J. Patrick Sutton Cases & Issues Blog

Hitting the Wall: Forbidden Modifications of Texas Home Equity Loans

This article examines the process of modifying or refinancing a Texas home equity loan. The short answer is: if you're behind on your home equity loan, there are very specific ways to legally modify that loan. It's not "illegal" or "prohibited," as the big lenders are now telling their desperate borrowers. But it is very difficult for borrowers already in arrears. Borrowers who are substantially behind on a Texas home equity need to be prepared for foreclosure.

As of this writing, in late 2011, Texans in financial distress are finding it difficult or impossible to get existing home equity loans modified or refinanced. Lenders (or their servicers, who may also be lenders in their own right) are telling their borrowers that workouts of home equity loans are "illegal" or "prohibited" under the Texas Constitution. While such statements are false, the truth isn't terribly more encouraging. In Texas, there's no quick-and-easy way to re-work a home equity loan after a borrower has missed payments. And, hard as this reality may seem, that's exactly what Texans intended when they voted in 1997 to amend the state constitution. They sought to protect Texas homesteads from predatory, unfair, and dangerous forms of home equity lending.

After Texas (finally!) legalized home equity lending, Texans responded quickly by catching up to other states in their level of home equity borrowing. In a stroke, all the untapped, uncollateralized market value in Texas homesteads became available to homeowners to purchase consumer goods. Equally important, home equity became available to lenders to make profit. It was a huge experiment in carefully-controlled lending.

When the housing boom got going in earnest around 2006, the amount of "home equity" grew accordingly, at least on paper. For no other reason than an increase in perceived "market value" in homes -- a belief bolstered by all-too-willing lenders and appraisers -- Texans could borrow more and more against their homes. By law, Texans cannot borrow more than 80% of that value, but in the housing boom, that number seemed to go only up. Home equity, seemingly intangible, became TV's, cars, and boats.

Never mind that equity that grew from nothing could just as quickly disappear, like some exotic subatomic particle in the cosmic ether. And that's just what happened.

As it turns out, under the 1987 Texas constitutional regime, a lender can't call in a Texas home equity loan just because a drop in the market causes the loan-to-value ratio to pass the 80% mark. Borrower and lender are stuck with their bargain. Unfortunately, the same bad economic conditions that create a high loan-to-value ratio through the falling value of homes also lead to drops in borrower income because of unemployment or other downturn-related factors. So, at the same time that loans are becoming a larger fraction of a home's market value, borrowers are losing the ability to pay.

This scenario happens with traditional mortgages too -- the loans that people use to purchase homes. And it's commonplace nowadays to hear of people being "upside-down" on their home loans, stuck with loans worth more than the underlying home itself. However, there's a important difference between a traditional home loan and a home equity loan, and that difference is what led the people of Texas to impose special rules on home equity loans that make them so much more difficult to make and to modify: whereas a traditional mortgage exists to finance home ownership, a home equity loan exists to finance consumer goods (among other things). That is, mortgages exist for the purpose of home ownership. Home equity loans exist for non-homestead purchases. It makes perfect sense that a mortgage is secured by the home it was used to buy. But does it make sense to use a home to secure the purchase of a consumer item? In that case, a homeowner has put something of enormous personal and financial value -- the homestead -- at risk of being taken away for the sake of something far less durable and intrinsically important. That's not my opinion. It's the judgment of the people of Texas as expressed in the Texas Constitution, whether one agrees with that judgment or not. (About 40% of Texans voted against the constitutional amendment.)

