Bank Lawyer's Blog

An Elephant Stampede

Two and one-half years ago, we were talking about an "elephant in the room" for the mortgage banking business: loan repurchase obligations. In November 2005, the problem was primarily with respect to subprime mortgage loans. Today, according to The Wall Street Journal, the elephant is stomping throughout the house, smashing furniture in every room, and leaving a memento of his presence on every loan originator's favorite sofa cushions.

Already burned by bad mortgages on their books, lenders now are feeling rising heat from loans they sold to investors.

Unhappy buyers of subprime mortgages, home-equity loans and other real-estate loans are trying to force banks and mortgage companies to repurchase a growing pile of troubled loans. The pressure is the result of provisions in many loan sales that require lenders to take back loans that default unusually fast or contained mistakes or fraud.

The potential liability from the growing number of disputed loans could reach billions of dollars, says Paul J. Miller Jr., an analyst with Friedman, Billings, Ramsey & Co. Some major lenders are setting aside large reserves to cover potential repurchases.

[...]

The fight over mortgages that lenders thought they had largely offloaded is another reminder of the deterioration of lending standards that helped contribute to the worst housing bust in decades.

Such disputes began to emerge publicly in 2006 as large numbers of subprime mortgages began going bad shortly after origination. In recent months, these skirmishes have expanded to include home-equity loans and mortgages made to borrowers with relatively good credit, as well as subprime loans that went bad after borrowers made several payments.

Many recent loan disputes involve allegations of bogus appraisals, inflated borrower incomes and other misrepresentations made at the time the loans were originated. Some of the disputes are spilling into the courtroom, and the potential liability is likely to hang over lenders for years.

The Wall Street Journal reports that Fannie Mae recently "said it is reviewing every loan that defaults -- and seeking to force lenders to buy back loans that failed to meet promised quality standards." Little bro' Freddie Mac is also increasing the number of repurchase claims. That's consistent with observations made two years ago. With those two GSE's being positioned as the linchpins of the federal government's "plan" (and we use that term loosely) to "save the mortgage market for the little guy," it will be hard for any loan originator who wants to continue to play the mortgage banking game to get in a cat fight with either of those big cats.  Expect "portfolio scrubbing" to be especially intense at both entities, given their history. As I've said previously, I represented clients on the wrong side of Fannie Mae during the last downturn, and it wasn't pretty.

The WSJ also reports that repurchase pressure is coming from bond insurers, such as Ambac and PMI, and REITs, like Redwood Trust Inc. While most claims are settled out of court, it appears that trial lawyers will not be left out in the cold.

Repurchase claims often are resolved by negotiation or through arbitration, but a growing number of disputes are ending up in court. Since the start of 2007, roughly 20 such lawsuits involving repurchase requests of $4 million or more have been filed in federal courts, according to Navigant Consulting, a management and litigation consulting firm. The figures don't include claims filed in state courts and smaller disputes involving a single loan or a handful of mortgages.

It's always comforting to know that some good will result from all this suffering.

It will certainly be bad for originators, but while some mentioned in the WSJ article, including everybody's favorite whipping boy, Countrywide, appear to have the financial wherewithal to fulfill their legitimate repurchase obligations (knock on wood), there are some who will not. Then, who gets stuck? I represented a lender that bought from the RTC a large block of servicing rights to loans originated by a failed savings bank. Unfortunately for the buyer, there were major problems with the loans, some dating from loan origination and some as the result of incompetent servicing prior to the purchase, which weren't discovered during due diligence (the consequence of either poor sampling or bad luck). FNMA started putting loans back like they were radioactive and there was no one to turn to, since the RTC gave limited warranties on the junk assets it sold. You just never know who's going to get stuck with the bill for loans that FNMA Mae buys, but it's rarely FNMA if there's any breathing body or inanimate object that Fannie can stick it to.

The WSJ also notes that many originators are increasing reserves to meet potential buyback liability.  Not increasing reserves by a conservative amount has its risks.

Lenders may feel pressure to boost reserves for such claims because of the fear they could be sued for not properly accounting for potential repurchases, says Laurence Platt, an attorney in Washington. At least three lawsuits have been filed by investors who allege that New Century Financial Corp. and other mortgage lenders understated their repurchase reserves, according to Navigant.

So, who wants to start a mortgage bank?

Adjusting The Underwriting "Shower"

As we said last October,

...[I]t's likely that some bad legislation will be enacted that will over-correct prior (and no longer persistent) market practices and exacerbate the current credit squeeze by making housing credit tougher to obtain and more expensive for prime, as well as "less than Grade A," borrowers. Trying to fine tune business practices is like trying to fine tune the hot and cold water in your shower. First it's too hot, then too cold, then too hot, then too cold, and on and on until you get it just right. That kind of tinkering is generally best achieved by market participants who've been scalded and/or frozen and are sensitive to all the "nuances."

