One of the most galling aspects of the mortgage meltdown is the sense that folks who made bad loans also made big profits, profits which they get to keep while everyday wage earners and investors are bruised and battered by economic upheavals.
A lot of people are wondering: Do those who made toxic loans have any responsibility? If so, how can they be made to pay?
Few mortgage loan officers or underwriters have been held responsible for mortgages that turned sour, in some measure because blame is often difficult to establish. The result is that fees and commissions earned during the past few years have been virtually untouched, even as substantial numbers of lenders, investors and borrowers have failed.
Now the immunity enjoyed by lenders may be at an end. A new and surprising player is looking at failed mortgages, and looking in a way which may suggest that many loan officers will have to pay up.
The Securities and Exchange Commission alleges that five California brokers sold “unsuitable” securities to customers, primarily variable universal life policies (VUL). “Most investors who bought these securities,” says the SEC, “lacked the cash or income to do so, but were urged by their brokers to raise the money to pay for the purchases and the monthly payments required for these products by refinancing their fixed-rate mortgages into subprime adjustable-rate negative amortization mortgages.”
According to the SEC’s complaint “each defendant was a mortgage broker as well as a registered representative and collected compensation from the mortgage refinancings as well as the sales of securities. In making the sales, the brokers allegedly misrepresented the expected returns from the securities, the liquidity of VULs, the nature of the VULs, and the terms of the new mortgages while failing to disclose material facts about the products. The defendants also allegedly falsified client account forms and order tickets relating to the securities sales.”
In effect, the SEC is saying that it’s a federal crime to misrepresent mortgage terms. Why? Because when a borrower is induced to take a bigger loan then he should, buyers of mortgage-backed securities face additional and undisclosed risks.
The SEC action opens a new front in the mortgage mess. For the first time loan officers are facing criminal charges because of allegations regarding mortgage originations.
Will the SEC’s approach pass muster with the courts? No one will know until the case goes through the legal system and no one has been proved guilty of anything. That said, what’s plain is that the SEC has opened a new front in the mortgage responsibility debate.
At first it may seem odd that mortgages are a federal matter since loans are secured by real estate and nothing is more local than dirt. But both real estate and mortgages have been considered within the stream of interstate commerce for decades.
The overwhelming majority of mortgages are funded with money that travels with electronic speed across state and national borders. In its 1980 McLean decision, the Supreme Court said “mortgage obligations physically and constructively were traded as financial instruments in the interstate secondary mortgage market.” The SEC complaint reflects the McLean decision because it argues that mortgages are routinely bought from local originators, packaged on Wall Street and involve some use of the mail system.
The Other Shoe
You can bet that myriad banks and mortgage companies are asking attorneys to carefully review the SEC complaint. They have good reason to worry: It’s easy to see how the SEC standard can be applied to many of the loans sold during the past few years.
For example, the SEC could limit its investigation to mortgages that were foreclosed within the first 12 to 18 months after origination. In the usual case, such loans should not fail because they were recently underwritten.
The list of potentially suspect loans can then be reduced by comparing borrower names with unemployment compensation lists, death certificates, insurance claims, locations within presidentially-declared disaster areas and communities which have suffered severe economic declines.
The remaining mortgages — perhaps a million or more — will then need to be divided into two groups:
First, failed mortgages made with stated-income loan applications from employed borrowers would be audited automatically. Why? Because such borrowers should have been underwritten with full documentation — something employed borrowers can readily produce.
Second, the remaining loan applications will be compared against actual tax returns.
The one public example of such an audit that we know of revealed stunning results.
In August 2006, Steven Krystofiak, President of the Mortgage Brokers Association for Responsible Lending, testified before the Federal Reserve and said his group compared the income figures for 100 stated-income loans against borrower tax returns.
- Ninety percent of the stated-income loan applications showed earnings that were exaggerated by at least 5 percent.
- Sixty percent of the stated amounts were exaggerated by more than 50 percent.
“Stated income loans,” Krystofiak testified, “help no one. Stated income loans cost consumers hundreds of dollars a year because of higher interest rates. Stated income loans hurt everyone, the home buyer, the institution who buys the loan on the secondary market, and even the home shopper who does not inflate their income to purchase a home. Because of stated income loans, home prices have gone up so dramatically that homes are now unobtainable for Americans wanting to use loan officers unwilling to commit fraud.”
What About Borrowers?
One of the key claims made in the SEC allegations is that fraud was possible because the “customers were unsophisticated and had little understanding of the mortgage products or securities sold to them.”
How is this any different than a situation where an option ARM is recommended to a typical borrower, someone without a master’s degree in finance? Just ask yourself:
- How many borrowers really knew what “recasting” means or that monthly payments could readily go up 50 percent or more with some loans?
- How many borrowers were told about prepayment penalties or understood their size and potential importance?
- How many borrowers understood the impact of negative amortization, the idea that loan balances could rise?
“The SEC allegations raise an important question,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the nation’s largest provider of foreclosure listings and data. “Why is it that protecting securities investors is a federal responsibility — while protecting mortgage borrowers is not?
“Had we protected home borrowers in the first place many of our current financial problems would have been avoided,” said Saccacio. “Mortgage-backed securities would have been fine if the underlying loans been properly underwritten. Insurance contracts related to mortgage-backed securities would have faced few claims, meaning that minimal reserves would have been sufficient to protect policyholders. Banks and other investors would not be reducing assets values by hundreds of billions of dollars. There would be no credit freeze. Most importantly, without toxic mortgages families would not have lost their homes, foreclosure inventories would not be bloated and property values would not have sunk.”
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.