Bank Lawyer's Blog

COMMUNITY BANKING IN THE 21ST CENTURY: THE REALITY

Here's another guest post from my friend, former community banker Pat Dalrymple, that, while not technically about bank law, is definitely about banks. Plus, I'm on the road, so Pat is taking a load off.

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The demise of community banking has been predicted for the last five years or so.  Despite certain significant advantages enjoyed by this group, primarily their market position,  and advertising muscle, the prophecy is become more likely, especially for the smallest institutions struggling for profitability.

The challenge to many $200 million asset and under  banks is, quite simply, putting on acceptable loan assets:  the post meltdown regulatory environment precludes many loans that made up much of the portfolios of small community banks.

Profits are anemic, or non-existent, in a plethora of institutions across the country, compelling management and directors to reassess the very viability of the traditional banking business model.

Many industry practitioners, particularly i small market operations, have lost sight of what banking really is, simply stated:  making a profit on the movement of money.  It matters not whether it’s Chase or the 2^nd National Bank of River City, or how the money moves or, indeed, who moves it.  The business of banking is raking in revenue as the commodity circulates.

Unfortunately, a lot of community banks, especially the smaller ones, aren’t doing this well at all.  Business customers, turned down for loans, are flocking to so-called “Shadow Lenders”, non-bank

Corporations that are rapidly stepping in where banks fear to tread, often as a result of regulatory mandates. Many commercial customers can qualify for SBA financing, but too few small banks facilitate these programs.

Senior depositors make up a disproportionately larger share of community bank customers, as compared to the big league institutions, but small depositories are doing nothing at all in the area of reverse mortgages.

And then there’s the most egregious failing of all:  few banks under, say, $100 million are making residential mortgages available in their markets. On all of these activities, banks aren’t earning a nickel, when nickels are sorely needed, what with loan to deposit ratios at 50 or 60%.  But somebody is counting up those nickels, and it comes to lots of nickels.

What should they do?  Here are some thoughts:              

BUSINESS LENDING:

 This is a category that sees the majority of rejections at insured financial institutions.  Many would have qualified pre-recession, some would not have.  All are bank customers, in one way or another, most are viable borrowers for some capital source, somewhere, and all represent an opportunity for revenue.

Large non-institutional lenders, those specializing in loans for operating capital, lines of credit, and financing for short term emergencies, to name just a few, pay well for referrals.  If a bank can’t make a requested loan, the customer is shown the door, and ends up at a shadow bank anyway, often paying an additional fee to a loan broker.  Why not guide this borrower, preserve the customer relationship, and get paid for it at the same time?

SBA LENDING:

Too few small banks use this resource.  It’s another ignored profit center.  If a bank doesn’t want to put any portion of the deal into portfolio, there are plenty of capital sources that will take the loans off its hands.  And, if the bank doesn’t want the processing hassle, then there are SBA lenders that pay for a simple referral.

HECM LOANS:

Reverse mortgages are one of those product categories that community banks haven’t even thought about.  This is a bit odd, considering that there are a lot of senior customers at small banks.  There’s a pervasive lack of knowledge and a body of misconceptions about this lending product, with banks probably being even more ignorant than their customers.

The HECM concept can be an exceptional program for certain senior borrowers, and bankers need to know more about it.  Reverse mortgage wholesale lenders have partnership models that can take all of the risk, compliance and otherwise, out of originating these loans, and most of the work.  A robust reverse mortgage origination campaign could be mounted by a bank with virtually no additional expense except that for marketing.

RESIDENTIAL MORTGAGE LENDING:

 The refusal to ramp up mortgage lending is a glaring abdication of community responsibility by small banks, and an incomprehensible rejection of a profit opportunity.

Every community bank should be the pre-eminent mortgage originator in its market, but virtually none are.  Rather, small institution customers get their home loans through mortgage brokers, correspondent mortgage companies, and the mortgage divisions of larger banks.

Banks can profitably originate mortgages with almost no risk if they use the large wholesale lenders that are eager to sign banks up as production partners.   The bank needn’t use its own money to fund the loans, and most, if not all of the compliance risk is taken on by the wholesale partner.

