Heading to non-recourse mortgage financings?
The real estate and banking excesses occurred in Spain were a lot like those in other countries: construction boomed, prices peaked rapidly and banks provided financing just as quickly. With a 20% official unemployment rate and real estate prices stumbling, those rosy days are now over in Spain and millions of Spanish home owners with negative equity face potential foreclosure proceedings.
The above scenario would be devastating for banks in jurisdictions where lending is non-recourse, as it would most likely encourage home owners to make the so called “strategic default”: walk away, and leave the bank one step closer to be converted into a real estate company. Spain, however, is one of the jurisdictions where lenders have typically full recourse to all assets of the defaulting borrower (not just the mortgaged property) and such very fine print in the mortgage deeds is catching up with borrowers. Article 140 of the Mortgage Law allows limited-recourse mortgage financing, but this is very rare in practice (and almost totally unseen in consumer financings). The deterrent effect of recourse is probably one of the reasons why Spanish banks so far seem to cope the storm relatively well: in a scenario of a potential foreclosure, borrowers give absolute priority to their mortgage payments (particularly if the collateral is the main residence) even though in some cases they are simply kicking their financial burden and housing problem into the future. Full recourse financings coupled with the fact that there is no other country in the world with so many home owners (more than 80%, doubling same statistics in other developed countries such as Germany -42%-, France -58%-, UK -65%- or the US -63%-) will make easy to understand why Spanish financial system has so far weathered the storm reasonably well[1].
The Spanish mortgage financing system has been recently shaken to its foundations after the Regional Court of Navarra (Audiencia Provincial de Navarra) upheld a ruling admitting that relinquishing title of a mortgaged property to the bank is sufficient to cancel the mortgage debt in full because it was “morally repellent” that the bank could pursue additional claims on the borrower because the property’s fall in value was a direct result of the financial crisis steaming from financial malpractices. The court ignored the principle of full recourse to the borrowers established by the Spanish Civil Code which clearly states borrowers “are liable for their payment obligations with all their current and future assets”.
Even though such ruling was seen by a vast majority as a judge going beyond the letter of the law who was moralizing about what things should look like in his ideal (non-legal) view, it ignited a debate that attracted more and more attention in the Spanish media and ultimately led the mainstream political parties to push for the reform of the current mortgage system.
The Proposed Amendment of Spanish Mortgage Regulations
Such call for reform was particularly intense during the recent local and regional elections that took place in Spain in late May 2011 as all political parties without exception (from the liberal Partido Popular to the socialist PSOE) tried to gain the sympathy of voters and promised changes to the Spanish mortgage regulations. Even though election promises are notable for being broken once in office, the truth is that there is already a proposal for the amendment of the Spanish Procedural Act (the “Proposed Amendment”) that is currently under discussion in the Spanish parliament which aims at steaming the tide of foreclosures providing the court with the means to weigh the different interest in conflict when a property has to be foreclosed.
As currently drafted, the Proposed Amendment provides for the borrower’s protection both before and after the foreclosure has taken place. As for the preventive protection, it intends to allow the borrower that has been served a foreclosure notice to file a motion for the suspension of the procedure. Such motion will be admitted provided always that the borrower can evidence that (i) the foreclosed property is the borrower’s dwelling and he has acted at all times in good faith; (ii) his income at the time of foreclosure is lower than the income it received as of the date the mortgage deed was signed; and (iii) he is unable to have access to a decent home while the foreclosure takes place.
The court, after hearing the borrower and the bank, may rule: (i) that the loan be refinanced in accordance with the economic situation of the borrower; or (ii) be converted into a lease agreement with a call option; or (iii) may even partially write off the debt if such measure is seen as the appropriate way to accommodate the interest of the bank with the right of the borrower to a decent home.
If the borrower does not file the motion to suspend the foreclosure or if it is dismissed, the Proposed Amendment advocates for the protection of the borrower in the form of allowing the mortgagee to repossess the property for an amount equal or higher to 75% of the value of the property given by the parties in the mortgage deed[2] or, alternatively and at the creditor’s choice, for an amount equal to the amount of the debt.
