Cross-posted from Ben Carter Law...
This essay is deeply indebted to two articles: "Defending Mortgage Foreclosures: Seeking a Role for Equity" by law professor David Super and a National Consumer Law Center report: "Servicer's Failure to Engage in Appropriate Loss Mitigation as a Foreclosure Defense. The NCLC article does not appear to be available online, but many other resources from the amazing National Consumer Law Center are available.
I’m writing today because it is down to you. You are the last, best hope for Kentucky’s homeowners–both those facing foreclosure and their neighbors.
Our neighbors’ homes are on fire. The foreclosure crisis blazes through our neighborhoods and continues to grow. One in four Kentucky homeowners owe more on their house than it is currently worth. One in ten is more than thirty days behind on their home loan.
Foreclosure is too expensive, too extreme, to be granted as a matter of routine—each sale adds fuel to the raging fire. Foreclosure devastates homeowners, destabilizes financial institutions, degrades neighborhoods, and impoverishes communities.
Kentucky faces a situation in which homeowners facing foreclosure are clueless, powerless, and unrepresented by counsel. The federal program designed to encourage banks to modify homeowners’ loans (HAMP) is a colossal failure. Reckless banks pursue foreclosure even to their own (and everyone else’s) detriment. Worse, problems with the banks’ own loan documents abound; their right to foreclose at all is deeply suspect.
The federal government first failed to adequately regulate mortgage lending. Now, it is failing to address the fallout. State and local government’s efforts to mitigate the losses have been similarly watered-down and ineffective. Frankfort lacks the political resources and local governments lack the financial resources to address a crisis of this proportion. Banks can walk all over a local government.
But, they can’t walk over you.
Kentucky, thank God, is a state that requires banks to seek judicial approval before taking a homeowner’s house. Some states don’t. I’m writing today to encourage you to apply much stricter scrutiny–both legal and equitable–on foreclosure proceedings than has traditionally been applied. I’m writing to ask you to incorporate alternative dispute resolution in your foreclosure cases that will ensure that the parties have explored in good faith every alternative to foreclosure before granting judgment in favor of foreclosing Plaintiffs. I’m writing to ask you to ensure that the foreclosures inflicted upon the community are only those that are absolutely necessary.
What is happening is not traditional; it’s extraordinary. It’s time to start treating it extraordinarily.
How We Got Here
Later in this letter, I will urge you to evaluate and question whether equity will permit the foreclosure the bank is asking you to grant. I will encourage you to aggressively apply equitable remedies in Kentucky foreclosure proceedings. To evaluate the equity of the situation, you need to know how all of these loans that are now in default came to exist in the first place.
In the past decade, the system set up by federal regulators, banks, and investors to finance home loans incentivized originating exotic, risky, and unsustainable loan products to Americans unlikely to appreciate the complex terms contained in their loan. Fraud and unconscionable practices pervaded the mortgage lending landscape. Lenders qualified borrowers for unaffordable mortgages by offering initially-low interest rates that obscured the true cost of the loan. Many homebuyers never knew their house payments would increase dramatically a few years into the loan. Borrowers who were savvy enough express concern about these “teaser rates” were told not to worry about the adjustable rate, that they would refinance the homeowner into a fixed rate before the rate adjusted. Banks paid mortgage brokers a “Yield-Spread Premium”—often thousands of dollars—to place homebuyers in loans with higher interest rates than the rate for which the homeowner’s credit history and income actually qualified them.
Not surprisingly, the victims of these lending abuses were often the very people who could least afford it: poor people and minorities. Often, these loans were written at 100% of loan-to-value, leaving homeowners trapped and unable to refinance out of spiraling interest rates once housing prices plummeted in the wake of the subprime mortgage meltdown.
After mortgage brokers and lenders placed homeowners in risky loans, they sold the right to collect payments on those loans to investment firms who then pooled those loans with thousands of other loans. Investors—from school boards in Iowa to the government of Iceland—bought the right to be paid proceeds from the revenue the pooled loans generated. Investment firms who purchased individual mortgages and created residential mortgage-backed securities grossly underestimated the riskiness of the loans they were purchasing and credit rating agencies likewise gave the securities the safest (“triple-A”) rating that many institutional investors required.
Because this system sold not only the right to collect mortgage payments, but also the risk of a defaulting loan, it removed any incentive from the loan originator to exercise due diligence, verify income, ensure sustainability, or prevent appraisal fraud. The system of securitization designed by Wall Street investment firms rewarded lenders who could originate as many loans as quickly as possible.
As is obvious in hindsight, the incentives surrounding this entire scheme of financing loans are exactly backwards. Mortgage brokers are rewarded not for finding homeowners the most affordable loan, but the most expensive. Originating lenders have no interest in the long-term sustainability of the loan, and investment firms only care that there are investors for the securities they’re creating. Credit rating agencies are paid by the very firms that they’re grading.
Before the housing bubble, lenders and the eventual investor (usually FannieMae or Freddie Mac) cared whether an individual homeowner could pay their mortgage payment. Suddenly, no one did. It was a system for financing home loans that did everything wrong. It was destined to collapse.
Foreclosure Hurts Everyone
Now that the collapse has happened, the mortgage meltdown and the broader economic downturn have introduced into the public conscience the ravages of foreclosure on individuals and communities. No one wins when a house is sold at a foreclosure auction.