There’s a simple way to determine the amount of revenue that a community bank might be leaving on the take:  take a given 12 month period, and determine how many bank customers secured a mortgage, either to purchase refinance, through another source.  Since small bank customers are among the most loyal consumers on earth, assume that a healthy percentage of those loans would have been initiated and facilitated by the bank, and then multiply the aggregate dollar amount by the “Lender Paid Compensation” offered by the wholesale lender.  The amount of foregone revenue is often shocking.

One final suggestion:

Market these services!  Someone once looked at the rapidly changing face of banking, especially as it relates to the little guys, and opined, “Bankers are like dinosaurs, standing in the swamp, waiting for the weather to change”.

Don’t wait.   Don’t let everybody else make that profit on money movement to your bank customers.

"Ability-to-Repay" Rule About to Crimp Entrepreneurs?

Rhonda Abrams, who writes about entrepreneurship, claims in a recent USA Today opinion piece that the CFPB's "Ability-to-Repay" rule will have what most social engineering legislation has: unintended consequences. For small businesses and entrepreneurs, one of those consequences will be that "getting a mortgage will become a whole lot harder soon."

And I'm betting it's going to be a heck of a lot harder for people who are self-employed or own a small business to qualify — assuming the business is run as a sole proprietorship, limited liability company or S corporation and income passes through to a personal tax return.

Why? The very sensible provisions were designed for people who receive paychecks rather than run businesses. Small-business owners and the self-employed are likely to have greater challenges with some of the provisions:

Among the problems for entrepreneurs, Rhonda points out the following:

• Verifying income for an sole proprietor or pass through entity depends on income shown on tax returns, rather than net worth (used as an alternative to tax return income in the "bad old" days of low-doc, no-doc loans). In addition, small business owners may show lower net income because they take aggressive positions on tax deductions and/or plow gross income back into the business. Fewer entrepreneurs may be able to provide the verification needed to satisfy the rule.
• Debt-to-income ratios may be tougher to meet because business debt shows up as personal debt, and, in the case of business lines of credit, the entire line shows up as debt even if no draw are made.
• Personal services businesses are often poor in hard assets but rich is goodwill developed by a highly skilled entrepreneur. In addition, entrepreneurs often live in high-home priced areas, and use their home as their office, which increases mortgage debt.

Abrams advises those entrepreneurs who've been thinking about taking advantage of low interest rates to buy or refinance, to do so this year. She also advises entrepreneurs to think twice about taking advantage of legitimate deductions that lower tax return reported income to the point where qualifying for a home mortgage loan may be jeopardized.

The abuses of the past engender remedies that cause disadvantages for some future borrowers, at a time when the country's problem is no longer that too many loans are being made but too few.

HELOCs: The Next Debacle?

I think we all know what this means, don't we?

A significant amount of home equity lines of credit will reach the end of their draw period beginning in 2014, about the same time the Federal Reserve plans to end its downward pressure on interest rates.

The Office of the Comptroller of the Currency released its first semiannual report on threats it sees to the banking sector. Included are still elevated levels of foreclosures, loosening underwriting standards and a wave of new products these firms are beginning to venture into.

But past loans could still raise major problems as well.

In 2012, roughly $11 billion in HELOCs reached the end-of-draw period, marking the moment when a borrower can no longer draw equity from their home and must begin paying back the principal plus interest.

By 2014, this number grows to $29 billion, nearly doubles in 2015 to $53 billion and could reach $111 billion by 2018, according to the OCC.

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The OCC said because home prices in many areas are still slow to recover since these loans were originated, many borrowers will struggle to refinance. This translates to heightened risk for banks still trying to untangle their balance sheets from the latest housing bust.

"Approximately 58% of all HELOC balances are due to start amortizing between 2014 and 2017," the OCC said. "Housing price declines have led to questions for the banking industry about carrying values and allowance levels that support home equity portfolios."

So, here's my uneducated guess: those banks with a heavy (or, even, not-so-heavy) portfolio of HELOCs are going to be examined with an electron proctoscope for potential weaknesses, real or imagined. After all, everyone knows that the last financial crisis was caused by lenders having granted credit to borrowers. Compounding the insanity of credit-granting is the fact that HELOCs are secured by second liens on residential real estate, and borrowers can pay down the principal and (GASP!) re-borrower it. I know, it's absolutely crazy.

