Mortgage Repurchases In A Changing Enviornment

...Plus Forensic Servicing Reviews

“The Securities and Exchange Commission pressed JPMorgan Chase & Co. to tell investors more about mounting demands to buy back defective mortgages, an obligation that cost the four biggest U.S. lenders about $5 billion last year. The SEC asked the New York-based company to disclose more about reserves set aside to cover the cost of repurchasing bad loans it sold to Fannie Mae, Freddie Mac and other investors, according to a Jan. 29 letter released today. The SEC also told the bank to provide more details on when and how it recognizes losses on mortgages that have been modified as well as on soured credit-card debt.

‘What they’re asking for is a lot more than the banks put out in the public domain right now,’ said Christopher Whalen, a bank analyst at Torrance, California-based Institutional Risk Analytics. “This is going to make life uncomfortable for a lot of the banks, because once they start mandating this kind of disclosures, it’s going to stay.” ¹

So begins a June 17, 2010, Bloomberg article. In recent months the condition of the mortgage repurchase market has changed dramatically. In this piece we will explore the state of mortgage repurchases, what the driving forces are, how the advent of forensic servicing reviews has changed the landscape, how the players are reacting to the current forces, and where the movement is going.

HISTORY
The suggestion of an originator repurchasing a delinquent mortgage loan from the investor is not new. In the 1970s, before the advent of conventional mortgage-backed securities, an active market existed for whole loans and participations between savings and loan associations nationwide. Typically if a borrower became delinquent, the originator would repurchase the loan at the original price plus interest. Originators usually did not reserve for these potential liabilities. The thinking at the time was that the offer to repurchase was not contained in the documentation, so it was not official. In addition, for the most part, instances of delinquencies – and potential “buy-backs” -- were limited. The industry had not suffered overwhelming instances of delinquency. . .yet.

With the advent of the “whole loan” and conventional mortgage securities markets in the late 1970s and beyond, standard Purchase and Sale Agreements provided for repurchase if an individual loan was found to be in breach of the Representations and Warranties contained in the Agreement. Generally speaking, the format and wording of these so-called “standard” Agreements has not changed materially in 30 years, especially as relates to the potential repurchase of individual loans.

What has changed is the experience of delinquencies across the entire spectrum of loan types, property location, documentation type, borrower eligibility and a host of other factors which drive mortgage payment performance. Instances of mortgage delinquency and failure increased monumentally with the advent of the “mortgage meltdown” and succeeding international financial crisis. This has caused a major swell in mortgage repurchase demands from every corner. Investors, originators, servicers and other players who never imagined, or planned for, such huge numbers, are devoting increasing resources to their efforts to either demand or rebut repurchases. Indeed, many companies have gone out of business, had to post huge reserves, or come under fire for not posting adequate reserves.

FREDDIE/FANNIE
As early as 2006, mortgage loan originators of all types, large and small, banks, brokers, mortgage companies and Wall Street-sponsored firms, began to feel the sting of the mortgage repurchase predicament. While repurchase demands began almost immediately, it was a drop in the bucket until late 2008, when Freddie Mac and Fannie Mae began to experience enormous losses.

Think of it as a “trickle-down” effect: a lender originates a loan and sells it to Freddie Mac or Fannie Mae. The loan does not perform as expected. Freddie Mac or Fannie Mae has securitized the loan and they may elect to “buy the loan back” out of the security. In order to offset their losses, they investigate the individual loan for underwriting or documentation errors, program violations or outright fraud. They then pursue the original lender in order to make themselves whole. . . . Now multiply this by thousands and thousands and you have today’s climate.

One lender tells us that they are currently receiving an average of 100 repurchase requests per week from Fannie Mae alone. It isn’t difficult to see that the situation is escalating rapidly and we’ve probably not yet seen anything near the peak. Increasing repurchase issues are beginning to plague the balance sheets of large and small lenders alike.

Fannie Mae published a February 26, 2010 Lender Letter -- “An Introduction to Fannie Mae’s Loan Quality Initiative” ² saying that they “conducted an extensive analysis to determine the primary drivers of repurchase requests and [are] launching the Loan Quality Initiative (LQ1) to identify and implement policy, process, and technology enhancements to improve the compliance with underwriting and eligibility guidelines and mitigate repurchase risk.” It appears that, with this Loan Quality Initiative, Fannie Mae is making an attempt to prevent a situation in the future like that which precipitated the unprecedented repurchase surge that we are now experiencing. One cannot help but make an observation and an inquiry: everybody knows that the primary drivers of repurchase requests are delinquencies and – what if they had decided to do this in 2005 instead of 2010?

