The residential mortgage loan market has suffered unprecedented turmoil as a result of the economic downturn. The level of delinquencies and foreclosures has risen sharply, but has yet to hit the high-water mark. The wave of subperforming and nonperforming residential mortgage loans has put many banks and mortgage companies out of business, with more on the brink of failure. It’s unclear what the effect of the Obama Administration’s recently announced plan aimed at preventing foreclosures by incentivizing loan modifications will be.
This turmoil has created opportunities for investors interested in buying pools of loans at a discount. Greater opportunities are on the horizon as more banks fail, others look to shed loans to shore up their balance sheets and the Administration’s plan to encourage private investors to purchase nonperforming loans takes shape. The potential players are not only those very familiar with the industry, but also newcomers from the world of private equity and hedge funds.
Early on, many potential investors sat on the sidelines, waiting to see how things would shake out. Recently, however, there has been an uptick in bid activity. Investors have been placing low bids on pools of subperforming and nonperforming loans, but big bid-ask spreads have stood in the way of many deals. As time goes on and the market shows signs of settling, the spreads will narrow and more deals will get done. Buyer beware, though, as such purchases come with many risks. Some will make big profits; others will suffer losses. The difference between winning and losing may be found in the ability to effectively mitigate risk and, of course, pricing.
This edition of the Financial Services Alert discusses the legal risks and considerations associated with purchasing residential mortgage loans.
Legal Authority and Compliance
A gating issue is the authority needed to purchase residential mortgage loans. Approximately 15 states require those that purchase residential mortgage loans to be licensed as a mortgage lender. Although mortgage lenders are commonly understood as persons that make loans, these states have defined the term “mortgage lender” in their licensing laws to cover those that also purchase mortgage loans.
There are many issues that go along with obtaining these licenses. The first is timing. Generally, after a complete license application is submitted to the state licensing authority, it takes approximately three months for a license to be granted. In a few states, however, it may take as long as six months or more. The licensing laws also contain requirements and restrictions on licensees. Licensees are also subject to examination for compliance with laws by the licensing authorities.
These licensing requirements do not apply to federally-chartered banks (federal savings banks and national banks) and their operating subsidiaries that purchase loans as the requirements are preempted by federal law. Some investors that are not federally-chartered banks have established trusts with federally-chartered banks acting as trustees, arranged for the trust to purchase the loans and gotten comfortable that the licensing requirements do not apply because the banks, as trustees, hold legal title to the loans. More risk-adverse investors have obtained the necessary licenses or have not obtained loans in states where licenses are required. Other investors that have purchased loans while their license applications were pending have used a hybrid approach, that is, they have placed the loans in a trust for which a federally-chartered bank serves as trustee and then transferred the loans to the investor’s licensed entity after licenses are obtained.
There are also a number of federal laws that govern residential mortgage lending and servicing. Some of these laws provide for assignee liability, that is, liability for secondary market purchasers that are innocent of any wrongdoing for violations of law by the mortgage loan originators. The primary federal law with assignee liability provisions is the federal Truth in Lending Act (“TILA”), which was amended and supplemented by the Home Ownership and Equity Protection Act (“HOEPA”). HOEPA applies to certain higher-cost mortgage loans that are perceived as potentially predatory, imposing significant requirements and restrictions on such loans, including assignee liability. Most states have passed their own so-called predatory lending laws to address alleged abusive loan origination practices. Although these state laws generally build on the HOEPA approach, they often cover more loans and have more significant requirements and restrictions. Like TILA and HOEPA, many state predatory lending laws also impose assignee liability.
As mortgage loan originators fail, purchasers have become substitute targets for plaintiffs alleging violations of state and federal laws with assignee liability provisions. Even if the originator or seller of loans has not failed, purchasers may still be sued as plaintiffs seek defendants with deep pockets. Many of these laws provide for statutory damages (and in some cases punitive damages) and private rights of action, including potential for class action law suits.
Residential mortgage lending is highly regulated, and more laws and regulations are on the way. The Obama administration and key Democrats on Capitol Hill have signaled that comprehensive mortgage reform legislation will be introduced this year. As of now, it is unclear what will be included in such a bill, but everything is on the table, including the so-called “cram down” legislation making its way through both the House and Senate, which would give bankruptcy judges broad powers to reduce unilaterally the remaining balance on a mortgage loan and modify or change the interest rate or term of the loan.