In many parts of the country, including portions that might not number among the usual suspects, HELOCs will be considered "high risk" and banks will be examined carefully to ensure that peach-fuzz-faced examiners are satisfied that credit officers who've been making HELOCs since decades before the examiners were even gleams in the eyes of their fathers are "competently" managing the risk. And if the worst comes to pass, and many HELOCs crash and burn, examiners who the previous year found that bank officers were adequately managing the risk will suddenly determine that those same officers were not only negligent from the get-go, but are the kind of folks who probably shouldn't be allowed to breed.

Hey! This is just another cycle in the wonderful world of arm chair quarterbacking to look forward to. The product changes, but the examination wheel turns full circle, year after year after year.

Power Grab

From the same witch's cauldron that brewed municipal ordinances that force lenders to maintain property they don't own, erupts another blatant attempt by local politicians to create buzz that they're actually accomplishing something useful for voters. What they're actually accomplishing is something quite different.

A handful of local officials in California who say the housing bust is a public blight on their cities may invoke their eminent-domain powers to restructure mortgages as a way to help some borrowers who owe more than their homes are worth.

Investors holding the current mortgages predict the move will backfire by driving up borrowing costs and further depress property values. "I don't see how you could find it anything other than appalling," said Scott Simon, a managing director at Pacific Investment Management Co., or Pimco, a unit of Allianz SE.

What s free market proponent finds "appalling" a statist finds "liberating."

Proponents say this would help residents shed debt loads that are restraining economic growth, while preventing foreclosures that are eroding the tax base. But unlike the beneficiaries of most recent mortgage-modification efforts, who must show hardship, these borrowers would have to be current on their payments to participate. And the program initially would focus only on mortgage-backed securities that aren't federally guaranteed—about 10% of all outstanding U.S. mortgages.

It would help only 10% of mortgagors, and not those most in need of help--those who can't pay their current mortgages. For the 10%, it's a sweet deal. The "government" (i.e., the taxpayers) takes the loss today of the "underwater" portion of the loan balance and the borrowers get all the upside. At least with TARP, the banks had to give the government preferred stock and a warrants "kicker," so the government could share in the theoretical upside as the economy recovers. In this case, the government stretches the power of eminent domain and seizes mortgages from lenders and socializes all the losses with no upside. The theory that helping a tiny minority of underwater borrowers will stabilize real estate values seems a reach, and not only to me.

A letter sent last week to city leaders from 18 trade associations, led by the Securities Industry and Financial Markets Association, warned that such a move "could actually serve to further depress housing values" by making banks less willing to lend.

The creators of this concept are a bunch of left-wing retreads from the Clinton administration and their fellow travelers, including former head of the RTC, and current Obama fund raiser, Roger Altman. Economist Madeline Schnapp thinks she's on to their real agenda, which she thinks has much more to do with turning control of real estate valuations over to the government than it does with "stabilizing real estate values."

TrimTabs' Schnapp doesn't like that rather than allowing the free market to determine the price of housing for private individuals, "government entities are using government coercion to determine, by fiat, housing prices and use the vehicle of eminent domain to remove property rights from private individuals."

"The government, not the free market, is now the arbiter of what is fair 'for the common good' all because a handful of local officials say the housing bust has created a public blight," Schnapp said. "This process has the potential to become highly political and by extension corrupt."

As former Obama White House Chief of Staff (and current Chicago Mayor) Rahm Emanuel famously declared, "You never let a serious crisis go to waste. And what I mean by that it's an opportunity to do things you think you could not do before."

Bank of America "Sues Itself." Yawn...

A reader emailed to ask why I wasn't all over last week's HuffPo "expose" about Bank of America "suing itself" in a foreclosure action. Since I've teed off on BofA on occasion for foreclosure missteps, my correspondent wondered why I wasn't picking this low-hanging "snark fruit." The reason is simple: it's a non-story.

Bank of America, as the servicer of a first loan owned by a third party, commenced a foreclosure action on a first mortgage loan. The bank, in its individual capacity, had a second lien loan on the same property. Since the foreclosing servicer must name all junior lien holders in the foreclosure proceeding if it wants to extinguish the junior liens, it named the bank. The bank is agent for the owner of the first lien loan and is also the owner, in its individual capacity, of the second lien loan. It has to name itself. This is "Foreclosure 101."