FORENSIC SERVICING REVIEWS

An area of recent interest is “forensic servicing reviews.”

According to Orange County, California attorney Michael Pfeifer, a nationally-recognized expert on mortgage repurchases, “Servicers that did not originate these loans, yet are currently servicing them, are not immune to the threat of repurchase. Many investor agreements make no distinction between seller and servicer in the representations and warranties they are required to make regarding each loan. So, when these are breached, both seller and servicer can be liable. Moreover, many of the problem loans on which repurchase demands are now being made could have been worked out or refinanced if their defects had been recognized early enough by diligent servicing.” ³

You’re faced with continued mortgage repurchase demands. Before you agree to buy back the loan, wait. . . .

Has the servicer performed all of its fiduciary duties diligently and completely, including but not limited to:

• Adherence to all federal, state and municipal regulations?
• Scrupulously upheld all investor policies and procedures to the letter?
• Adopted and implemented all mandated modification requirements?
• Followed all MI guidelines?
• Performed ARM adjustments properly?
• Applied and disbursed escrows appropriately with all funds accounted for?
• Investor reporting and remitting performed in a correct and timely manner?

According to Pfeifer, “Another relevant question to raise is whether the party demanding repurchase has performed all of its obligations under the contract. Nonperformance by the party demanding repurchase often occurs in the critical area of post sale and default servicing.

This is particularly important when loans are sold servicing-released and the party with the repurchase obligation has little or no influence over how the loan is serviced once it is sold.

While seller/servicer contracts often attempt to make third-party servicers ‘independent contractors,’ a court may nevertheless construe them to be an agent of the purchaser.”

Since the advent of “Making Home Affordable” in February of 2009, tens of thousands of mortgages have been modified, either temporarily or permanently. The guidelines, especially in the early stages of the programs, were imprecise and not always interpreted correctly by servicers. The potential exists for a repurchase depending on whether the servicer has performed all of its expected duties according to mandated requirements. This is a constantly-evolving issue.

MORTGAGE INSURERS
Mortgage insurers have experienced considerable losses for some time. Insurers continue to mount aggressive efforts to rescind coverage or deny claims. The companies have devoted extensive resources to the investigation and cataloguing of deficiencies in the mortgage loans they insured in the past, and which have become delinquent.

Mortgage insurance companies continue to deny claims while delinquencies, losses and spiraling servicing costs drive mortgage originators to fight back. In December of 2009, Bank of America filed suit against mortgage insurer MGIC Investment Corp. ⁴ According to a December, 2009 article in The Business Journal of Milwaukee, “MGIC and other mortgage insurers are reviewing more claims as mortgage delinquencies continue increasing, placing pressure on insurers’ profits and their capital to cover the losses.”

PHILOSOPHIES
The manner in which you approach repurchase issues will dictate your success. The way you decide how vigorous and hearty your pursuit of repurchases should be is personal and unique to you as an investor. You must make the decision whether to pursue every possible issue in every area, focus on specific areas and issues, or something in between. You can, and should, take direction in this from legal counsel and other experts, but in the end they can only advise you of the areas of consideration and potential success rates based on outlay of resources and capital. You must make the final decision. You may want to try to negotiate a settlement with a particular originator before undertaking, or even threatening, legal action. If the originator is a good source of product, and you believe that he is reasonable and would be willing to work with you, it may be prudent and financially sound to attempt negotiations before embarking upon a course of due diligence, research, legal intervention and possible relationship damage.

If you decide to pursue every possible repurchase for every reason, you may not only be disappointed, but you may actually harm your chances for valid claims. For example, if you choose to demand repurchase of every loan for which the appraisal appears to contain less-than-perfect comparable sales, your chances for success with other claims could be diminished. If you send the originator a letter that says, “We demand that you repurchase this loan because Comps 2 and 3 are more than 1 mile from the subject property,” you not only have little chance of having this loan repurchased, you have damaged your credibility for other claims you make with the same originator. The days of these types of claims, and any success with them, are long gone. The increase in sophistication and support in just the last year is staggering. If you are reasonable, educated and well-researched, you will prevail.

We’ve seen companies that stonewalled and refused to do anything, and we’ve seen companies that literally stopped functioning to deal with repurchase demands, and everything in between. As repurchase demands escalate, lenders are being driven out of business. Even large nationwide lenders are devoting huge amounts of resources to defending issues. It’s essential that an originator have a plan for how to refute repurchase demands, and to what degree.

Several major players have materially changed focus from a couple of years ago. Whereas at the outset they threw everything they could against the wall and tried to make it stick, recently they have gotten more selective. They seem to believe that if they concentrate their energies on the more egregious issues such as debts not being paid off at closing or the borrower not being employed where he said he was (which are both relatively easy to prove), their levels of success will improve and stay exponentially high.

