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   ARTICLE   |   From Scotsman Guide Residential Edition   |   June 2007

Staving off Buybacks

As the market shifts, some lenders may be passing on loan buybacks to brokers

As the foundation of the nonprime-mortgage market becomes increasingly shaky, and as the players struggle to stay above ground, litigation among mortgage brokers, lenders, borrowers and even Wall Street investors has increased steadily. What litigation often ignores, however, is the depth to which mortgage-industry players are interconnected and the intrinsic benefit the nonprime industry provides this country.

The circumstances plaguing the industry, although not new, have caused the various players to take different approaches to solving the elevated threat to their respective bottom lines. Investors typically retain the right to demand that lenders buy back loans upon borrower default or other irregularity that would threaten a loan pool’s investment quality. In the past, because most lenders had enough capital to repurchase defaulted loans — and because the incidence of buybacks was not significant — they historically worked out the issues with borrowers directly.

Today, however, the greater instances of defaults in lower-credit-quality and nontraditional-mortgage loans have triggered provisions in whole-loan sale agreements that require lenders to repurchase large blocks of loans. This has driven many nonprime lenders into bankruptcy or out of business. In addition, buyback demands have resulted limited or closed warehouse credit lines.

Lenders that lack the capital to fund loan repurchases are turning to other parties — including brokers — in an effort to offload bad mortgage loans. Increasingly, lenders have filed lawsuits against brokers that allege breach of the broker agreement and that demand reimbursement and other damages stemming from the origination of defaulted loans.

To understand where we are today and the severity of the situation, it is essential to first understand the market that led us here.

Nonprime’s rise and fall

A skyrocketing real estate market and a rise in home values offered the perfect backdrop for the growth of the nonprime-lending market. Investors looking for high returns and low-credit consumers hoping for homeownership created the perfect storm. The result was a high-volume and fast-paced nonprime market that seemed to be heading for the stratosphere. According to the Federal Reserve, less than 5 percent of mortgage originations were nonprime in 1994. By 2005, this number increased to about 20 percent.

The nonprime industry evolved into a common business model throughout the U.S. mortgage industry. Borrowers with spotty credit were now offered nontraditional loans with high — and often adjustable — interest rates. Mortgage brokers aggressively solicited borrowers, and many lenders lowered their underwriting standards to meet the growing demand in the investment community. Lenders also received seemingly limitless financing from investment firms and banks in the form of warehouse credit lines, which were used to finance the individual loans. Investment banks pooled and securitized the loans, thus spreading each individual loan’s inherent risk.

All sectors benefited.

  • Borrowers with weak credit could buy homes.
  • Large institutional investors received high rates of return. 
  • Wall Street could offer another attractive and relatively stable investment to clients. 
  • Lenders received greater return on high-rate loans and higher compensation upon assignment. 
  • Brokers received larger fees from borrowers and because of the high note rate, they received substantial yield-spread premiums from lenders.

In an attempt to allocate the inherent risks, the players entered into various agreements with one another. Given each party’s relative negotiating position, however, the agreements were not always entered into on equal footing.

Because investment banks provided the money to fund these loans, their agreements with lenders typically required full warranties and indemnities and, in the event of default, loan buybacks. Some even had net-income requirements: If the lender failed to show positive earnings in any quarter, all loans would be subject to buyback, whether in default or not. In turn, some lenders imposed similar obligations on brokers, requiring brokers who originated a defaulted loan to buy it back.

In a flourishing market, these buyback obligations appeared innocuous, posing little risk to brokers whose relationships with lenders were lucrative for all concerned. But as the market tightened, and as an increasingly skittish investment community exerted pressure upon lenders, the agreements formed a litigation trend. They are the vehicle by which the players are now attempting to pass their losses on to one another.

A domino effect

In 2006, mortgage rates hit four-year highs, home-sale volume declined and home-price-appreciation rates decelerated. In some areas, home prices also fell, leaving the most-recent nonprime borrowers vulnerable to payment difficulties.

With the increase in nonprime delinquencies, the industry has faced a blow. With more borrowers defaulting on their mortgages and some investment banks taking significant hits on earnings because of their mortgage-backed-securities holdings, Wall Street has pressured lenders to buy back bad mortgages. Investors are using the repurchase agreements as grounds for insisting on these loan buybacks.

This pressure has a domino effect on the rest of the industry. Most lenders do not have the capital to buy back these loans. Therefore, some are suing mortgage brokers under the broker agreements in an attempt to cover the buybacks. In turn, some mortgage brokers are suing real estate appraisers and title companies in an effort to recover some of their losses.

Pressure also is coming from borrowers. Many nonprime borrowers who have found themselves unable to make their payments are suing lenders and brokers in an effort to avoid foreclosure or to receive restitution for some of their losses. Several Truth in Lending Act class actions — termed “rescission class actions” — have appeared against investment bankers and claim that these high-cost, high-risk loans would never have been made but for Wall Street’s lust for high-rate investment vehicles.

The effects of the troubled nonprime-mortgage industry also are felt across the nation’s economy. Because of their substantial holdings in mortgage-backed securities, some of Wall Street’s largest investment banks stand to suffer significant declines in earnings. Lenders are declaring bankruptcy or closing shop at alarming rates because of these buybacks’ financial ramifications. And mortgage brokers are left with fewer lenders and loan programs in which to place their clients.

