Mortgage Lending

Secondary Marketing Fraud Question from an Anon Caller

Question from an anonymous phone caller:

“I work at retail bank. When rates were dropping, I asked my processor to lock several FHA loans.  All the paperwork to lock was completed and sent to management.  Management did not lock the loans, hoping to ride the wave down and earn extra yield for the bank….rates rose and many of my customers lost the ability to lock at the rate we promised.  They were furious and not surprisingly took their refinance business elsewhere. I lost the ability to earn income on those loans and my company also lost interest and fee income. I feel horrible for those customers and I have all kinds of emails saved showing our company promised to lock their loans.  I complained to management and I was fired.  What can I do to report this? I don’t want to have this happen again to customers at that bank.”

 A: Is the bank state or federally chartered? If the bank is state chartered you can file a complaint with DFI.  If the bank is federally chartered, find out the name of their federal regulator from the bank’s website.  The FBI also takes whistleblower complaints on cases like this as the FBI is HUD’s enforcement arm: http://seattle.fbi.gov/ I ran this by our local Seattle FBI Field Office and Jim Siwek, Assistant Special Agent in Charge, HUD-OIG Investigations, says to contact the Seattle FBI office here: (206) 220-5390 or the direct HUD-OIG hotline: 1-800-347-3735. Other ways of contacting HUD:

Mail:
HUD OIG Hotline
451 7th Street, SW
Washington, DC 20410
 FAX: (202) 708-4829
 Email:  hotline@hudoig.gov

Case Study: NAACP v. Novastar

Novastar and its mortgage broker Bell South Mortgage (Bell) conspired to maintain a policy of denying all loans secured by row houses in Baltimore and discouraged the referral of such business. Over a period of time, HUD sent shoppers to Bell/Novastar who were repeatedly treated differently based on protected characteristics of race, color, racial composition, and national origin. Property type is strongly correlated to the racial composition of neighborhoods in Baltimore. Two thirds of all row houses in the city are occupied by African Americans.

As a result of this policy, individuals in the community were denied equal access to credit, capital, banking services and loan products; and made housing unavailable on a prohibited basis, a clear violation of Fair Housing law. Loan officers repeatedly told shoppers, “We don’t do row houses.” In some cases Novastar and Bell refused loans where the borrowers had more than adequate credit scores, income, financial stability and even low LTV ratios.

When Bell joined with Novastar it was given a Company Program Manual  listing Unacceptable Property Types. Row houses were not listed. Bell also secured an exclusive warehouse credit line from Novastar, agreeing that Novastar would fund all of Bell’s loans. At the time, Bell had several unclosed Baltimore row house loans, which Novastar refused to fund, and warned that using another warehouse line to close those loans would be a violation of their exclusive warehouse agreement. Bell assigned the loans to another lender for a fee. Bell and its staff continued to refuse loan applications on row houses in Baltimore even after being informed that this was a violation of Fair Housing laws.

Plaintiffs sought injunctive relief as well as money damages, cease and desist orders, attorney’s fees, and enjoining Defendants to modify their lending practices to comport with the law.   
The N.C.R.C. and N.A.A.C.P. in their COMPLAINT claimed the following:

I. Defendants policies and practices violated the provisions of the Home Mortgage Disclosure Act by redlining: refusing to grant credit in a community or neighborhood. Their actions have had a disproportionately adverse effect on African Americans and other people of color compared with Caucasian applicants by virtue of denying the financing of the type of property chosen for security purposes. This contributed to the economic destruction of a Baltimore neighborhood, depreciation of property values, higher foreclosure rates, street crime and the creation of housing ghettos.
II. Defendants policies and practices violated The Civil Rights Act of 1964, which prohibits racial discrimination in the formation and issuance of contracts, and intentional interference to pursue and hold real property. Defendants through their willful conduct contributed to racial hatred, and denied African Americans the right to own property.
III. Defendants policies and practices violated the provisions of The Equal Credit Opportunity Act which prohibits a creditor from discouraging an applicant from making application for credit by refusing to consider the security property offered.
IV. Defendants policies and practices, through the disparate impact theory,  a provision of The Fair Housing Act and other legislation by imposing different requirements or conditions on a loan on the basis of elements other than credit, the result of which was racial discrimination.