Jane worked in the compliance area of a national mortgage lender. She was bored with compliance and thinking about moving on. A friend in the company told her that the lender was facing an increasingly-vigorous onslaught of repurchase demands. One thing led to another and Jane found herself in charge of refuting hundreds of repurchase demands from aggressive, savvy players, mostly Wall Street firms. Her company elected to provide every resource possible, along with legal support and an attitude of, “We will methodically and energetically refute every repurchase demand with everything we’ve got.” Jane took advantage of the research resources and support and, before you could say “Success!” she had established a reputation for doing her homework and being right. Pretty soon, her adversaries learned not to send her cases that were not absolutely ironclad because they knew that she would intelligently defend them with timely, well-researched backup. After a while, her reputation fed on itself – that is, not only did investors know not to send her frivolous requests, but they were assured that every request they sent would be defended so intelligently and knowledgeably, in some cases it wouldn’t be worth their time, money and energy. Hence, the rigid and dynamic philosophy ended up being not only successful, but legendary. Jane experienced a 98% success rate and earned her company’s hearty support. They lost only two or three appraisal issues out of hundreds because of her vigilant efforts to support values and expose inferior data.

Some lenders traditionally “police their own product.” If they discover an error in compliance, underwriting, documentation or closing, they make immediate, comprehensive efforts to correct the errors, disregarding the costs. Here’s an example: CityWide Bank, a major national lender, discovers an error in the Right to Cancel form for the Williams loan, which was originated 4 years ago. Rather than take the risk that the same error might be discovered by the investor, by the mortgage insurance company, or by the examiners, which might prompt a more extensive review of all of CityWide’s loans, they decide to refund all the costs that the Williams paid at the inception of their loan – without any further prompting or threats from any corner. This path is increasingly taken by more and more lenders, including the very large ones. The theory is that it would be much more expensive in the long run if the issue is not resolved upon discovery by the lender itself. Many loans today are the subject of “forensic audits” which, if an error is uncovered, could lead to legal action and end in complete rescission of the loan.

MORTGAGE DETAILS
No discourse on the state of mortgage repurchases would be complete without a discussion of mortgage details and how they influence the success of a repurchase demand campaign. Sometimes it seems that there are as many theories, statistics and topics as there are players in the markets. Everyone has his own opinion as to what caused the problems, how to resolve the issues and what demands – and rebuttals – are successful. An article published March 5, 2010 in Bloomberg News,⁵ otherwise informative and worth reading, with excellent information and perspective, quotes a Washington lawyer who states that, “The most common (repurchase reasons) include inflated appraisals or falsely stated incomes in the loan applications. . . .” Not only is this generally untrue, but “inflated appraisals” and “falsely stated incomes” as repurchase reasons, have met with limited success in the past. Both are areas that are subjective and difficult to prove. Perhaps what was meant was “the most common repurchase requests.”

The Bloomberg article goes on to say that most repurchase demands are made within 3 years of origination. While we generally agree with that statement, we’ve heard stories from lenders who are being met with claims that go back 7 years. At what point does the potential liability go away? Which brings us back to the beginning. “JPMorgan told the SEC that 75 percent of its current repurchase requests stem from loans originated in 2007 and 2008 and that it is able to file claims against third-party originators on 40 percent of all repurchase requests.” ⁶ Again, the trickle-down effect. But how many of those 40% currently possess the wherewithal to comply, and indeed, how many of them are still in business?

RESEARCH
The most successful players are those who make the philosophical and legal commitment to be consistent, vigorous and persistent, and to devote the right kinds of efforts to being successful in their repurchase demands or defenses. The most powerful tool in the arsenal of any player is extensive research and the employment of Internet sites (many free of charge) to make one’s case.

When we started building our arsenal of resources in 2006, the sources available were but a handful compared to what is accessible today. The sheer number of online public records, legal filings, investigative tools and media makes it possible for the diligent, resourceful group to successfully make its case.

Many individuals currently employed in the mortgage repurchase field are licensed private detectives. Some parties have resorted to borrower and employer interviews that may not be authorized or legal, obtaining income tax records using improper or incomplete forms, and otherwise determining loan deficiencies that may or may not be valid. Critics are increasingly vigorous and vocal in their censure of these techniques. These matters will no doubt be settled in the courts.

Efforts to mount a repurchase demand campaign (or a vigorous defense) can be expensive. In order to ensure success, it’s necessary to devote the resources to do it right, and in some cases it can cost thousands of dollars just to defend one loan. Initial expenditures can be heavy, but the potential for recovery is striking. In most cases you only need to recover one loan to pay for review of a group of loans.

