Repurchase & Buyback Demands, Representations and Warranties Claims in Residential Mortgage-Backed Securities
Former high-level banking executive, high-level banking regulator, consultant to over 75 banks, and renowned nationwide banking expert witness Don Coker explains some important factors in banking, mortgage banking, and mortgage-backed securities litigation involving repurchase and buyback demands based upon alleged breach of representation and warranty claims contained in the documents creating the business relationship between the mortgage loan originator and the purchasing lender or investor.
This article explains nationwide industry standard practices and procedures in the relationships between Purchasers and Originators, and how to handle many of the common factors that are integral parts of a typical mortgage repurchase demand or buyback demand based upon representations and warranties claims in residential mortgage backed securities (“RMBS”) transactions.
The Mortgage Banking Process
There are numerous ways that the mortgage lending process can take place, but this article deals with the process wherein a mortgage lender – let’s call them the Purchaser – contracts with a mortgage Originator to originate a certain volume of mortgage loans of a certain type or types.
The contract between the Purchaser and the Originator may be called a Correspondent Agreement, a Delegated Underwriting Agreement, a Bulk Purchase Agreement, or some similarly titles contract.
Having served in several high-level capacities in the mortgage banking industry, including serving a few years as a high-level banking regulator with responsibility over some sizable bank-owned mortgage operations, and later on serving as a consultant to and frequent expert witness for many of the major mortgage banking and mortgage origination companies, I have had the opportunity to read, work with, and become familiar with the documents used to establish the relationships between Originators and Purchasers. My experience also covers the securitization of mortgage loans into mortgage-backed securities (also referred to as asset-backed securities) and sometimes split up into various tranches, and the sale of mortgage loans and mortgage loan portfolios to Fannie, Freddie, and many other institutional Purchasers nationwide.
While these documents establishing the working relationship between Purchasers and Originators vary in their content, they all cover the same basic matters in one form or another.
Problems can emanate from these contracts if they are unclear, contradictory, or ambiguous, especially in the area of the “Representations and Warranties”. I have seen many of these contracts that state both that any misrepresentations or untrue statements of fact found in the loan transaction shall not apply to information the Originator obtained from the borrowers yet elsewhere in the contract state that the Purchaser can demand cure or repurchase of any loan that was originated and underwritten based upon any materially inaccurate information or material representation made by the borrower(s).
Here is an example of paraphrased language dealing with this area:
"The Originator warrants that no statements or information contained in the documentation for each loan purchased by the Purchaser contains any misrepresentation or untrue statement of fact or omits a fact necessary to make the information not misleading. The provisions of this section shall not apply to information obtained from appraisers, escrow agents, title companies, closers, credit reporting agencies, or the loan applicant(s) unless the Originator knows or has reason to believe that any information provided by such entity is not true, correct or valid in any material respect and the Originator knows or has reason to believe, after performing its normal due diligence and quality control review, should have known that any information provided by the entities including the loan applicant(s) is not true, correct or valid in any material respect.”
Contrast this with the following language that appears in the same document:
Cure or Repurchase Remedies
"If the Purchaser, in its sole and exclusive discretion, determines that any loan purchased pursuant to this Agreement was underwritten and/or originated based upon any materially inaccurate information or material misrepresentation made by the loan borrower(s) or any of the Originator’s staff during the underwriting and approval of the loan…” then the Purchaser can demand that the Originator cure the defect or repurchase the loan from the Purchaser."
This contradistinction presented by these two elements contained in this same document clouds the document’s interpretation. It is my opinion that the Originator would be justified to interpret this document as it would normally be used in the mortgage banking industry, and that interpretation would be that the Purchaser of the mortgage loans would not hold the Originator responsible for a borrower’s misstatements and misrepresentations.
Characteristics of Common Loan Types
While some litigation brought by Purchasers against Originators involve low documentation (“low doc”) or no documentation (“no doc”) mortgage loans, some also involve full documentation mortgage loans.
● Stated Income – Stated Asset (“SISA”) Mortgage Loans
It is elementary that loans with a higher level of risk – such as SISA mortgage loans where income and assets are simply stated by the borrower and not verified by the originator or other lender – inherently have a greater likelihood of mortgage fraud, and therefore must provide to the investor an interest rate, fees, and possibly other terms that result in a higher yield for the lender than would be the case for less risky loans where a higher level of verifications would be required. SISA mortgage loans provide the investment owner with higher yields, and concomitantly higher levels of risk, relative to other available mortgage loan investments.
● Stated Income – Verified Asset (“SIVA”) Mortgage Loans
Likewise, it is elementary that loans with a higher level of risk – such as SIVA mortgage loans where income is simply stated by the borrower and not verified by the originator or other lender - inherently have a greater likelihood of mortgage fraud, and therefore must provide to the investor an interest rate, fees, and possibly other terms that result in a higher yield for the lender than would be the case for less risky loans where a higher level of verifications would be required. SIVA mortgage loans provide the investment owner with higher yields, and concomitantly higher levels of risk, relative to other available mortgage loan investments.
● Second Mortgages
Second mortgages, which can include Home Equity Line of Credit (“HELOC”) second mortgages, carry a higher level of risk than do first mortgages. This is because a drop in the value of the collateral property can cause the second mortgage lender’s equity cushion to shrink or disappear. The high risk and high yield of these investments are considered in establishing their purchase price. Essentially, what happens in many cases where a second mortgage has experienced a severely reduced collateral cushion is that the Purchaser demands on some pretextual basis that the Originator repurchase the loan, thus obtaining the enjoyment of higher than market yields that the Purchaser demanded from the beginning of the relationship, but to avoid the higher risk that the Purchaser knew that it was accepting by purchasing these higher-risk types of mortgage loans.