The allegations of Professor Alan White are absurd. It strikes the professor that this set of facts is "classic robo foreclosure." He further mocks the attorneys and paralegals who worked for the bank of this matter.

"It is a little bit mindless on the part of the lawyer," White said. "They don't need to sue themselves."

The only thing relatively "mindless" is a law professor who touts himself as a predatory lending expert and who either doesn't understand basic foreclosure law or, if he understands it, mischaracterizes what "must" be involved.

A commenter identified as "InkMiser" sums up the problem with the article quite well.

The bank is perfectly correct in naming itself in the case because of its second mortgage interest. Professor White obviously knows nothing about foreclosures, land titles, and the ABSOLUTE statutorily mandated need to name as defendants all persons with an interest in the property. Although there may be robo-signing involved in the case, it has nothing to do with the requirement for BOA to sue itself. What the article misses is WHY BOA had a second mortgage. It had a second mortgage because (and although I'm guessing, it is an educated guess) the when the property was purchased, the buyer did not put down sufficient money to avoid paying private mortgage insurance. The first mortgage is for (usually) 80% of the purchase price and the second mortgage is for the balance of the price. The other thing this story missed is the nuance in paragraph 5. BOA is filing suit, but it admits it doesn't own the loan. It is only servicing the loan for its "investor." There are many things very wrong with the mortgage industry in America. A bank naming itself as a defendant in a foreclosure case in which it has an interest in the property is not one of them.

Other knowledgeable commenters make similar points, and also discuss various reasons why the bank as junior lender may be "hanging in there" as opposed to merely releasing the junior lien. One of those potential reasons may have to do with the adverse tax effect on the borrower of debt forgiveness. Admitting that there may be a method to the madness doesn't fit the ideological agenda of either HuffPo or Professor White, who blogs at Credit Slips. That blog is known as the former hangout of Liz Warren and a purveyor of fevered screeds that bash banks with arguments that don't pass the smell test. Obviously, he's the kind of "go to" talking head HuffPo loves.

So, dear correspondent, I've now offered a post about the story. How do you like it so far?

I'll Be Watching (And Chasing) You

When strategic defaulters are considering walking away from their homes, they'd be advised to make certain that if they have an outstanding second lien loan on their home, they either plan to pay it or otherwise hide their assets in a remote location and leave the country. You never can tell when the junior lender might retain a guy like Leo Stawiarski Jr. to track you down, sue your hindquarters, stew your pet rabbit "Alf," and then start getting nasty. Actually, Leo sounds like a calm, rational, patient, and persistent lawyer, who understands how to analyze the situation and deal with the "walk-aways" in ways that results in many of them discovering that they didn't walk away far enough.

In an interview posted yesterday on Housing Wire, Leo lays out the options. First, you work with a borrower to see if you can't get a sale, a short sale, or a repayment plan worked out, based on the financial condition of the borrower and the value of the equity in the collateral. If you can't work it out, you beat the borrower over the head with a club and keep beating him or her until they pay up pursue your contractual rights under the loan documents and applicable law. You sue the borrower, obtain a judgment, and then execute the borrower on the judgment, pursuing the ever-popular garnishment of wages and/or bank accounts. He doesn't discuss other tactics, such as filing the judgment lien in the real estate records, where it clouds title to any real estate you may buy or sell in the foreseeable future (or for a few years, at any rate), and, of course, the ever popular remedy of "kneecapping," used to great effect by the IRA to discipline miscreants in Northern Ireland yet sometimes frowned upon by law enforcement authorities in this country.

Leo isn't heartless, although since we're describing an attorney, that might mean he's got a heart the size of the judgment center of Charlie Sheen's prefrontal lobes or of Kirstie Alley's hips. It's difficult to be certain. Regardless, he understands that borrowers may be in dire straights, but ultimately, that's not his problem.

While we understand that borrowers may find themselves in difficult financial circumstances, as a lawyer representing the second mortgage holder, my primary focus is to enforce the terms of the binding contract between the lender and the borrower. At LCS Financial, our objective is to ensure that the borrower meets their contractual obligations to our clients, taking into account the borrower’s ability and willingness to repay the indebtedness.