The legal result of this judgment is that while lenders may foreclose on home equity loans, they may not continue to chase the borrower for any deficiency following the foreclosure sale. Thus, if a home equity loan balance is $100,000, but a foreclosure sale yields only $50,000, a lender cannot sue the borrower for the $50,000 balance. Not so with a traditional mortgage, where borrowers in Texas are routinely sued for deficiencies following foreclosure. Lenders doing home equity lending in Texas must underwrite loans carefully and -- dare one say it? -- conservatively so that a declining market doesn't wipe out part of what they're owed. The Texas Constitution addresses this for the benefit of both borrowers and lenders by absolutely forbidding home equity loans from exceeding an 80% loan-to-value ratio when made. The market may decline later, but, historically, 20% drops in market value have been rare. The current housing bust breaks the rule, but even so, the 80% rule left a safety cushion for lenders.

As a corollary to this, however, once a borrower has taken out a home equity loan for 80% of the market value of a home, if the market declines, it becomes very difficult (but not impossible) for the borrower to refinance their loan. If, at the time the refinance is sought, the loan-to-value ratio exceeds 80%, the only way to refinance is for someone to put cash into the deal. You would expect that to be the borrower, but in many cases, the borrower wants to refinance because they can't make their monthly payment already; they've got no cash to bring to the deal. There's no reason why the lender can't bring money to the table too, but that means outright forgiveness of debt. There are good reasons for a lender to do that, since the long-term value of a payment stream on a 30-year loan can far exceed some modest sum required to bring the loan back to the 80% mark. That is, it can be a rational decision for a lender (even when federal income tax issues for the borrower are considered, since debt forgiveness is considered "income" in some situations).

So why are lenders now telling borrowers that modifying their home equity loans is "illegal?" Because the unstated premise is that borrowers with home equity loans are already behind on their loans. That single issue -- the existence of unpaid interest -- implicates important restrictions that underpin the Texas home equity lending structure.

To understand how, suppose you're an avaricious lender who wants to get around the Texas home equity rules. You know you can't issue a loan with a loan-to-value ratio greater than 80% and that you must comply with all sorts of strict formalities when you originate the loan. But you also know your borrower is ready and willing to accept more debt. Why not simply get around the loan origination rules and issue a simple "modification" of the loan later, after first jumping through the regulatory hoops? That way, you haven't "issued" a home equity loan that breaks any rules. All you've done is "modify" a loan already in force. You can give the borrower what he wants -- more debt to buy a fancy car -- and reap the benefits of earning more interest on that debt. Easy, right?

Wrong! It should come as no surprise that the Texas home equity rules don't allow this sort of end-run-around the 80% rule or any other aspect of the home equity lending rules. It is illegal for a lender to just "modify" a loan in some quick, easy way to increase principal. No matter how willing a borrower is, the lender cannot increase the principal amount of a Texas home equity loan without originating a whole new home equity loan with all the formalities, including a closing event and lots of disclosures. And if the loan-to-value ratio would be greater than 80%, even this sort of full-blown refinance is impermissible.

Conclusion: a lender may not increase the principal amount of a Texas home equity loan without complying with all the rules for home equity lending under the Texas Constitution, and under no circumstance may the lender modify or refinance in a way that permits the loan-to-value ratio to exceed 80%.

Now suppose you're a borrower who has missed some payments and needs to restructure your loan to get lower payments. You want your lender to lower the interest rate or extend the loan term or do whatever it takes to make your payment more affordable. You beg your lender for a loan modification or refinance or whatever it takes to accomplish this goal. Impossible?

No, not impossible, but difficult. What happens to the past-due interest? The lender cannot put it into the principal with a simple "modification," since that's flatly illegal under the Texas Constitution. Furthermore, if the lender isn't careful, putting that past-due interest into principal could increase the loan-to-value ratio past the 80% mark (it's easy to do if the lender isn't paying attention to the requirement of an appraisal to determine fair market value). Also flatly prohibited.

Unless the lender is willing to do a wholesale refinance (basically, originating a new home equity loan with all the bells and whistles and a closing at a title company or a lawyer's office), the only way to deal with the past-due interest is for the loan to be brought current -- i.e., no past-due interest. Either the borrower has to come up with money to do that, or the lender has to forgive the interest. Then and only then can a simple "modification" occur that reduces the interest rate, extends the term of the loan, etc. Again, there may be good reasons for a lender to forgive interest to turn a non-performing loan into a performing loan, and there is evidence that this is happening where the borrower's finances support continuing payments at a reasonable level.

