THE NUTCRACKER: A bankruptcy judge has ruled that the debt on a stated-income mortgage can't be collected in bankruptcy -- even though the borrowers lied on the loan application by exaggerating their income by more than 100 percent.
Tanta, at Calculated Risk, elucidates the decision by Judge Leslie Tchaikovsky, from the federal Bankruptcy Court in Northern California. To boil the decision down to its quintessence: The judge ruled that the loan was a fundamentally different type from what the lender purported it to be. Therefore, the debt shouldn't have to be paid back in bankruptcy.
At issue was a home equity line of credit for $250,000. The borrowers were serial refinancers -- doing a cash-out refi and living off the cash, then doing it all over again. The borrowers' combined income never exceeded $65,000, but on that $250,000 HELOC, they stated on their application that they made $190,800 a year. They lied on the loan application, which is against the law.
The borrowers ended up owing $683,000 on the house with their first and second mortgages combined. On income of $65,000 a year, insolvency was inevitable, and they filed for Chapter 7 bankruptcy in April 2007. National City, author of the $250,000 HELOC, told the court that it should be allowed to collect some of that debt, arguing that the borrowers had obtained the loan through fraud.
But Judge Tchaikovsky said no. And the reason for her rejection of National City's claim could have widespread implications. She said that the industry standards governing stated-income loans were not "objectively reasonable." She ruled that these industry standards don't take into account the borrowers' ability to repay. Therefore, she ruled, this stated-income HELOC was based upon the value of the asset, rather than the borrowers' ability to repay.
Basically, National City was behaving like a pawnshop and not like a bank, Tchaikovsky ruled. It wasn't betting that the borrowers would be able to repay; it was betting that the home's value would keep rising, so the bank would be able to collect after foreclosure.
Tanta concludes: "This is going to give a lot of stated income lenders--and investors in 'stated income' securities--a really bad rotten no good day."