It’s the greatest of all the homeowner laurels, the legal protection those in financial distress crave. Ostensibly.

The homeowner bill of rights movement may be the white knight of borrowers, a citizen savior, but there are far-reaching ramifications. And they come with big numbers attached.

At its core, the HBR movement seeks to generate a seismic shift in the traditional model governing who bears the loss when a real estate-secured loan defaults and the collateral — the real property — is liquidated.

Of course, this means a new interpretation of the headline-grabbing foreclosure-eviction-REO sale paradigm for disposition of defaulted loans, the darling of the voracious, sob-story-craving mainstream press. But, crucially, this is also the tried-and-true market clearing process. And, to be sure, this process is also the one established by the contract between borrower and lender.

So, what gives?

The most commonly used number when evaluating the foreclosure process is that it returns, on average, 50% of unpaid principal balance. With that generalized number in mind, there are two very different ways to dispose of the 50% loss: using the traditional model or the one put forth by the HBR movement.

Under the traditional model, the investor’s 50% loss on the property benefits the third party who purchases at the foreclosure sale, buys the defaulted note or plucks the property from REO. Under the HBR movement model, however, the borrower enjoys that benefit, via a loan modification or some other form of payment for a short sale or deed in lieu.

In essence, under the HBR model the goal is to give away most of the decreased value of the loan to the defaulting borrower and his or her attorney. It’s an appealing approach: Why not give the borrower the benefit of the decrease in value rather than give it to the market. After all, the investor is going to suffer the loss of the forced collateral liquidation anyway, so what difference does it make to the investor whether that loss benefits the borrower or some other unknown buyer? This is also the basis of the net present value model of loan modification. Under the NPV approach, if the investor can benefit by receiving a better return than through a forced collateral liquidation — meaning the loss is less severe — then the investor benefits.

The NPV model has a seductive ring; why not lessen the loss while at the same time helping out the beleaguered homeowner, rather than an unknown third party? But it also contains a trap — the paradox of the NPV model. For at its core is a serious flaw. The value of the loss and, hence, the amount of the subsidy given to the homeowner depends on state law. The more costly the foreclosure or eviction process, the higher the loss incurred on default.

Under the NPV model, the greater the cost to foreclose or evict, the greater the subsidy to the borrower for defaulting. So if a state can make a foreclosure extremely expensive, then the NPV model would require that the subsidy offered to the borrower via a loan modification, or other foreclosure alternative such as a deed in lieu or short sale, increase.

The paradox, then, is based on the NPV model making the costs of foreclosure/eviction a zero-sum game between the borrower and the investor — or owner — of the loan: The less the state law imposed transaction costs to liquidate the collateral via foreclosure/eviction/ REO sale, the less the subsidy to the defaulting borrower.

Likewise, the greater the cost of the process’ transaction costs, the greater the subsidy. In other words, the more expensive state politicians can make the foreclosure process, the greater benefit those politicians provide to their constituents. And, let’s not forget, lenders do not vote; homeowners do. So the paradox creates a significant political incentive for state politicians to greatly increase the costs of foreclosing on their voters.

Let’s take things a stage further, focusing on the most relevant aspects of a forced liquidation’s transaction costs. These costs consist of several components, but for the purposes discussed here, we will hone in on four interrelated components: the legal expenses associated with foreclosure; those incurred obtaining possession of properties occupied after foreclosure; the expenses related to legal claims brought against investors and servicers by borrowers for alleged violations of their rights during the foreclosure process; and the carry cost of the loan during the foreclosure/eviction/REO sale process (the longer the time to liquidation, the greater the carry cost).

For a model, look no further than a settled case subject to the California Homeowner Bill of Rights statute: Singh v. Bank of America. Because the California HBR applies only to nonjudicial foreclosures, we will look at how the NPV impacts on the last two components: litigation costs and carry cost.

The case

In 2004, the borrowers at the center of the case purchased a new home for $412,000, making a 10% down payment, an 80% first loan and a 10% second. In November 2005, they consolidated the first and second into a new first loan. In December 2005, they borrowed an additional $199,000, securing it via a second lien. In 2011, they filed for bankruptcy and obtained a Chapter 7 discharge in 2012. According to online real estate site Zillow, the home is valued at $290,000.

The lender started the foreclosure process on the first lien. In turn, the borrower claimed he had filed loan modification documentation with the lender, which he alleged elicited no response. The borrower said in a declaration that he was merely asked to fill out financial documentation, a request to which he acquiesced. His servicer then scheduled a foreclosure sale for April 2013.

