Aftershocks of the Housing Crisis

I didn’t expect to find a paper in the American Bankruptcy Law Review that has such a strong social justice element—though, admittedly, this is not a publication I read regularly. But this paper—Randomly Distributed Trial Court Justice—written by my colleague Gary Neustadter, chronicles the legal aftershocks of the housing crisis and demonstrates both that there is still money to be made from the poorest of those affected by the mortgage crisis and that how they fare in our court system seems entirely random.

Gary’s paper meticulously tracks what happened to a set of mortgages bought on the secondary market that were then subject to suit in bankruptcy court. The loans were bought by Heritage Pacific Financial, LLC, and the complaint Heritage made hundreds of time was the same: that the borrowers had fraudulently misstated their incomes, and, as such, that the borrowers could not discharge their mortgage obligations in bankruptcy court.

All of these suits should have failed. Under California law, Heritage bought only the mortgages, not the underlying fraud claim. Because the legal claims Heritage made were exactly the same for each case, they should have prevailed zero times. But they didn’t. We should be concerned about two things: that the wrong result was ever reached in spite of the law’s clarity, and that the results varied among identical cases. This was a natural experiment that shows that even the results from a court case—the gold standard, not a second-best substitute like arbitration—can change based on the judge, who is represented by counsel and who isn’t, and the like. Some of the results are predictable and depressing, but others were surprising: defendants who represented themselves, for example, obtained “no payment” settlements at a slightly higher rate than those with counsel (36 percent to 31 percent).

So why didn’t anyone discover that the claims were baseless until Gary looked at them? The reasons, in Gary’s view, are systemic. A defendant who wanted to make a substantive challenge to Heritage’s claim would have had to pay her lawyer to investigate the legal and factual basis behind it. Heritage, on the other hand, just had to write one complaint and simply substitute names, addresses, and amounts. Heritage was the repeat player, with economies of scale. Perhaps individuals just wanted a lawyer to make the problem go away. Given the risk that a defendant might pay for research that fails to uncover any good defense, leaving her stuck with the cost of damages and the additional legal fees, it might be rational at the individual level to simply roll over and settle.

More ironies abound. For those defendants that did fight Heritage, there was a colorable claim that Heritage’s argument was so without merit that it could be held liable for the defendants’ attorney’s fees. This was, in fact, the ruling in three cases. No one was able to collect, however. After collecting from other defendants, Heritage closed up shop and declared bankruptcy.

The paper is long and, at times, fairly technical. The story it tells, though, is incredibly important. It’s not enough for the law to be on your side—you have to have the resources to hire a good lawyer to find the argument to make it. I’m not sure that’s such a happy story about our legal system, but I sure am glad someone took the considerable amount of time and energy to tell it.

[Cross-posted at The Reality-Based Community]

David Ball

David Ball is an Associate Professor at Santa Clara School of Law. He writes and teaches primarily in the fields of criminal law and criminal procedure, with a special focus on sentencing and corrections. He also serves as the Co-Chair of the Corrections Committee of the American Bar Association.