"goin' Round in Circles" . . . and Letting the Bad Loans Win: When Subprime Lending Fails Borrowers: the Need for Uniform Broker Regulation

• Publication year: 2021

86 Nebraska L. Rev. 737. "Goin' Round in Circles" . . . and Letting the Bad Loans Win: When Subprime Lending Fails Borrowers: The Need for Uniform Broker Regulation

737

Cassandra Jones Havard(fn*)

"Goin' Round in Circles" . . . and Letting the Bad Loans Win(fn1): When Subprime Lending Fails Borrowers: The Need for Uniform Broker Regulation

TABLE OF CONTENTS

I. Introduction ....................................................... 738
II. The Mortgage Broker Industry--The Structural
Framework ......................................................... 743
A. Mortgage Brokers and Financial Intermediation .................. 743
1. The Mortgage Broker Industry ................................ 743
2. The Economics of the Mortgage Transaction ................... 744
a. Financial Intermediation ................................. 744
b. The Market Imperfections ................................. 748
i. Transaction Costs ..................................... 749
ii. Information Costs .................................... 751

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iii. Agency Costs ........................................ 752
iv. Moral Hazard ......................................... 752
B. Reckless Lending ............................................... 754
1. Underwriting Inefficiency and the Subprime
Market ...................................................... 755
2. Tolerating Default and Reckless Lending ..................... 758
3. The Market as a Social Actor: A Symbiotic
Synthesis ................................................... 762
III. Mortgage Brokers--The Corrective Framework ....................... 765
A. Banking Law and Federalism .................................... 766
1. Federal Preemption ......................................... 767
2. Watters v. Wachovia ........................................ 769
3. Cooperative Federalism ..................................... 771
B. Fiduciary Duty ................................................ 775
1. Fiduciary Duty--A Comparison of Dual Agency,
Independent Contractor, and Implied Duty of
Good Faith ................................................. 778
a. Dual Agency ............................................. 778
b. Independent Contractor .................................. 781
c. The Duty of Good Faith .................................. 783
2. Fiduciary Duty and Economic Risks ...........................784
a. Mortgage Brokers as Market Monitors ..................... 784
b. Mortgage Brokers and Transaction Costs .................. 786
IV. A Partial Response to a Market that Fails Borrowers ............... 790
A. Why a Federal Approach is Needed ............................... 790
B. Defining Fiduciary Duty Principles for Mortgage
Brokers ........................................................ 792
V. Conclusion ......................................................... 793

INTRODUCTION

Home ownership is an American dream. Yet, America faces a crisis in the residential housing market that threatens that dream for Approximately 2.2 million borrowers with home equity totaling$164 billion or almost one-third of outstanding subprime mortgages will face foreclosure.(fn2) An even greater number of subprime home

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loans, 16.31% are delinquent, with 2.12% beginning foreclosure in the third quarter of 2007 and 6.89% of the delinquent subprime loans in foreclosure at the end of the third quarter.(fn3) Loans totaling $164 billion are delinquent in monthly mortgage payments.(fn4) Ironically, these rising delinquency and foreclosure rates are due in large part to greater access to credit for homebuyers through the subprime lending market.(fn5) Though subprime lending6 has filled a credit gap and addressed the problem of access to mortgage financing by creating a new

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market for home ownership, it has created more opportunities for abusive lending.(fn7) Borrowers have entered into financially detrimental and imprudent loans, often without being fully aware of or understanding the substance of their commitments. These often predatory loans are characterized by product terms and features such as inter-est-only, high loan-to-value ("LTV") ratios, low start rates, and adjustable rates. Borrowers also have entered into mortgage agreements with high debt-to-income ratios; loans in which the monthly payment was large relative to the borrower's income.(fn8) Many of these borrowers received loans without providing supporting documentation of their income or even providing a down payment.(fn9) The rising number of subprime mortgage foreclosures threatens to undermine the significant home ownership gains made over the past two decades.(fn10)

Some argue that the current crisis merely represents market fail-ure.(fn11) The massive defaults in the subprime mortgage markets, the explanation goes, demonstrate that credit-impaired borrower markets are risky and have no place in the usually stable mortgage sector. This explanation supports the imperative that private, free market policies are the best solution to address both imperfections and inequality in the market and that the current subprime mortgage crisis is a neces

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sary market correction.(fn12) Irrational borrowers, the line of reasoning continues, who accepted, rather than rejected, onerous loan terms must now bear the consequences of their actions.