Impacted most, however, are borrowers with spotty credit who now have fewer options available to pursue homeownership. Although some argue that bringing down the nonprime industry will benefit consumers, the nonprime market helped many people who would not have qualified for a standard mortgage purchase homes. A number of these people became success stories.

But the recent downturn in the nonprime-mortgage industry coupled with the lawsuits is causing lenders and brokers to stiffen their requirements, thus sharply reducing the number of applicants who can qualify for a mortgage.

A new type of lawsuit

Mortgage brokers are finding themselves in the middle of some of the lawsuits involving nonprime mortgages. In the past, when loans went into default, borrowers brought a lawsuit against the lender, the broker, the appraiser, the title company or the loan servicer.

The claims against brokers in those suits ran the gamut from breach of contract to tort claims for fraud and negligent misrepresentation to statutory claims for violation of state consumer-protection statutes and statutes regulating mortgage brokers. Those lawsuits also sometimes included tort claims not often associated with contract cases, such as intentional and negligent infliction of emotional distress. But mortgage brokers rarely were pursued unless there was evidence of blatant fraud or corruption.

Given the current environment, however, another type of lawsuit has emerged. In these new cases, some lenders that lack the financing to buy back defaulted loans from investors are suing the brokers upon whom their future stream of loan applicants depends. These lawsuits have been instituted throughout the country and include claims for breach of contract (based on the broker agreement), breach of warranty, fraud and negligent misrepresentation. Specifically, some lenders allege that brokers failed to verify the borrower’s information adequately and that brokers knowingly or negligently submitted false information about borrowers’ income, employment or intent to occupy the property.

Put simply, the lenders allege that they would not have underwritten certain loans had brokers done their job properly. In effect, lenders have taken the position that brokers, by signing the broker agreement, have warranted that the information provided is true and accurate — and if it turns out not to be, brokers, not the lenders, are responsible.

In defense, brokers allege that if they provided inaccurate information, they also were defrauded by borrowers. Further, brokers have asserted that lenders that charged borrowers an underwriting fee failed to follow their own underwriting policies and so were equally culpable for identifying false information in the loan package.

Even this most basic review highlights the gridlock that these lawsuits will inevitably create in the nonprime market. As the players become embroiled in litigation, they stop doing business with one another and instead spend scarce resources trying to hash the issues out in court.

Where do we go from here?

As of press time, lender-initiated lawsuits against brokers were pending in many jurisdictions, including Pennsylvania, Georgia, Washington state, California, Florida and others. These lawsuits typically seek damages for the default of one or more individual loans. The claims brought against brokers primarily are based on an alleged breach of a broker agreement. But some lawsuits also assert claims of fraud, negligence and the violation of state consumer-protection and broker-practices acts.

So long as the investment community exerts pressure on lenders and as the incidence of mortgage defaults continues to increase, the number of lawsuits against brokers likely also will grow.

Litigation, however, often is the most costly and least efficient option for solving the industry’s current problems. Mortgage brokers, lenders, home appraisers and title companies should work together — rather than sue each other — to find a way out of this web. They should cooperate with one another to negotiate with Wall Street collectively.

Many times, lenders knowingly made high-risk investments, and investors knew the loans they were buying went to borrowers with poor credit and a higher probability of being unable to make the payments. Investment banks encouraged lenders to extend loans using nontraditional terms and products to reach a larger market segment.

Investors cannot knowingly take a risk and then, when it falters, demand full recompense without taking any responsibility. A resolution of this national quandary likely lies on the federal regulators, not in courthouses.

In the meantime, there are practical steps mortgage brokers can take to protect themselves and their businesses. They must ensure that they are complying with the state and federal regulations that currently govern their industry. They also must keep abreast of the new regulations that change so frequently.

The regulations are complicated and often appear contradictory. State, regional and national organizations such as the National Association of Mortgage Brokers and the MBA are excellent resources for understanding what works and what doesn’t.

Most state regulators also maintain Web sites that contain the most-current state laws and regulations, as well as links to relevant federal regulatory Web sites, such as the U.S. Department of Housing and Urban Development’s Real Estate Settlement Procedures Act site (www.hud.gov/respa). Using an attorney at the outset to ensure compliance also can be effective.

Prevention is still the best medicine. Brokers also should review the contracts they sign with lenders to make sure they are worded carefully and clearly. There should be a provision in the agreement that affirms that both parties are responsible for performing due diligence and for undertaking their respective underwriting processes on each loan. Each party should be responsible for its own negligence or lack of diligence, but agreements should not place the responsibility for borrower fraud or misrepresentation upon brokers unless they knew or should have known. This will help reduce the risk of lawsuits down the road.

The broker agreements, as presently worded, tend to be one-sided and onerous, placing all liability in the event of default on brokers. But brokers are in no better position to buy back a defaulted loan than lenders whose lines of credit have dried up.

The parties must work together to ensure that a loan application is complete and accurate. Lenders and brokers have due-diligence obligations for which they are compensated. Fulfilling such obligations will minimize the likelihood of inaccurate or incomplete information in the loan package and thus the likelihood of future defaults.

Taking these extra steps will minimize the risk of future defaults and any future buyback demands that have dominoed and created the current chaos in the industry.

Attorneys D. Elaine Conway and Mary Schug of Lane Powell contributed to this article.

 


 


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