Homeowners lose their home. They always lose the emotional equity they’ve invested into their home, and often any financial equity, as well. They lose the stability that homeownership provides. Their world suddenly uncertain, homeowners bear the cost of moving and reestablishing housing in another neighborhood, sometimes another city or state.
Lenders lose money along every step of a foreclosure sale. A 2008 paper by the Mortgage Bankers Association acknowledges lenders often lose in excess of $50,000 in each foreclosure, or 30–60% of the outstanding loan balance.
From the moment a homeowner stops paying their mortgage, lenders lose money. While the loan is delinquent, lenders lose principle and interest payments, as well as taxes and insurance payments. They must maintain the property, if necessary, and invest in trying to collect the on the loan. Once the home is in foreclosure, lenders must hire lawyers, pay court costs, and administrative fees. Then, they then must hire a company to maintain the property and secure the property. Finally, after the home is sold in foreclosure, the lender often must restore the property before selling it and hire a realtor. If the lender is lucky, the property will sell at a deeply discounted rate, if it sells at all.
Beyond the parties to the contract—the homeowner and lender—foreclosure hurts innocent neighbors and plagues communities with a vicious cycle of depreciation and degradation.
Because houses sold at a foreclosure auction are eventually sold for a fraction of what they otherwise would have, foreclosures damage the value of neighboring homes. When a neighborhood’s homes begin to depreciate, many innocent homeowners find themselves “upside-down” on their own loans. That is, they suddenly owe more on their homes than they are worth. When a family needs to move or refinance, they find doing so next to impossible. Even for those hoping to remain in the neighborhood, a foreclosure sale on a neighbor’s property, over which they have no control, strips them of equity and reduces the value of their investment.
This collateral damage (literally and figuratively) is exacerbated by the fact that many foreclosed properties are not properly maintained and remain vacant or abandoned for months or years. Researchers in Philadelphia have determined that properties within 150 feet of an abandoned property lose $7,627 in value. Those within 300–450 feet lose $3,542. Properties on a block with an abandoned house sell for $6,715 less than those without a vacant property. Metropolitan Housing Coalition, 2009 State of Metropolitan Housing Report 16 (2009). Louisville currently has between 7000 and 8000 vacant properties—a number that has doubled in the past six years—and the roughly 250 foreclosure sales scheduled each month continue to grow the number of vacant properties. The Center for Responsible Lending anticipates that Kentucky will lose $2.2 billion in home equity due to nearby foreclosures between 2009 and 2012. That’s an average loss of $2,610 per home.
Because of foreclosure sales, deeply discounted REO properties, and the glut of vacant and abandoned properties depress property values, ordering a foreclosure sale will reduce the local government’s property tax revenues–the lifeblood of municipal budgets. Not only will it reduce the money local governments bring in, foreclosures require the government to spend up to $34,000 per foreclosure on “inspections, court actions, police and fire department efforts, potential demolition, unpaid water and sewage, and trash removal.” All told, the Joint Economic Committee of the U.S. Congress estimates that each foreclosure costs all parties $80,000.
Kentucky Judges Should Consider Equity and Equitable Remedies
Five hundred years ago, England developed equitable proceedings for cases in which the strict enforcement of rigid legal principles made the attainment of justice unlikely. Our own legal system, descended from the English system, requires courts to exercise both legal and equitable jurisdiction. Modern practice in Kentucky merges the two systems of law and equity. Ford v. Gilbert, 397 S.W.2d 41 (1965). The Kentucky Constitution “imbues the circuit courts with the general power to determine all matters of controversy arising under common law or equity.” Hisle v. Lexington-Fayette Urban County Government, 258 S.W.3d 422, 432 (Ky. App. 2008).
In Hisle, the Court notes that “[a]lthough modern partition proceedings generally involve statutory provisions, the jurisdiction of equity courts to partition real property is very ancient and has existed in common law both in England and this country since its founding.” Hisle at 431. Therefore, statutes that govern partition of land “supplement, or are supplemented by, the traditional jurisdiction of equity courts to decree partition.” Hisle at 432 quoting Atkinson v. Kish, 420 S.W.2d 104, 110 (Ky. 1967).
Similarly, in a foreclosure proceeding, the statutory provisions intersect with equitable considerations. Equitable relief is available in states, like Kentucky, where foreclosure is a statutory action. Union National Bank of Little Rock v. Cobbs, 509 A.2d 719, 721 (Pa.Super. 1989). “Foreclosure is peculiarly an equitable action, and the court may entertain such questions as are necessary to be determined in order that complete justice may be done.” Morgera v. Chiappardi, 813 A.2d 89, 98 (Conn. App. 2003) quoting Hartford Federal Savings & Loan Assn. v. Lenczyk, 217 A.2d 694 (1966). Emphasis in original. “The determination of what equity requires in a particular case, the balancing of the equities, is a matter for the discretion of the trial court.” LaSalle National Bank v. Freshfield Meadows, LLC., 798 A.2d 445 (Conn.,2002).
Today, Kentucky courts  have the ancient opportunity and duty to weigh the equities present in each foreclosure case. To evaluate the equity of the situation, the Court should ask itself two questions:
- Does the bank deserve the right to foreclose on this particular homeowner?
