The Law of Mortgages - Part 2: The Crash
The following is a rough transcript of this podcast episode together with sources imbedded as links:
My name is Nathan Green, and I am a practicing lawyer.
This is the second part of a multipart podcast series on the law of mortgages. In the previous installment I talked about the history of mortgages. In this installment we are going to discuss how mortgages are actually enforced and we are going to talk about how massively impactful mortgage rules are.
And in any conversation about the sharp edge of the stick that is mortgage enforcement there is an interesting piece of mortgage trivia that should be brought up, what the word mortgage means.
Mortgage is the combination of a latin word, mort, meaning death and a French word, gage, meaning pledge. A mortgage is, literally, a death pledge. Why was it called that? Honestly after researching this a bit I don’t know. There are two popular explanations but neither one is very satisfactory to me and I have my own theory, I’ll tell you all three and let you judge.
The first theory is the most common; basically that a mortgage is called a dead pledge because the pledge dies upon it being paid out in full. The refutation to this is that this is true of every pledge. They all exist until they have been satisfied.
The second explanation is that young lords would borrow money and pledge to repay it upon the death of their father and them inheriting the estate. I like this one better because it plays into my mental image of young lords and its more… well morbid. The problem with it though is that the very heart of a mortgage is that it is secured against land. Until a lord actually took possession of the family estate he couldn’t create a security interest in it.
I have a third theory as to the meaning of the word. I couldn’t find anything beyond these two explanations when I did my research but if a mortgage is a dead pledge it must contrast with a living pledge. And that phrase I did find referenced in a parliamentary briefing memo. In old property law there used to be a distinction between the fruit a tree produced, and the tree itself. This makes a great deal of sense for an agrarian society but to our modern way of thinking not so much. In fact my property law book talks about an anchient thirteenth century method to secure a mortgage, where the borrower gives the lender a lease for a dollar a year, and the lender then gets the revenues the land produces during that year. This scheme has an interesting side benefit in that it might avoid questions of Usery and religious prohibitions on lending for interest.
Anyways in the briefing memo I found a living pledge seemed to relate to the fruit of a tree (or the product of a machine, or the crop grown on land, it’s the idea the product as opposed to the producer). And if you imagine it that way, one way of borrowing where you are secured against the product, the fruit, of the land… live… and another where you are secured against the land itself, the underlying title… dead… that makes sense.
In fact in the next podcast we are going to talk about Sharia lending and this is one of the distinction sharia lending attempts to make.
Anyways, I think if asked which of these three theories is my favorite, even though the third is mine and probably hits the most bases in terms of offering a full explanation, the rich son borrowing against the death of his father is just too good to ignore.
In either case we will go into the details of enforcing these dead pledges in this podcast and you will see, some of them can be deadly. We will also talk about how tiny changes to the laws in this area can have huge impacts on the global order.
Specifically there are two sentences in a piece of Canadian legislation called the Interest Act which may have created a situation as dangerous as the United State’s 2008 real estate crisis, and no one is talking about them.
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Disclaimer
This is not legal advice
The information here in any form is for entertainment purposes only.
You should not rely on or take or fail to take any action based upon this information.
Never disregard professional legal advice or delay in seeking legal advice because of something you heard here.
This is not legal advice.
This is not legal advice.
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I’m going to start with a gross over-simplification that skips several important pieces of legislation and common law principles and say that there are, generally two ways to enforce a mortgage against land, a forced sale and a foreclosure. To understand the difference between a foreclosure and a forced sale, which I’ll call a power of sale, you need to understand one of the quirks of Canadian, Australian, English, and American law. The split between legal rights and remedies and equitable ones.
Here is the elevator pitch: back in the old days if you wanted a court order saying someone had to pay you X dollars you went to a court of law. If you wanted a court order saying someone had to DO something, like give you title to their land, or stay away from you, you had to go to a court of equity.
Longer story.
Today we are all kind of familiar with the common law system. We all know that if a judge settled something earlier, then the court is supposed to do the same thing if the case comes up again. The latin term is Stare decisis. We might say precedent.
By the way. Law has a lot of latin phrases res ipsa loquiter, stare decisis, per deum, ad hoc, actus reus, bona fide.
