May 20, 2016
By Dennis H. Doss
John had read in the newspaper that the company that sold him a “borrower payment dependent note” had recently failed. A judge had appointed a trustee (a really expensive lawyer) to run the company. He wasn’t surprised. Their huge IT apparatus and complex web platform meant there were a ton of mouths to feed, a host of computers to churn out code and a big rent check that needed to be paid every month. John put his feet up and relaxed. He knew a good borrower when he saw one. The borrower he was paired up with was solid gold; never late. The collateral for the loan was income producing and the loan-to-value ratio was absurdly low.
So it came as a bit of a shock when John received a letter (on obviously expensive paper) from the (obviously expensive) court appointed lawyer:
As you may have read in the press, I was appointed by the courts to oversee the liquidation of the company that issued borrower payment dependent note number 12345 (“BPDN”) to you. Unfortunately, no further payments will be made while we collect the mortgage loans the company owned and process the claims of its many creditors. I realize that the borrower paired to your BPDN may be faithfully paying but I would like to remind you that you did not lend money to this individual, you lent money to the company I am now liquidating. Your claim for payment will be on par with hundreds of general creditors of that company. Please be patient as this process will take many months, if not years. We apologize if this results in any inconvenience.
“Inconvenience,” thought John, as he put his feet down in a stupor. After a few minutes staring at the ceiling, stunned, he got up and slowly walked toward the cabinet containing his favorite 25 year old scotch. As he took his first sip, it dawned on him– he could no longer afford what he was drinking.
Ask any Bureau of Real Estate deputy—the pages of mortgage history in California have page after page detailing mortgage companies that failed holding title to mortgage loans after giving their private investors unsecured promissory notes. Many of the mortgages these companies made were good loans; others not so good. But because the investors held nothing more than unsecured or poorly secured promises to pay by the failed mortgage company, and the mortgage company had title to the mortgage loans themselves, the investors were thrown into the pot of the company’s unsecured creditors and consequently lost most of their money.
Peer-to-peer lending isn’t new. Peer-to-peer lending occurs when one non-professional investor lends money to a borrower. Traditional peer-to-peer lending has been the backbone of the private money industry Doss Law has represented for 39 years. It was going on well before that.
The Real Estate Law has evolved to prevent failures from repeating themselves. To protect investors who provide peer-to-peer financing, the Law requires persons who sell financial instruments tied to the performance of mortgage loans to have a real estate license. Business and Professions Code Section 10131(d) and 10131.1. It contains many other protections, learned though the pain of past failures. First, the broker must vest ownership in the mortgage loan into the investor’s name in the official real estate records. (Sections 10233.2 and 10234). Secondly, it requires a special notice to the BRE if a broker borrows money from his or her clients. (Section 10231.2). While not prohibited, it is highly discouraged and consequently the notice usually triggers a BRE audit. After all, brokers like lawyers, are supposed to faithfully represent their clients, and borrowing from him is an inherent conflict of interest. Third, in our State, the law requires mortgage brokers to vet the suitability of mortgage investments before taking money from their clients. BRE Form RE 870 is used for this purpose. Lastly, brokers are required to put any money they collect from their clients’ investments into to a trust account subject to quarterly reports and an annual audit submitted to the BRE.
Legitimate mortgage funds like those that Doss Law creates are an exception to direct vesting. But there, title to the loans is vested in the name of a wholly investor-owned entity. The loans are usually collected by a third party servicer. The pool manager’s assets are separate and distinct from the fund it manages. If the broker fails, the members simply hire a new manager.
If the BRE and Department of Business Oversight read this article I urge them to enforce existing licensing and disclosure laws to bring the issuers of borrower payment dependent notes into compliance with the law while the real estate market is still healthy. Your other licensees are following your rules and deserve a level playing field. These new kids on the block don’t deserve any special treatment because they have put a high tech spin on a practice you know has historically resulted in disaster. From a disclosure standpoint, these companies should be telling their buyers: “You aren’t investing in the mortgage you selected with care; you have invested in us. Your payment is not dependent on any borrower’s payment. It is dependent on us having enough money to pay you. If we fail, you will likely lose all of your money.” If they sell a product tied to the performance of a real estate assets, they should have a license and follow the same rules the law abiding clients of Doss Law follow.
Our bottom line take on borrower payment dependent notes: you can put a new dress and lipstick on this pig but at the end of the day you are still kissing an ugly pig.