- Should the Court allow the bank to inflict a foreclosure on the community?
Does the Bank Deserve the Right to Foreclose on This Particular Homeowner?
As an initial matter, the court should examine the Plaintiff’s own conduct and its relationship to the homeowner. “Equitable defenses invite the court to consider only the plaintiff’s ethical standing and to deny all remedies if the plaintiff does not meet equity’s standards.” Dan B. Dobbs, Dobbs Law of Remedies § 2.3(3) at 80 (2d ed. 1993). Courts can examine the behavior of the parties over the life of the loan: from the origination of both the note and mortgage, to their validity, to their enforcement. Bank of New York v. Conway, 916 A.2d 130 (Conn. Supp. 2006).
For example, when a “mortgagor is prevented by accident, mistake or fraud, from fulfilling a condition of the mortgage, foreclosure cannot be had.” New Haven Sav. Bank v. LaPlace, 783 A.2d 1174, 1180 (Conn. App.,2001). Courts have also recognized other equitable defenses to foreclosure: unconscionability, abandonment of security, usury, accident, fraud, equitable estoppel, laches, breach of implied covenant of good faith and fair dealing, tender of deed in lieu of foreclosure, a refusal to agree to a favorable sale to a third party, and violations of state consumer protection laws. Id.
What is the Plaintiff and What Has It Done to Avoid Foreclosure?
In the context of a foreclosure on a person’s home, a constellation of considerations often undermines the Plaintiff’s equitable standing to pursue a forfeiture of that home. From the origination of home loans, to their securitization, to their servicing, and finally to the treatment of defaulting homeowners, the mortgage brokers, appraisers, realtors, banks, investment firms, and investors purposefully and profitably participated in a tremendously flawed lending system. These flaws erode the Plaintiff’s equitable standing to now insist on the drastic remedy that requires a family to forfeit their home.
Failing to consider origination abuses would encourage the kind of schemes constructed within the last decade in which each party to the loan, from origination to securitization, sought and profited from plausible deniability of such abuses. The Plaintiff in most cases will not have originated the loan. It may not have been there when the appraisal was massaged. It may not have paid the broker for placing the homeowner in a more expensive loan than was justified by the homeowner’s credit score. It may not have written risky loans to people who didn’t understand the loan’s terms. But, it intentionally chose to participate in the system by purchasing those loans from the originating lender. It sought to profit from the fraud and unconscionable actions perpetrated by mortgage brokers, realtors, appraisers, and lenders. The Plaintiff’s hands became unclean when it shook the dirty hands of the loan’s originators.
Plaintiff’s willingness to participate in a reckless lending environment fraught with fraud, unconscionable lending practices, and bad faith impacts its equitable standing to now seek the extreme remedy of foreclosure. But the inquiry into equitable standing does not end there. The Court must inquire into any servicing abuses, as well as whether and how diligently the Plaintiff has pursued other, less drastic, loss mitigation options in the face of the homeowner’s alleged default.
*When the homeowner began struggling with the mortgage payments, did the Plaintiff consider a forbearance agreement in cases of temporary hardship? *Did it offer to modify the homeowner’s interest rate as it was spiraling out of control? *Did it structure its loss mitigation and loan modification departments in ways that encouraged participation by homeowners? 
*Did it consider accepting a deed in lieu of foreclosure or the sale of the property to a third party? *Did the Plaintiff insist on pursuing foreclosure even while telling the homeowner it was considering him or her for a loan modification?
Failure to provide meaningful loss mitigation options to struggling homeowners damages the Plaintiff’s equitable standing to now seek a forfeiture of the Defendant’s home.
Has the Servicer Participated in HAMP in Good Faith?
The existence of a federal program that is designed to encourage services to modify struggling homeowners’ loans adds an additional layer to the Court’s analysis of the Plaintiff’s equitable standing.
After creating an incredibly risky and ultimately disastrous system for financing home purchases, banks and investment firms received $700 billion of taxpayer money as part of the Troubled Asset Relief Program (TARP). As part of that program, lenders and servicers of home loans could opt in to the Home Affordable Modification Program (HAMP), allowing them to access $50 billion in taxpayer money. The federal government intended HAMP to “help up to 7 to 9 million families restructure or refinance their mortgages to avoid foreclosure. Home Affordable Modification Program, Supplemental Directive 09–01 1 (April 6, 2009). Under HAMP, a lender or servicer receives cash payments for modifying loans in its portfolio according to the requirements of the program. Once it has opted in to the program, a lender or servicer is obliged to review all of its loans for eligibility under HAMP.
Participation in this program is optional, compliance with its regulations is not. Numerous state and federal courts have found that a lender’s violation of a federal law designed to prevent foreclosure should be raised by the borrower in state court as an equitable defense in a foreclosure proceeding, instead of as a private cause of action. Similarly, state courts also have found that a lender’s non-compliance with federal FHA, HUD, or VA guidelines designed to prevent foreclosure may be raised by the borrower as an equitable defense in a foreclosure proceeding.
