Predatory lending is at the forefront of the current regulatory and political agenda. Widespread media attention has prompted numerous states, regulatory agencies, and the federal government to enact or propose legislation and rules.
Though initiatives against predatory lending may initially appear to affect only originators, secondary market purchasers must be aware of the underlying issues. Regulators and consumer groups are examining the "causes" of predatory lending and have increasingly looked to the secondary market, perhaps hoping to assign responsibility for enabling predatory lending to institutions that purchase whole loans or invest in mortgage-backed securities. Secondary market purchasers may prove tempting litigation targets.
Also, lenders engaging in warehouse financing secured by residential mortgages may find that the value of their collateral can decline as a result of predatory lending practices, which could give rise to borrower set-off rights.
Should legislators and regulators conclude that secondary market participants have either contributed to the increase in predatory lending or failed to take steps to avoid doing so, they may seek to impose burdensome regulations on those who purchase and invest in residential mortgages.
In light of the potential risk posed by initiatives meant to discourage predatory lending, secondary market participants must mitigate their exposure to liability or a reduction in the value of collateral tainted by such liability. Some suggestions:
Do not rely solely on representations and warranties. Unless the counterparty is so creditworthy that a lender would lend on an unsecured basis, representations and warranties as to the worthiness of the mortgage loans should not be the sole source of comfort about the quality of the mortgage loans. Though representations and warranties in a purchase or lending context are useful, they become meaningless once the counterparty is insolvent.
At the beginning of a new relationship with a counterparty, conduct extensive due diligence on the loans it originates and its origination procedures.
Events such as reorganizations and acquisitions often affect the origination and/or underwriting of loans. In cases in which the counterparty has bought a branch or an office, a secondary market participant or purchaser should consider visiting the acquired property to ensure that loan originations are made in accordance with the standards that it has relied on for that counterparty.
At the first indications of trouble with a counterparty, whether it is failure to make or remit payments on a timely basis, failure to deliver table-funded documents on a timely basis, or breach of financial covenants, a secondary market lender or purchaser should consider increased due diligence. An increase in compliance problems for loans appears to be correlated with a counterparty's increasing financial difficulties. One would expect a company which is in need of money to use every effort to increase originations of loans in order to sell them in the market faster; this in turn could lead to at best, carelessness, and at worst, fraud.
Find out what quality control checks have been instituted. There are several questions you can ask:
- What are originators instructed to and authorized to say to borrowers at the point of first contact and at point of signing of documents? For example, is there a script or guide to answer frequently asked questions?
- At what point in the process are disclosure documents sent to the borrower, and at what point is the borrower asked to sign documents?
- Are conversations taped to prevent unscrupulous behavior or verbal descriptions which vary from the loan documentation?
- What measures do the originators take to ensure that the brokers' behavior is in compliance with law (both with respect to appropriate disclosure documents and with respect to predatory lending practices)?
- If the counterparty originates prime as well as subprime mortgages, what measures are instituted to ensure that borrowers who may qualify for lower rate mortgage loans are offered such products?
- Finally, what measures are taken to control exceptions to underwriting guidelines, and what level of approval is necessary for such exceptions?
Find out if there is pending litigation against the originators from which you plan to buy loans. Do the same for brokers that the originators acquire loans from. Contact state banking departments, state consumer affairs offices, and attorneys general offices in the states where these lenders or brokers originate most of their loans to determine if complaints have been filed against them. Investigate further if the complaint rate appears high. If the originator has a Web site, check it and read any content to ensure that the originator's practices and marketing efforts are consistent with its stated policies.At the beginning of a new relationship with a counterparty, conduct on-site due diligence. This way you ensure that quality-control procedures and other guidelines are followed.
Examine originators' default rates in their portfolios, including subprime portfolios. Excessively high rates may indicate a pattern of originating mortgage loans to borrowers who, at origination, were and continue to be unable to repay them. Such analysis must include an assessment based on credit grade concentration, since this factor may skew results from portfolio to portfolio.
Require the servicer to contact borrowers by telephone soon after default. As part of the contact, the servicer should take note of what borrowers say they were told about their loan and its terms at origination. Since often the servicer is not the originator, such interviews can be a reliable source of information.
Examine originators' and brokers' production rates, compensation structures, and marketing. Excessively high production rates may indicate predatory lending practices. Compensation programs in which underwriters are paid based on volume alone may foster predatory lending. As for marketing, ensure that there is no targeting of certain groups of people or "reverse redlining."
If the counterparty has deviated from using standard Fannie Mae or Freddie Mac forms, review its forms to ensure that it has proper protections and complies with applicable law. If the counterparty uses addenda, review the forms to ensure compliance with applicable law and that provisions are not onerous.
Conduct due diligence periodically. You can do this either by spot-checking the counterparty's operations or by a random sampling or re-underwriting of mortgage files to ensure integrity of originations.
Review documents against underwriting guidelines. Ensure that exceptions to the underwriting guidelines are based on legitimate and defendable compensating factors. Confirm that the underwriter based its approval in part on the mortgager's ability to repay the indebtedness. Make sure that mortgage loan does not qualify for a higher grade category.
Review the preliminary title report to check date of last recording of mortgage. If the date is within two years, consider ordering a "date down" (for West Coast states and other computerized states) that would list the entire recording history on the property for the prior two years or more. Numerous mortgages recorded within a short period may be an indication of "flipping" or refinancing, which is not beneficial to the borrower.
Compare the loan application to the final disclosure documents. This is to determine whether the amount of proceeds borrower originally anticipated receiving was actually received (rather than paid to the originator as points and fees); if the anticipated proceeds have not actually been received, it could indicate nonbeneficial refinancing.
Conduct targeted due diligence. Target samplings to higher-balance, higher loan-to-value and higher interest rate loans. Such loans may have a higher incidence of problems and may also attract more scrutiny if they default.
Set maximum coupons and up-front fees at market prices. If mortgage coupons or up-front fees are above market, it is more likely the case (absent significant credit problems) that the mortgages were originated as a result of predatory or deceptive practices or without adequate or appropriate disclosure.
In certain instances, a highly regulated parent company may be able to ensure that formal guidelines and procedures are in place and followed.
Ms. Gelernt, a partner at Cadwalter, Wickersham & Taft, a New York law firm, specializes in mortgage banking and asset finance. Sushila Nayak, an associate with the firm, contributed to this article.
