09/18/2012 10:59 am ET Updated Sep 19, 2012

Liar's Loans

Repeat a lie and it becomes truth.

A great lie is repeated as the cause of our current economic crisis, and it prevents us from dealing with reality.

In the current economic crisis, one of the favored explanations of our plight is the term "liar's loan." The term rolls of the tongue and provides a convenient explanation for the wave of defaults on residential real estate loans. It is posited that bad people, doing bad things, resulted in a bad result. The explanation puts the blame on greedy, lying homeowners and lenders who were ready to close their eyes for momentary gain.

The only problem is that when held up to analysis, the "liar's loan" explanation has little to do with our current financial crisis, particularly in California.

Let's go back to basics. A real estate loan is an asset based loan. An "asset based loan" looks to collateral for security (here, the collateral is the residence that secures the loan). While the borrower's credit is certainly a consideration, in the lenders' world, the lender looks to the collateral as its primary guaranty for repayment.

In the logic of the lender, an asset based loan recognizes that there may be defects in the borrower's application or bad things that could put the borrower in default, but the collateral guaranties the lender's return.

While the borrower may keel over tomorrow with a fatal heart attack, or lose his job or suffer another of the ordinary risks of life, in making the loan, it is the lender's expectation that the collateral (the real property) will make it whole. For the most part, where the loan is made properly with realistic appraisals of the collateral, it usually a great business deal.

"Loan to value" is the key in an asset based loan (that is, the ratio of the value of the collateral to the amount loaned). The basic assumption of the real estate market of recent years was that an appreciating real estate market would justify loans, even with a small down payment.

The upward march of the market justified and vindicated real estate loans, even with a nominal loan-to-value at the inception of the loan. The expectation was that, even with a leveling out of the real estate market, even in the event of default, the lender's expected loss would be minimal and manageable by recourse to the collateral.

In the search for villains as fall-guys for our economic collapse -- the media and Congress, liberals and conservatives, Republicans and Democrats -- have attached themselves to the "liars' loan" explanation. It is repeated that if all these bad people had not lied on their loans to buy a home, everything would be OK. It's convenient, but as noted, if the borrower's ability to repay the loan is secondary to the security of the loan, the "liar's loan" canard does not make sense.

At least in California, one of the primary problems with the "liars' loan" explanation lies in California law. In California and many other states, a lender has no recourse against a borrower on a failed residential real estate loan. Without going into all the technicalities of the law, the short of it is that if a lender forecloses on the loan by taking back the collateral (i.e., filing a notice of default and selling the property at a foreclosure sale without filing a lawsuit), the lender cannot obtain a deficiency against the borrower. If the lender takes the collateral, the lender is without any further remedy against the borrower.

In simple terms, the "anti-deficiency" laws say that the lender's only recourse is against the collateral and the lender cannot seek a" deficiency judgment" against the borrower. (A "deficiency judgment" would be the difference between the value of the collateral on sale and the amount due on the original loan, but for the most part, in practice and in California law, no such deficiency is allowed.)

The truth of the matter is that the collapse of the real estate market destroyed the assumptions that normally supported residential real estate lending. In California, Arizona, Nevada and many other states that are hard hit by the collapse of the real estate market, real estate values have imploded. As we know, in areas like the Inland Empire of California, residential real values are less than half of what they were only a few years ago. Even in more solid areas, the normal cushion of a down payment of twenty percent would not be sufficient to guaranty the lender protection from loss.

As a concrete example of the current problem, take a typical residential loan in the Inland Empire, Palmdale or Lancaster. Assume that the buyer put down say ten percent on the purchase of a home valued at $500,000. Currently, the value of that home is probably something on the order of $200,000. Even if the buyer had misstated his income, the misstatement is largely irrelevant to the lender's loss. The collapse in the value of the residence securing the loan destroyed the lender's assumption that it can be made whole by recourse to the collateral.

Taking our example one step further, in many cases, the borrower received an ARM (adjustable rate mortgage) or another loan where optimistic assumptions about the economy and the real estate market were key to the borrower's ability to repay the loan. In the current market, the borrower is attempting to repay a loan where he is unlikely to ever realize in the near future the value of his purchase. With the added weight of an upward adjustment of the interest payment on the property, there is little incentive (in fact, disincentive) for the borrower to remain in the property.

For most borrowers, given a reasonable payment schedule, the borrower would prefer to stay in the home and to continue making payments on the property. Given the bleak prospect of ever recovering the original purchase price and the burden of a payment schedule made more difficult by higher interest rates in the case of ARM loans, the borrower has little alternative, but to walk away.

For the lender, default is a house of cards. On default and foreclosure of the loan, the lender accelerates the spiral of declining real estate values and creates an unfriendly market for sale of the collateral.

A cooperative solution would be for both the borrower and lender to share the pain of the decline of the real estate market. Borrowers are ready to accept the burden of continued payments if given relief from the terms of the original loan, but lenders need to lighten the burden by accepting some share of the loss, accepting a modification of both the terms of repayment and the principle balance. For the most part, borrowers are powerless to change the equation, but with lenders control of the levers of power, lenders have mostly refused to accept their share of the problem.

The "liar's loan" explanation is a convenient explanation for our current problems, but as a false statement of the problem, it sets us in the wrong direction. In the Angelides commission hearings and the Levin Senate hearings, the "liar's loan" refrain loomed large. The vilification of borrowers and of loan officers who processed the original loans continued. President Obama has hued to the conventional wisdom in his insistence that only "responsible" borrowers will receive relief from their defaulted loans.

Unfortunately, until we are ready to accept a truthful analysis of the current problem, we will not be able to provide a realistic solution to our current dilemma. We need to put aside fault finding with easy explanations like the liar's loans and address the current reality that all parties have been hard hit by a tsunami of declining real estate values.