Resolving how and whether a servicer has complied with the HAMP regulations require courts to both enforce legal rights and weigh equitable considerations. Like the facts surrounding the origination and servicing of the loan, a servicer’s compliance with HAMP will affect their equitable standing to pursue a foreclosure action.
How HAMP Works
Broadly speaking, HAMP requires the lender or servicer to ask itself, “Would modifying this loan under the terms of HAMP yield a loan that is more or less profitable than foreclosing on the property?” If modification is more profitable, the participating entity must offer the homeowner a conforming loan modification. If foreclosure is more profitable, the lender can proceed with foreclosure. This analysis is called a “Net Present Value” (NPV) calculation. Many courts have held that a servicer’s failure to comply with similar loss mitigation requirements in the FHA loan program was a defense to foreclosure.
To appreciate the importance and difficulty of doing a proper NPV analysis, it is critical to understand what variables go into a Net Present Value calculation. To properly perform an NPV, banks must compare the value of the income from a foreclosure sale to the value to the investors of a modified loan. Many variables go into calculating the potential loss from a foreclosure sale. Unfortunately, the participating lenders claim their NPV models are “proprietary,” so we cannot be entirely certain what variables lenders consider. However, the FDIC provides their “Mod in a Box” calculator to the public and it provides the masses an idea of what the calculation involves.
To calculate the value of the income from a foreclosure sale, the bank must consider variables like the likelihood that the homeowner will “cure” the deficiency, making foreclosure unnecessary. Further, the lender must anticipate the amount for which the property can be resold in a post-foreclosure sale, how long such a sale would take, and what costs would be involved (including maintenance, taxes, legal fees, court costs, inspections, etc.).
With so many variables to consider, participating servicers can make mistakes in their Net Present Value analyses. Sometimes, the value of the property (a consideration in its potential resale value) has declined without the servicer’s knowledge. Sometimes, the homeowner has significant defenses to the foreclosure that need to be litigated prior to foreclosure, increasing both the time and cost of foreclosure.
Without production of the NPV analyses, the court and homeowners have no way of verifying the accuracy or veracity of the foreclosing parties’ analyses. Without a court order, homeowners have no assurances that the servicer or bank has done the math properly and according to the HAMP’s requirements. This math will determine the homeowner’s fate and whether or not the homeowner will, in fact, remain a homeowner. This lack of transparency violates public policy and is especially disturbing in light of the recent economic crisis. The banks and servicers entrusted to perform the NPV analyses are the same banks whose math counseled for the origination of risky adjustable rate mortgages written at 100% loan-to-value. Their math assured investors that securitizing subprime loan products was a safe bet, that housing prices would continue to climb. That banks and servicers now expect homeowners, courts, and communities to trust them to do the math correctly behind closed doors strains credulity and demonstrates, still, the height of hubris.
To ensure participating lenders are complying with their obligation to accurately perform a Net Present Value analysis and to ensure taxpayers are getting value for their investment in the HAMP program, this Court, operating in equity, should order participating lenders to produce their NPV analyses prior to ordering a foreclosure sale. The stakes are too high for everyone—banks, homeowners, neighbors, and communities—to not get this right.
How HAMP Doesn’t Work
A homeowner is extremely lucky if the only shortcoming in the process of applying to HAMP is their bank’s failure to “show their work” on their Net Present Value analysis. So much pain exists in the process before the bank ever has the chance to do the math wrong. As has been well-documented elsewhere (LINK), servicers routinely *lose homeowners’ paperwork *ask for additional paperwork *ask for duplicative paperwork *encourage homeowners to miss a payment “in order to be eligible” for a loan modification *say one thing on the phone and another in paperwork *misapply payments *extend three-month trial modifications for 8, 10, 12, 15 months *deny modifications they had previously accepted.
Plaintiffs will characterize their actions in court—filing foreclosures and pursuing judgments and sales—as innocent and harmless steps designed to protect its legal rights. They are not. Plaintiff’s actions actually damage the homeowners’ ability to get a loan modification, contrary to the goals of HAMP, the purpose of servicers’ voluntary participation in the program, and the requirement to participate in good faith.
One of the variables banks and servicers include in their NPV analysis is the cost of successfully taking a piece of property through a foreclosure sale; these costs include legal fees and court costs. Typically, banks pass along these costs to the homeowner in a modification, adjusting the unpaid balance upwards by thousands of dollars. By increasing the unpaid balance of the loan, modifying that loan so that the monthly payment is 31% of the homeowner’s gross monthly income (a requirement under HAMP) appears less palatable. The higher those foreclosure fees (and ultimately the unpaid balance of the loan) are, the less likely a homeowner is to receive a modification.
Similarly, another variable banks estimate when deciding whether to modify a homeowner’s loan is the months to a foreclosure sale. The more months before achieving a foreclosure sale, the more expensive the foreclosure becomes and the longer it will be before the house is ultimately resold by the bank to recoup its investment. As the months to a foreclosure sale rise, modification becomes an increasingly profitable alternative under a NPV analysis. By aggressively pursuing legal claims, banks are taking affirmative actions to keep the months to a foreclosure sale low and decreasing the homeowner’s likelihood of receiving a loan modification. Thus, by pursuing foreclosure even while considering a homeowner for modification, banks and servicers are undermining the taxpayer-funded program in which they chose to participate and that program’s stated goals.