Two days prior to the sale, the borrower’s attorney filed an action for violation of the California HBR, alleging the foreclosure sale was being held in violation of the dual-tracking prohibition. Why? Based on a claim the borrower had not received the mandatory written denial of his loan modification, a step required by the HBR and which must also contain a right to appeal. The court issued a temporary restraining order staying the foreclosure sale, and set the matter for a preliminary injunction. The servicer opposed the injunction request. However, the borrower won, his attorney then filing a motion for legal fees and costs, seeking approximately $20,000, using a base rate of $250 per hour. Shortly before the hearing, the case was settled on confidential terms.

At this juncture, be warned not to assume the servicer made a mistake. That would be erroneous. This borrower does not appear to be a viable candidate for a loan modification of the first lien due to a large cash-out second. But whether or not this borrower could have qualified for a loan modification at all is made irrelevant by a pillar of the HBR movement: the Miranda-izing of the nonjudicial foreclosure process, a facet discussed in the first article in this series, published in the May edition of HousingWire.

Form over substance

The issue in the case is not if the borrower’s loan modification application had any merit. What matters is whether or not that loan application was properly denied in writing and that the foreclosure sale process was placed on hold until that denial was final. As will hopefully become clear, the cost of this alleged procedural failure by itself immediately could exceed 50% of the UPB.

This case is also an excellent example of the “Harris Rule,” an exemplar of another HBR movement pillar described in the first article: making servicers pay for a borrower’s attorney. Under this aspect of the Harris Rule, the servicer and investor must pay for the borrower’s attorney if the case is filed prior to the foreclosure deed recording and a preliminary injunction is issued.

It was highlighted in the first article that preliminary injunctions would be extremely easy to obtain, which occurred in this case. A point of caution, however: It may be that the loan modification was properly denied. All that matters is the borrower alleged it was not.

The bottom line is that the intended impact of the Harris Rule is well illustrated in this case. It could be argued that the borrower likely does not qualify for a loan modification and he clearly lacks the funds to hire an attorney, based on the alleged facts.

Absent the Harris Rule, any attorney taking the case would have been forced to invest $20,000 in time and costs just for the injunction. And absent the Harris Rule and the very pro-borrower structure of the HBR, it is highly unlikely that this borrower would have been able to find an attorney willing to take his case. As it turns out, because of the Harris Rule, his attorney most likely made money on what appears, overall, a marginal case for loan modification.

The true cost of the HBR

The paradox of the NPV is driven in large part by an “NPV inside the NPV” — the method by which attorneys value lawsuits, with a calculation similar to that done on a foreclosure NPV. In this model, the attorney for the borrower essentially calculates how much it will cost the servicer to defend the case, adding any exposure.

If, for example, the borrower’s attorney estimates that in order to win the case the bank’s legal expenses are going to be $150,000, a realistic verdict in the case would be $200,000, with a 50% chance of success, thus valuing the litigation at $100,000. The NPV of the litigation would be $250,000 ($150,000 in legal expenses and $100,000 in exposure). Note that the NPV inside the NPV does not require that the $150,000 in legal expenses be spent, only that it would be spent if the borrower forced the case forward.

Using the Singh case as a model, prior to the HBR, the NPV inside the NPV had a value of zero. After the HBR, the NPV inside the NPV value is at $250,000. This number is based on the bank having to pay double legal fees under the Harris Rule, and reached based on legal fees alone and valuing the $600,000 damages claim in Singh at zero. These figures are believed conservative.

This is an excellent example of the paradox of the NPV model: The California HBR transferred the $185,000 loss, giving it entirely to the borrower and his attorney. Assuming the case adds six months to the timeline at a $3,000-per-month carry cost — the UPB is listed by the borrower at $371,000 — the total additional cost to the bank manufactured by the HBR is about $270,000 (the $250,000 NPV and a $20,000 carry cost). That loss is a very large poker chip for the borrower and his attorney.

A concluding caveat is that this example is limited to cases that are filed prior to deed recordation and for which an injunction is issued. Other cases filed under the HBR will have a differing NPV calculation, but the size of the subsidy given to the borrower will still be significant.

The paradox of the NPV is that by increasing the cost to foreclosure/evict/REO sale by $270,000 (including carry cost), the use of the NPV model moved the investor’s financial position from +$185,000 to -$85,000. The result? The investor is in a very weak position to negotiate settlement.

Shocking results

Transcending all of this, then, is the impact of combining two things: the HBR movement’s push to shift the investor’s loss to the borrower’s benefit rather than that of a third party, and the NPV model used by the industry. The results are shocking when the California HBR is used as the model. If anyone is underwater on an asset, under the NPV paradox, it is the investor owning loans secured by realty in states adopting HBR statutes — not the homeowner.

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