How do you pronounce them? With confidence. They don’t have a day at law school, at least they didn’t at mine, where they bring in a linguist who teaches you how to say this stuff. You say it the way your professors say it, and they all say it a bit differently.
Now maybe they bring in a linquist at Harvard. What I do know is that Latin is a dead language. Linguists actually use historic examples of old puns, misspellings in graffiti, and that kind of thing to figure out how these words should be pronounced. However if you want to actually say one of these phrases the odds that you are saying it to a linguist, or someone taught by a linguist who can convincingly say you are wrong, is basically zero.
So as long as you are using them correctly, saying them with confidence, and following basically the standard pronunciation, no one will ever call you out on it if you say bona fide vs. bona fidA.
One of my processors at law school had a habit of having one sentence in each lecture that contained both a latin pharse, and a French one (and you do have to make sure the French is pronounced correctly). You ever want to sound a lot smarter than you are, toss out a sentence like this:
“At the time there were criticisms that this was simply an ad hoc response, however in retrospect it appears that this was deliberately laisez faire.”
Anyways, back to old common law. There was a time in England when the idea of stare decisise, precedent being set by old judgements, got to the point that courts were getting tied into a codified system. A+B+C=D and it doesn’t matter whether there is also an X, Y or Z involved. Things got to the point where the crown had to start hearing appeals from these courts and making special exceptions to the rules when it was just to do so.
For example. Let’s say I agree to sell you my car, it’s a white Ford Bronco. But the day before I sell you the car OJ Simpson borrows it to drive to the airport. Suddenly my old ford bronco is worth WAY more than it’s blue book value. So I refuse to perform the contract and offer to pay you the difference between the value of a white ford bronco in the blue book and the purchase price you were going to pay (say 50 bucks). The courts of law would have said that is the correct outcome.
But our contract was for THAT car, and it turns out that car is worth a lot more than I agreed to pay for it. I should be able to force you to give me that car, not the value of some identical car. So you appeal to the courts of equity, you want specific performance of the contract.
When mortgage lenders tried to get title to the property, they were seeking an equitable remedy, specific performance. They didn’t want their lost profits, they wanted the land.
The split is important because it means that if we have a mortgage contract I actually have a choice of which court I go to. If I go to an equitable court I can get the land. What happens if I go to a court of law?
This is the second broad remedy to lenders. They can go to a court, get an order for X dollars in damages, then have the sheriff seize and sell the land, and pay the X dollars out of the proceeds of the sale, with any remainder going back to the borrower. This is called a power of sale.
In my legal system the courts of law and equity are merged. A judge can dispense both kinds of orders – which is just a wonderful simplification of the system.
In any event… The phrase, the spoiled children of equity… That really applies more to the equitable remedies being sought. As such it is typically easier for a lender to get a power of sale than it is for them to foreclose, or take title themselves.
There is an interesting consequence of this however. In a foreclosure the basic idea is to exchange the debt for the land. You could owe a dollar on a million dollar property and the lender gets the million dollar property free and clear. On the other hand what if you owe a million dollars on a property only worth a dollar? This is known as being under-water on a mortgage. And if the lender forecloses (depending on your jurisdiction) they might be extinguishing their debt.
A power of sale however preserves the debt (again depending on your jurisdiction) and if there is not enough money in the land to satisfy the mortgage, penalties, interest, legal fees, in full… you would still typically owe it.
From a lender’s perspective then going power of sale has a lot of advantages. Its faster than a foreclosure typically, it lets you preserve your debt regardless of property values, it lets you bypass a lot of common law craziness.
A lot of people listening to this right now are saying “well that isn’t how it works!” And you are all absolutely correct. In some jurisdictions a mortgage lender isn’t allowed to pursue a borrower for debt after taking the house regardless of if by foreclosure or power of sale. I am sure there are jurisdictions where foreclosures are prohibited at law and only powers of sales can go ahead. I am sure in some jurisdictions when they say foreclosure they mean the same thing I do when I use the words power of sale. I’m sure there are jurisdictions where a person who forecloses can’t take the equity left in the property above their debt. Just in Canada and the USA we have over sixty different jurisdictions and each one is going to have its own little twists on what to call things, and what the rules are. And those sixty jurisdictions ignore the sub-jurisdictions that might exist if there are special rules for native land, retirement communities, veterans, etc. etc.
