Just when you thought things could not possibly get worse a new worry is emerging on the housing front: Is the FHA going to demand billions in paybacks from weary lenders and servicers? If yes the foreclosure market could change substantially, and with it the housing sector and the entire economy.
The FHA doesn’t actually make loans, it insures mortgages made with private-sector money. As long as the loan meets FHA standards the government will provide insurance. With such coverage buyers can purchase with just 3.5 percent down while lenders have 100 percent coverage if there are any losses.
The catch is that lenders have total loss protection only if the FHA accepts their claims. Now a team of analysts from FBR Capital Markets led by Paul J. Miller (no relation) “believe that FHA claim denials could become the next drag on the industry” as the government tries to offset FHA foreclosures by simply agreeing to fewer lender claims.
The analysts also say something else: Even if the loan is current it’s possible that the FHA may still file claims against lenders and servicers if the paperwork isn’t technically correct. Why? Because FHA reserves are limited and foreclosures could increase if home prices remain depressed. One way to reduce risk and increase reserves is simply to sue lenders for breaching FHA standards.
Last May the Justice Department sued Deutsche Bank and its MortgageIT subsidiary under the False Claims Act, alleging that they engaged in “years of reckless lending.”
“According to our complaint,” said Assistant Attorney General Tony West, “these lenders put millions of dollars of taxpayer funds at risk and violated the integrity of this important program by making false certifications to HUD.”
The government alleged that MortgageIT underwriters “endorsed the mortgages by falsely certifying that they had conducted the due diligence required by HUD rules when, in fact, they had not. By endorsing ineligible mortgages and falsely certifying compliance with HUD rules, MortgageIT wrongfully obtained approval of these ineligible mortgages for FHA insurance, thereby putting millions of FHA dollars at risk.”
In other words, the government said it was unfairly exposed to possible losses — not that it actually paid out additional claims. This may not sound like a big deal but the Justice Department could get more than $1 billion in damages.
“Even if the case settles for a nominal dollar amount,” said FRB, “it is significant in that it is one of the first large-scale FHA examinations of claims. Moreover, this case has spooked industry players especially as the U.S. Attorney commented that there could be more to come.”
Once an FHA loan is originated payments must be collected and if payments are not made the mortgage must be foreclosed. This work is done by servicers who operate within a lengthy list of standards.
KBR argues that “if the agency is looking for a way to deny a claim, the servicing process is an easy target. This means that even if a loan was cleanly underwritten, mistakes made in the servicing process could be enough to warrant a claim denial.”
The catch is that while lending and servicing are different businesses, the same players largely dominate both arenas.
According to John Walsh, the acting Comptroller of the Currency, “the servicing portfolios of the eight largest national bank mortgage servicers account for approximately 63 percent of all mortgages outstanding in the United States — nearly 33.3 million loans totaling almost $5.8 trillion in principal balances as of June 30, 2010.”
Can They Pay?
In the world of litigation it doesn’t make much sense to sue parties without cash. Even a successful court judgment won’t mean much if collection is limited or impossible.
We generally look at huge banks and servicers as bottomless sources of cash, but that’s not true. Even the biggest corporations fail RealtyTrac — consider that the Dow Jones Industrial Average has continuously included only one company — GE — since it was founded in 1896.
The once-unthinkable issue is this: With massive claims by pension funds, insurance companies, government agencies and borrowers, what happens if lenders, servicers, ratings agencies and insurance companies lose so much they’re unable to pay?
Bank of America, now the owner of Countrywide Financial, “would consider putting the unit into bankruptcy if litigation losses threaten to cripple the parent” according to Bloomberg News.
“There are huge public policy questions that need to be considered,” said RealtyTrac spokesman James J. Saccacio. “We already have the government suing 17 major banks and brokerages for loans sold to Fannie Mae and Freddie Mac. Claims worth hundreds of billions of dollars against lenders and servicers have been made by private-sector investors. The robo-signing scandal has slowed foreclosures nationwide and questions about the electronic recording and transfer of mortgage notes remain unsettled. It would be in everyone’s interest to resolve these matters as quickly as possible and re-establish the housing market.”
According to HUD spokesman Lemar Wooley, as of mid-September the FHA was insuring 7.15 million loans. Of this inventory 2.47 percent were in foreclosure and 1.22 percent were in bankruptcy. In comparison, the Mortgage Bankers Association says fixed-rate prime mortgages have a 2.56 percent foreclosure rate while the rate for prime-rate ARMs is 9.16 percent.
The FHA numbers can be difficult to interpret. For instance, how many borrowers facing foreclosure also declared bankruptcy? Is there a double-counting?
Possible FHA claims have been over-estimated in the past. For instance, between October 2009 and June 2010 HUD expected 600,000 claims but only 290,000 came in. Instead of paying out $13 billion, the final bill for the period was $9.4 billion. Saving $3.6 billion is no small matter.
At the heart of the KRB report is a very simple question: Are minor paperwork problems a good reason to sue lenders — especially if the loans are performing?
After all, if the money is coming in who really cares if some technical “i” was not dotted or a minor “t” was uncrossed? Where’s the hurt? Aren’t such claims nothing but frivolous lawsuits?
Lenders and servicers certainly believe a “contract is a contract” when originating a mortgage. Underwriters now ask for endless streams of verifications and certifications from loan applicants. And when applicants submit allegedly-false paperwork charges of mortgage fraud can follow.
The reason we have FHA, VA and conventional loans is that each type of financing has very specific underwriting standards. Investors who buy mortgage-backed securities weigh the risks of such financial instruments on the basis of the loans they contain — meaning that 5,000 conforming loans in an MBS should be just that, conforming. If the loans are not conforming then investor risk increases and so should requirements for higher interest rates, assuming investors even want to buy such paper.
A Way Out
Given the ugly nature of potential FHA suits is there a way out for lenders and servicers?
In a curious way the answer is yes:
- Foreclose less and modify more, thus reducing the inventory of distressed homes that holds down home values.
- Refinance existing loans to lower rates for all borrowers. Making homes more affordable will reduce foreclosures and put more consumer money into the economy, thus bulking up the job base and tax revenues. And not just FHA loans, but all mortgages so that those who have been making their payments also benefit.
Why would lenders agree? Because such arrangements can be part of a grand accommodation, a trade of less liability and fewer suits in exchange for a smaller number of foreclosures and thus reduced FHA claims. Moreover, a lot of troublesome loans could be removed from the books.
Peter G. Miller is syndicated in newspapers nationwide and operates the consumer real estate site, OurBroker.com.