LEGAL
There is no substitute for good legal advice. A prudent manager will obtain the best legal advice available, whether outside counsel or in-house, before embarking on a repurchase demand campaign or mounting a defense effort.

Increasingly, law firms nationwide showcase their talents for assistance with this type of work. A caution and an analogy: just as any surgeon can bill himself a plastic surgeon, any lawyer can bill himself as a mortgage expert. In attempting to engage a so-called mortgage repurchase expert, layers of queries, references, investigation and results-oriented proof are warranted. While there are a number of individual attorneys, and firms, that have moved to the forefront, it’s likely that just any old lawyer will not only not be of assistance to you, but may lead you down the wrong path, causing damage and the unnecessary allocation of time and money.

After all the detail and posturing, the mortgage repurchase game is fundamentally a legal struggle. The exercise of putting together the details is the building block, but it must be supported by the proper legal framework. According to attorney Michael Pfeifer, “The legal enforceability of any contractual repurchase demand rests on the ability of the party demanding repurchase to demonstrate: 1. unambiguous contract terms binding on the two parties exist that require purchase under specified circumstances; 2. those circumstances are present in this case; 3. the party demanding repurchase has complied with all of its obligations under the contract; and 4. there is now, or, with the passage of time, will be damage, loss or injury if the repurchase demand is not honored. Unless all requirements are met, a solid argument can be made that repurchase is not required.” ⁷

What will the future bring? Not everyone sees the issues in the same way – they bring different financial positions, different driving forces and different politics to the table. Some believe former mistakes are coming back to roost for many players. Sure, you made huge profits in the past, but now you have to set aside a reserve and you may face lawsuits. Others will tell you that this is just the beginning of a key political struggle. Who will the survivors be?

The area of mortgage repurchases is so constantly, intensely spiraling – there is so much going on – that more compelling news is revealed every day. According to a March 8, 2010, Wall Street Journal article, ⁸ “Lenders such as Bank of America Corp., J.P. Morgan Chase & Co., Wells Fargo & Co. and Citigroup Inc. will brave stiff headwinds this year as they face demands to buy back defectively underwritten mortgages.
Annual reports filed by major mortgage lenders show big surges in the volume of loans being repurchased in 2009. Wells Fargo said it bought back mortgages with balances of $1.3 billion, triple the 2008 total of $426 million. Losses on bought-back loans doubled to $514 million from $251 million in 2008, according to the San Francisco company.

Bank of America repurchased $1.5 billion of first-lien mortgages that were sold off by the Charlotte, N.C., bank through securitizations but are tied to faulty underwriting, up sharply from $448 million in 2008.

As of Dec. 31, J.P. Morgan had set aside $1.7 billion to meet repurchase claims from investors, a 55% jump from $1.1 billion a year earlier.
Last year, lenders bought back about $20 billion of loans with faulty underwriting, according to Barclays Capital estimates. About half of the total was written off because the loans were delinquent.”

The costs of mortgage repurchase have received a great deal of press and anyone researching the subject is bombarded daily with new information. A mortgage banking consultant who has his finger on the pulse of the industry says the average mortgage company has not seen the worst of it. We think this is an understatement.

¹ Dawn Kopecki, “JP Morgan Pressed for More Data on Fannie, Freddie Loan Buybacks,” Bloomberg, June 17, 2010, <http://www.businessweek.com/news/2010-06-17/jpmorgan-pressed-for-more-data-on-fannie-freddie-loan-buybacks.html>

² “Lender Letter LL-2010-03, An Introduction to Fannie Mae’s Loan Quality Initiative,” Fannie Mae, March 5, 2010, <https://www.efanniemae.com/sf/lqi/pdf/lqisummary.pdf>

³ Michael Pfeifer, “A Legal Safety Net,” Mortgage Banking, June, 1995,  <http://www.pfeiferlaw.com/articles-and-achievements/index.html>

⁴ Rich Kirchen, “MGIC Sued by Bank of America,” The Business Journal, December 23, 2009, <http://milwaukee.bizjournals.com/milwaukee/stories/2009/12/21/daily28.html>

⁵ Bradley Keoun, “Fannie, Freddie Ask Banks to Eat Soured Mortgages,” Bloomberg.com, March 5, 2010, <http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ad._QCyroAdI>

⁶ Kopecki

⁷ Pfeifer

⁸ Aparajita Saha-Bubna, “Repurchased Loans Putting Banks in Hole,” The Wall Street Journal, March 8, 2010,  <http://online.wsj.com/article/SB20001424052748704869304575103930012368938.html>