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   ARTICLE   |   From Scotsman Guide Residential Edition   |   March 2008

Measuring Borrowers in a New Legal Landscape

As underwriting-related claims enter the litigation stage, brokers are wise to listen up

c-2008-03_devlin_spotThe continued increase in lawsuits rooted in the nonprime crisis and the current regulatory proposals intended to address this crisis will significantly impact how and to whom residential mortgage brokers can make loans. Although compensation and licensing are issues in some of these suits and proposals, underwriting methods continue to be one of the most-significant areas of focus for brokers, the lawyers hired to represent them and the lawmakers charged with regulating them.

Underwriting is, in its fundamental sense, the establishment of criteria under which credit will be extended and borrowers’ ability and likelihood to repay a loan will be analyzed. A sharpened focus on underwriting is not surprising, given many regulators and industry professionals blame relaxed underwriting standards and the “originate to distribute” model as causes for the nonprime crisis.

Comptroller of the Currency John C. Dugan summarized this viewpoint succinctly while addressing the American Bankers Association this past Oct. 8:

“When a bank makes a loan that it plans to hold, the fundamental standard it uses to underwrite the loan is that most basic of credit standards … : The underwriting must be strong enough to create a reasonable expectation that the loan will be repaid … [B]ut when a bank makes a loan that it plans to sell, then the credit evaluation shifts in an important way: The underwriting must be strong enough to create a reasonable expectation that the loan can be sold -- or put another way, the bank will underwrite to whatever standard the market will bear.”

Most likely, brokers will feel the impacts of past underwriting tactics and new underwriting changes more than any sector of the residential mortgage market. In addition, underwriting standards accepted just a few months ago have resulted in lawsuits in which brokers are typically a prime target.

Going forward, brokers must be attuned to new legal requirements that may emphasize that there should be a reasonable likelihood of a borrower repaying a loan and that the loan should be suitable. Challenges and opportunities can arise from analyzing two types of current lawsuits, those related to loan buybacks and those related to race-based discrimination.

Buyback litigation

The past few years have seen a dramatic increase in the number of buyback suits, in which lenders demand that their brokers repurchase or indemnify them for bad loans. Frequently, these loans have featured an early payment default.

Although many of the loan products at issue in these suits have disappeared or exist in reduced capacity, they still can lead to litigation. Buyback suits are particularly unfortunate. They pit former business-partners against each other, forcing each to expend considerable time and money. Nonetheless, when certain high-risk loans become unmarketable or unattractive to hold on lenders’ own books, the lenders frequently view litigation against their brokers as a means to recoup at least some of their losses.

When brokers receive a buyback demand, they may want to know:

  • Why is the lender looking to us to bear the loss of a risky loan that it knowingly funded?
  • Will the lender remove our brokerage from its approved list if we refuse the buyback demand?
  • Do we have sufficient funds available to repurchase the loans at the amounts demanded?
  • How can we deal with unmeritorious buyback demands cost-effectively?
  • How can our brokerage reach an acceptable resolution with the party making the demand?

Some of the questions have easy answers, while others depend on circumstances. When a lender initiates a buyback suit against its broker, the lender typically asserts claims for breach of contract and the duty of good faith and fair dealing. Often, these claims are based on a written broker agreement between the parties.

Depending on the circumstances, the lender may also bring noncontractual claims, such as fraud or misrepresentation, and seek additional damages beyond the loan’s purchase price. For example, if the lender has had to borrow money itself to repurchase the loan from an investor, it will often claim the interest, fees and other costs associated with obtaining the money it used to fund its own buyback.

It also is important for brokers to know if the lender -- which may face buyback demands from investors or wholesale lenders -- has repurchased the loan(s) at issue. If not, or in case of a partial repurchase, brokers could establish that the lender does not have a sufficient legal interest in the loans to maintain the lawsuit.

Another important step is obtaining the subject loan products’ underwriting guidelines, generated by the lender or investor.

By reviewing the loan files, underwriting guidelines and other documents produced in an attorney’s discovery request, brokers can prove that they provided all the requested information to the underwriter and that the underwriter acknowledged receipt of requested information. For example, if there is an allegation that a broker provided inaccurate information about a borrower’s income on an application for a stated-income product, it may be possible to obtain income verification or other documentation that the lender received or was provided before closing. Thus, brokers can limit or avoid liability by showing that the party performing the loan underwriting knew or should have known of the alleged inaccuracies in the loan-application documents and that it decided to take the risk of funding the loans anyway.