Before the trial was held, Bell asked the judge for summary judgment,  claiming it was only following the dictates of its “exclusive source of warehousing and funding.” Its agreement required that all loans must be sold to Novastar thus it had no other choice. At trial Novastar raised an unusually large number of issues with respect to the wording of the law, citing numerous cases and questioning the interpretation and meaning of whether or not the law applied to this case.

The lenders denied the accusations and set out these AFFIRMATIVE DEFENSES

I. Type of property. Independent appraisals show that row house properties in Baltimore are in a transitional state. Many are being converted to commercial or mixed-use enterprises. This, not lack of financing, has resulted in value depreciation. Our Company Program Manual at ¶5.3 Unacceptable Property Types reads: Commercial use or a mix of commercial and residential properties. Clearly, many row houses in Baltimore are “mixed use”, as most appraisals point out. This violates our written policy, which was not drawn frivolously. Empirical evidence we have provided demonstrates that losses on this property type exceed those of other type of dwellings. As further evidence of excessive risk, private mortgage insurers have refused to insure loans on row houses.

II. Intentional Interference. We have shown that there are other mortgage lenders in Baltimore and elsewhere that offer financing to row house buyers.  We fail to see how our actions prohibit borrowers from shopping the mortgage market for other sources willing to accept this type of security. Our Company Program Manual at ¶2.3 Regulatory Compliance reads: We comply with all federal and state regulatory requirements in granting mortgage loans. We have provided the court with a recent pipeline and portfolio report showing that a large number of our borrowers are African American and other minorities and the security properties are located in a variety of neighborhoods, towns, and rural areas  . We fail to see how our conduct in these cases intentionally interfered with these borrowers right to contract for the property desired.

III. Discouraging Applicants. We have shown a number of examples where national mortgage lenders regularly publish U. S. Postal zip codes showing geographic areas in which they will not grant credit.   These typically are areas where lending experience has shown that unreasonable business risks have been found through empirical evidence. We ask the court: How does this differ from avoiding row housing? We believe we should have the same right to define when, to whom, and where we will grant credit without the interference of government and claim this right specifically in this case. We deny discouraging borrowers from applying for credit because in every case cited we informed the borrower of our willingness to finance real property in many other locations.

IV. Racial Discrimination. Refusing to accept real property offered as security for a loan is not against the law. The decision to lower lending risk profiles and elect not to finance row houses is racially neutral – it is not directed toward any race –- it is directed toward real property and therefore cannot be found racially discriminatory.  As an example of our neutral policy we refer to our Company Program Manual, at ¶6.2 Minimum Value Requirements. There is no minimum value requirement for Citizens and Resident Aliens with our company because we long recognized that this is discriminatory by its very nature.  (Non-resident aliens and piggybacks are limited to $75,000 because of secondary market considerations not internal company policy). We have provided the court with example after example of lending companies that have loan minimums whose adverse and disparate effect is directly similar to the case at hand. We will make mortgage loans other companies refuse because we understand the need for making capital available in large or small amounts – a racially neutral policy. We contend that minimum loan amounts are also discriminatory but counsel can find no case in the court’s jurisdiction where lenders have been challenged under civil rights statutes.

Trial Notes
Mentioned in this suit is the fact that lenders have been sued by several cities using two theories of “Public Nuisance” In City of Cleveland v. Deutsche Bank Trust Company, et al. Common Pleas. January 10, 2008. The city claimed that lenders were the cause of high foreclosure rates, blocks of unoccupied residences that were more expensive to police and protect against fire damage and empty blocks of neighborhoods decreases property values and loss of revenue

Notes on the defenses raised:

I. Defendants provided audited internal data showing greater-than-average losses on row houses, together with an article from the Baltimore Sun newspaper, which reported that some units in Baltimore’s row houses were being used as boarding houses and even Bed & Breakfast Inns, in violation of the zoning laws. Zoning violations are often considered a default in mortgage lending.

II. The pipeline and application data used were taken from published HMDA reports, and the Mortgage Bankers Association provided data on the number of foreclosures and average losses to member companies in the same geographic region.

III. Copies of advertisements and loan program brochures of other lenders provided information on zip code lending restrictions. It was and is a common practice. Plaintiffs did not refute it.

IV. The disparate theory holds that when an action has a disproportionate effect on some group (racial, ethnic, etc.) it can be challenged as illegal discrimination even if there was no discriminatory intent.

The question is whether someone who does not engage in racial discrimination can violate the federal Fair Housing Act. The claimant need not prove that individuals were treated differently because of their race. Instead, it is enough to show that a neutral practice has a disproportionate effect – that is, a disparate impact – on some racial group.

