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Garn Act

DEFINITION

The Garn Act was enacted in 1982 order to strengthen lenders’ ability to enforce due-on-sale clauses.

EXPLANATION

Throughout the 1970s, the economy in the United States was hurting due to skyrocket inflation rates. In many instances, interest rates went above 20 percent, causing loss of earnings, investments, and a retraction in the economy. To alleviate the pain consumers and business were feeling due to the high interest rates, the government had to act.

The government passed the Germain Depository Institutions Act of 1982, also known as the Garn Act, to help alleviate the negative economic conditions. This legislation was enacted into law by congress and signed into law by former president Ronald Reagan. The whole purpose of the act was to reduce the burden imposed on banks and insurance fund agencies to help them offset losses and reduce the cost of lending.

Purpose of Garn Act

When the Federal Reserve increased interest rates beyond what was affordable for consumers, the cost of borrowing was made more expensive for lenders and consumers. It became more expensive for lenders because they had to pay out higher rates to borrow money. This subsequently increased the cost of borrowing for average consumers.

The Garn Act deregulated the mortgage market and allowed lenders to provide lower interest mortgage rates including those to borrowers with lower credit ratings. This deregulation of the loan market initially increased economic activity and ultimately reduced the cost of borrowing money. Its purpose according to President Ronald Reagan was to “ensure availability of home mortgages.”

Mortgages make up a significant percentage of overall borrower debt, therefore the need for reduced interest rates was vital. While the act certainly achieved its goals of reducing overall interest rates, opponents claim that it was a short sided strategy that reduced the overall quality of loans because of loan deregulation.

History of Garn Act

The mid to late 1970’ marked a period in the United State’s where inflation increased as the cost of goods, services and gas increased substantially. The Federal Reserve sought to reverse this trend by increasing the federal reserve rate, which caused banks to increase their rates dramatically. While the Federal Reserve felt the need to increase rates to combat run away inflation, unfortunately it adversely caused the growth rate and borrower’s abilities to afford mortgage payments.

Traditional banks were among the hardest hit group as they could no longer approve borrowers for mortgages at reasonable interest rates. The problem was banks depositors were earning higher interest than the interest banks were making on their mortgage debt issued prior to the increases in the federal rate. Lenders were losing money because they were offering more money to depositors than they could make off lending. This caused many lenders to be put out of business.

The following are exceptions to a due-on-sale clause:

The creation of a lien or other encumbrance subordinate to the lender’s security instrument which does not relate to a transfer of rights of occupancy in the property;

The creation of a purchase money security interest for household appliances;

A transfer by devise, descent, or operation of law on the death of a joint tenant or tenant by the entirety;

The granting of a leasehold interest of three years or less not containing an option to purchase;

A transfer to a relative resulting from the death of a borrower;

A transfer where the spouse or children of the borrower become an owner of the property;

A transfer resulting from a decree of a dissolution of marriage, legal separation agreement, or from an incidental property settlement agreement, by which the spouse of the borrower becomes an owner of the property;

A transfer into an inter vivos trust in which the borrower is and remains a beneficiary and which does not relate to a transfer of rights of occupancy in the property; or

Any other transfer or disposition described in regulations prescribed by the Federal Home Loan Bank Board.

Pros vs Cons

Pros

Many previous government imposed regulations and restrictions dating back to the Great Depression were removed to incentivize smaller asset managing companies to generate bigger profits.

Cons

Although the intent of the act was to save banks and thrifts from going out of business, ultimately in many cases this did not occur. There were many instances where insurance depositors tried to salvage struggling banks from going out of business at virtually any cost. This kind of recklessness increased Insurers losses which led to a good number of these banks not surviving as a result. Eventually these losses led to another legislative bill being enacted known as the the FDIC Improvement Act of 1991.

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