Even if the Plaintiff’s own equitable standing is impeccable, the Court’s inquiry into the equities of the case does not end there. Given taxpayers’ significant investment into this program and its goal of drastically reducing the number of foreclosures, the community has a broader equitable interest in ensuring its success.
Should the Court Allow the Bank to Inflict a Foreclosure on the Community?
While courts will inquire into the behavior of the Plaintiff and the circumstances surrounding the origination, servicing, and enforcement of the note and mortgage, a foreclosure involves broader equitable considerations. Courts not only consider strict equitable defenses, but also “balance hardships that the parties, other affected persons, and the public would face under various possible outcomes.” Handbook of Modern Equity, de Funiak, William Q., 42–46 (2d ed. 1956). Again, trial courts “may examine all relevant factors to ensure that complete justice is done.” Johnnycake Mountain Associates v. Ochs, 932 A.2d 472 (Conn. App. 2007). Here, this examination requires inquiry into the devastating impact of foreclosures on the parties and the community. Furthermore, courts must consider the hardships caused by securitized loans, as well as Plaintiff’s compliance with federal efforts to stabilize the housing market and end the foreclosure crisis.
Kentucky courts have long-recognized the doctrine of equitable waste to prevent parties from abusing their own rights to the detriment of others. The Kentucky Court of Appeals, then the Commonwealth’s highest court, held in 1912 that:
[E]quity will sometimes restrain equitable waste. Equitable waste is defined by Mr. Justice Story to consist of ‘such acts as at law would not be esteemed to be waste under the circumstances of the case, but which, in the view of a court of equity, are so esteemed from their manifest injury to the inheritance, although they are not inconsistent with the legal rights of the party committing them.’ The same author further says: ‘In all such cases the party is deemed guilty of a wanton and unconscientious abuse of his rights, ruinous to the interests of other parties.’ Lord Chancellor Campbell defines equitable waste to be ‘that which a prudent man would not do with his own property.’ Landers v. Landers, 151 S.W. 386, 391 (Ky.App. 1912). Internal citations omitted.
When operating in equity, then, courts will intervene to avert financial ruin, even if a party may be legally entitled to ruin either itself or others.
In foreclosure cases, courts should undertake a complete inventory of the cost of the foreclosure to both the parties and the larger community. “Balancing … public interest and third person rights … admits a modicum of economic analysis into the equity case.” Dobbs at § 2.4(6) at 112. When the court weighs the equities in a foreclosure proceeding, it must consider the effect a foreclosure sale will have on innocent homeowners in the neighboring area.
As discussed above, lost equity, maintaining and reselling foreclosed property, lost investment, depreciation of nearby properties, and lost tax revenue add up quickly to make foreclosure an exceptionally costly remedy. Unfortunately, due to perverse incentives for servicers in Pooling and Servicing Agreements, lenders cannot be relied upon to manage their interest in the property “as a prudent man would” as required by the Court in Landry. Instead, lenders pursue foreclosure to their own detriment and the detriment of the homeowner, neighbors, and the larger community. In these cases, the court is required to consider the public interest and third party rights in an economic analysis of the equities in a foreclosure case. The high cost of foreclosure to all involved make it a remedy that should only be granted when all other options have been exhausted and other equities compel it.
Beyond the barrier posed by the servicers’ warped incentives, securitization creates another barrier to a mutually beneficial settlement. Stock, called "certificates, in residential mortgage-backed securities are divided into tranches; investors in various tranches can have very different financial incentives. Investors in a RMBS receive different returns on their investment and receive payment in different orders of seniority. So, even when these notes were effectively securitized, the certificateholders of the security have very different interests. Some (those with the most seniority) will prefer pursuing foreclosure, while investors in more junior tranches will profit by a mortgage reformation. In this situation, many servicers will decline to act to modify a home loan, citing either the constraints of the Pooling and Servicing Agreement or exposure to potential liability to one investor or another.
This situation is inequitable. Foreclosures devastate homeowners, neighborhoods, and communities while servicers and their investors fail to pursue alternatives to foreclosure. Kentucky courts, operating in equity, should require both parties to a note secured by real estate to negotiate in good faith before pursuing the drastic and costly remedy of forfeiture through a foreclosure sale.
When a homeowner has applied for a HAMP modification, the securitization of the homeowners loan can prevent modification. Under HAMP, if a loan has been securitized (and 85% of outstanding home loans have), the servicer must get approval from the trustee of the residential mortgage-backed security–approval the investor is not obligated to give. Many homeowners go through months of heartache and hassle trying to get their loan modified only to be told, simply, “the investor is not participating.” When this occurs, Courts must be deeply skeptical of the Plaintiff’s equitable standing to pursue foreclosure. If a servicer has asked an investor’s permission to modify a loan, it’s because the servicer has already calculated that EVERYONE, including the investors, will lose less money modifying a homeowner’s loan than by foreclosing on the home. The investor’s non-participation in this situation is profoundly inequitable.