Discrimination allegations

Recently, race has emerged as a factor in the evaluation of underwriting standards. A borrower’s race or ethnicity is part of the information that most lenders with offices in metropolitan areas must report in accordance with the Home Mortgage Disclosure Act of 1975 (HMDA).

HMDA data are intended to help determine if lenders are serving their communities’ housing-finance needs and to enforce federal fair-lending laws. The approximately 8,900 lenders subject to HMDA account for an estimated 80 percent of all U.S. residential mortgage lending.

In 2004, there was an increase in the amount and type of HMDA data publicly available. These included information about high-cost loans -- mortgages with annual percentage rates above certain designated thresholds. The HMDA data for 2004, 2005 and 2006 indicate that blacks and Hispanics were more likely to obtain higher-priced loans than non-Hispanic whites. Although HMDA data have limits, which can weaken this conclusion, the perception of racial inequities in the loan-underwriting process has still started to show up in court.

In recent months, Baltimore Mayor Sheila Dixon and the City Council filed suit in federal court against a large national lender, alleging that its lending practices discriminated against black borrowers and caused numerous foreclosures. The plaintiffs allege that this reduced tax revenues and increased the city’s costs. The city also contends that the lender made high-cost loans, with an interest rate at least 3 percentage points above a federal benchmark, to 65 percent of its black borrowers in Baltimore and to only 15 percent of its white customers in the area.

The plaintiffs further claim that refinances involving black borrowers were more likely to be at a higher cost and to involve prepayment penalties than were refinances for white borrowers. Finally, the city claims that the lender allowed mortgage brokers to charge higher commissions when they put borrowers in loans with higher interest rates than the customers qualified for based on their credit profiles. In sum, Baltimore claims that the lender failed to underwrite mortgage loans to traditional criteria, setting up the borrowers for default.

Baltimore seeks to recover unspecified damages to redress the diminished property-tax revenues and higher costs it claims it incurred, such as those for fire and police protection in neighborhoods hard-hit by foreclosures and default.

Race and underwriting also have appeared in class-action litigation. The National Association for the Advancement of Colored People (NAACP) has filed a class-action complaint against a number of lending institutions “in the business of issuing [non]prime mortgage loans.” In its complaint, the NAACP claims that the defendant mortgage lenders “are engaged in institutionalized, systemic racism” because “African-American homeowners who received [non]prime mortgage loans from Defendants were over 30% more likely to receive higher rate [non]prime loans than Caucasian borrowers with the same qualifications.”

The NAACP alleges violations of the Fair Housing Act and the Equal Credit Opportunity Act, as well as racial discrimination under 42 U.S.C. §§ 1981 and 1982. The stated goal of the NAACP’s lawsuit is to enjoin the defendant lenders from continuing their “discriminatory practices, to compel their compliance with applicable federal law, and to ensure Defendants’ continuing compliance with applicable federal law.”

Understanding the existence of the suits and complaints is wise for brokers in today’s environment.

•  •  •

Although uncertainty remains, underwriting standards will be an area of regulatory and legislative emphasis in the months and years to come. For example, the Federal Reserve’s proposed regulations have included the requirement that lenders demonstrate borrowers’ realistic ability to afford the loans they obtain. Similarly, the Mortgage Reform and Anti-Predatory Lending Act of 2007, House resolution No. 3915, has required the same. However these shape up, it is likely that a return to more-traditional and -conservative underwriting practices will be a major feature.

As the national residential mortgage market attempts to recover from the nonprime crisis and likely begins a move back toward more-traditional underwriting standards, the market will continue to deal with a variety of lawsuits. These suits’ outcomes will turn, directly and indirectly, on the nontraditional underwriting standards prevalent in the nonprime market.

Recently filed class actions and lawsuits based on federal civil rights laws are focused on how race played a role in the underwriting and making of residential mortgage loans. The host of legislative and regulatory changes poised to enter into force will create a new playing field for mortgage-lending lawsuits and change underwriting for all players in the mortgage industry.  


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