In Search of the Perfect Loan
Let’s be clear on this point: too many bad actors within the mortgage industry helped bring about the pain and suffering millions of Americans endured during the multi-year housing crisis (and some still are). Let’s also be clear on another point – the Federal Housing Administration had no part of the push to put borrowers into sub-prime, interest-only, Alt-At, or other non-traditional mortgage products.
Yet one would surmise based on the number of lawsuits filed by the Justice Department against FHA lenders that the FHA caused the housing crisis. In reality, it is just the opposite.
In late 2011 and many times since then, Moody’s economist Mark Zandi offered this opinion regarding the vital contribution of the FHA: “the FHA shows how government action during the Great Recession forestalled a much worse economic fate. If FHA lending had not expanded after private mortgage lending collapsed, the housing market would have cratered, taking the economy with it.” Similar accolades have been offered by the Center for American Progress and others. Putting a number on Mr. Zandi’s comments, between FY 2008 and FY 2013, the FHA endorsed 8.37 million mortgages (including forward mortgages, both purchase and refinance; and reverse mortgages) with a dollar value of $1.496 trillion.
Putting a more human face on these historic levels of activity, more than eight million families and individuals representing every state in the union purchased their first home, refinanced into a lower interest rate, or secured a reverse mortgage – all because of the FHA and their network of approved lenders. More than 25 percent of the first-time homebuyers were minorities. The refinance activity includes existing FHA borrowers who lowered their rate as well as non-FHA customers who wanted the safety and security of an FHA-insured mortgage.
Photo Courtesy of Forbes
In so doing, the FHA helped pump close to $1.5 trillion of mortgage liquidity into the economy during the worst housing crisis in our nation’s history. This is an amount that is almost equal to the annual gross domestic product (GDP) of Australia.
Fast forward a couple of years and lenders who previously embraced the FHA, are now worried that its punitive side has tipped the scales decidedly against them – the very same entities we need to help re-open the mortgage market to working class families.
JPMorgan Chase (Chase) CEO Jamie Dimon made a long overdue public statement the other day regarding FHA lending: “So the real question is, should we be in the FHA business at all? We’re still struggling with that.”
My only surprise by his comment was that it took so long for an executive within a large FHA lender to publicly make it. Mr. Dimon’s statement was not unwarranted as earlier this year Chase settled with the Justice Department for $614 million around allegations they violated the False Claim Act.
The False Claim Act (FCA) dates back to the Civil War and has largely been a means by which the government can later recoup damages from persons or entities who knowingly submit to the federal government “a false or fraudulent claim for payment or approval.” In most instances the FCA involves treble damages.
Since 2011, the FCA has been used as a “drone strike” of sorts against FHA lenders with devastating results. The price tag so far for a handful of FHA lenders totals $4 billion or so in settlements.
While not involved in the Chase matter, the involvement of our firm in other FCA cases paints a somewhat troubling view of the government’s heavy-handed approach to resolving FCA cases.
Here’s the normal sequence of events. The Justice Department/US Attorney’s Office will issue a subpoena to a lender demanding loan files and other supporting documentation which may include a number of completed quality control (QC) reports over a certain period of time. From our experience the time frame has generally been loans originated from 2006 to 2011.
Who exactly Justice uses to review a sample size of the loan files is unknown, but based on that review, Justice may inform the lender they are filing suit for violations of the FCA (typically in the Southern District of New York). For our part, our firm has a stable of seasoned FHA retirees who spent the better part of their careers working at the FHA mostly within the Quality Assurance Ddivision.
Getting back to the loan file review process, the essential point is this: within the FHA, the primary reason a loan goes to default is due to what is defined as “curtailment of income” which can come about due to a loss of employment or change in familial status – other definitions FHA cites to identify a borrower’s predicament.
The Justice Department, again in our experiences, seemingly disregards that key fact as they studiously review the defaulted loan files in question looking for errors – material or otherwise. The next step is to take the number of loan files with errors and then extrapolate the loss sustained by FHA when the mortgage insurance claim was paid over the entire defaulted portfolio of FHA loans over the period of time in question.
Let’s assume that during the origination process, the borrower’s income was incorrectly tabulated and was off by an insignificant amount. Justice will often argue that it is, nevertheless, a material defect. While an error in computing a borrower’s income could be material on its face, the reality is often that the borrower defaulted because they lost their job. Or in many cases died or divorced.