As I said last week, that's a lawyer who's just doing his job. Don't like it? Change the system.

I happen to agree with his comments about strategic defaulters. I especially appreciate an observation that isn't made often enough. Ultimately, strategic defaulters screw a lot more people than lenders.

These defaults adversely affect neighborhood property values because they lead to excess inventory and property deterioration. Moreover, strategic defaults generally impact taxpayers. Most loans are now government owned, insured, or guaranteed which means taxpayers are essentially funding strategic defaults. The key is to create an environment of responsible homeownership where financially capable borrowers honor their obligations because they know there will be consequences if they simply walk away. One of the clearest ways to create such an environment is for servicers and lenders to pursue their remedies when faced with strategic defaults.

Low-key, rational, and relentless. The perfect temperament for a "collector"

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I'm off to the annual Texas Bankers Association Legal Conference. See you next week, or if you'll be there, see you tomorrow..

Passing The Buck On Buybacks

I was talking over lunch the other day with a senior executive of a large community bank that is in the midst of litigation with a rather large loan servicer that is attempting to force the bank to repurchase loans that were originated by the bank during a comparatively short-lived foray into the mortgage banking business in the mid-2000s. The loans were sold to FNMA and as readers know from my many posts on the topic, FNMA has been trying to force repurchases down the throats of loan servicers at a blistering pace. In turn, the servicers have been seeking solvent originators and trying to pass the buck back to them, where, truth be told, it belongs, assuming that FNMA has a legitimate claim.

There's the rub.

According to my lunch companion, while FNMA's auditors have scoured the loan files and found technical defects that might support a breach of warranty claim in some instances (and he wasn't conceding that point), they had yet to demonstrate that the alleged breaches caused any damages. Not surprisingly, not one loan with respect to which a repurchase demand has been made is performing, yet the servicer hasn't been able to demonstrate that the breaches relate in any way to the causes of the borrowers defaulting on the loans. The servicer's position (and I assume FNMA's, as well) is that they don't need to make that connection, they just need to show that representations or warranties have been technically breached. At this point, neither side is backing down.

As we've seen, the GSEs have been unrelenting in their pursuit of repurchase demands whenever a loan goes bad and they think they've got a snowball's chance in the Gobi of making a repurchase demand stick. They're being  backed up by buyers and insurers of mortgage-backed securities that are collateralized by residential mortgage loans. Recently, the trade group that represents bond insurers sent a letter to Bank of America CEO Brian Moynihan that demands that B of A repurchase half of all residential mortgage and home equity loans that the insurers have examined and that were originated between 2005 and 2007, totaling somewhere between $10 billion and $20 billion. The trade association also demanded that regulators force the bank disclose and reserve for this potential liability. The bank refused to respond to the demand, although rumor has it that the bank will tell the trade group to do something to itself that would be impossible for most human beings, although perhaps not for Lady Gaga.

The Bloomberg article that discusses the the trade association's demand letter to Bank Of America also discusses why banks like Bank of America (or the bank my lunch companion works for) aren't simply collapsing in a heap of liquid jello when big bad GSEs and loan servicers make these demands.

Banks manage to repel about half of the buyback claims they receive by showing they’re invalid, according to Moshe Orenbuch, the Credit Suisse analyst who tabulated the bank’s losses from 2008 through the second quarter of this year. The banks probably have adequate reserves, Orenbuch said in his report last month.

It’s unlikely that “a valid defect exists for every loan repurchase request,” Bank of America said in its second-quarter regulatory filing. Even if claims are valid, losses probably would be less than the full value of the loans because the underlying real estate acts as collateral, the filing said.

“The resolution mechanism for disputes with the private insurers is a lot less developed” than with Fannie Mae and Freddie Mac, said Chris Kotowski, an analyst at Oppenheimer & Co. “There is a team of highly paid lawyers on all ends of this correspondence doing the kind of jousting that they do, hoping to draw the opponent into some legal faux pas.”

As I informed my lunch mate, while there's certainly enough money involved and potential defenses available to make this an issue worth fighting about, the ultimate winners in this Clash of the Titans would be, as they often are in the land that loves to litigate, the law firms handling both sides of the dispute. He responded that it's only fair that you pay for your thrills, and before the bank ever again decides to get into a line of business like residential mortgage banking, it will remember the pain caused by this adventure (and the legal bills will help reinforce the painful memories) and will make sure it understands all the risks that could occur if the "unexpected" happens.

