Nontraditional Mortgage Products -- The Slippery Slope Became an Avalanche

On December 28, 2006, in my second post on this Blog, I wrote about the foreseeable and serious problems that would result from the boom in "creative" financing (sub prime loans, loans made with no down payment, ARM loans with low teaser rates that would reset in 2007 & 2008). I called the post, "'Creative'" Financing -- The Slippery Slope in 2007." This became the biggest economic and real estate story of 2007, as the slide turned into an avalanche.

But this blog is not about economics or predicting the future. So what really changed in the area of real estate law as a result of the creative financing fiasco?

As discussed in my last post, borrowers who negotiate a loan reduction or lose their homes to foreclosure will not be required to pay federal income taxes on phantom income.

The California Legislature has enacted a new law to warn borrowers about "nontraditional mortgage products." After January 1, 2008, Senate Bill 385 will require additional written disclosures for nontraditional mortgage products (e.g., loans that negatively amortize or bear interest only). The additional disclosures must be made in both disclosure statements and advertising. A violation of the new law may be a crime. Unfortunately, a mortgage broker cannot determine the content of the additional disclosures by reading SB 385 itself. Rather, the mortgage broker is referred to various guidelines and regulations to learn what he must disclose. SB 385 also broadens the definition of a real estate broker for lenders. This is significant because it is a crime in California to act as a real estate broker without a license. To read the highlights of SB 385, see Business & Professions Code section 10240.3 and Financial Code sections 215.5 and 22171.

In an apparent attempt to curb mortgage fraud, in California effective January 1, 2008, a notary public who acknowledges a document must certify under penalty of perjury under the laws of the State of California that the facts acknowledged by the notary are true and correct, including that the signer has presented documentary proof that he is who he says he is. (It is no longer good enough for a notary to state that they personally know the signer.) Civil Code section 1189.

That's about it. The other laws regulating brokers, lenders and borrowers are pretty much the same. And there are no new laws against financial institutions, lenders and borrowers from "creatively" finding new ways to lose money.

U.S. Mortgage Relief Act

Until yesterday, debt that was forgiven in a foreclosure or as part of a loan workout was classed as income. For example, a homeowner who negotiated a short sale with her lender was required to recognize as income the amount of the loan that was forgiven.
That changed when President George W. Bush signed the Mortgage Forgiveness Debt Relief Act into law.

The measure will eliminate income taxes for many homeowners who must restructure their mortgages as they face foreclosure. The new law relieves a homeowner of the burden of paying additional income taxes if his lender has reduced the original loan amount to make it easier to continue making the mortgage payments. The law is a response to the rising waive of foreclosures and the re-setting of interest rates in 2008 on as many as 1.8 million mortgages.

DISCLOSURES IN THE SALE OF RESIDENTIAL REAL ESTATE -- No Fairytale Endings

Let's imagine that you were interested in purchasing house in Beverly Hills -- just for fun, let's call it the Hansel and Gretel house. Let's also imagine that you found a local broker to represent you in the negotiations with the seller. In our fairytale, the broker had competed unsuccessfully for the listing on the house and in the process learned that it required significant structural repairs. After the house was put on the market, your broker fails to tell you about all of the problems with the house he previously learned about. You do not learn of the structural problems until after the close of escrow. Can this story have a happy ending for the non-disclosing broker?

The Court of Appeal recently answered "no" in Michel v. Moore & Associates, Inc. (2007) 156 Cal. App. 4th 756. In that case a real estate agent, Larry Kirkpatrick of Moore & Associates, conducted a walk through of a house in the hopes of getting a listing. In the process, the agent Kirkpatrick took notes about problems with the house that would have to be disclosed by a listing broker to a buyer, including symptoms of structural problems (cracks in the pool, sliding doors that don't close properly, hardwood floors that are separating and damaged stucco). After another broker got the listing, Kirkpatrick showed the house to the eventual buyer. The buyer learned from the Transfer Disclosure Statement that there were interior cracks, but did not learn the other information contained in Kirkpatrick's notes.

Following the close of escrow and significant rains, further cracking appeared in the interior walls of the house. The buyer conducted an investigation and discovered the floor was out of level and there was a major soil instability problem. The buyer sued Moore & Associates.

At trial the jury returned a verdict in favor of Moore & Associates on the grounds that Kirkpatrick did not fail in his duty under Civil Code section 2079 to conduct reasonably competent inspection and did not fraudulently conceal any facts.

The Court of Appeal reversed, holding that Moore & Associates owed a fiduciary duty to the buyer that is broader than the more limited, non-fiduciary duty under Civil Code section 2079. Under the broker's fiduciary duty, he must inform the buyer of all information in his possession that is material to the buyer's interests, regardless of how the information is obtained. The failure to make such disclosure is actionable as "constructive fraud," which is easier to prove than actual fraud because the latter requires proof of intent to defraud.

The moral to our fairytale -- when in doubt, disclose. Non-disclosure cases are quite common in residential real estate transactions. I have handled a number of them in my law practice, including a six week trial of a case involving a crack in a closet. It is up to the seller to tell the broker everything that it is material about the house, but the buyer's broker also has a duty disclose all material, adverse information about the property.