Two recent Justice Department settlements, one with a large nonbank mortgage lender and the other with a small one, speak volumes about how much Federal Housing Administration lending has changed.
Franklin American Mortgage in Franklin, Tenn., on Wednesday agreed to pay $70 million for knowingly originating home loans that did not meet the guidelines of the Department of Housing and Urban Development, which oversees the FHA. A day earlier a much smaller lender, RanLife in Salt Lake City, agreed to pay $1 million for underwriting loans that failed to comply with HUD's regulations.
Those dollar figures might seem like peanuts compared with bank settlements in the hundreds of millions or more. But more of the FHA market is shifting to nonbanks, and the cases highlight nonbank lenders' tendency to under-report deficiencies and their other shortcomings. Moreover, the cases underscore the reason why big banks have backed away from the business in the first place — legal risk.
If independent mortgage lenders were uncertain about the threat of stiff fines before, Principal Deputy Assistant Attorney General Benjamin C. Mizer sought to make it clear that smaller, independent mortgage banks are drawing law-enforcement scrutiny.
"We will hold accountable anyone whose conduct results in loss to the government, whether it is a large bank or a smaller mortgage lender," Mizer said in a press release in the Franklin American case.
The settlements come at a time when thinly capitalized nonbanks have filled a big void left by large banks pulling back from making FHA loans. Large banks held 65.4% of the market in late 2012, compared with 23.5% this fall, according to data from the American Enterprise Institute's International Center on Housing Risk. FHA loans are largely made to first-time homebuyers and those with lower credit scores, and they tend to have higher default rates.
In both cases settled by Justice last week, loans went into default and put HUD on the hook for potentially millions of dollars in FHA insurance claims.
In the Franklin American case, the Justice Department said the lender violated the False Claims Act, a Civil War-era law that extracts treble damages from violators. The RanLife settlement began as a fraud investigation by HUD's Office of Inspector General.
Franklin American is the 22nd-largest FHA lender, and as a wholesale lender it underwrites, funds and endorses FHA loans purchased from mortgage brokers, many of them in California.
For six years beginning in January 2006, Franklin American reported very few deficient loans to HUD even though its post-close audits identified substantial percentages of its loans had deficiencies, the Justice Department said. In 2010 between 22% to 30% of its loans were considered to be of poor quality, but only 50 loans with deficiencies were self-reported to HUD, Justice said.
The company also employed unqualified junior underwriters to perform important underwriting functions, set high quotas for underwriters of 201 to 225 loans per month, and "subjected underwriters to discipline if they did not meet their quotas," Justice said.
Joe Taylor, Franklin American's senior vice president and corporate counsel, said in a statement that Justice's inquiries "have been customary within our industry."
"We chose to settle this matter without admission of fault and negotiated this monetary settlement amount to avoid a protracted and costly legal process," Taylor said.
HUD requires that all mortgage lenders conduct quality control and review a sample of FHA loans that become 60 days delinquent in the first six months, based on the number of FHA loans originated each year.
Self-reporting deficiencies have not been at the top of most mortgage bankers' "to do" lists. Of the 1,748 active FHA lenders, just 88 self-reported deficiencies in 2013, according to FHA's Lender Insight newsletter.
"Lenders have to take the self-reporting requirement more seriously," said Daniella Casseres, an attorney at Offit Kurman.
Though it would be easy to conclude that lenders with high early-default rates are targets, Franklin American's was actually below the industry average. It has an early-default rate of 0.56%, compared with 1.06% industrywide, leading some experts to conclude that large lenders are being targeted generally.
Brian Chappelle, a mortgage consultant and co-founder of Potomac Partners, said the two settlements are reverberating through the industry.
"For a large lender, you get selected because you're big. For a small lender, you typically get selected because of a high default rate, a referral from another agency or from a complaint," Chappelle said.
HUD has reviewed roughly 25,000 FHA loans in each of the past four years, or roughly 4% of overall volume, Chappelle said. About half of the loans initially appeared to have serious problems. But when lenders provided additional detail, only 6% ended with a request to the lender to indemnify the loan to FHA, he said.
A 12-page fact sheet released by the Justice Department stated that a Franklin American executive vice president wrote in an email in early 2009 that underwriters needed to review eight loan files a day and that those "doing the bare minimum" would be terminated. Justice officials also appeared to admonish the company for tying underwriting bonuses to the number of loan files reviewed.
Casseres said that since the Justice Department specifically mentioned an underwriter bonus based on a 201-loans-per-month quota, lenders likely will be revisiting quotas and bonuses.
"Lenders need to look at whether they want to continue to offer bonuses based on quotas as HUD prohibits lenders from paying its underwriters on a commission basis," she said.
She also is advising clients to ensure that junior underwriters are not playing a key role on FHA loans.
"If you're going to have junior underwriters on staff, they need to be closely supervised from someone with experience on FHA loans," Casseres said.
FHA lenders are required to sign an annual HUD certification stating that loans do not have "material violations," and that no deficiencies or defects would render the loan ineligible for FHA insurance. The mortgage industry has tried unsuccessfully to water down the annual certification requirement.