Preventing a Return Engagement: Eliminating the Mortgage Purchasers' Status as a Holder-inDue-Course: Properly Aligning Incentives Among the Parties

Abstract

I divide this paper into three relatively brief parts. In Part I, I recount the factual dynamics that created the perfect storm leading to the current foreclosure miasma. I pay particular attention to the transfer of mortgages on the secondary market as either MBS or CDOs and the differing incentives that the mortgagor (principal), originator/lender (agent), and transferee/principal have at the time the mortgage is executed given the current state of the law. In addition, I briefly trace the development of exotic mortgage devices-adjustable rate mortgages (ARMs) or variable rate mortgages (VRMs)-and their misuse by mortgagors, paying particular attention to the complexity of the transaction and the cognitive dissonance that occurs when these transactions are completed. I demonstrate that mortgagors enter into these mortgages with inadequate and incomplete knowledge of their terms because of the incentives originators have to execute and complete mortgages at whatever cost given their value and transferability on the secondary market. I conclude this part with a focus on the role of the assignee as principal in purchasing the mortgage from its agent, the assigning originator, and the lack of incentives the principal has to police the original transaction between the mortgagor and originator.

In Part II, I address two possible solutions to the foreclosure miasma that, at first glance, seem warranted to resolve the current and future foreclosure miasmas. First, I address the claim that the way to preclude any future crisis is to eliminate exotic financing devices. Although the elimination of exotic financial devices would preclude most instances of originator misconduct, I ultimately conclude that such a broad remedy is both hurtful to the very class of individuals it is designed to protect and unnecessary once incentives are provided to the originators to be truthful about the costs and effects of exotic financing devices.

In the latter part of this section, I address the related claim that one way to resolve this issue is to eliminate the transferability of mortgage notes by eliminating the secondary market for mortgages. As one might guess, the elimination of the secondary mortgage market would have disastrous consequences on the liquidity and availability of mortgages, and should be avoided at all costs. Instead, I argue that assignees can play a very valuable role as monitors of originators' efforts and should be viewed as part of the solution, rather than as part of the problem. By eliminating their status as holders-in-due-course, these transferees, in search of positive investment returns, will be more selective with respect to the notes they invest in.

Part III picks up where Part II concludes and asserts that the only way to properly incentivize transferees to establish an appropriate principal-agent relationship with originators, and to properly monitor those agents, is through a two-step process. The first step requires the elimination of the holder-in-due-course status as it applies to the transferees of notes initiated by originators. The second step requires the increased use of the doctrine of unconscionability by aggrieved mortgagors who have been induced to contract for unperformable mortgages by originators engaged in predatory lending practices. I focus on the formation of the contract that leads to the execution of the note and the mortgage securing the same and, subsequently, the remedy that is deployed when a mortgagor successfully brings an action claiming that a contract is unconscionable. By doing this, I show that courts have the power to reform these unconscionable contracts in a fashion that allows the mortgagor to retain their home by reducing their mortgage payments to an amount approximating the payment in the original term.

This power of reduction (via the judicial use of reformation) ex post will limit the assignees' income from their investment, and will provide the assignees with the appropriate incentives to police originator behavior in a way to preclude unperformable (unconscionable) mortgage contracts. Finally, I defend the core thesis of this Article that the transferee, rather than the government or the mortgagor, is the most efficient regulator and monitor of the transaction that takes place between the mortgagor and the originator. By correctly aligning the transferee/assignee's interest with those of the originator, transferees will have an incentive to monitor the behavior of the originator, a monitoring role that cannot be filled by the mortgagor given the complexity of the transaction.