Thus, it is a misstatement -- it is false -- for a lender to say that a modification of a Texas home equity loan is "prohibited" or "illegal." It's neither, but it can only occur if the loan is current (i.e., no past-due interest) as of the date of the modification. Though unclear, it might even be permissible for the loan-to-value ratio to be over 80% at the time of the modification so long as no new principal is added to the loan as a result of the modification. A lender can rationally decide that it's better to keep a loan performing at some level than allow it to go into foreclosure. That's an underwriting question. What a lender cannot legally decide to do is make the loan bigger through simple modification. That creates a situation where a borrower starts paying interest on interest (because old, past-due interest got rolled into a new, increased principal sum). That's textbook predatory lending, and that's what the Texas Constitution forbids.

For Texas home equity borrowers who are way behind on their loans, and far past the point where any lender is willing to forgive all the past-due interest, there is probably no choice but loss of the home. This is the advice that lenders should be giving their borrowers, instead of just a bald, misleading statement that a modification is "illegal." The lenders are just unwilling to tell borrowers that the lenders won't forgive past-due payments in order to modify the loan. I believe that a certain number of borrowers, if told that they need to come up with the past-due interest in order to qualify for a modification, would find a way to do so -- I have seen it happen. But at bottom, the question is whether a borrower so far gone should be pursuing extended loan terms at all.

If this result seems harsh, remember that the borrowers entered into the home equity loan process precisely out of a willingness to lose their home for the sake of monetizing "equity." It's not reasonable for anyone to believe that putting a home up as collateral doesn't present real risk. The Texas home equity laws don't forbid the loss of the homestead. Just the opposite: they are premised on it. They try to limit the circumstances that tend to place the homestead most at risk, but at the end of the day, collateralized lending is still about gambling on the real estate market.

A significant ameliorating factor is that unlike traditional mortgage borrowers, Texas home equity borrowers can't lose more than their homes. Lenders cannot pursue borrowers for the deficiency after a foreclosure sale, and that in itself provides some solace, particularly where (as is more and more the case as of 2011) loan-to-value ratios on fancy subdivision homes bought new in 2005 and leveraged two years later has shot way past 100%. I have represented regular mortgage borrowers in painful mortgage deficiency collections suits, I can attest to the value of the home equity sanctuary from deficiency suits. At some point, the pain does end with home equity loans gone bad.

One question that remains is, why are lenders overstating the difficulty of modifying or refinancing home equity loans? Why not work within the limits of the law to keep payments flowing? The answer, I believe, is that the Texas home equity laws leave so little room for lender error. The rules must be followed to the letter, and the penalty for noncompliance is the financial "death penalty": outright forfeiture of the loan by the lender. That wouldn't be so bad if it were just the occasional error. But home equity lending practices don't usually spawn isolated errors; they spawn systemic, portfolio-wide errors. Home equity lending is all about standard forms and practices -- it has to be so that mistakes don't get made owing to cowboy variations that don't comply with the cinched straight-jacket that Texas home equity loans must fit into. If a lender's standard practices are illegal by a whisker, all the loans in the portfolio are at risk of forfeiture because all were issued in accordance with the same practices. It therefore behooves a lender to avoid anything remotely threatening such a catastrophe to its bottom line. Home equity loan modifications that involve complicated per-loan calculations and risk assessments require a large commitment of expertise and resources. Now, I don't think the difficulty justifies misstating to borrowers what the Texas Constitution says, but it does explain why lenders err on the side of caution. It's far easier to just tell everyone, "forget it, no mod for you," than to spend time and money evaluating every borrower for a transaction fraught with perils to the lender.
J. Patrick Sutton Cases & Issues Blog