This podcast is a bit of an experiment for a lot of reasons, but one of them is that I am still struggling to find a way to talk about what I think will be of interest to you, the big broad strokes of law. While at the same time those broad strokes often include some detail that is specific to one legal order or another yet I find those things deliciously interesting and am hoping that you do as well. As I have tried to think of how to do this, the thing I wanted to avoid was spending ten minutes talking about the big Canadian case for some proposition of law, and then ten minutes talking about the big New York case on the same proposition that went the other way, and then five minutes talking about what underlying issues the cases had in common, and what was different. That kind of thing exists in academic commentary but I`m not sure how entertaining it would be. Odds are if there was a market for that a lot of people who be subscribing to academic journals together with newsweek.
I had a professor in law school who used to say that the law was always changing, and it is, if you pick up a law school text book a shocking number of the cases in it will be from the 30 years immediately before the book was published – which means that most senior lawyers never got taught the majority of the law that applies to their practices in law school. What my professor said law school does is teach you how to think like a lawyer. And that is absolutely true. Law has a certain unchanging logic to it where issues are dissected and ordered, and that doesn`t change.
For example. You loan someone money. You secure that loan against the person`s house. If they default on the loan you have recourse to the underlying asset. But what if the asset is worth more than the debt? What if the asset is worth less than the debt? Regardless of what your local rules are, there must be an answer to these two questions, and I am letting you know what the original common law answer to those questions was. Except even that isn’t really true, because it isn’t like there was a moment the common law came into being and this was rule 1. Rather at some arbitrary point in the past when mortgages looked mostly like what a modern mortgage looks like these were the basic options (subject to a huge number of twists and qualifications) and our current legal system kind of grew off these things in the way dogs might all have a common ancestor regardless of breed. But something came before that common ancestor and that common ancestor mated with other things along the way as the family tree started to really branch out.
The specific legal system you live in can have different names for these things, and different rules for how these things are handled, and there is certainly room for reasonable people to disagree on what should happen in these different situations. But the logic always stays the same. It is a bit like being a plumber. The kind of pipes you use, or the kind of material to join those pipes, could change from place to place. But everyone needs their plumbing to perform the same basic functions. Clean water in, dirty water out, and generally water runs down.
I hope that makes things about as clear as mud.
You can’t really talk about mortgages and social policy without talking about the 2008 sub-prime mortgage crisis in the united states. This is such a politically charged topic, and I like talking about politics far too much for my own good, that I am actually a bit afraid to go into it as I would like this podcast to be as non-partisan as possible. However everyone should agree that the surface cause of the 2008 crash was people defaulting on their mortgages, and those defaults not having been properly anticipated by the market.
There were other things that certainly qualify as a cause. There was a huge amount of fraud happening. There was stupidity and bad behavior by wallstreet, banks, mortgage writers, ordinary people, etc. I don’t want to get into the politics of this and there are certainly arguments on all sides of the political spectrum when it comes to who is to blame. But the fundamental issue was that people did not pay their mortgages and the “system” was based on the premise that they would.
There were really two kinds of mortgages at the time that contributed to this. The first was called a sub-prime mortgage. Which was basically a mortgage made to someone who couldn’t afford it. A “prime” borrower would be someone who was basically guaranteed to pay back to loan taking into account the amount of the loan and the person’s income. A sub, or below, prime borrower… Anyways the thinking was that house prices will always go up, so what does it matter if they can’t afford the mortgage? They can just sell the house for a profit if they get into trouble with monthly payments and everyone wins. Did you hear the phrase Ninja mortgages? NINJA – No income, no job.
The other kind of mortgage that was relevant to all this though was called an ARM, an adjustable rate mortgage. This is a mortgage where there is an initial period, several years long, where the interest rate is low. You sign a 20 year mortgage and for the first five years say you pay 1% interest, and then it goes up to 5% for the remainder of the term.
Michael Burry, who was featured in the big short, figured out that people had borrowed huge sums of money using these ARMS and when the interest rate went up they wouldn’t be able to afford the new payments, and would default on mass.
Now, the united states has very long term mortgages. Many people borrow with the intention of keeping the same mortgage for its life and after 20 years or so owning the house outright.
I write this in March of 2017 when many people say Canada is in the midst of a real estate bubble much like the United States of 2008.
