Friday, October 21, 2005
This may be more of a business law post than a property post, though it does involve mortgages. In addition to my public persona as a property geek, I have a secret identity as a business organizations professor and former corporate litigator. I usually leave business law commentary to Professor Bainbridge, the good folks over at The Conglomerate, the Business Law Prof Blog, and the Corporate Compliance Prof Blog, but I might occasionally dabble in it here.
I've seen a lot on the web lately about interest-only mortgages, which are the latest home financing craze. As their name implies, the monthly payments on interest-only mortgages only cover the interest on the loan; no principal is paid off. Most interest-only mortgages sold today are interest-only for the first ten years of the loan period, after which the borrower starts paying principal. Many interest-only mortgages also are ARMs, where the interest rate on the loan will increase as interest rate benchmarks increase.
I should say at the outset that interest-only mortgages can make sense for certain types of borrowers, especially those with short time horizons. I had one when I lived in New York, and it made a lot of sense for me at the time. But many financial institutions seem to be marketing interest-only mortgages as some kind of new wonder-product that allows ordinary consumers to save money on mortgage payments. As this post explains, however, interest-only mortgages are both expensive and risky for ordinary investors.
I want to focus here one potential consequence of the default and interest rate risks inherent in the current species of ARM interest-only mortgages. Imagine a person buying a $500,000 home, financing 80% with a 4.5% interest-only mortgage that is a 1 year ARM (that is, the interest rate is fixed for only one year). Say the initial monthly payments are $2,000 per month. Now imagine that housing prices decline dramatically and interest rates rise -- a not unrealistic scenario right now. Two years after closing, the person might have a house worth $400,000 (still the value of the outstanding loan principal) or less and a mortgage interest rate of 8.5% (remember not that long ago when that seemed like a good rate). So the person has no equity and payments of $3,000 per month. If the person can't make the higher payment, there goes the house. (As a side note, the last time interest-only mortgages were popular was in the 1920s. Hmmmm, I wonder what happened next.)
Now think back about what happened when the loan was first issued. The person was probably shown a schedule of payments based on the 4.5% interest rate and a truth-in-lending statement. Maybe the loan officer fully explained all of the risks involved and showed the person a schedule of payments based on an 8.5% interest rate. Then again, maybe not. One of the things that makes interest-only mortgages such a marketer's dream is that they allow a person to buy a big house with small payments. Who wants to rain on the sales parade by talking about falling housing prices and rising interest rates? I might be wrong, but some of the sales pitches that I've seen on the internet make me think that risks are not being adequately disclosed by at least some lenders.
Unless the lending institution has papered up this and other similar transactions very well, they are now exposed to a consumer fraud class action. In fact, this potential problem with interest-only mortgages reminds me of some life insurance sales-practices class actions I worked on early in my litigation career. Traditional whole-life insurance policies accumulate interest at a rate tied to the insurance company's rate of return on investments. In the early 1980s, interest rates were incredibly high and many people thought that rates would stay high. During this era, many insurance companies started marketing "vanishing premium" life insurance policies. The idea was that you would pay premiums for, say, seven years. At that point, enough money would have accumulated in the policy that at a high interest rate would be sufficient to cover the premiums for the rest of the life of the policy. Guess what? Interest rates went down. Insurance companies made less money on their investments (mostly bonds), so they started paying less on their policies. Premiums returned. Class actions ensued.
The key to the vanishing premium problem from a litigation standpoint was what the policyholder was shown at the time of purchase. Many policyholders bought based on "illustrations" that showed premiums based on the current interest rate continuing into the future. Some illustrations contained disclosure of the interest rate risk. Some did not. Mediocre disclosure is not going to protect a corporation of any sort in a consumer class action.
Life insurance companies paid out hundreds of millions in dollars (actually, probably a few billion) in settlements in the vanishing premium cases. These cases would be very small potatoes compared to the potential amounts at issue in litigation over interest-only mortgages. There is a nice symmetry between vanishing premium life insurance policies and interest-only mortgages. The former projected high returns in a high interest rate environment. The later project low payments in a low interest rate environment. Both assume that a historically-unusual interest rate environment will last forever. The fundamental disclosure issues are basically the same.
There is one big difference between the vanishing premium cases and interest-only mortgages. Federal Truth-In-Lending laws require a certain amount of disclosure of interest rate risk. They also may preempt many state-law consumer fraud claims. I'm not sure, though, that the currently-required disclosures would be sufficient to protect lenders from the added risks of interest-only mortgages. I'm also not sure that even if the Truth-In-Lending laws protected lenders from problems with interest rate disclosure that they would protect them from other sales practices that could be construed as misleading. Maybe they would -- if you have an opinion on this, please leave a comment.
If I was the general counsel or compliance officer of a financial institution that sells interest-only mortgages, the first thing I'd do is call a lawyer who litigated vanishing premium cases in the late-1990s and talk about mortgage sales practices (among others, pretty much any litigator at Debevoise & Plimpton would know about this stuff). And while I was at it, I'd also think about whether my disclosure statements adequately covered the risk of massive defaults if property values crash or interest rates spike.
If I was a plaintiffs' class action lawyer right now, I'd start polishing up a form complaint.
[Comments are open, but will not post until I have a chance to review them, so there might be a delay]