June 2008

Last week, Judge Leslie Tchaikovsky, a bankruptcy judge in the Northern District of California (National City Bank v. Hill, United States Bankruptcy Court, Northern District of California, Case No. A.P. 07-4106 (May 28, 2008)) issued a ruling that could have enormous impact on future lending practices and workouts in the current subprime meltdown.  The underlying circumstances are typical.  In the words of the ruling,

This adversary proceeding is a poster child for some of the practices that have led to the current crisis in our housing market.  Indeed. The debtors, the Hills, bought their home in El Sobrante, California, twenty years ago for $220,000. After at least five refinances, their total debt on the home at the time they filed for Chapter 7 in April of 2007 was $683,000.”

The case involves a borrower pursued by a subordinate lender attempting to collect a subprime mortgage.  The subprime second trust deed was a “stated income” or “liar” loan.  In these borrowing situations, the borrower is not required to document his income with income tax returns, pay stubs, or other records.

The first trust deed foreclosed on the home at the amount owed to the senior lender.  The line of credit lender (who was in a second position) then pursued the borrower.  The borrower filed bankruptcy, but the lender objected to a debt discharge based on §523(a)(2) of the Bankruptcy Code.  Under this section, debts obtained under “false pretenses, a false representation, or actual fraud” are not dischargeable.

The lender argued that the debt should be non-dischargeable because the debtors made material false representations (namely, lying about their income). The Court concluded that the debtors had lied to the bank, but the Court then held that the bank did not “reasonably rely” on the misrepresentations.  Stated otherwise, if you make a “liar loan”, you cannot make claims about the lies.   In the Court’s words:

However, the Bank’s suit fails due to its failure to prove the sixth element of its claim: i.e., the reasonableness of its reliance.  As stated above, the reasonableness of a creditor’s reliance is judged by an objective standard.  In general, a lender’s reliance is reasonable if it followed its normal business practices.  However, this may not be enough if those practices deviate from industry standards or if the creditor ignored a “red flag.” See Cohn, 54 F.3d at 1117. Here, it is highly questionable whether the industry standards – as those standards are reflected by the Guidelines – were objectively reasonable.  However, even if they were, the Bank clearly deviated to some extent from those standards.  In addition, the Bank ignored a “red flag” that should have called for more investigation concerning the accuracy of the income figures. … Based on the foregoing, the Court concludes that either the Bank did not rely on the Debtors representations concerning their income or that its reliance was not reasonable based on an objective standard.  In fact, the minimal verification required by an “income stated” loan, as established by the Guidelines, suggests that this type of loan is essentially an “asset based” loan. In other words, the Court surmises that the Bank made the loan principally in reliance on the value of the collateral: i.e., the House.  If so, the Bank obtained the appraisal upon which it principally relied in making the loan.  Subsequent events strongly suggest that the appraisal was inflated.  However, under these circumstances, the Debtors cannot be blamed for the Bank’s loss, and the Bank’s claim should be discharged.” (Emphasis added)

Precisely because the loans are subject to such abuse, we have previously called for Congress to outlaw liar loans.

Fulcrum Inquiry is a financial consulting firm that performs forensic accounting and economic studiesappraisals and financial investigations.