Posted on May 28th, 2008 in Mr Mortgage's Personal Opinions/Research
A phenomenon not yet discussed in any great degree is the forced buybacks of defaulted loans by the original lender or investor due to early payment defaults, fraud and lender ‘negligence’. I have written about this many times and today the Wall Street Journal had a wonderful story out entitled ‘Investors Press Lenders on bad Loans’ from Ruth Simon and Jams R. Haggerty on page C-1 confirming this. Below is my summary.
In the past, it was industry standard for a lender to ‘rep and warrant’ loans they sold to a particular investor for up to six months against default, commonly known as an ‘early payment default’ (EPD). Loans that defaulted at the first payment, known as ‘first payment defaults’ (FPD), and have always been a buyback. However, over the past couple of years, many mortgage investors/purchasers have pushed their lender clients into longer ‘EPD’ provisions, with many running up to a year. This, of course, significantly increases the percentage of defaulted loans for which the original lender/investor is liable.
The auditing of defaulted loans looking for fraud or lender negligence is escalating at a feverish pace. This is being spearheaded in many cases by the mortgage and bond insurers, but even Fannie, Freddie, banks and the investment banks are picking up the pace. At this point in time considering the damage that has been done to the bond and mortgage insurers, they have nothing and everything to lose. Perhaps soon they will release detailed reports on the amount of fraud and negligence on the defaulted prime, ALT-A, subprime and home equity loans that they insure. When this news breaks it will shock the world. Everything thinks they have a handle on how pervasive outright fraud was. But nobody has a handle on ‘white-lie’ fraud and broader negligence, such as increasing income and/or asset levels on stated income/asset loans and making investor guideline exceptions on large percentages of their loans.
If any sign of fraud is found on a defaulted loan, in most cases the originating or selling lender/investor is liable. If the originating entity is no longer in business, as is the case with most middle market mortgage bankers and brokers, then the original ‘investor’ or loan purchaser carries the burden in many cases. Most likely, these are your big named banks and Wall Street banks. A few examples are Lehman’s Aurora Loan Services for Alt-A loans, Merrill’s First Franklin for subprime, Wells Fargo for non-conventional Jumbo intermediate-term ARM’s and Chase for Home Equity Lines/Loans.
Recent research reports have found that on limited documentation loans, income was inaccurate to the high-side in 90% of the cases studied.A recent report by the NY Fed showed that 83.2% of the ALT-A universe in CA and 73.1% nationally was limited income documentation. The same report found that limited documentation subprime loans accounted for 47.5% of the CA and 33.8% of the national universe. Home equity lines/loans were mostly limited documentation, including limited appraisal requirements. Pay option ARM limited doc numbers are tougher to find but being in the industry for years, my guess is that they mirror the ALT-A stats fairly closely.
Along with fraud, defaulted loans are being audited for ‘lender negligence’, which in most cases means that the loan underwriter did not follow the investor guidelines. Lender negligence is very vague and could mean that the loan underwriter missed something, were too liberal in the way they calculated income on tax returns, missed debt on a credit report, calculated income incorrectly, did not review the appraisal thoroughly enough or a variety of other things along these lines that are common when underwriting a mortgage loan.
Another type of lender negligence may lie in the lender granting ‘exceptions’. Exceptions are just what they sound like…an exception to the investor underwriting guidelines. Early on, ‘exceptions’ were a more formal deal that may have required manager or investor approval. But, in later years most underwriters made exceptions unilaterally. Many of these were based upon ‘compensating factors’ in the file such as higher than usual cash reserves or a lower than usual loan-to-value, both of which are considered to be strong points. However, exceptions were also made regularly based upon pressure from a client, broker, loan officer and even production manager.
The following story does a great job summarizing lender malpractice even at the investor level. The writer adds, “It suggests that auditors working for Wall Street investment bankers knew how preposterous these loans were, and that could mean Wall Street liability for aiding and abetting fraud.” http://www.npr.org/templates/story/story.php?storyId=90840958&ref=patrick.net
Ultimately, I believe that outright fraud, ‘white-lie’ fraud and lender negligence will be major deciding factors in the ownership of loans and the accompanying losses. Especially fraud and negligence surrounding income and assets used on limited documentation loan applications. An example of a practice that could lead to a fraud or negligent buyback decision was when the borrower left the income and asset portion of their hand-written loan application blank at the request of the loan officer. For years it was industry standard for the borrower not to include income and asset calculations because a) borrowers are terrible at calculating income and assets b) if they put an income/asset level on the application that was too low for the investors debt-to-income requirements a new hand-written application would have to be taken c) a large percentage of loan application were done over the phone or internet d) income and assets were the last item calculated because on limited documentation loans, the income and assets used were a function of what was needed to fit the guidelines of that particular investor.
The Journal story cites a lawsuit filed in Dec in LA Superior Court where units of the mortgage insurer, PMI Group, alleged that WMC Mortgage Corp breached it’s ‘reps and warrants’on a pool of subprime loans insured by PMI in 2007. Within eight months, the delinquency rate was at 30%. The suit also alleges that a detailed audit of 120 loans that PMI asked WMC to repurchase found evidence of ‘fraud, errors and misrepresentations’.
In my opinion, this story is only getting started and is where many of those currently taking this hit on defaulted loans will turn in placing blame for their losses. They would be stupid not to. -Best, Mr Mortgage
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