To the contrary, the current crisis in the subprime mortgage sector is due to a market that has failed borrowers.(fn13) Mortgage market expansion should be seen as a means to address economic inequality with the expectation that the market operates in a manner consistent with borrower expectations.(fn14) Market-driven innovations, such as the subprime lending market, must be scrutinized for inequality in the treatment of vulnerable borrowers. Such inequality must be rooted out and rejected to ensure that the financially under-served receive their fair share of economic growth. In the context of subprime lending, that fair share is measured against policies and practices that cause marginalization and subordination.(fn15) Quite simply, this theory advocates that subprime lending policies must support mortgage sustainability.(fn16)

Mortgage sustainability, or affordable mortgage financing, is presently impacted negatively by the securitization of subprime loans. Securitization of loans is an underappreciated factor that paralleled the evolution of the subprime mortgage market.(fn17) Securitization has increased the availability of subprime mortgage credit and spawned a more significant function for mortgage brokers in the lending process.(fn18)

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Mortgage brokers perform many of the tasks involved in loan origi-nation.(fn19) They are also instrumental in identifying a broader market of lenders for potential borrowers. A mortgage broker's specialized knowledge and access to multiple lending sources is particularly helpful to borrowers who have been traditionally excluded from the market due to credit risks. When mortgage brokers function effectively and legitimately, they recommend loans with reasonable terms that are suited to the borrower's financial circumstance. But mortgage brokers' actions go largely unchecked and consequently some brokers recommend deceptive, unreasonable loan terms and unnecessarily high interest rates.(fn20) The combination of the effects of unscrupulous mortgage brokers and subprime lending has failed to fully protect credit-impaired borrowers, resulting in higher delinquency and foreclosure rates. Seventy percent of the now delinquent subprime loans were made by mortgage brokers.(fn21) Thus, the role of the mortgage broker in the subprime market requires critical examination.

The primary regulation of mortgage brokers currently resides with the states, with some states having little or no regulation.(fn22) Federal regulation of mortgage brokers offers an answer to the abuse that has accompanied the expanded access to subprime loans. This Article argues that the mortgage broker industry requires strengthened joint federal and state legislation because an unregulated industry poses a significant economic risk by confusing the interrelated issues of access with quality.

Part I of this Article discusses the structural framework of the mortgage broker industry. It describes the use and development of

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mortgage brokers and how some loans they endorse involve potentially reckless lending practices. These are loans designed to disadvantage borrowers because they are designed to fail. It then explains how these practices support abusive, predatory lending. Part I concludes by arguing that the societal costs of home ownership loss for a particularly vulnerable segment of borrowers justify a more comprehensive federal program.

Part II presents the corrective framework for the mortgage broker industry. Beginning with a discussion of the federalism debate in banking law, it briefly reviews the constitutional feasibility of any federal regulation in this area. It argues that the current legal framework is inadequate to address the potential economic risks that mortgage brokers impose. The private securitization of subprime loans creates a moral hazard thereby justifying the need for the imposition of a fiduciary duty.

Finally, Part III addresses why a federal approach is needed and explains what such a regime should address. Recognizing that all borrowers, not just subprime borrowers, will benefit from mortgage broker regulation, it argues for a comprehensive change in the regulatory structure and applies the standard to all mortgage finance participants. Adopting this standard replaces the existing ad hoc, voluntary acts that currently protect only some borrowers and will result in an appropriate level of mortgage finance regulation that offers greater protection to all mortgage borrowers.

II. THE MORTGAGE BROKER INDUSTRY-- THE...