No federal legislation has yet passed both houses that directly affects prime loans, but the market is in the process of an "overcorrection" of underwriting practices that is making prime home mortgages more difficult to obtain. That's what a Federal Reserve Senior Officer Opinion Survey released yesterday reveals.

In the January survey, significant numbers of domestic respondents reported that they had tightened their lending standards on prime, nontraditional, and subprime residential mortgages over the past three months; the remaining respondents noted that their lending standards had remained basically unchanged. About 55 percent of domestic respondents indicated that they had tightened their lending standards on prime mortgages, up from about 40 percent in the October survey.2 Of the thirty-nine banks that originated nontraditional residential mortgage loans, about 85 percent reported a tightening of their lending standards on such loans over the past three months, compared with about 60 percent in the October survey.3 Finally, five of the seven banks that originated subprime mortgage loans noted that they had tightened their lending standards on such loans, a proportion similar to that in the October survey.

[...]

About 60 percent of domestic respondents indicated that they had tightened their lending standards for approving applications for revolving home equity lines of credit over the past three months.

I can verify this trend by personal experience. I refinanced my home mortgage last month, in response to a solicitation made by my current home equity line of credit lender, who sent me a "pre-approved" solicitation for a cash-out refinance loan at a very favorable rate. I'm pleased to report that our FICO score was excellent, so the rate and points were "prime." However, in his first contact with me, the loan officer reported that the lender would not require proof of income (I assumed that this was because they had received it the previous year when the HELOC was originated, not that this was a "stated income" loan). He called me the next day to advise that underwriting standards had tightened and that documentary income verification and deposit verification would be required or I would have to pay some additional points. Providing documentation was no problem for me, other than that the time I spent collecting and faxing documentation could have been better spent punishing legitimately billing my clients.

When it came time for an appraisal, further surprises were in store. The appraised value of my house this spring was 4% lower than the appraised value last spring, even though I am lucky to live in an area of the country, in fact, in a specific neighborhood, where the average real estate sales price has increased 3% last year. Both appraisals were performed for the same lender. Amazingly, the latest appraised value, although lower than last year's value, was exactly what I needed in order to obtain the amount of the first lien loan I applied for and to retain a HELOC in the existing amount from the same lender, and yet not exceed the maximum loan-to-value limits imposed by state law. I was absolutely stunned by this coincidence...

I know as well as the next guy that appraisal practice is not an exact science, and I have no reason to believe that the appraiser didn't do his job properly. On the other hand, it's obvious that while some lenders may have been pressuring appraisers to "pump it up" during the peak of the subprime feeding frenzy, the worm has turned. Appraisers now appear to be much more conservative.

I don't think that it's coincidental that my lender, which also happens to be my personal banking institution, is a major "player" that seems not to have participated in the excesses of the subprime meltdown. Rather, it appears to be one of the big winners, and one that may very well end up acquiring less conservative institutions.

In the late 1970s and 1980s, there was a conservative federal savings bank in Colorado called First Federal Savings Bank of Lakewood. It was run by a man named Malcolm ("Bud") Collier. During much of that time, I was one of the attorneys who represented the Colorado Savings & Loan League, and I'd often see and interact with Bud. I recall that we also did some legal work for his thrift. Other, more "high flying" S&L managers would laugh about Bud, because he said that all he knew was the residential mortgage lending business and that was what he was sticking to, regardless of the pressure the regulators were putting on him to diversify into acquisition, development and construction lending (a topic for another time). Other S&Ls grabbed onto the riskier loans and rode them right into insolvency. Bud not only survived, he prospered. He eventually converted his mutual association to a stock association owned by a mutual holding company (one of the first in that region), then later sold out to a larger commercial bank holding company when it was time to cash in his chips.

Obviously, he had the last laugh.

We appear to be in the initial stages of the "hot/cold" fine tuning of the underwriting process, with the conservative institutions, those who didn't cause the problems, trying to get it "just right" for a post-subprime world.  It will likely take a little time, but the survivors will eventually adjust it well enough to keep the residential mortgage markets intact. That is, they will if Congress, state legislatures, or the regulators don't manage to overreact and throw a monkey wrench into the works.

We'll Be Watching You

Over the next week or so, banks will be innundated by the analyses of law firms and other banking consultants as to the implications of the Interagency Guidelines on Nontraditional Mortgage Product Risks that were issued by the federal banking regulators last week. There will much yipping and yapping about "what it all means." Just like the talking heads on the Sunday morning network television news shows, the few will be telling the majority what they should think about it all, with the unspoken undercurrent of all this jabber being "pay us vast sums, because we know more than the other guys, and certainly way more than you, you stupid banker."