Highly regulated means more legal risk. Purchasers must approach loan acquisitions with their eyes wide open to these risks. Many purchasers have managed the legal risks effectively. One of the greatest opportunities to mitigate risk is to conduct comprehensive, loan-level due diligence before pricing a potential purchase.
Purchasers should have a due diligence team that understands the legal requirements and related risks and can quickly evaluate the portfolio. If a purchaser does not have the internal capacity, law firms and consultants that specialize in residential mortgage loan due diligence can be hired. Some of the legal areas to examine are set forth below.
High Cost Mortgage Loans. Loan file reviews should be conducted to determine if loans are covered by HOEPA and any state predatory lending laws. If a loan is covered and will be included in the purchase pool, the review should determine if the applicable legal requirements and restrictions were complied with by the originator.
Other Regulatory Compliance. The file reviews should also evaluate compliance with other applicable federal and state laws. TILA and other disclosure requirements can be difficult to comply with as their requirements are often complex. For example, TILA’s annual percentage rate is a complex calculation and computation checks in due diligence can uncover systemic use of incorrect calculation methods. Prospective purchasers should also determine whether any of the loans (and the seller) have been in any litigation, including class action litigation.
Sale and Broker Agreements. Many sellers have acquired loans through wholesale channels or a broker network. If a loan was acquired by the seller from someone else, details about the original seller and the underlying purchase agreement are relevant to determine if any recourse may be available (e.g., repurchase, indemnification). The same is true for loans sourced through brokers.
Servicing Agreements. The loans may be serviced by one or more third parties. If that is the case, an evaluation of the servicers and a review of the underlying servicing agreements should be conducted. This review may cause purchasers to consider transferring servicing to a different servicer. It is not uncommon for servicing agreements to require per loan deboarding fees, termination fees and immediate reimbursement of servicing advances (e.g., payments made by the servicer to cover unpaid taxes and insurance) at the time of transfer.
The business side of due diligence will primarily focus on valuation issues considered in pricing the portfolio, including those noted below.
Underwriting Guidelines. Generally, sellers categorize the risk level of their loans by letter grade (A, Alt-A, B, C, etc.), but there is no grading consensus in the industry. The same is true for the level of documentation required of a borrower (no-doc loans, low-doc loans, etc.). The top-line grades and labels are less important than understanding their application. Typically, each risk category will include rules about the loans (e.g., (maximum loan-to-value ratio, loan size, type of property) and the borrowers’ credit history (e.g., credit score, debt-to-income ratio, history of delinquencies). If a seller has obtained updated credit scores, the more recent scores should also be reviewed.
Underwriting Exceptions. Many lenders permit exceptions to their underwriting guidelines, if there are believed to be compensating factors. Therefore, to fully assess portfolio risk, the circumstances and extent of any exceptions should be understood.
Property Valuations. In many cases, property values at origination do not accurately reflect current values, and purchasers should therefore obtain updated appraisals by automated valuation models or other methods.
Loan Products. There has been a proliferation of loan types designed to help borrowers afford their homes. The types may go by different names that are not standard in the industry. For each loan type, it is important to understand the timing, mechanism and limits of any future rate adjustments, any conversion options (i.e., ability to convert from an adjustable rate to a fixed rate), negative amortization features, payment options and prepayment penalties.
Statistical Modeling. Many purchasers hire consultants to predict, by statistical modeling, future loan performance and collateral risk, using portfolio data.
Contracts to purchase residential mortgage loan portfolios range from essentially “as is” deals to those with a number of loan-level representations and warranties, covenants, and remedies that provide for indemnification or loan repurchase in the event of a breach of a representation, warranty or covenant. Detailed purchase agreements can include close to 100 loan-level representations and warranties, ranging from compliance with law representations (i.e., the loans have been originated and serviced in compliance with law) to acceptable investment representations to broad fraud representations.
