MBA: Quirky, Inconsistent State Mortgage Laws Could Benefit from Standardization

The recent crisis in housing with its attendant foreclosure issues has underscored how different the laws relating to consumer protection, foreclosures, professional licensing and other issues surrounding real estate and mortgages vary from state to state.  Now the Mortgage Bankers Association's Research Institute for Housing American (RIHA) has released results of a study which explores how different some of these legal characteristics are and how they came to be.

"The Historical Origins of America's Mortgage Laws" by Andra Ghent, Assistant Professor of Real Estate and Arizona State University's W.P. Carey School of Business, examines the differing legal frameworks for foreclosures, redemption rights, and deficiency judgments in different states and focuses on how and when they came into existence.  

Ghent says that differences between title theory and lien theory underlie many of the differences from state to state.  If a state follows title theory, the lender retains title to the property until such time as the borrower pays off the mortgage while under lien theory, the borrower owns the property during the duration of the mortgage and the lender's interest in the property is limited to situations in which the borrower defaults on the mortgage.

Despite at least four distinct attempts over the last century to create a uniform mortgage code the author says mortgages today continue to be governed by a very diverse set of state laws with older states much more likely to have adopted title theory from the English system.  There is some tentative evidence that title theory may also have a role in circumventing usury law.

States also differ in whether the standard real estate security instrument is a mortgage or a deed of trust. With the latter the legal title to the property is entrusted to a third party known as the trustee. Unlike a mortgage where there are only two parties, there are three parties in a deed- of-trust transaction and the trustee sells the property if the borrower defaults. In states that follow the lien theory of mortgages, the equitable title nevertheless remains with the borrower. The main reason some states use a deed of trust rather than a mortgage is because, when lenders began including power-of-sale clauses into mortgages, some judges viewed it as improper for the lender himself to be able to sell the property.

Some states require the lender to go to court and receive a judge's approval to foreclose while in others the lender may sell the property himself if the mortgage contains a power-of-sale clause or, in the case of a deed of trust the trustee is obliged to sell the property on the lender's behalf. States that allow the lender to sell the property without a judge's approval are known as nonjudicial foreclosure states.

Another state by state variation is in redemption rights which allow the borrower to redeem the property by paying off the entire balance of the mortgage. A redemption period is the time frame during which the borrower has redemption rights. When the period precedes the foreclosure sale they are equitable redemption rights; when they follow they are known as statutory redemption rights. Because statutory redemption rights cloud the title of the property for prospective buyers at the foreclosure auction, they are arguably more problematic for lenders than equitable redemption rights.

The equitable right of redemption had become quite a nuisance for lenders by the time mortgages became commonplace in early America and there has been a tendency for states to shorten or reduce redemption periods since the 1930s.

Unlike their British counterparts, American lenders could bid at a foreclosure sale and were often the only bidders.  They could bid far less than the debt or fair market value of the property, leaving borrowers liable for the deficiency.   The possibility that the borrower would both lose both his property and owe a substantial deficiency judgment in excess of his true debt if the lender bid less than the debt eventually led states to adopt rules about fair market value being paid at foreclosure sales.

Those states that did not have fair market value rules in place by the Great Depression soon enacted them and many states tried to enact similar laws preventing the lender from pursuing the borrower personally for a deficiency.  In some states courts held these anti-deficiency laws unconstitutional while in others they were upheld. 

Ghent points out that differences in mortgage laws have real consequences. For example, foreclosure is much slower in judicial foreclosure states.  This may increase the number of foreclosures by extending the free-rent period. Even if judicial foreclosure affects only the timing of foreclosure, rather than affecting whether foreclosure even occurs, a prolonged foreclosure process may delay recovery in the housing market. And differences in state foreclosure laws affect loan size. Other studies show that state laws that restrict deficiency judgments increase the risk of foreclosure.

In summary Ghent says, "There do not seem to be clear economic reasons for the different patterns of development in America's mortgage laws. With the exception of anti-deficiency statutes, mortgage laws seem to be the outcome of path-dependent quirks in the wording of various proposed statutes and decisions of individual judges. Rather than responses to differences in economic circumstances, mortgage laws are extremely slow to change. While slow adjustment of laws is perhaps necessary to maintain the integrity of the rule of law in a common law legal system, the result is a diverse set of laws that seem poorly suited to a mortgage market that is increasingly integrated across state border"

Mike Frantantoni, RIHA's Executive Director said that Ghent's research "shows that, historically speaking, mortgage laws in this country are not the result of intentional design, nor were they necessarily driven by a consistent set of economic events or circumstances.  As a result, there may well be significant gains from ongoing efforts to harmonize these laws across the states."