I thought about telling him that they might have gotten a clue of the elephant in the room if they'd been reading my blog back in 2005, but that would have been immodest and, besides, he was picking up the check.

Immoral Hazards

While guys like John Dugan get their knickers in a twist about the "moral hazard" of granting limited accounting forbearance to community banks who want to amortize commercial real estate losses, the Main Stream Media wrings its hands about big bad mortgage lenders who expect a borrower to pay back money he or she borrowed and, when the borrower doesn't pay it back, not only foreclose on the home but sue some of the borrowers for the deficiency. When will the madness stop!

First out of the moral outrage starting gate was The Washington Post, which a couple of weeks ago ran a story entitled (with just a hint of incredulity) "Lenders go after money lost in foreclosures."

Over the past year, lenders have become much more aggressive in trying to recoup money lost in foreclosures and other distressed sales, creating more grief for people who thought their real estate headaches were far behind.

In many localities -- including Virginia, Maryland and the District -- lenders have the right to pursue borrowers whose homes have sold at a loss to collect the difference between what the property sold for and what the borrower owed on it, also called a deficiency.

Before the housing bust, when the volume of foreclosures was relatively low, lenders seldom bothered to chase after deficiencies because borrowers had few remaining assets to claim and doing so involved hassles and costs. But with foreclosures soaring, lenders are more determined to get their money back, especially if they suspect borrowers are skipping out on loan they could afford, an increasingly common practice in areas where home values have tanked.

The story relates the sad fact that many of these borrowers are forced to file bankruptcy.

"I am definitely seeing more people come through my door who walked away from houses a year or two ago and thought they were as free as the dead," [bankruptcy attorney Nancy] Ryan said. "They're stunned when they realize they're not."

That about says it all for a segment of the population that considers a legal obligation a mere inconvenience and is "stunned" when the counterparty actually enforces its rights.

The article does correctly observe that most lenders don't pursue deficiencies where they expect the borrower has few valuable non-exempt assets other than the home. It also notes that since second lenders are most often left out in the cold in a foreclosure these days, they are more likely to sue than are first lien lenders.

The story also features a couple who did a short sale with the express understanding that the home equity lender reserved the right to come after them for the unpaid balance of its debt. Nevertheless, the borrowers reacted bitterly when the second lender actually called to collect six months later. They stated that they should have trashed the home and let the lender foreclose. Apparently, they failed to appreciate the fact that by taking care of the home and doing a short sale, they very likely lowered the ultimate amount of the deficiency liability that they owe by a substantial amount, especially if the alternative was wrecking the interior of the house and then letting the lender eventually foreclose. That course of conduct made good business sense.

The attitude displayed in these cases appears to be that since times are tough, lenders need to let borrowers off the hook and absorb the losses themselves because, I assume, the borrowers are "entitled to it," even if they can afford to repay all or a hefty portion of the deficiency. A bank's management that enacted and followed a policy of doing that would be in breach of its fiduciary duties to its shareholders and, when viewed by a regulator other than Sheila Bair, would have engaged in an unsafe and unsound banking practice. The lender would also very likely be insolvent itself in short order.

Obviously, each case needs to be analyzed on its merits, and in many cases, the borrowers lack of financial resources will justify the bank not pursuing the deficiency. However, the bank's management has an obligation to act in the bank's best financial interests, not in the borrowers' best financial interests. If the two interests coincide, great. If not, and the borrower has assets to go after and no apparent legal defense to enforcement of the bank's right to be paid, the bank has a duty to enforce that right.

I realize that a distraught borrower, especially one raised in the land where every mother's child has a right to a flood of unending self-esteem and a guarantee (enforceable by the government) that nothing bad will happen to him or her until he or she eventually tragically dies for no good reason at all other than that life is ultimately meaningless, might have difficulty grasping the harsh dose of reality that legal contracts are enforceable. However, aren't these some basic concepts that we expect major market media outlets to fathom and to put into perspective for the reading public? Is that asking too much?

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I'm off until next week. Y'all have a most excellent Independence Day.

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.