Since the advent of the subprime crisis, sellers have been making fewer loan-level representations and warranties, causing purchasers to rely more on due diligence. The spectrum of representations and warranties that purchasers receive corresponds to loan performance. Generally, loans that are subperforming or nonperforming are sold with deeper discounts and with the fewest representations and warranties (closer to “as is”). Loans that are reperforming (i.e., they were nonperforming but now are performing) or “scratch and dent” (i.e., performing but have some defect, such as missing loan documents) are sold at more modest discounts and with limited recourse. Performing loans may be sold at a premium with more extensive representations, warranties and recourse. In any event, purchasers should prioritize their loan level representations and warranties “wish list” for negotiations, focusing on the ones that address the most significant risks that cannot be mitigated by due diligence.
Purchasers should also assess counterparty risk. All sellers are not created equal. A well-capitalized seller with the ability to repurchase loans as a result of breaches of representations or warranties is certainly a better counterparty than a seller in financial difficulty. If a seller has a parent company that can be a source of strength, purchasers should consider including the parent as a party to the purchase agreement, if only as a guarantor of the seller’s indemnification and repurchase obligations.
Purchasers should obtain control of the loan servicing as soon as possible. The seller should be able to assign the current servicing agreement to the purchaser without the servicer’ s consent if the servicing agreement contains market assignment terms. If the servicing will be transferred to a different servicer, a new servicing agreement will have to be negotiated. Depending on the extent of the negotiations, it can take 30 days or more to negotiate a servicing agreement. Purchasers often begin negotiating new servicing agreements before the closing date of the loan portfolio purchase to allow the transfer to occur as close to the closing as possible. Transfer timing can be affected by federal law, which requires borrowers to be given notice of a servicing transfer not less than 15 days before the effective date of the transfer.
If the loans are subperforming or nonperforming and servicing will be transferred to a new servicer, purchasers should be prepared to see the number of slow-pay loans increase for at least several months. A good servicer of subperforming and nonperforming loans (known as a “special servicer”) will have a “high-touch” platform (e.g., contact made with borrowers as soon as a payment is late), and the new servicer will be out of touch with the borrower for some period of time as the loans are transferred and boarded onto the new servicer’s platform. Special servicers should be considered for subperforming and nonperforming loans as they have specific expertise in this area, particularly in maximizing the return on assets through different work-out strategies.
Mortgage loan servicing is also a highly regulated field, with most states requiring licensure under mortgage banking or collection agency/debt collector laws. In addition to loan portfolio due diligence, purchasers should also conduct due diligence on their potential servicing partners.
Special attention should be paid to the servicer’s familiarity with the modification guidelines of the Obama administration’s proposed foreclosure mitigation plan. The plan attempts to prevent foreclosures by incentivizing loan modifications and is complex. Under the plan, the federal government would match an investor’s interest payment reduction dollar-for-dollar that results from taking a borrower’s monthly payment from 38% of his or her monthly income down to 31%. Lower interest rates are expected to be in place for at least five years. Alternatively, investors could choose to reduce principal balances, with the federal government sharing in the cost. Servicers would receive $1,000 for each eligible modification, and an additional $1,000 each year for up to three years as long as the borrower stays current. Servicers can also receive $500, and investors $1,500, for modifying “at-risk” loans for which the borrower is still current. A borrower can receive up to $1,000 a year for up to five years towards reducing his or her principal balance if the borrower stays current. Investors of modified loans would be provided with a partial guarantee from the FDIC linked to declines in the home price index.
Of course, servicer incentives must be aligned with the investor’s interests as not every modification is a good business decision.
Daily communication between the investor and its servicer is a must in this environment.
 The state licensing statutes generally contain exemptions from the licensing requirements for state-chartered banks. A number of states also exempt brokers-dealers and insurance companies from licensure.
 For example: “There are no circumstances or conditions with respect to the mortgaged property, the mortgagor, the mortgagor’s credit standing, the mortgage loan, the mortgage or the mortgage note that could cause private institutional investors to regard the mortgage loan as an unacceptable investment, cause the mortgage loan to become delinquent, or adversely affect the value of the mortgage loan.”
 For example: “No error, omission, misrepresentation, negligence, fraud or similar occurrence with respect to the mortgage loan has taken place on the part of any person, including, without limitation, the mortgagor, any appraiser, any builder or developer, or any other party involved in the origination or servicing of the mortgage loan or in the application of any insurance in relation to the mortgage loan.”