because they couldn't afford the mortgage payments anyway, there's always the chance that foreclosed buyers (and their lawyers) will smell $$ which will result in a lawsuit being filed (even a class action) to put pressure on a host of parties (principally the old lender and the new title insurer) to throw $$ at them to make them go away.

That said, most underwriters require Indiana title companies to take extra steps to clear the way for a valid sale, including (this isn't an exhaustive list):

1. Verifying Indiana's foreclosure requirements were met and that it's too late for an appeal.
2. Verifying the foreclosed borrower has moved out.
3. Verifying no tenants live there.
4. Making sure there aren't any rights to redeem the property (especially if agricultural land or if IRS liens were foreclosed).
5. Verifying Indiana hasn't filed a lawsuit against the foreclosing lender to stop foreclosures generally.
6. Verifying no lawsuit has been filed to attack the foreclosure or to recover damages.
7. Making sure the foreclosing lender isn't pursuing a deficiency judgment against the former owner.
8. Verifying the amount owed on the foreclosed mortgage is greater than the current sale price.

In addition, sometimes the foreclosed owner has to sign a quitclaim deed in favor of the new buyer. Realistically though, quitclaims may be hard to get.

If title companies work their way through all these issues - and most of the time they can - buyers can close. So, if the unlikely happens in the future and buyers’ properties are taken away, buyers would have claims against their title underwriters for the face amounts of their policies.

Walking away from your mortgage – Risk or reward?

An idea has been making the rounds. That underwater borrowers – owners whose homes are worth less than what’s owed on their mortgages – should stop making payments and let their lenders foreclose.

The thinking is this: because house prices in some markets have declined so steeply it will take years for property to be worth what it was before the economic meltdown, many owners – even those not financially strapped – don’t see the point of continuing to fork out monthly payments, especially if they don’t intend to stay in the house long-term.

But does this so-called ‘strategic default’ really make sense?

On the plus side, the strategy of getting out from under heavy debt and not throwing good money after bad amounts to pulling the plug on a lose-lose situation. Given the months on end it takes lenders to foreclose and repossess property, owners can stay in their houses rent-free while padding their bank accounts with money otherwise thrown down the rat-hole.

Sounds good on the surface. Trouble is, strategic default has serious consequences.

Deficiencies

Depending on the state, the defaulting owner may have to pay the deficiency – the difference between the amount owed and the price brought at the foreclosure sale. So, if you have to pay the balance anyway, what’s the point in walking away? Sure, the deficiency might be discharged in bankruptcy, but not everyone is that far in the hole. Bankruptcy, remember, is only for the insolvent – those who owe more than they own.

Keep in mind too that state foreclosure laws vary, especially about whether lenders can go after borrowers for deficiencies. So, persons contemplating a strategic default need to know what their state allows.

Painting with a broad brush, most states east of the Mississippi (Indiana among them) allow lenders to collect deficiencies, while many western states do not. It comes down to state law and the papers signed at closing (mortgages in the east, deeds of trust in the west).

To foreclose mortgages, lenders have to go to court. When that happens, borrowers usually have the right to redeem (buy the property back) and lenders can go after the deficiency. Deeds of trust, on the other hand, allow lenders to take property back without going to court, the trade-off being borrowers can’t redeem but don’t have to pay the shortfall. Then again, some states’ procedures are a hodge-podge of both methods.

To find out what each state requires, check out www.foreclosurelaw.org.

Credit scores

Anytime a debt isn’t paid on time or in full, a borrower’s credit score will suffer. So whether a borrower is selling short (the lender agrees to take less than owed), or losing the house in foreclosure, or filing bankruptcy, the borrower’s credit score will drop.

Some strategic defaulters rationalize a credit score hit because they don’t plan to buy another house. They’re over home ownership and perfectly happy to be renters. But credit scores can keep rearing their heads. Landlords run credit checks. So do car dealers. And interest rates on credit cards may be higher as credit scores plummet.

Taxes

Thanks to the Mortgage Forgiveness Debt Relief Act of 2007, the deficiency forgiven by the lender is not taxable as income to the borrower who has defaulted and is being let off the hook. (The IRS considers debt forgiveness the same as receiving cash, and therefore taxable.) This law provides welcome relief but is temporary, applying to forgiven debt only in years 2007 through 2012. And, it’s limited to debt on owner-occupied principal residences, provided the debt was incurred to buy the house, build it, or remodel it (or to refinance that debt). In other words, debt pertaining to a refinance to take out cash to, say, buy a car isn’t covered. For more on the MFDRA, see my September 27, 2010, blog, which covers IRS Form 1099-C (‘C’ stands for cancellation) that lenders will send forgiven borrowers and IRS Form 982 that borrowers must file with their federal return (even if the cancelled ‘income’ is excluded).

Remember too, the MFDRA is a federal law applying to federal income tax. State income tax laws aren’t affected by it. So, unless a state has enacted a similar law, state income tax on the forgiven debt may still apply.

- Morrie Erickson

Banking – How safe is your money?

Suppose you sold your house in October, 2010, and netted $300,000 after expenses. Because you won’t be closing on your purchase for a few weeks, you deposit your net proceeds in a savings account at your bank so it can earn interest in the meantime.

Should you be worried whether your $300,000 is protected if your bank fails before your second closing? Yes, you should.

In response to the economic meltdown in the fall of 2008, the FDIC came up with a temporary liquidity guarantee program (TLGP) which increased the insurance coverage on bank accounts generally (including interest-bearing accounts) from $100,000 to $250,000 through December 31, 2009. But the TLGP also provided unlimited coverage for non-interest-bearing accounts (so-called transaction accounts) under the Transaction Account Guarantee Program (TAGP). Within certain time frames in 2008 and later, banks could opt out of the unlimited coverage under TAGP, which some banks elected to do because of the fees charged to them by the FDIC for this extra coverage.

In 2009, the $250,000 limit was extended through December 31, 2013. However, the unlimited protection under TAGP was extended only through December 31, 2010, with banks being given another chance to opt out after the first half of 2010. Because the banking sector seemed to be more stable by mid-2010, many banks opted out of TAGP this past July.

Now, back to your $300,000. Is it or is it not protected? After your first closing, only $250,000 of your $300,000 deposit was covered because it was in a savings account that earned interest. The remaining $50,000 in your savings account is not insured, even if your bank didn’t opt out of TAGP (because TAGP doesn’t cover interest-bearing accounts). To be fully protected, you should move the extra $50,000 in your savings account into a regular checking account and make sure your bank is still participating in TAGP. If it isn’t, consider switching banks.

But, let’s fast-forward to January 1, 2011.

Thanks to the Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law on July 21, 2010, banks must participate in TAGP as of January 1, 2011. No longer will banks be allowed to opt out. However, under Dodd-Frank, TAGP will have a limited life of two years, expiring at the end of 2012 – unless Congress extends it in the future.

What this means is during the uncertain economic times we’re in, depositors will need to balance earning interest against protecting principal. Because interest rates are so low, most may prefer the TAGP safety net. Ultimately, decisions will be made in part based on the strength of individual depositors’ banks. A useful tool in finding out your bank’s strength is www.bankrate.com.

By the way, in addition to making TAGP mandatory, Dodd-Frank made permanent the $250,000 FDIC limit for bank accounts generally, including interest-bearing accounts.

- Morrie Erickson