Kentucky courts already recognize that when the state seeks to condemn property under its power of eminent domain cases that the condemning authority has the “additional duty … to negotiate in good faith for the acquisition of property prior to initiating condemnation proceedings.” Golden Foods, LLC v. Louisville & Jefferson County Metropolitan Sewer Dist., 2005 WL 1049388, 3 (Ky. App., 2005). The two situations—eminent domain and foreclosure—are similar. Both involve parties with radically different levels of bargaining power. Both involve the forfeiture of real estate to the party of greater power. In foreclosure suits, courts should exercise their equitable jurisdiction and withhold foreclosure until the party seeking to foreclose can offer convincing evidence of having negotiated in good faith and can demonstrate that no other alternative to foreclosure exists.
Remedies Available in Equity
Sitting in equity, the Court has broad discretion to fashion a remedy that does justice in a particular case. It can refuse to grant a foreclosure sale: “[w]here the Plaintiff’s conduct is inequitable, a court may withhold foreclosure on equitable considerations and principles.” Morgera v. Chiappardi, 813 A.2d 89, 91 (Conn. App. 2003). In cases in which the alleged delinquency is caused by unemployment, disability, or other loss of income, the Court may stay a foreclosure to provide the Defendant time to find employment, apply for benefits, or otherwise remedy the loss of income. When a homeowner has applied for a loan modification, the Court may dismiss premature suits for foreclosure when the Plaintiff has not finished evaluating that homeowner for a loan modification. Similarly, the Court may stay a foreclosure proceeding until a servicer or bank gives convincing evidence of having negotiated in good faith with a homeowner. Negotiating in good faith will include exploring less-costly alternatives to foreclosure like short sales, deeds-in-lieu of foreclosure, reasonable payment plans to erase the arrearage. Courts may modify mortgage payments as required by the demands of equity.
A bank’s failure to explore all options to avoid inflicting a foreclosure will impact their standing to pursue a foreclosure. Courts do not need to wait on homeowners attorneys to make these arguments or question the bank’s equitable standing. As a judge in Kentucky, you can inquire sua sponte into the parties’ standing, as standing impacts the court’s subject matter jurisdiction. Kentucky Employers Mutual Insurance v. Coleman, 236 S.W.3d 9, 15 (2007). If a bank is behaving recklessly, the Court may dismiss the case for lack of subject matter jurisdiction because the bank’s bad acts rob it of the equitable standing it needs to pursue foreclosure in our courts.
Alternative Dispute Resolution in Foreclosure Cases
Courts across the country are changing their judicial processes to ensure that the parties have exhausted all alternatives to foreclosure, bargained in good faith, and deserve to proceed with a foreclosure sale.
Right now, we have a situation in which clueless homeowners lack information about the civil process and the resources available in the community to assist them in responding to the complaint and exploring alternatives to foreclosure. More than 80% of all homeowners facing foreclosure will lack the benefit of legal counsel. In an adversarial system of justice, this virtually guarantees that the homeowner will be steamrolled in a proceeding in which our system of justice has broken down.
The failure of our system to efficiently assist clueless homeowners in finding legal counsel should concern each member of the bar. Combine vulnerable homeowners with a failed federal loan modification program and lack of legal counsel and you have a situation that is most easily defined simply as “pain.”
If timely information delivered credibly is combined with the counsel and advocacy of an attorney and a judicial program with teeth, we can enter world that involves less pain, that avoids unnecessary foreclosures, and helps our community recover from the housing crisis as quickly as possible.
The first thing we did in Jefferson County (and, frankly, the most important thing you can do) is attach a Notice to each foreclosure complaint before the Sheriff delivers the complaint and service of summons. The Notice should be full-color (or a least printed on colored paper) and should contain a phone number homeowners can call to receive a referral to an attorney or housing counselor.
You will need to work with your local bar association and legal aid offices to develop a referral system that works for your jurisdiction.
National best practices for these foreclosure mediation programs are emerging and include:
- An automatic stay of the foreclosure proceedings until the servicer has established its good faith compliance with its obligations
- Transparency from all parties that includes production of net present value calculations and loan documents
- Active, neutral oversight from an official with the power to impose sanctions on parties
- Requirement to pursue alternatives to foreclosure in good faith
- Sustainable funding mechanisms that allow program administrators to be paid
- Oversight of attorney’s fees and foreclosure costs
The Franklin County Circuit Court has implemented a program that incorporates many of the emerging national best practices. A copy of the Court’s order is available here.
In Franklin County, the Court issues an automatic stay in every foreclosure case. If the homeowner takes no action within 20 days, that stay is lifted. However if the homeowner is participating in Franklin County’s foreclosure mediation process, the stay will remain in place until the parties agree on an alternative to foreclosure or the servicer can demonstrate that they have analyzed and pursued every other alternative to foreclosure and they are both legally and equitably entitled to the extreme remedy of foreclosure. A mediator oversees this entire process and can report to the Court regarding the efforts both sides are making to avoid a foreclosure.
It’s Down to You
The foreclosure crisis rages across our state. Banks add fuel to the fire with each foreclosure they pursue. with each foreclosure sale, surrounding homes lose value. Despite profiting from their subprime lending spree, the TARP bailout, and the Home Affordable Modification Program, banks are actively seeking to foreclose, adding unnecessary costs to the loan and diminishing homeowners’ chances to qualify for loan modifications. Banks chose to play with fire in the risk-filled world of residential mortgage-backed securities; they now expect the Court to stand aside and watch as our neighborhoods burn.
