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Lax Underwriting, Foreclosures and Credit Crunch Stimulate Misery Industries

Jimmy Lathrop Sept. 1, 2008

I worked as a bank attorney for mortgage refinances and advised purchasers and sellers of real estate in New York City during the "Golden Age" of the housing boom. Once home prices started to level off and the subprime lenders began collapsing, the refinances and sales dried up, but coincidentally, my landlord/tenant practice began to pick up. You see, many first-time homebuyers were given the "Big Kiyosaki" pitch, where owning multifamily properties would create "cash flow" and turn everyone into "Rich Dads".

Clearly, Robert Kiyosaki didn't have New York City in mind when he was pitching his real estate speculation to the public, but lots of real estate brokers hijacked his talking points and persuaded many first-time home buyers into becoming landlords. Many times, the prospective buyer's income and credit would have been insufficient to merit a purchase, but lax underwriting regulations permitted potential borrowers to "impute" rental income to make up the shortfall when purchasing two or three family homes with $500,000 and $600,000 mortgages.

These underwriting standards did not take into account New York State's tenant-friendly regulation, housing laws which have been famously described as "an impenetrable thicket". Working-class people, two-income families, many of them new arrivals to this country, purchased these multi-family homes and very soon thereafter found themselves in Housing Court chasing down tenants who refused to pay rent or overstayed their welcome by creating nuisances and destroying the premises. In all fairness, many new homeowners were ill-prepared for the responsibility of fixing overflowing toilets and tenants slow-paying their rent while the fixed rate kicker ran out and the insurance and tax bills were due by the fifteenth of the month - no excuses or extenuating circumstances. Many homeowners didn't have the cash reserves to withstand the absence of rental income.

I usually volunteer at the Housing Court Resource Center in Brooklyn every Thursday night, but one Monday morning in December of 2006, I had some time to kill before an 11 a.m. hearing, so I popped in to see if I could assist the attorneys employed by the Unified Court System. I wasn't surprised to see that the room was full of people at 9:30 a.m., but sifting through the intake sheets, I was mildly surprised to see that all of the people waiting were landlords seeking free legal advice on how to take their tenants to court for nonpayment. I asked one of the permanent staff if it was always like this and he told me that in the last few months, they were seeing more landlords than tenants, a reversal. Over the coming months I began to see more unsophisticated first-time buyers with multi-family properties coming in for consultations. They were learning some hard lessons in becoming a "Rich Dad".

I didn't realize it then, but looking back on it, those were some signs of serious strains. These were homeowners who had no money to spare on landlord attorneys who made their profits on low cost high volume caseloads. They spent the whole weekend worrying about how they were going to pay their mortgage and even took the day off of work to see how they could compel their tenants to give up their "cash flow" to pay their mortgage.

I sat in courtrooms and heard homeowners beg for relief to judges. New York City's Housing Court is better suited for tenants taking on big commercial landlords who are constrained by rent regulation. These big slumlords let their apartment buildings get run down, take the loss on rent to be made up on capital depreciation to offset other more profitable endeavors. For the big commercial landlord, it is cheaper to hire a volume landlord attorney to harass the tenants than to do the structural repairs necessary to keep the building in the high standards of the overlapping state agencies which oversee housing matters. However, in this type of forum where the system protects tenants from indifferent landlords, the small-fry landlord doesn't have a chance.

A brand new landlord would get upset hearing the judges minimize their financial straits with such aphorisms like: "Everyone has to live somewhere but not everyone has to be a landlord". A small landlord doesn't see that a judge is the last line of defense before a tenant goes into a homeless shelter at the expense of the City, or huddling in a bus station either to be victimized or to victimize someone else to get through the night. All the first-time multifamily homeowner sees is that he or she has been given the controls of a jumbo jet in midair and the pilot has jumped out with his bag of cash and a parachute, and the ground is coming up fast. Usually the outcome isn't as zany as the movie Airplane!

In February of 2007, New York State passed the Home Equity Theft Prevention Act [HETPA] which was enacted to curb a type of growing bank fraud called "foreclosure bailouts" or "sale leaseback" transactions. Let's image we have a married couple with children who own a two family home. The catalyst could be an illness, one of the parents losing a job or their tenant stops working and starts avoiding the owners. As the bills pile up, the household credit score drops. The homeowners want to refinance the house, but there is insufficient income or credit to roll over the loan. The homeowners file for bankruptcy, or the house goes into pre-foreclosure proceedings which become public record. At that point a "pink sheet" or distressed homeowner newsletter service prints their name and address, and the vultures start to circle.