However, the theory is difficult to apply. Suppose a landlord refuses to rent to people who are unemployed, and it turns out that this excludes a higher percentage of whites than Asians. A white would-be renter could sue. It would not matter that the reason for the landlord’s policy was race neutral and had nothing to do with hostility to whites. He would be liable, unless he could show some “necessity” for the policy. This would hinge on whether he could convince a judge or jury that the economic reasons for preferring the rent to the gainfully employed were in some way essential.

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Questions.

Did Novastar engage in racial discrimination?
Is it possible for a company that does not engage in racial discrimination to still be found in violation of Fair Housing laws?
If yes, how so? If no, why not?
Here is a link to the Fair Housing Laws for your review.

Case Study: Carnell v. KMC

Carnell, a self-employed 64 year old single man with no dependents, applied to KMC Mortgage Co. (KMC) to refinance a first and second mortgage and get cash to buy tools for his small business. Besides what he earned as a general handyman, he received Supplemental Security Income (SSI) for a disability. At application he talked loudly to himself, had questionable personal hygiene and wore slightly ragged clothing. He boasted loudly how he “took care of himself,” doing his own cooking, etc. The broker determined that – subject to the appraisal – there was sufficient equity to pay off the underlying mortgages, cover loan costs, and leave about fifteen hundred dollars, but warned him that his monthly payment was likely to be much higher than his current payment. Carnell advised KMC to go ahead with the deal because he “needed the money.”

The appraisal was sufficient but noted that the home’s interior was so filled with personal items, books, magazines and debris that the owner had made high narrow lanes in order to use the rooms. A preliminary title report showed a junior lien in favor of King County Public Assistance securing a loan that was used to assist in purchasing the property. The loan terms required no monthly payments with interest at 4% per annum to accumulate as long as Carnell occupied the home as his principal residence. Upon sale of the home, the entire principal balance was payable. There was a property tax abatement certificate on the home as long as Carnell used it as his principal residence.

The credit report showed 1×30 and 2×60 in the last two years and the credit score was within the guidelines of KMC’s investor. His use of credit was sparse and included one very small balance, never exceeding three hundred dollars. An old pickup truck used in the business was paid for and the business was run on a cash basis. His tax returns showed an average combined monthly income for the last three years of $1,066. and the current monthly payment on the first mortgage was $454. He had little cash reserves with an average bank balance in the high threes.

The broker contacted CALFUND (the investor) by phone to discuss “how we can put this together.” The investor advised that this was a case where the underwriting theory of attributable income could be used.  Because Carnell’s SSI income was not taxable, and the property tax abatement lowers even more tax liability, it would allow KMC to “gross up” the SSI income “to an appropriate amount.” KMC adjusted Carnell’s income by 25%. The investor subsequently indicated by phone that the loan would be approved provided there were no debts other than the new mortgage; and he paid an additional 1% of the loan amount because of the increased risk.

The broker telephoned Carnell with the loan approval and informed him of the new monthly payment, then asked if he had any questions. He responded that he was quite happy and had no questions. KMC did not notify him of the additional cost at this time, explaining that they prepared a new GFE and mailed it to his residence as required by regulation. Carnell claims he never received the notice.

In preparation to close the loan, final payoff statements were ordered from the holders of the first and second mortgages. King County P.A. responded with a final principal amount that included all of the accumulated interest and a per diem charge.

Examination of the loan documents showed that KMC changed its initial GFE and final Settlement Statement to include an additional two percent with one percent going to the investor and an additional percent listed on line 808 of the closing statement as a brokerage fee. A brokerage fee had already been combined with the investor’s fee and reported on line 801 of the closing statement. Carnell signed all final documents without comment or question and the investor wired the funds to escrow.

Seven months later, failing to cure payment delinquencies, Carnell defaulted on the loan. The file showed that he had difficulty meeting monthly payments. The investor demanded that the broker buy the loan back. KMC responded that the investor itself had helped put the loan together. When asked for proof of this, KMC revealed the phone conversations it had with an employee of the investor. The investor found no record of the conversation. The issue between KMC and the investor remained unresolved.

Several months later, the property was foreclosed upon and Carnell lost his home. A lawsuit was brought against both KMC and the investor to recover damages and rescind the entire transaction, seeking to put Carnell in the position he was before applying to refinance. Several violations of state and federal law were claimed in the suit.