There are a lot of differences between the American and Canadian real estate markets. But there are also a lot of similarities. And one of the big similarities comes from the Interest Act which was passed in the 1800s.
The interest act contains a short provision, two sentences long, that says any mortgage can be prepaid after its fifth anniversary for a penalty that is no more than three month’s interest.
Now I said a minute ago I liked focusing on the broad strokes, and here I am talking about a piece of Canadian legislation that doesn’t apply anywhere else in the world. Why should you care? Why am I zooming in on one jurisdiction? Because I want to show you what it is like to be on the other side of 2008, and I want to show you just how sensitive and large the mortgage market it.
The 2008 crisis showed us how interconnected global finance is, but if you imagine that massive, sensitive, interconnected web, from a systemic level how significant should a single country’s laws have to be in order to influence that web? You would intuitively think that the web should be resilient enough that minor, superficial laws in a country wouldn’t impact it, and that the big laws that could influence it should all be very carefully considered and identified as having this potential.
It is easy, after the crash, to say “well of course that had to happen” but when prices are going up quickly, everyone is making money, and the nay-sayers are hearing things like “he predicted 15 of the last 2 recessions” you start to emotionally understand why it is so difficult to objectively look at the systems we set up. Of course we can look at failures and say this is why something failed, but before it fails can we look at a piece of public policy legislation and objectively ask whether it is going to lead to a crash?
It is easy to be right in retrospect. It’s like the kid who checks the answer in the back of his text book and goes “oh yeah, I knew that, obviously”. But I think something very weird is happening with the Canadian housing market and I think this rule is both contributing to it, and going to play a role in things going very bad for Canada when the crash happens.
We will talk about how, but the point of this isn’t that I am right. I’m probably wrong, I’m not a macroeconomist, I’m just a guy who is a bit too interested in the law and society. But the point is you can make a reasonable argument for a seemingly benign law leading to significant bad consequences, and that when considered in advance that reasonable argument sounds like holding a sign on the street reading “the end is here”.
So, back to Canadian mortgage rules. The Interest Act made it so that after five years, the maximum damages for ending the mortgage early is three month’s interest penalty.
Let’s unpack that a bit. First let’s understand what is meant by a five year mortgage. If you have a 500K mortgage on your house we don’t mean that your payments are 500K divided by five years. The amortization of the loan, the notional idea of how long it would take to pay if you just make your monthly payments, that is still 20 years, 25 years, whatever. A five year mortgage means that at the end of five years you have to pay the bank back and get a new mortgage. Most people just get a new mortgage with the same bank and the whole thing is pretty transparent.
Let’s unpack it a bit more now. Why this rule? Well lots of people want to get out of mortgages for a variety of reasons. Sometimes they want to sell their house to move, to upgrade, to cope with the loss of a job. Point is, they might be seven years into a twenty year contract and want out. Actually for the banks this type of situation is generally self-correcting. If you are a big bank and someone has a mortgage with you and wants to move or upgrade to a bigger house you can just transfer the mortgage. This actually happens a lot even on mortgages shorter than five years. The bank doesn’t have to do it necessarily, but let’s say it is pretty common for them to anyways and everyone wins.
The other situation you might want to get out of a mortgage is if interest rates are falling. This is the more problematic situation from the bank’s perspective.
Lets say you are a bank and I sign a contract with you to borrow a million dollars for twenty years at 10% interest a year. Depending on the payment schedule the bank might get back as much as $2,000,000 in interest over the life of that loan, which is great for the bank.
As soon as that contract is signed on my financial statements I would also show a million dollars in cash coming out, and a contract, worth 1 million in principal and a further 2 million in interest, goes onto my books (less some adjust for present value).
In ten years, if something happens and I don’t get repaid, I have to take a loss on my books.
Now, ordinarily it is actually pretty hard for the bank to actually take a book loss on a loan. If I loan you a million dollars on a property it is probably worth 1.5 million. If the day after you sign the mortgage you refuse to carry on with it. I sue for damages. What would I get?
The standard in law is that we want to put a party into the same position they would have been in had the contract been performed.
So I get my million bucks back, I get my legal fees (as the contract says I do), I also get my lost profits. Now the courts are not stupid. They won’t just give the bank 2 million in lost interest, because the bank could turn around, take its million dollars, and lend it to someone else and make their 2 million that way. What the bank is entitled to is its costs to re-lend the money, plus the time gap it takes them to find a new borrower and the reduction in interest they can get.