At Bank Lawyer's Blog, we pride ourselves on our utter lack of worthwhile comment, as well as on our ability to wander down rabbit trails that lead only to an abrupt end when, like a rabbit, we're snatched up by a hawk or an owl (depending on the time of day) and devoured. We should post a warning at the top of this blog that reads: "Move Along. Nothing To See Here."

But we don't. And some of you still read this blog. The world is a mysterious place.

In that spirit, we'd like to focus on one "issue" we've gleaned from the Guidelines that we find pithy and important, but is likely to be missed by those with larger cerebrums and more time to spend "parsing the nuances." There's nothing more refreshing to the uncluttered mind than belaboring the obvious, and no minds are more uncluttered than those which inhabit this rodent hole in cyberspace.

In the "Overview of Public Comments" subsection of the "Supplementary Material" section of the Guidelines, the federal regulators discuss a problem raised by "many commenters." We assume that those "many commenters" were federal financial insitutions, their hired guns, and trade groups that cater to them. If we had actually read the comment letters, we would have known for certain who these commenters were, but that would have diverted our attention from the latest episodes of Dancing with the Stars, and with Emmitt Smith "in the running" for the title of Captain Twinkle Toes, we must set our priorities and stick to them.

At any rate, the "concern" raised is "that the guidance will not apply to all lenders, and thus federally regulated financial institutions will be at a competitive disadvantage." If there's one thing that a federally regulated financial institution hates worse than government regulation, it's government regulation that doesn't apply to a state supervised competitor. Federal preemption of state law is, of course, in full accordance with the laws of nature and God's plan for mankind, but "guidelines" that "guide" only the federally regulated are "an abomination in the eyes of the Lord and a perversion of all that is right and good." 3 J. Williams 43

The federal regulators responded to this concern by noting that both the Conference of State Bank Supervisors and the State Financial Regulators Roundtable "committed to working with state regulatory agencies to distribute guidance that is similar in nature and scope to the financial service providers under their jurisdictions. These commenters noted their interest in addressing the potential for inconsistent regulatory treatment of lenders based on whether or not they are supervised solely by state agencies. Subsequently, the CSBS, along with a national organization representing state residential mortgage regulators, issued a press release confirming their intent to offer guidance to state regulators to apply to their licensed residential mortgage brokers and lenders."

While such public sentiments are all well and good, those of us who toil at Bank Lawyer's Blog are generally the paid minions of federal financial institutions and fully support their need, and their federal regulators' need, for lebensraum. Any competitive disadvantage that would impede the dialectical unfolding of the ultimate triumph of federal oversight of all banking (and "bank-like") institutions everywhere in the world (and, eventually, beyond) is bound to cause a rip in the fabric of the time-space continuum, which, in turn, could possibly result in such bizarre consequences as the restoration of the 10th Amendment to the U.S. Constitution to a place in our legal system above that of an amusing historical anachronism and OCC hood ornament. Such a horror is so far beyond the pale that even contemplating its possibility causes us to break out with a severe rash.

The dust hasn't settled and already the mouthpieces for state-regulated mortgage brokers are whining about trying to apply the federal guidelines to them. From yesterday's American Banker (paid subscription required), we heard this blubbering:

...the Mortgage Bankers Association objected, arguing that the agencies came up with a "one-size-fits-all" approach to underwriting that ultimately will hurt industry innovation.

"The guidance overreaches," said Kurt Pfotenhauer, the MBA's senior vice president of government affairs. "The foreclosure and delinquency rates are well within historic norms. We think this level of regulatory guidance is therefore not warranted."

Quite cryin' Kurt and take it like a man. No lender thinks any of this is "warranted." The Bush Administration is still fuming over giving Gitmo detainees a fair trial, but life is not always fair, except for jihadists. The federally regulated banks have this advice for you: "Butch it up!"

So, Mr. and Ms. "CSBS" (and we include you, General Counsel "Buzz" Gorman) and "SFRR" (which sounds like the start of a profoundly complicated syllable in Norwegian), and you, too, Mr. and Ms. "state regulatory agency," as well as the other members of your Politburo, you had better get crackin' with making sure that all regulated financial institutions and mortgage lenders and brokers everywhere, federal and state, suffer and suffer alike. We've noted your public promises and we'll darn well hold you to them.

Just like Madonna's good pal Sting, we'll be watchin' you.

Credit Card Banks: Not A Dry Eye In The House

According to a page 1 article in yesteday's The Wall Street Journal (paid subscription required), credit card issuers are being poleaxed by a diabolical trend: each month, consumers are paying off their credit balances in full. No "revolver," no interest, no late payment fee, no over-limit fee. That means lower income.

Much lower income.

