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   ARTICLE   |   From Scotsman Guide Residential Edition   |   June 2008

Tracking the Perfect Storm

The liquidity crisis has led to more buybacks, litigation and a return to full documentation

The housing market and mortgage industry have changed dramatically in the past year. Much of the fallout came from the increase in stated-income loans during the mortgage boom. Further, with stated-income loans, the rate of mortgage fraud increased, as borrowers often inflated their income to qualify for a greater loan amount.

As a result, the volume of mortgage delinquencies is at a historical high. Further, conventional wisdom dictates that one- to four-family residences will continue to depreciate at an unprecedented rate, and the economy will suffer a recession.

This unfortunately creates the perfect storm that likely will lead to more delinquencies and foreclosures, spurring quicker residential depreciation. It is a snowball effect with no end in sight.

Further, there has been much fallout from these events. Litigation has increased, with more mortgage lenders requiring originators to buy back defaulted-upon loans. Scratch-and-dent lending is on the rise, as brokers lacking liquidity to buy back loans turn to other sources. And more brokers now originate only fully verified loans, as many lenders no longer accept or fund stated-income loans.

Here’s a look at how each of these affects the mortgage environment for today’s brokers.

The impact of fraud

Many mortgage lenders are looking for reasons to find others to bear the losses that result from delinquencies. In master loan-purchase agreements (MLPAs) between lenders and originators, which were standard through 2007, originators make representations and warranties about the loans they originate. These state that the items in the loan files are accurate and true.

If there is a breach of any representation or warranty, a lender may require originators to repurchase -- or buy back -- the applicable loans at a price that would help it recoup its purchase price, all accrued and unpaid interest, and other incurred costs and expenses to preserve the asset.

Further, when a loan becomes delinquent, lenders will spend the time and money to review the mortgage file meticulously. It’s often not difficult; mortgage fraud has been a pervasive breach of the representations and warranties in MLPAs, regardless of whether the originator knew of the fraud.

Mortgage fraud includes any material misrepresentation borrowers make on their mortgage loan application, including inflated lengths of employment, false job titles, false occupancy, inflated home values, omitted debts, false assets and inflated income.

Many stated-income loans can contain some income exaggeration. Therefore, allegations of material breaches of representations and warranties have grown exponentially, leading to actual and potential lawsuits. Defenses are almost nonexistent; however, some defense attorneys have alleged that the lenders themselves were at fault by creating guidelines that allowed for stated-income loans in the first place.

The scratch-and-dent boom

Regardless of these lawsuits’ outcomes, repurchase obligations have led to a liquidity crisis in the mortgage industry. Brokers typically do not have enough cash to buy back the loans and cannot borrow enough cash. Thus, an industry of scratch-and-dent lenders has begun to flourish.

These lenders arrange to buy nonperforming loans at less than par -- or less than 100 percent of the loan’s unpaid principal balance. The originator makes up the difference. These differences likely will amount to billions of dollars. With this much at stake, litigation likely will increase precipitously.

Scratch-and-dent lenders often find ways to liquidate the loans profitably, such as a loan refinance or resale or foreclosure of the home. To maximize revenue from such liquidations, lenders need a mitigator with default-management skills, including loan-origination and real estate owned liquidation expertise and experience. Many loan-servicers lack this personnel because a full refinance used to be the solution for these issues.

In addition, because so few loans were delinquent, loan-servicers often were willing to reduce their fees to historically low levels to service more loans. Thus, many servicers, still bound by these agreements, don’t have enough capital to find, hire, train and manage default managers and loss-mitigators.

These issues have led to lawsuits for servicing-agreement violations, which almost universally contain language requiring that loans be serviced “in accordance with proper, prudent and customary practices in the mortgage-origination and servicing business.”

Stricter underwriting

Increased fraud, defaults and buybacks also have led to stricter underwriting guidelines. In addition, lenders now spend a lot more time, effort and money ensuring that there will be no breaches of the representations and warranties in a loan-purchase agreement. Loan-origination costs have therefore skyrocketed.

At the least, lenders now require significantly more homeowner equity in purchase and refinance transactions, compared to earlier this decade.

Although the outcome of this change is unclear, it would not be surprising if protected classes of borrowers -- such as the elderly, women, blacks and Hispanics -- feel the effects. These groups may have lower home equity, lower income or worse credit histories. If so, litigation in these areas also could increase.

The reset effect

More than $500 billion of adjustable-rate-mortgage loans are estimated to reset this year, according to the Wall Street Journal. These resets likely will lead to significantly higher interest rates and payments for borrowers.

Fortunately, this payment shock is capped by ceilings on the amount by which an interest rate may increase at each adjustment date. Nevertheless, many borrowers cannot bear the increased payments, which likely will lead to more defaults, more foreclosures and greater residential depreciation.

To avoid the inevitable litigious mess from an increase in defaults, many mortgage brokers now only originate loans for which they can fully verify the data. Therefore, the number of stated-income loans likely will drop significantly. Further, they typically will only be funded when originators find other evidence of the income, in which case they will no longer be true stated-income loans.


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