On October 23, 2007, the New York Times reported that Representative Barney Frank (D-MA) has introduced new legislation in Congress that could drastically increase borrowers' ability to challenge mortgages in foreclosure. The proposed law would give borrowers new defenses against any lender that failed to verify, prior to closing, that the borrower had a reasonable ability to repay the loan based on documented income, credit history and debt levels. Moreover, Borrowers would have a claim not only against the originating lender, but also against downstream, secondary-market investors.
The latter aspect of the legislation appears intended to account for the fact that whereas the mortgage market once was a purely local affair, it is now a global financial industry with institutional-sized ramifications. This week's news about Merrill Lynch is a perfect example of how global the mortgage market has become. The world's largest brokerage firm has significant negative exposure to losses arising out of sub-prime mortgage-backed securities. The firm's directors and shareholders, looking for a fall guy, have forced CEO Stanley O'Neal to resign.
I see people every day that got suckered into loans they could never afford. Despite my tendency to harp on the idea of taking personal responsibility for the consequences of your own greed, I am not necessarily opposed to new regulation of the retail mortgage market. There are, after all, real abuses, and there are (at least some) real victims.
I'm not sure it makes sense, however, to give mortgage-fraud victim the ability to go after secondary-market investors for relief.
There is a concept in real estate law known as the bona fide purchaser for value. The concept is mirrored in the law of commerce, as codified in the Uniform Commercial Code, which is the law in every state in this country (albeit with very minor local variations). The concept is simple, and is best illustrated by example.
Suppose you defraud a fellow out of his house. Let's say he's in financial trouble and offer to be his straw buyer, getting a bailout loan in your name. Suppose the house is worth $800,000 and he owed $400,000. Now you, being the accomplished scam artist that you are, you get a bailout loan of $600,000. You pay off your victim's loan, pocket the remaining $200,000, take the deed, and promise the guy you'll sell him back his house next week.
You don't sell him back his house, though. You sell it to me, instead. Now, I don't know the original owner, I don't know you, and I don't know the background. I'm just a guy moving to New York from Minnesota who needs a house, and I buy it from you for $800,000. I get my own mortgage and drop down my down payment. After we close, I've got title to a house that I paid $800,000 for. You pay off your $600,000 loan and keep the balance of my $800 grand.
When I evict the original owner, who has long since been unwittingly reduced to a mere tenant, he'll tell his story, and I'll say that it's not my problem. I'm a bona fide purchaser for value. I paid a real and fair price for the house with no knowledge of any prior monkey business. He's on the street, and I'm sitting in front of his old fireplace sipping brandy on a winter evening. End of story.
The now homeless former owner can sue you - if he can find you - but that's about all. The reason it has to work this way is that the law has to prioritize the rights of two people who are innocent - me and the chump. The Law, as a matter of public policy, makes the choice in my favor.
That's not just a hypothetical example, by the way. It's an actual example from my current files.
The same rule applies to negotiable instruments and other forms of commercial paper. If the chump writes you a check and you endorse it over to me, I can collect on that check if I gave you something of reasonable value in exchange, and I was not part of your tainted transaction.
This process of cutting off borrowers' (or payors') defenses is an essential and well-established aspect of commercial and financial practice. The alternative would be chaos in the banking and business worlds.
All that could change if Congress starts carving out exceptions to the rule that a bona fide purchaser or assignee of a negotiable or transferable instrument takes the asset free of the defenses that may apply against the assignor or transferor. This could be a very slippery slope indeed.
I anticipate that financial institutions whose interests could be affected - and that's pretty much every financial entity you could think of - will use their gentle influence to modify the proposed legislation before it gets written into the statute books. I'll be watching.
Comments(1)