For card issuers, which profit by collecting interest on unpaid balances, that's bad news. In the past, when interest rates crept up, as they are doing now, fewer cardholders could afford to pay down balances.

"Normally at this point in the economic cycle, you start to see payment rates decline. But that's not happening," says Richard Srednicki, who runs the credit-card business at J.P. Morgan Chase & Co., the nation's second-largest card issuer. "It is a tougher business if payment rates continue to stay up and consumers continue to pay off more. It's something we've got to understand and work at."

Although consumers are using plastic for more of their daily purchases, they are giving card issuers fits by juggling their debts more shrewdly. When cardholders are hit with high interest rates on one card, they routinely transfer balances to new cards at lower rates. And in recent years, as real-estate values soared and mortgage rates fell sharply, more consumers wiped out credit-card debts altogether by borrowing against their homes.

To make matters worse for card issuers, federal bank regulators issued new guidelines in 2003 meant to ensure that cardholders pay off more each month than just the fees and interest charges that have accumulated. To comply with the rules, many banks have raised minimum-payment requirements, bumping up the payment rate further.

[...]

Last year, banks notched pretax profits of $30.6 billion on credit-card operations, down 3% from the year-earlier period, the first such decline since 1998, according to CardWeb.com, a closely held firm that tracks the industry. The after-tax return on average assets -- one measure of industry profitability -- was 1.21% at year-end, down from 1.48% a year earlier, CardWeb reports.

[...]

The payment guidelines issued by federal regulators in 2003 were intended to discourage banks from carrying credit-card customers who are unable or unwilling to pay off any of their principal balances. Many banks raised minimum-payment requirements, with some doubling them to 4% of unpaid balances.

Some banks are worried the new rules will pinch profits. J.P. Morgan has estimated they will reduce credit-card profits by $500 million in the second half of 2006. The bank attributed the expected reduction to higher payment rates, higher delinquency rates and the cost of providing credit counseling to financially struggling cardholders.

Once again, the law of unintended consequences applies. The 2003 guidelines cited in the article were adopted to address safety and soundness concerns of the regulators and to reduce risk to banks, by lessening the risk of default by credit card holders. Well, they worked. There's little danger of default when the borrower pays the entire balance off each month. Of course, the effect of the guidelines has been to substantially reduce income to credit card banks. That, In turn, could increase the risk that those banks, in order to replace the lost income, will implement other riskier practices. It certainly will make life less pleasant for those consumers who continue to use their credit cards as revolving lines of credit. As the article notes, banks are raising fees on those borrowers.

The fun never ends.

Huh?

Ever the optimist, I misjudged the century into which Texans were willing to move vis a vis their state lending laws. I guessed the early 20th Century, and was at least a century ahead. Maybe a millennium.

Yesterday, Texans refused to approve a constitutional amendment that would have removed usury limits on large commercial loans to businesses, but approved another amendment that allows the proceeds of reverse mortgages to be received in the form of a revolving line of credit. In other words, in Texas, businesses are not judged to be capable of protecting themselves from evil lenders without state protection, but old folks are. Voters must have conferred with experts at the White House prior to voting, because those results are less than completely sensible.

I hope Texans continue to enjoy the domination of banking in the state by out-of-state banks. Especially in commercial lending, Texans continue to eat their own.

What, Me Worry?

Last May, federal bank regulators issued "Credit Risk Management Guidance for Home Equity Lending." As they stated in the opening paragraph of the Guidance, "[t]he agencies have found that, in many cases, institutions' credit risk management practices for home equity lending have not kept pace with the product's rapid growth and easing of underwriting standards."

The agencies then outlined the product, risk management and underwriting rsk factors about which they were concerned, including the following:

• Interest-only features that require no amortization of principal for a protracted period;
• Limited or no documentation of a borrower’s assets, employment, and income (known as “low doc” or “no doc” lending);
• Higher loan-to-value (LTV) and debt-to-income (DTI) ratios; 
• Lower credit risk scores for underwriting home equity loans;
• Greater use of automated valuation models (AVMs) and other collateral evaluation tools for the development of appraisals and evaluations; and
• An increase in the number of transactions generated through a loan broker or other third party.

The remainder of the Guidance addressed ways in which the agencies thought the banks should better address those risk factors.

While regulatory gudiance doesn't have the direct force of law, it does set forth the practices that bank regulators expect banks to follow if they don't want to see themselves written up for "unsafe and unsound banking practices" at their next examination. Bankers ignore such guidance at their peril.

Well, bankers must be feeling lucky, because the Federal Reserve Board yesterday released a survey of senior lending officers from October that revealed that "only a few domestic banks reported having tightened their lending policies in response to concerns expressed in" the Guidance. I guess that the banks surveyed must have felt that the regulators must have talking about "the other guys," and not them.

"Everything's good here."

Stay tuned.