Announcing the $25 billion settlement over foreclosure practices last week, President Obama made a point of reminding everyone his administration recently created a task force to investigate possible misconduct by banks involved in mortgage origination and securitization.
"The mortgage fraud task force I announced in my State of the Union address retains its full authority to aggressively investigate the packaging and selling of risky mortgages that led to this crisis," the president said. "This investigation is already well underway. … We're going to keep at it until we hold those who broke the law fully accountable."
Clearly, the issue is here to stay.
The burden of the collapsed housing market continues to weigh down the economy. Even if most banks were guilty of nothing more than sharing the irrational exuberance about the economy in general and home prices in particular, it would be hard to deny that there were problems ranging from mistakes in judgment or carelessness to negligence and outright fraud in some cases.
With the establishment of the Residential Mortgage-Backed Securities Group – co-chaired by New York’s assertive Attorney General, Eric Schneiderman – the risks of being made the public target of regulatory, civil, or even criminal action are high. Rather than wait for government or plaintiff lawyers to find them, banks who were involved in the syndication of mortgage backed securities should effectively control their exposure through a proactive, rigorous self-study program to determine the scope of their participation with these securities, and their own practices in the origination of mortgages. If these practices fell short, banks that engage in such a self-initiated examination will be able to approach MBS purchasers and the regulators from a far stronger position, therefore becoming participants in managing their own fate.
For the strategy to succeed, the team doing the study must not only be effective, operating under the full authority of and reporting directly to the bank’s board. It must also be seen as effective. Thus, while it could be done by internal lawyers, accountants and risk assessment personnel, for the sake of credibility it is best to have outside counsel lead the process. The study will look not only at the specific procedures the bank followed in handling the mortgages, but also the context – the incentives and compensation structure – in which those procedures operated.
At the beginning of this process, the board should determine whether to launch a full-scale audit, or to look at a sampling of the mortgages as an indicator of potential risk. This determination will be based on a number of factors. How active was the lender in originating and securitizing mortgages, subprime loans in particular? Were there third parties – vendors or outside agents – active in the originating process? What, if any, misconduct occurred through their actions?
Were the mortgages properly made? The determination begins with the credit memo, which set forth the facts upon which the bank would make each type of loan. Presumably, these would include such important pieces of information as property value, borrower’s income, etc. The real concern, though, is whether those conditions were in fact met. Were the borrower’s credit history and income verified? Did the property undergo an acceptable appraisal? And finally, was the mortgage documentation properly prepared and signed? It is becoming apparent that many institutions, especially in the subprime market, may be found to be delinquent in matters of verification and appraisal. But for a bank to discover and control the disclosure of this information is vastly preferable to having it discovered and released under adversarial conditions.
Beyond the actual behaviors involved in the origination of mortgages we can expect increased scrutiny of the corporate context in which those behaviors took place: were they simply failures of oversight, or were they actively encouraged? The difference between faulty mortgages being issued because of poor execution, and their being issued because of an enterprise-wide culture of producing loans no matter what, will be at the center of regulators’ attention. To prepare, the internal auditors will need to examine how the persons originating the loans were compensated. Were any steps in the underwriting and/or due diligence process routinely left out because of the need to generate loans and meet specific business volume targets?
With the results of the internal audit in hand, the board can begin to evaluate its risks. What is the likelihood of the bank becoming a target, of regulators or of plaintiffs? What weaknesses did the audit reveal? The board will need to consider, too, where the dangers lie. These can run from reputational damage, to vulnerability to stockholder lawsuits to the potential criminal culpability of some of the bank’s officers.
These considerations will inform what must ultimately be a judgment call as to whether or not to act preemptively in reaching out to the authorities if there appears to be serious exposure to risk.
There are a variety of remedies that might be suggested: changes in compensation schemes or underwriting procedures, more effective due diligence, etc. Some of these might be painful; some might merely be best practices that should be adopted even without the regulator’s shadow over the bank.
Whatever the remedy, to the extent that it is the result of a considered internal process, driven by the board and responsive to the bank’s long-term needs, it is a solution that works.
Deryck Palmer is a partner at the law firm of Pillsbury Winthrop Shaw Pittman. He can be reached at email@example.com