KMC’s position was that it did nothing wrong, claiming that a customer had applied to refinance his home; the company followed usual and customary lending procedures and gained loan approval.  It was not unusual for details to have been discussed with the investor. It followed all regular procedures of loan brokerage and complied with disclosure rules. After learning that the final loan costs were greater than estimated they acted in good faith by re-disclosing. They further pointed out that the final settlement statement revealed all of these charges but were not challenged at closing.

The investor claimed that it dealt with KMC at arms length and could find no record of offering “extraordinary assistance” in qualifying Carnell. It was against their policy to offer step-by-step procedures to brokers in order to customize a loan to fit corporate matrixes, “A loan either fit our program or it didn’t,” according to their testimony. Further, the contract between KMC and the investor contained a provision with regard to early defaults, which they chose to exercise.
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Questions.
A broker must use reasonable care in managing a file from application through closing to assure a standard of care commensurate with the duties of agency and brokerage. Some courts have even held licensed brokers to a higher than reasonable standards because the general public considers them experts. In considering how this case was handled, what would have caused you concern if it were given to you for review? Be prepared to discuss the following:

1. What kind of a borrower does Carnell look like on paper?  Does an applicant’s conduct and demeanor at application have relevance to the case or should they be overlooked? After all, they have nothing to do with credit – by law the only basis on which we are to judge credit worthiness.

2. Documentation. Are there any inquiries you would have made or any additional documents/exhibits you would have required before continuing to process and submit this case for approval? Explain what and why you would order more documentation.

3. Customer Service. Consider the position of the borrower before and after dealing with KMC Mortgage Company. Did the broker help the borrower achieve what he wanted? Was the borrower well served?

4. Verdict.  If you were on the jury would you find in favor of Carnell or the broker/lender?

Informed Consent for Mortgage Lending

In Part 4, of a 6-part series, the Mortgage Professor states, as follows:

“In sum, regardless of why borrowers refinance, the question of whether they receive a net benefit from it is for borrowers alone to answer. Loan providers do not have the information needed to second-guess them.”

He goes on to say that

“on the other hand, borrowers often make their decisions on the basis of incomplete and sometimes misleading information. Instead of requiring lenders to assume responsibility for borrowers’ decisions, let’s make them responsible for providing borrowers with the information they need to make better decisions.”

The National Association of Mortgage Fiduciaries supports the Mortgage Professor’s theoretical position that holds residential lending professionals (all retail mortgage salespersons, no matter where they work) to a certain standard of practice.  What the industry must determine is exactly what this standard of practice should be.  NAMF would like to make a few comments sketching out a position in this matter.  We can first start with the idea of professional “responsibility,” which implies that lending workers must focus their attention on the needs and interests of their clients.  We believe that this requires, at a minimum, that lenders fully inform their clients of the relevant information and consequences to their potential borrowers.  This obviously mandates a standard of truthfulness and completeness.  Anything less than this opens the door to moral subjectivism and a moving standard that manipulates the hopes and dreams of borrowers.

Nevertheless, NAMF believes that the standard could be and should be higher.  NAMF believes that the standard should include a fiduciary duty that absolutely requires the informed consent of borrowers to the terms of their loan.  Informed consent has both an objective and a subjective standard.

Criteria have already been formulated to determine the risk category of a borrower.  Lenders ought to be required to carefully explain the category within which a borrower falls.   However, there should also be a subjective standard; here, lenders would be required to probe into the financial situation of a borrower if that lender determines that the borrower is unsophisticated.  Each lender would be required to make sure that a borrower asks the relevant questions and receives full and complete answers to them. This is analogous to a layperson gaining the benefit of informed consent at a surgeon’s office or a lawyer’s office.  Surgeons and lawyers do not guarantee results, for a fiduciary standard does not require it.  Analogously, lenders would not be required to guarantee a particular kind of result to a borrower.  It would be up to each borrower to determine his or her value choices in the face of complete and accurate information; the duty of each lender would be to facilitate informed consent. In fact, a form attesting to informed consent could be provided.  It would make sure that each borrower was alerted to the recommendation of seeking third party review of loan documents and that the borrower had ample time and opportunity to do so.  This procedure could be carefully addressed by way of a written code of ethics or state/federal regulatory guidelines.  We do not see any good reason why the standard for mortgage lenders should be any lower than the standard for lawyers and medical doctors.

Originally published May 1, 2007 in Inman News co-authored by Jillayne Schlicke