A Burning Debate
It is still soon to ascertain whether the Proposed Amendment will succeed, but the truth is that the idea that the full recourse system should be changed or at least watered down is permeating the Spanish society and we might see some changes in the near future[3]. This debate is spreading everywhere: At the European Union level, there is a proposal for a Directive on Credit Agreements Relating to Residential Property that ultimately aims at “ensuring that foreclosures are avoided wherever possible”. In the United States, the Federal Government has approved the Making Home Affordable Program which provides “eligible homeowners the opportunity t modify their mortgages to make them more affordable” as well as the Hope for Homeowners Program under which “borrowers facing difficulty with their mortgage will be eligible to refinance into FHA-insured mortgages they can afford and lenders will be encouraged to write-down the outstanding mortgage principal balances to 90% of the new value of the property”.
The goals of the Proposed Amendment and the above mentioned directive and US Programs are based on the assumption that foreclosures should be seen as the last resource and that negotiating should be attempted before enabling the bank to foreclose on the property. Foreclosures have severe social consequences for individuals and the society as a whole. The underlying principle is that the key to prevent or limit foreclosures is to make sure that mortgage payments are affordable to homeowners in the belief that they will not default (even in negative equity) if they can meet the monthly installments.
Some will argue that if full recourse disappears, the incentives for stop paying will significantly increase in an interest rate rising scenario, unemployment benefits fading away and house price reductions. True. But such new scenario will also most likely break the lenders’ unwillingness to renegotiate the mortgages to make them more affordable before initiating the foreclosure. At the end individuals look to maximize profits and minimize losses as corporations do and if big players (and banks) decide to strategically default on their own properties when it is efficient to do so[4], why shouldn’t individuals be allowed the same?
If there is a universal lesson that can be drawn from the recent and still ongoing crisis is that leverage is lethal and that the best way to limit the damage of a likely property bust is to have more control over the amount of debt that is made available to borrowers. If policy makers decide that the mortgage lending system should weigh more on the borrower’s side, we think that such change cannot be implemented without better aligning the goals of prospective homeowners and lenders more closely.
Lenders mortgage default risk models have traditionally shown a direct relationship between the initial loan-to-value rates and default rates. Accordingly, we understand that a non-recourse system cannot be implemented without going back to stricter credit standards that would make both the lender and the borrower responsible for the investment they are doing. That is, for a reasonable and better risk allocation, a non-recourse debt would inevitably require a meaningful down payment from the borrower. Requesting from the borrower to pay a substantial part of the purchase price will affect its decisions as it is likely that he will be more reluctant to pay more than the real value of the property thus minimizing his incentive to default[5]. Also, non-recourse financing will inevitably be more expensive for the borrower in fair compensation for the higher risk that lenders will incur.
Finally, another angle for the discussion that policy makers should stress (whether or not full recourse to borrower exist) is the role of education. Financial literacy does not seem to be an educational priority and we should really address the profound consequences of a poor educational system that ignores basic economics and law (interest, amortization, recourse and non recourse, etc) that if properly implemented would prevent some homeowners from committing mistakes in their credit decisions, especially, in the type of mortgage they choose.
[1] Even for second homes, average figures in Spain (33%) significantly exceed those in other European countries (14% in France, 18%% in Italy, and 5% in UK).
[2] The current mortgage regulations foresee that the mortgagee is entitled to request repossesion for an amount equal or higher than 50% of the auction reference price.
[3] Some even argue that recourse loans would have encouraged banks to lend even when all the information pointed towards a future of sustained price declines.
[4] On 2010, Morgan Stanley walked away from five San Francisco office buildings it purchased as part of a landmark $2.43 billion deal. The $770 billion firm called it “a negotiated transfer to our lenders” after deciding it didn’t make sense to keep throwing good money after bad.
[5] Banks traditionally used to request borrowers to make a down payment of 20% of the home value which was meant to be a buffer that would absorb the losses resulting from a reduction of value. From 2000 on, those credit standards relaxed up to the point where in some cases no down payments were made in the belief that the property value would continue to increase. During the booming days, very high LTVs were acceptable for banks.