So, if interest rates drop. My borrower asks why he should be paying 10% when he can borrow today for 5%. If the bank has to relend to someone else, the best they can now do is 5%, So they have to make up that 5% for 20 years, or a million bucks. Before the Interest Act, subject to other things, the bank could insist on being paid its lost interest. After the Interest Act’s five year rule, they were capped once five years had passed, which is really just another way of saying they were capped on any mortgage longer than five years.
What is the bank’s profit on a 20 year mortgage if, after the first five years, it can be cancelled for a fixed sum payment? Impossible to say. It would be X if the contract were honored, it would be Y if the contract were not.
Now I was not in the board rooms of Canada’s banks for the years and decisions that followed. But, I do not think it is a coincidence that today the longest mortgage being generally offered in Canada is on a five year term.
Why does this matter? It matters because, because of two sentences in the Interest Act, a few years after you buy a house, get a mortgage, and start making your payments, you are going to have to repay mortgage 1 and get a new mortgage, mortgage 2, on new terms.
Why does that matter? Because after five years, or three years, or two years, your new mortgage can be for a completely different amount than the first, at a completely different interest rate. It opens the entire agreement up for a total rewrite. It makes every mortgage written in Canada worse than an adjustable rate mortgage. With adjustable rate mortgages the future interest hike was generally known, not anymore. With adjustable rate mortgages the amount of the loan couldn’t change. Not anymore. Worse than an adjustable rate mortgage it makes them adjustable rate mortgages that can be called if house prices drop.
Imagine this, today in Canada the average home in the GTA is a million dollars, with 200,000 in equity, your money that you brought in as the down payment basically. At 3% interest your monthly payment is about 4,000, give or take. Now that is serious money, after tax money too because Canada doesn’t allow mortgage interest deductions. But it is doable, and if you want a million dollar home that seems like a pretty reasonable sum all things considered.
But Interest rates are at historically low levels. If inflation were at 2%, and the bank had some kind of risk cost in making a loan and some kind of administrative cost on top of that, it is hard to imagine them making more than a half or a quarter of a percent in profit on that loan.
What happens if in five years interest rates go up to 5%, what happens if they go up to 7%? That would be a perfectly normal interest rates by historic standards. At 5% monthly payments would be about $5,500. At 7% monthly payments would be about 6,800.
Imagine a family struggling to make the 4,000 a month payment. Where are they supposed to find an additional 1,500 a month, where are they supposed to find an extra 2800 a month? You can’t free up that kind of money from your budget by shopping at the cheaper grocery store and cutting out restaurants.
More significantly though, what if house prices drop because of rising interest rates making monthly payments higher? What if people don’t buy a house based on the price, but based on their monthly payments?
If that happens the bank is under no obligation to lend again when the term of the mortgage is up. Every five years everything in the mortgage changes, the interest, the amount the bank is willing to lend you, the only thing that stays the same is how much you owed…
If you paid a million dollars (with 200K of your own money and 800K of the banks) on a house now worth 750K, the bank could very well say they are only willing to lend 600K, and want their first 800K back. What then?
This is worse than an adjustable rate mortgage. In an adjustable rate mortgage you don’t have to requalify for the loan, the amount of the loan doesn’t change, the lender can’t ask for the loan to be repaid (absent a default of course), and you generally know what the terms of the mortgage are for its life.
I’m going to argue that the 2008 crisis was, at its most basic level, caused by a failure of the public or policy makers to understand what that a mortgage, as originally envisioned was a way to borrow against a property already owned. Today a mortgage is a way to finance a purchase. And when you are using a loan to finance a purchase there are always going to be two parts to that, one part is the simple finance element, but the other part is a leveraged investment.
It is easy, too easy, to think of a mortgage only as a secured loan. In fact however it is also the only leveraged investment the average person will ever make.
Let’s say you buy a house worth 500k and over three years its value goes up to 600K. That’s great, six or seven percent a year growth. But six or seven percent growth on what? If you have 100K of your own money in the house, and the other 400 is the bank’s money, you have doubled your 100K. You didn’t make 6 or 7%, you made 33%. Why? Because you didn’t just invest your money, you invested the bank’s money too. You made their money work for you.