The Court does not have to stand aside. Rather, the Court has the obligation to weigh the equities in each foreclosure case and decide whether the Plaintiff has the legal and equitable standing to impose the costs of foreclosure on innocent neighbors and the city’s strained coffers. You have the authority to evaluate the equity of the situation and craft equitable solutions unique to each case. Or, you have the authority to order a mediation at which each alternative to foreclosure will be considered and eliminated prior to allowing the Plaintiff the extreme remedy of foreclosure.
Federal and state officials have failed to adopt policies that would reduce the foreclosure crisis and the unemployment crisis. It’s down to you.
It’s up to you.
Throughout this letter, I will use the word “bank” and “servicer” interchangeably. There is a difference. But, when I’m referring to a “bank” pursuing foreclosure, I mean “the entity charged with servicing the loan and exploring loss mitigation options.” This will often, in fact, be a servicer. About 85% of all home loans have been bundled into residential mortgage-backed securities; those lines are usually managed by a “servicer,” not a “bank.” That servicer would often be the entity responsible for collecting and accounting for payments, determining default, initiating and prosecuting the foreclosure, and exploring alternatives to foreclosure. ↩
For a general overview of the risks of adjustable rate, interest-only, and payment-option mortgages, see Mark Zandi, Financial Shock: A 360° Look at the Subprime Mortgage Implosion and How to Avoid the Next Financial Crisis 35–38 (FT Press 2009). Zandi reports that the lending industry regarded payments scheduled to “rise substantially” as “a problem for another day.” He also notes that because ARMs “shift substantial risk to borrowers when rates fluctuate…the delinquency rate on ARM loans is 50% greater than on fixed-rate loans.” ↩
While some unqualified borrowers received loans, other borrowers received high-cost loans when the borrower’s income and credit history qualified them for more traditional, affordable loans. The National Community Reinvestment Coalition issued a report, “Income is No Shield” in 2008 describing in detail the disparate impact the lending environment had on minorities, regardless of income or credit score. In Louisville, specifically, the report found that low-to-middle income African-Americans were 2.3 times more likely to receive a high-cost home loan than their low-to-middle income white counterparts. Even middle-to-upper income African-Americans were 1.3 times more likely to receive high-cost home loans than their white counterparts. Again, this report is adjusted for traditional lending risk factors such as income and credit score and reflects the likelihood of receiving high-cost (and therefore high-risk) loan products by race. The report suggests that, reprehensibly, in recent years lending institutions have regarded race as a risk factor when originating loans. ↩
Often the true loan-to-value was even greater than 100% when one considers that many of the loans were justified based on inflated appraisals. ↩
To say that “no one wins” is not entirely accurate when a loan is serviced by a company that is not the owner of the note. A third party often services the loan when the loan has been securitized into a REMIC (Real Estate Mortgage Investment Conduit). In these cases, the trust will hire a third party to collect payments from the thousands of loans pooled in the security and divide the proceeds according to various investors’ rights under the Pooling and Servicing Agreement (PSA). In many PSAs, the loan servicer is paid a nominal fee for collecting the monthly checks, but gets to keep the proceeds of fees that flow from a homeowner’s default and resulting foreclosure. Thus, PSAs create in servicers the perverse financial incentive to foreclose even when both their investors and the homeowner would benefit from a negotiated settlement or loan modification that kept the homeowner in the home and monthly checks flowing to the investor. Many of the provisions of the President’s Home Affordable Modification Program aim to overcome these misaligned incentives. ↩
Mortgage Bankers Ass’n, “Lenders’ Cost of Foreclosure” p. 2 (May 2008), available at http://www.mbaa.org/files/Advocacy/2008/LendersCostofForeclosure.pdf . ↩
Id. at 4–5 (May 2008). ↩
It is worth noting that the MBA acknowledged in 2008 that the current “softness” of the housing market could push the losses investors experience in an REO sale “even higher.” Since that statement, the housing market has not stabilized and remains soft. ↩
In 2008, “ten million American homeowners, a fifth of all mortgage holders, are now in this untenable financial situation.” Mark Zandi, Financial Shock: A 360° Look at the Subprime Mortgage Implosion and How to Avoid the Next Financial Crisis 44 (FT Press 2009). In Kentucky, 1 in 4 homeowners are underwater. ↩
Another report from the Metropolitan Housing Coalition notes that “[T]he best defense to a home becoming vacant and abandoned due to foreclosure is quick action by the homeowner to seek assistance from a reliable nonprofit housing counseling program in seeking a loan modification from the creditor. The chance of a property becoming vacant and abandoned is greatly diminished by the owner negotiating new loan arrangements and remaining in the home as long as possible.” Metropolitan Housing Coalition, *Vacant Properties: A Tool to Turn Neighborhood Liabilities into Assets*. Plaintiff’s are far less likely to be guilty of equitable waste if they engage in rigorous good-faith negotiations with homeowners in default. ↩