Recently, the CEO of BB&T Kelly King shared that BB&T was required to disclose a matter regarding HUD’s request for FHA loan documents.
His remarks on CNBC seemed to follow a common theme: “this is not egregious bad underwriting,” he stated. “For example if someone took out a loan 10 years ago and maybe they got a $5000 gift from their parents technically you are supposed to get a gift letter from the parents,” he continued, “let’s say we didn’t get the gift letter and the loan has been handled perfectly well for 10 years but the person loses their job and now they are in default. The fact that we didn’t get the gift letter from a $5000 gift from their parents 10 years ago had nothing to do with them losing their job and not being able to make their loan payments.”
A reasonable person would probably agree with that logic.
Whereas in the past the FHA might seek indemnification for this type of hypothetical mistake (requiring the lender to make FHA whole should the loan default in the first five years), now the weapon of choice is the FCA. So much for reasonableness.
Now begins the back and forth between Justice and the lender’s legal team that many times is not about the facts of the case but rather a negotiation of how much will the lender settle for.
If the False Claim Act is the left-hook, the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) is the right jab to the chin. Not only does FIRREA have a 10-year statute of limitations woven into its legislation but also the “nuclear option” that can hold directors personally liable. As such, it is no surprise lenders are signing the FCA settlement forms post haste.
Given the Justice Department’s zeal in pursuit of FCA settlements I have every reason to believe the end is nowhere in sight. Of course, the deep pocket lenders were the initial targets (some FCA cases were born of what were originally qui tam cases) so one can logically expect regional and smaller FHA lenders to be served up next. Justice is also reportedly now using the FCA in pursuit of multifamily housing, reverse mortgage, and nursing home lenders as FHA has similar lending programs that helps meet that critical need.
In FHA’s storied 80 year history, never has the False Claim Act been used in such a far-reaching manner that now seemingly requires perfection in the loan origination process lest lenders pay a very steep price later – both financial and reputational. In my opinion, that is a striking historical footnote.
An important point to this discussion is FHA’s history of monitoring lender performance – totally removed from the Justice Department’s actions over the past few years. FHA’s Quality Assurance Division (QAD) has been in place since 1983 and has a successful track record of conducting compliance reviews of FHA lenders’ origination and servicing activities.
To reiterate, reviewing FHA loans is the sole function of this office. They are the bona fide experts when it comes to detecting violations and most germane to this discussion determining if a violation meets their standards of materiality. When it does, as previously noted, the lender or servicer will receive an indemnification agreement that will make FHA whole if the loan goes bad in the first five years. In addition to the QAD team, FHA field offices sample recently insured loans, again citing deficiencies and making a determination of materiality.
Another option for making sure that non-compliant loans or lenders with a pattern of misconduct are appropriately sanctioned is HUD’s Mortgagee Review Board. Along with a support staff and legal team, it is the Board’s responsibility to take action when appropriate – including sanctions ranging from a Letter of Reprimand, to indemnification requests, assessment of civil money penalties up to the withdrawal of the lender’s FHA approval.
To make a short comparison – you have FHA staff experts determining if a violation of FHA rules exists and then determining how serious the problem is. If it is serious, the lender or servicer is expected to make FHA whole if the loan goes bad. Then you have the Justice Department who declares all violations as material and thinks that the “fair” settlement is three times the claim paid. It is no wonder Mr. Dimon and Mr. King are fuming and worse in Mr. Dimon’s case, questioning the efficacy of the FHA product.
To be clear, blatant fraud in the loan origination, servicing, and claims process should never be tolerated and violators should be punished as such. But in the instance of FHA lenders who may have incorrectly tabulated income or made some other immaterial error, which in the end had nothing to do with the loan defaulting, it’s no wonder lenders like Chase are now publicly saying that maybe FHA lending just isn’t worth the risk.
For their part, the FHA has been working on a series of new initiatives across the risk management and quality control waterfall in an effort to help calm lenders’ concerns around back-end enforcement while also encouraging them to serve more qualified borrowers further down the credit spectrum. Hopefully those changes, which are coming out this summer and into the fall, will help calm FHA lenders who are increasingly concerned about the punitive side of FHA lending.
As the FHA celebrates its 80th birthday in July 2014 and in full recognition of its vital role since 1935, it is critical to our nation’s housing finance system that the FHA product is available to working class families and first-time homebuyers for decades to come.