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   ARTICLE   |   From Scotsman Guide Residential Edition   |   August 2007

How Contracts Can Lead to Buybacks

Facing regulatory scrutiny, lenders are passing the buck — literally — to brokers

Not long ago, mortgage lenders demanding that brokers buy back “bad loans” essentially didn’t exist. Today, however, they are becoming more common.

Although many factors contribute to the increase in buyback demands — from an increase in fraud and default rates to concern about predatory-lending practices — a major motivating factor has been governmental guidance and warnings to lenders.

In May 2005, the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of Thrift Supervision and the National Credit Union Administration jointly issued guidelines to home-equity lenders. Lender credit-risk practices, they said, failed to keep pace with the rapid growth of loan products and the easing of underwriting standards.

The agencies’ credit-risk-management guidelines admonished lenders to have adequate audit procedures and controls to verify that third-party brokers are not paid to generate incomplete or fraudulent mortgage applications. The regulators also said lenders must monitor the quality of loans by origination source, in addition to uncovering early payment defaults and incomplete packages. In addition, the guidelines cautioned lenders to retain oversight of all critical loan-processing activities conducted by mortgage brokers and to take appropriate action when they uncover irregularities.

In turn, some lenders have acted by enforcing loan-buyback clauses in their contracts with brokers. Brokers face increased liability and increased demands for loan buybacks from lenders, not to mention a potential financial strain. For brokers, it’s paramount to understand lender contracts and how buybacks can come into play.

What it means to brokers

For mortgage brokers, lender contracts, in a word, mean liability. When mortgage brokers sign these agreements, they are basically guaranteeing they will buy back a loan if the lender discovers a misstatement, is required to buy back a sold loan or cannot sell the loan for any reason.

For example, say borrowers misstate their income with a stated-income, no-verification-of-assets loan. A lender can use the borrowers’ misrepresentation as a basis to require the broker to repurchase the loan. In addition, brokers may be liable for the accuracy of an appraisal, statement that a property is intended to be owner-occupied and other borrower declarations on a 1003, such as being current on debts and the amount of debts.

Even if there is no evidence that the mortgage broker has done anything wrong, these buybacks can happen. Often, this is because the agreement provides that brokers warrant that as of the date the loan closed, all submitted information is accurate — including the borrower’s representations. Although there is no requirement to verify any information, these agreements hold brokers liable for inaccuracies.

A common example of representations and warranties is the representation that all documents the broker provides — including borrower tax returns, uniform residential loan applications (1003s) and appraisals — are true and correct regardless of the independent review by the lender.

The liability isn’t just a matter of an infrequent loan fraud perpetrated by a rogue loan officer in collusion with a borrower. It often results from often-burdensome contracts between mortgage lenders and brokers that insulate the lender from its own underwriting and quality-control shortcomings.

Lender/broker contracts also use words such as “warranty,” “guaranty” and “representation” to describe the assurances brokers provide regarding the fundamental criteria for making a loan. These agreements can hold brokers liable for misrepresentations even if the lender independently underwrites or investigates the file.

A defense may be feasible in jurisdictions that adhere to what is referred to as the “context rule of contracts.” Under this rule, a court may consider evidence outside of the contract itself to determine what the parties intended when they entered the agreement. For example, it can be argued that the lender must not rely on the broker’s assurance of a borrower’s income when it is a no-income-verified loan. This rule lets the court consider the meaning of words such as “warrants” in the context of the agreement, not strictly according to the dictionary definition.

What brokers can do

To protect themselves against the possibility of buybacks, brokers should first read the agreements and determine if the warranties, representations and assurances in the contract are realistic. If they are not, then request that the language be changed. Some lenders will accept deletion of entire clauses.

Review new agreements, renewals and existing contracts carefully. Some attorneys offer a form addendum to existing agreements that can modify the language in question. You may send a modification addendum to the lenders with which you are already in contract — and be prepared to negotiate changes.

In addition, increasing your internal quality controls can help minimize the likelihood of misrepresentations. It also is beneficial to educate all loan originators in your company about the risks of the loans they are doing. Not only is might your company risk buying back bad loans, but individual loan officers also are at risk for civil damages — and in cases where fraud is involved, they can risk criminal charges. Write indemnities and warranties into the agreements with loan officers so they know about and participate in risks associated with their conduct.

Finally, consider approaching your national, state and local trade associations to lobby for change within the industry.

•  •  •

For brokers, the solution to the buyback dilemma can come from:

  • Quality control and monitoring of the product you offer to reduce risks where possible;
  • Avoiding personal guarantees of lender contracts; and
  • Negotiating changes in the language of the wholesale-lender contract.

Buyback demands are the latest threat to mortgage brokers’ business stability. If brokers don’t react to this threat, they must start preparing to deal with loan buybacks.


 


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