Friday, August 12, 2011

Appeals Court Rules failure to properly disclose teaser rate for Option ARM might constitute Fraud

by Calculated Risk on 8/12/2011 01:05:00 PM

This is an interesting California Appeal Court ruling in the case BOSCHMA et al., Plaintiffs and Appellants, v. HOME LOAN CENTER, INC.

The plaintiffs are arguing that defendant failed to disclose prior to plaintiffs entering into their Option ARMs: (1) the loans were designed to cause negative amortization to occur; (2) the monthly payment amounts listed in the loan documents for the first two to five years of the loans were based entirely upon a low teaser‘ interest rate (though not disclosed as such by Defendants) which existed for only a single month and which was substantially lower than the actual interest rate that would be charged, such that these payment amounts would never be sufficient to pay the interest due each month; and (3) when [plaintiffs] followed the contractual payment schedule in the loan documents, negative amortization was certain to occur, resulting in a significant loss of equity in borrowers‘ homes, and making it much more difficult for borrowers to refinance the loans [because of the prepayment penalty included in the loan for paying off the loan within the first three years of the loan]; thus, as each month passed, the homeowners would actually owe more money than they did at the outset of the loan, with less time to repay it.

The court ruled that even though someone with industry knowledge could figure out the details, the teaser rate wasn't properly disclosed: The root of the alleged deficiencies in defendant‘s disclosures is defendant‘s use of a significantly discounted teaser rate rather than an initial rate set near the rate that would result from the application of the variable rate formula in the Note (an index plus 3.5/3.25 percent). The teaser rate creates an artificially low (compared to the actual cost of credit) initial payment schedule and guarantees that the actual applicable interest rate (after the first month of the loan) will exceed the interest rate used to calculate the payment schedule for the initial years of the loan. If the initial interest rate were set using the Note‘s variable rate formula, it would actually be possible that interest rates would adjust downward (or stay the same) after the first payment and no negative amortization would occur. In other words, the disclosures‘ conditional language is accurate absent a significantly discounted rate. An Option ARM loan without a teaser rate would result in a higher initial interest rate, higher initial minimum payments pursuant to the payment schedule, and a much narrower gap (even if interest rates increased) between the borrower‘s payment ―options. Of course, without a teaser rate, the surface attractiveness of Option ARMs would have been greatly diminished precisely because the stated (initial) interest rate and (initial) payment would be higher. (emphasis added).

The court wasn't sure about damages though: Did plaintiffs suffer damages as a result of defendant‘s fraud? Plaintiffs‘ theory of damages (lost home equity) is problematic. Every month in which plaintiffs suffered negative amortization was a month in which they enjoyed payments lower than the amount needed to amortize the loan (or even to pay off the accruing interest). In exchange for gradually declining equity, plaintiffs retained liquid cash that they otherwise would have paid to defendant (or another lender). Viewed in this manner, plaintiffs‘ only ―injury is the psychological revelation (whenever it occurred) that they were not receiving a free lunch from defendant: plaintiffs could have low payments or pay off their loan, but not both at the same time. But plaintiffs‘ allegation of lost equity in their homes is sufficient at this stage of the proceedings to overrule defendant‘s demurrer. We construe plaintiffs‘ allegations (including the allegation that the prepayment penalty precluded refinancing into a better loan) broadly to encompass an assertion that they were misled into agreeing to Option ARMs, which led to lost equity in their homes because the terms of the Option ARMs put them in a worse economic position than they would have been had they utilized a different credit product.

Although it is clear one plaintiff used the Option ARM to refinance (so the damages are "problematic"), it is unclear if the other plaintiff used the Option ARM to refinance or to purchase a home. I think the damages would be more clear for a home purchased in 2005 than for a refinance. At that time these products were being used inappropriately as affordability products, and if the teaser rate had been properly disclosed, the plaintiff might not have bought the home and wouldn't have suffered significant losses.

As a reminder, back in 2005 it was common to qualify borrowers not using a fully amortizing rate. Options ARMs were frequently used as an affordability product; they were the only way to buy a home for many borrowers. (I was actively contacting regulators in 2005 to try to get that changed). The rule wasn't changed until the Non-Traditional Mortgage Guidance was released in Sept 2006 (a little too late).