May 29, 2008
Liar Loans and Bankuptcy Discharge
Posted by Fred Tung

Judge Leslie Tchaikovsky, a bankruptcy judge in the Northern District of California, has issued a whopper of an opinion holding that a mortgage lender on a stated income loan is not entitled to rely on the "stated" income in the loan application for purposes of bankruptcy discharge. 

A stated income loan, of course, is a loan where the borrower "states" her income without also being required to document the amount of said income--e.g., cough up pay stubs.  Whether the lender could "reasonably rely" on the stated income is critical to the question whether a debtor may discharge the debt in bankruptcy.  Section 523(a)(2) of the bankruptcy code precludes the discharge of certain debts procured by fraud.  In this case, the lender would have had to reasonably rely on the false statement of income in the debtors' loan application, in order for the debt to be deemed not dischargeable.

The mortgage loan at issue was an equity line that was underwater and rendered unsecured after the first mortgage lender foreclosed on the debtors' house.  Judge T. apparently did not believe the debtors' protestations that they unwittingly signed the false loan app.  However, the lender didn't get any sympathy either.  Not only did the judge question the reasonable reliance of the individual lender, but she questioned whether industry guidelines on stated income loans were objectively reasonable.  The minimal verification for stated income loans suggests that they're essential asset-based loans--loans made in reliance only on the value of the collateral!

Now, this seems intuitively right to me.  Personally, I never liked the term "liar loan."  I know perfectly respectable borrowers and lenders who engage in these stated income deals--especially for purchase money mortgages--with all parties understanding that it's really the big downpayment that enables the deal.  When it gets to equity lines, though, it starts to look more speculative.  Especially in the actual case, the debtors' last credit extension from the lender was a $50,000 extension on their HELOC--from $200K to $250K--six months after the HELOC was first made.  This extension relied on an appraisal that showed a 9% increase in the value of the house over six months.  Not that appreciation like that is impossible in some parts of NorCal, but it seems pretty aggressive nonetheless, especially for a no-doc loan.

Big win for borrowers--even undeserving ones, as the case illustrates.  As if things weren't ugly enough in the mortgage and residential MBS markets.  OTOH, separating deserving from undeserving borrowers may be cost-prohibitive.  Even good debtors are likely to have trouble footing the bill for nondischargeability litigation, so that as a practical matter, many good but wealth constrained debtors would end up settling on disadvantageous terms.  As between informed banks and the mixed pool of deserving and undeserving debtors--depending on your assumptions about the mix--it's probably better to put the costs on the lenders, both on fairness and efficiency grounds.

HT to Tanta at CalculatedRISK.  As far as I can tell, the decision has not yet been published.  But keep an eye out:  In re Hill (City National Bank v. Hill), United States Bankruptcy Court, Northern District of California, Case No. A.P. 07-4106 (May 28, 2008).

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