David Newton, “Widespread Panic: Why the Mortgage Lending Industry Can Calm Down About Amending Cramdown” 98 Ky. L.J. 155, 159 (2009) quoting NeighborWorks America, Foreclosure Statistics, http://www.fdic.gov/about/comein/files/foreclosure_statistics.pdf . ↩
U.S. Congress, Senate Joint Economic Committee, Sheltering Neighborhoods from the Subprime Foreclosure Storm, Special report by the Joint Economic Committee, 1, 110th Cong., 1st sess. (Washington: GPO 2007) available for download at http://jec.senate.gov/archive/Documents/Reports/subprime11apr2007revised.pdf ↩
Master Commissioners may also consider arguments based in equity. CR 53.04 notes that courts may “specify or limit [a commissioner’s] powers and may direct [the commissioner] to report only upon particular issues or to do or perform particular acts.” However, the rule is clear that absent such limitations, the commissioner “has and shall exercise the power…to do all acts and take all measures necessary or proper for the efficient performance of his duties.” Without a referral that specifically directs the commissioner to consider only issues of law, the commissioner has the duty to consider issues of equity, as well. ↩
Consider, for example, the successful loss mitigation efforts of Shiela Bair and the FDIC in their administration of the failed California bank, IndyMac. The FDIC created a loss mitigation program that automatically qualified homeowners for a loan modification rather than placing onerous, opaque, and frustrating requirements on the borrower. ↩
Lillard v. Farm Credit Services of Mid-America, ACA, 831 S.W.2d 626 (Ky. Ct. App. 1992). See also, e.g., Farm Credit Bank of Spokane v. Debuf, 757 F.Supp. 1106 (D. Mont. 1990); Federal Land Bank of St. Paul v. Overboe, 404 N.W.2d 445 (N.D. 1987); Burgmeier v. Farm Credit Bank of St. Paul, 499 N.W.2d 43 (Minn. App. 1993); Western Farm Credit Bank v. Pratt, 860 P.2d 376 (Utah Ct. App. 1993). ↩
See, e.g., Williams v. Nat’l Sch. Of Health Tech., Inc., 836 F.Supp. 273, 283 (E.D. Pa. 1993), aff’d, 37 F.3d 1491 (3d Cir. 1994); Fed. Nat’l Mortg. Ass’n v. Moore, 609 F.Supp. 194, 196 (N.D. Ill. 1985); Wells Fargo Home Mortg., Inc. v. Neal, 922 A.2d 538 (Md. 2007); Union National Bank of Little Rock v. Cobbs, 567 A.2d 719 (Pa. Super. Ct. 1989); Fleet Real Estate Funding Corp. v. Smith, 530 A.2d 919 (Pa. Super. Ct. 1987); Hayes v. M & T Mortg. Corp., 906 N.E.2d 638 (Ill. App. Ct. 2009); Countrywide Home Loans, Inc. v. Wilkerson, 2004 WL 539983 (N.D. Ill.); ABN AMRO Mortg. Group, Inc., 2009 WL 1066511 (Iowa Ct. App.); Ghervescu v. Wells Fargo Home Mortg., 2008 WL 660248 (Cal. Ct. App.). ↩
There will be instances in which even when the NPV calculation demonstrates that foreclosure is more profitable that equity will demand some alternative other than foreclosure. Under HAMP, homeowners who have significant equity in their homes will be the least likely to qualify for a loan modification. The cruel irony of the program is that homeowners who have invested most in their homes and made payments most regularly and over the longest period of time will be the most likely to lose their homes because lenders are more likely to recoup the full Note value of the loan in foreclosure. Equity will require some solution other than foreclosure in these cases. ↩
Maine has established the FDIC’s program as the NPV analysis standard at court-ordered mediations. “Mediations conducted pursuant to the program must use the calculations, assumptions and forms that are established by the Federal Deposit Insurance Corporation and published in the Federal Deposit Insurance Corporation Loan Modification Program Guide as set out on the Federal Deposit Insurance Corporation’s publicly accessible website.” 14 M.R.S.A. § 6321-A . An overview of the program and how the Excel spreadsheet operates is available here. The Net Present Value test is available as an Excel spreadsheet. ↩
This abandonment of property becomes even more inequitable when one considers the bank’s active contribution to neighborhood disintegration. Judge Boyko notes that while “financial institutions or successors/assignees rush to foreclose [and] obtain a default judgment,” the bank will then “sit on the deed, avoiding responsibility for maintaining the property while reaping the financial benefits of interest running on a judgment. The financial institutions know the law charges the one with title (still the homeowner) with maintaining the property.” ↩
See also Bank of New York v. Conway, 916 A.2d 130 (Conn. Supp. 2006). ↩
In times of economic crisis, the state has the power to alter the terms of contracts between private parties to protect the vital public interests. “The reservation of state power appropriate to such extraordinary conditions may be deemed to be as much a part of all contracts as is the reservation of state power to protect the public interest in the other situations to which we have referred. And, if state power exists to give temporary relief from the enforcement of contracts in the presence of disasters due to physical causes such as fire, flood, or earthquake, that power cannot be said to be nonexistent when the urgent public need demanding such relief is produced by other and economic causes.” Home Bldg. & Loan Ass’n v. Blaisdell, 290 U.S. 398, 439–40 (1934). ↩
The Center for Responsible Lending [estimates] that over 800,000 Kentucky homes will lose an average of $1,800 in equity due to nearby foreclosures between 2009 and 2012. That’s $2.2 billion in lost equity statewide. ↩