The U.S. Court of Appeals for the First Circuit is yet to rule in a key force-placed flood insurance case, but the member judges have already declared who's to blame for the feud between banks and mortgage borrowers: The federal government.

The class action, Kolbe v. BAC Home Loans Servicing, turns on the seemingly simple question of how much flood insurance banks and mortgage servicers can contractually require 8 million Federal Housing Administration homeowners to buy. A the core of the dispute are poorly written regulations and years of mixed messages from the Department of Housing and Urban Development, multiple First Circuit judges indicated at a hearing earlier this month.

"You [HUD] have this court divided, you have courts around the country divided," Judge Kermit Lipez told a HUD attorney, according to a recording of a April 3 hearing. "This was just a lousy job of drafting [regulations] … it seems preposterous to suggest this is plain language."

Added Chief Judge Sandra Lynch added that the HUD attorney "might want to convey that sentiment when you return to Washington."

Bank of America (BAC), BAC Home Loans Servicing's parent, and HUD declined to comment on the Kolbe case.

Force-Placed insurance is a form of coverage that banks purchase to protect the homes of borrowers who allow their standard coverage to lapse. The bank-servicer ultimately passes on the cost of the flood and other force-placed replacement coverage to homeowners and mortgage investors. Flood coverage often costs considerably more than other types of hazard insurance.

The confusion over what force-placed flood insurance is legally required stems from HUD's conflicting advice. The regulator's official position is that the amount of flood coverage must be "at least equal to" the replacement cost of a home or the outstanding principal balance, whichever is lower.

In practice, however, HUD and bank regulators have urged banks to require that borrowers cover replacement values. That means a borrower with a $5,000 mortgage and a home valued $200,000 would be required to obtain flood coverage equal to the entire market price of the home — at a potentially prohibitive cost.

The discrepancy between the two standards creates an awkward situation for banks, says Jim Gilpin, executive vice president of Massachusetts based Miniter Group, which brokers force-placed coverage for small banks. If servicers demand only enough flood insurance to protect the balance of a loan held by the Federal Housing Administration, they run the risk of getting into trouble with its parent, HUD. If servicers demand that homeowners buy full replacement coverage, they risk infuriating borrowers.

"You're damned if you do and damned if you don't," Gilpin says.

The Kolbe case comes at a time when state insurance commissioners, consumer advocates, and even some federal regulators are looking at how best to address the high cost of force-placed hazard insurance. Consumer advocates allege that banks and insurers collude to inflate the price of the insurance and split the profits. After New York state's Department of Financial Services uncovered evidence of such kickbacks, it reached a settlement with Assurant Inc, the country's largest force-placed insurer, which banned them. The Federal Housing Finance Agency has also announced plans to halt commissions ultimately paid by Fannie Mae and Freddie Mac.

The Kolbe claim incorporates the force-placed kickback allegations, but also adds a new grievance specific to force-placed flood insurance. For many years the named plaintiff, Stanley Kolbe, had purchased enough flood insurance to cover the outstanding balance of his FHA mortgage. After Bank of America took over the servicing of his loan, it demanded that Kolbe buy an additional $46,000 of coverage to cover his home's full replacement value.

Kolbe bought the insurance while protesting the requirement and filed his class action. It alleged that Bank of America had no right to demand replacement value coverage and that it was motivated to do so by the prospect of a finder's fee from the underwriter — an type of payment that Kolbe's suit described as a "kickback."

A three judge appellate panel sided with Kolbe in a split ruling last year, finding that Bank of America overstepped its contractual authority by requiring replacement-value coverage. Bank of America appealed, putting the case in the hands of the nine judges of the First Circuit.

The case has drawn considerable interest from mortgage trade groups and consumer advocates. The Mortgage Bankers Association wrote in an amicus brief that banks face "a large and growing number of putative class action cases" that promise "millions of dollars in litigation expense and potential liability" if the ruling in Kolbe's favor is not overturned.

Consumer advocacy groups, including the National Consumer Law Center and AARP, took an opposing stance; they asserted that forcing homeowners like Kolbe to buy more insurance risked pushing them into foreclosure.

"If you have the amount of flood insurance the national program requires, why do you need more than that?" says Julie Nepveu, an AARP attorney. "We should be looking at a playing field that starts with the assumption that fees are going to be reasonable."

HUD also weighed in with an amicus brief, asserting that FHA mortgage servicers have the right to demand borrowers fully insure their homes against floods–even if they're not in flood zones.

"The lender has a contractual right to require the borrower to carry insurance against floods  —  and any other type of hazard  —  'in the amounts and for the periods that Lender requires,'" the amicus brief said. "HUD has organized its mortgage insurance program on the premise that lenders can and should make such determinations."

The First Circuit's judges are skeptical that HUD ever made that clear, according to a recording of the case's oral arguments.

"If that was your [HUD's] interpretation, why didn't you amend the regulation following the appropriate procedures rather than state a position in the middle of litigation?" Judge Lipez asked.

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