For stocks this is called leverage. In the USA if you want to borrow the bank’s money to buy stocks regulations limit you to 1:1. You have a dollar, the bank can lend you another dollar. In Canada right now you can get a house with 10% down, or a 9:1 leverage ratio.
Why is there federal regulation capping leverage ratios for stocks at 1:1? Because it is crazy dangerous to borrow money to put into the stock market. Let’s say you could leverage yourself 9:1 in stocks just like real estate. You take your dollar and borrow 9, so you have ten bucks. You buy stock in IBM. If the stock goes up great. But if it goes down, at all, 5% say. You don’t lose five cents, you lose 50. If the stock goes down 10% your dollar is gone. If the stock goes down 25% you lost your dollar and you lost 1.50 of the banks and you owe it to them.
You are probably saying that I have this completely wrong, that a house is not an investment, it is a financed purchase. You make your monthly payments and you won’t have a problem and at the end you will own the house free and clear (no matter what it is worth).
But that is exactly my point. If we are talking about buying your primary residence, on a twenty year mortgage with a twenty year amortization where you just make your payments as set out and the interest rate is known in advance, then yes a mortgage looks very much like a simple financed purchase.
The five year rule for mortgage penalty payments resulted in the banks making most of their mortgages five years or less. When you buy a house you don’t just have to make your monthly payments, every five years you have to find someone willing to lend you enough money to pay back the bank for what it was owed and enter into a whole new contract, at a new interest rate, for a new amount.
A once every five year opportunity for the bank to say “actually the house isn’t worth that much anymore, so we will only loan you half.”
Or, and this is also perverse, once every five years the bank to say “listen, the value has gone up. Money is cheap right now, why not take some equity out of the house and take your profits.”
Think of it like letting your money ride on black at a roulette wheel. You can win a spin once, twice, three times, four times, five times, but eventually you have to lose, and just one loss will take all your original chips and all your winnings to date.
And people aren’t just doing this for their primary residences, they are buying “investment” properties. There is very little argument that this is a financed purchase at that point, and really it looks much, much, more like leveraged investing.
This is exactly what a mortgage is now. You buy a million dollar house with 100K in cash and you are making a 9:1 leveraged investment hoping that real estate prices do not decline.
In the United States the ARM mortgages had it right there in black and white, after x years payments go up to Y. It is hard to feel sympathy for people who didn’t read that language, but the bank couldn’t make a margin call. If you had a 25 year mortgage they didn’t get to ask for their money back or you to put more into the house. You just had to keep making your monthly payments.
And that is how a simple little rule that says you can pay off your mortgage after 5 years, made every mortgage in Canada structurally more dangerous than the USA’s pre financial crisis adjustable rate mortgages. I think we have better systems and our borrowers are better able to pay their debts, but I’m talking the structure of the system.
I think it is one of the interesting flaws of our modern world. Our economy is so efficient, our professionals so educated, that once the rules of the system are set the one who adapts fastest, the one who adapts the most perfectly, the one who can turn a complex, multi-factored problem (assessing the credit worthiness of a borrower, the value of a house, and the risk of default) into some efficient to apply and “good enough” formula, well they win. They win quickly, they grow quickly, and pretty soon the entire economic ecosystem has been taken over in a Darwinian evolution. Yet how will this animal, perfectly adapted for is current environment, fare when the environment changes? Will it be resilient and adaptable? Or will it find itself, like the dinosaur, unsuited for the new reality of the world?
And for those of us interested in public policy, how can you look at a rule that is 125 years old now, as this five year mortgage payment rule is, and say that it was a mistake? How can you look at the success our system had in avoiding the worst of the US excesses, and say it still has fundamental problems. Am I just wrong? I’m a lawyer not an economist. I’m taking wild guesses about why things are the way they are in Canada. But how can we have systems that identify where the system has become too well suited to its current environment and can’t survive an upset?
One of my favorite phrases is that sometimes you don’t have to be right, you just have to be not wrong. I might not be right about any of this. But I think I have made a plausible argument for why I’m not wrong. And isn’t that in and of itself enough to ask some very scary questions about our mortgage system?
In the next podcast in this series we will delve into the world of sharia lending, and if you thought western rules about mortgages were influenced by the past… hold onto your hats. Thank you for listening, and remember, as always, This is not legal advice.