Enter the "foreclosure specialist". The bailout artist, who targets unsophisticated and desperate people, approaches the homeowners with a scheme to "save the home". The homeowners are told that the home will be "sold" to a straw buyer but the homeowners will still continue to live in the home, paying rent to the straw buyer or the bailout artist. A portion of the proceeds are to be held "in escrow" to pay the mortgage, and after a year, "once their credit is repaired", the house will be sold to the original homeowner. "Bank Fraud" is never mentioned.

The homeowners are brought to a closing without an attorney. Usually, the bailout artist swipes a bunch of equity from the house using an inflated appraisal and lax underwriting standards through a check made payable to a shell company. The straw buyer is given a few thousand for his troubles.

The original homeowners make between one and six payments to the bank until the servicing is transferred to another entity on behalf of a pooled mortgage trust. The bills are not coming to the house and scammed homeowners have no way of knowing who the new servicer is, because the straw buyer and the bailout artist have moved onto the next mark. The homeowners try contacting their "friends" but they are long gone. The anxiety of the unknown begins to weigh down on them but they hold a shred of hope that the mortgage is still being paid through the "escrow" taken at the closing.

Six months later, a foreclosure notice is sent to the home, and all illusions are swept away with the realization that they are exactly where they were at the beginning - desperate, except they have lost the ownership of their home as well as any equity that may have been left had they sold to a real buyer, or even gone through with an auction.

To top it off, they are ashamed that they allowed themselves to be duped, ashamed to be called a deadbeat, when all they wanted was a home in a decent neighborhood where they could raise their children in peace and have "the good life". Many of them are ashamed, feeling that they were failures. I'm sure there will be commentators on the "blame the underwriters" side or weighing in on the "homeownership is not for everyone, why should we bail them out" so I don't need to get into it, suffice it to say that there is enough blame to blanket all of us.

This brings me to what I was doing on Friday. I was in Housing Court in Staten Island representing a couple who were caught up in one of these scams. I met with an attorney from one of the largest foreclosure attorney firms in New York State. She told me that their home office in Buffalo had opened another office in Long Island to deal with the volume of cases. On a sleepy Friday in August, her firm was representing 17 bank-owned properties as landlords seeking to evict their former owners. I use the term "bank owned" loosely because the banks were Trustees for these mortgage backed pools.

I've worked in the Housing Court for five years and I have never seen a higher proportion of bank-owned landlord tenant actions. This means that these houses, in New York City, are not selling at auction. If you have ever been to a courthouse auction in Brooklyn, there exists a core group of buyers with access to hard money lenders who will outbid an outsider just to shut them out. But now, even the hard-core distressed property buyers are sitting on their cash because they know that prices have farther to go. Sure, a condo in Manhattan will sell at auction, but there are plenty of foreigners with favorable exchange rates who think nothing of plunking down inflated prices for ugly handbags at Barney's.

But that is not your everyday reality. Once you leave the Never-Never land of Manhattan, the outer boroughs are feeling the same desperate pinch as other communities in the nation. I need to mention that in New York State, a judgment of foreclosure, from start to finish, takes an average of 400 days. That is real inventory, not imaginary Case Schiller inventory. That means that the pig is still making its way down the python.

I hear a lot of talk about how the economy has grown in the last year, but the equity markets don't seem to reflect that growth. It may be that the GDP figures that the government uses to project "growth" don't differentiate from these misery industries like foreclosure attorneys, sheriff's auctions, moving companies and distressed property managers from industries which bring stability to communities through steady employment, living wages and, well, positive endeavors. Yes, theoretically, the former Governor of New York patronizing a prostitute creates an increase in GDP, but that does not translate into an equivalent amount of economic wealth for the state and the nation. Kevin J. Phillips wrote a more eloquent article in the May 2008 issue of Harper's entitled "Numbers Racket: Why the Economy is Worse Than We Know."

There are certain optimists calling bottoms, and pessimists saying that the worse is yet to come. From my vantage point on the ground, it's not pretty, and it's not "growth".