It is my professional opinion that the business proposition and bargain that the Purchaser seeks in situations such as that just described is an unreasonable business proposition that does not provide a fair bargain for exchange.
One might ask why the Originator would enter into a relationship where some of the terms of the relationship might be open to interpretation; and the simple four-part answer is (1) that the Originator was justified as interpreting the documents that establish their relationship with the Purchaser as they would commonly be interpreted in the industry, as explained above, (2) that the secondary mortgage market when most of these Purchaser and Originator relationships began was comprised of a very few large lenders who were in a position of superior strength that enabled them to dictate terms to originators on a “take it or leave it” basis, (3) that the Originator could reasonably expect repurchase demands to occur at a reasonable level, which means that repurchase would only be requested if there truly was a deficiency in the Originator’s underwriting, instead of at the higher level that the Purchaser chose to pursue, which are not based upon underwriting deficiencies at all, and (4) that the Originator was in no position to see the one-sided manner in which the Purchaser would attempt to interpret the contract until long after the contract was signed, loans sold, and repurchase demands by the Purchaser began.
Regarding (3) above, it is my professional opinion that it would have been reasonable for the Originator to assume that the Purchaser would proceed in an industry standard manner only requesting buybacks where there was a true violation of the program guidelines and where a true violation was jeopardizing the future of the mortgage loan rather than requesting a large number of buybacks simply because the Purchaser had second thoughts regarding their original investment philosophy and now want to offload their originally defined investments back to the Originators that originated the mortgage loans according to the Purchaser’s guidelines. Shifting the risk of the investment to the Originator in a nonstandard manner, as the Purchaser sometimes attempts to do, creates a situation where no Originator could possibly have on hand or otherwise have access to sufficient funds such as would be required to buy back the volume of loans that the Purchaser arbitrarily demands. It is my professional opinion that this is an unreasonable and unworkable business model and practice that no Originator would go into if there was any realistic expectation that the Purchaser would demand arbitrary repurchases of large numbers of mortgage loans.
Regarding SISA loans, the Purchaser’s guidelines often state that mortgage loans with documented income and/or assets are classified as “Ineligible Program/Processes.” This means that the Originator was prohibited from verifying a borrower’s income or assets during the mortgage loan underwriting process. Accordingly, it is disingenuous of the Purchaser to later complain that the Originator did not verify income and assets when the Purchaser’s own policy and procedure manual specifically precludes these same verifications.
It has been my experience that everyone in the mortgage banking and investment businesses knows that Stated Income mortgage loans carry more risk of mortgage fraud or borrower fraud than do other mortgage loans where the borrower’s income is documented during the mortgage loan underwriting process. That is why Stated Income mortgage loans provide the investor, the Purchaser in this case, with a higher yield than would be offered on mortgage loans where the borrower’s income is documented. The Purchaser sought this higher yield and certainly would have understood the increased risk.
It is often the case that the Purchaser failed to act to protect itself by not requiring, or even permitting, the originating lender to verify the borrowers’ stated income during the loan origination process.
Likewise, it is often the case that the Purchaser failed to act to protect itself by examining mortgage loans before they purchased or otherwise accepted them from The Originator, even though in some cases, the Purchaser charges a Pre-Purchase Review Fee which indicates that they actually do review the mortgage loan file before they purchase it.
It also is common that the Purchaser failed to act to protect itself by examining mortgage loans immediately after they purchased or otherwise accepted them from The Originator.
And finally, it is common that the Purchaser failed to act to protect itself by examining mortgage loans purchased from The Originator before The Purchaser sold the purchased loans in the secondary market, such as to Fannie or Freddie or Ginnie.
Factors Affecting the Underwriting of Individual Loans
Here are some of the problem factors often cited by Purchasers as justification for their repurchase demand or buyback demand, and some explanation of how to analyze the problem:
● Misrepresentation of Income
This should be a moot point for any stated income loan, such as a SISA or SIVA loan. For loans where the Originator is not required to verify the borrower’s stated income, the only requirement for an Originator that I have seen stated – if any at all is stated - is that the income must be reasonable, which of course, is extremely vague. If a salary has to be justified, there are available databases that can provide comparative information.
● Misrepresentation of Employment
This goes hand-in-hand with the borrower’s income and should be a moot point for any stated income loan, such as a SISA or SIVA loan. If verification of the borrower’s employment is required, the verification can be accomplished by a standard Fannie Mae form 1005 Verification of Employment to an address independently verified as the employer’s address; or employment verification can be accomplished by a telephone call to a telephone number known to be correct for the employer. W-2s are issued in January of each year covering income earned during the previous year. Clearly, it is unreasonable for the Purchaser to fault the originator for failing to have in the mortgage loan file a document that did not exist at the time the loan was underwritten, as I have often seen happen.
● Misrepresentation of Debt-to-Income Ratio
If a borrower’s income or employment are misrepresented, then it is pretty much a certainty that the debt-to-income ratio will be out of whack since that was the purpose of the misrepresentation of the income and employment in the first place.
● Misrepresentation of Occupancy
Borrowers buying a house to serve as their primary residence sign a document at closing verifying that they will reside in the house as their primary residence. If after closing a borrower then elects not to move into the house, then it is beyond the scope of the Originator to be able to detect this deception before it occurs.
● Misrepresentation of Debts
It sometimes happens that a debt might be paid off out of the proceeds of the subject loan, but this debt will still appear on the borrower’s credit report that was issued right before the mortgage loan closing and becomes a part of their mortgage loan file.
● Misrepresentation of other Mortgage Liabilities
Sometimes unbeknownst to an Originator, a borrower may close on another mortgage loan on another piece of property a few days before or after the closing of the subject mortgage loan. When this happens, it is not uncommon for the other closing (or closings) not to appear on the borrower’s credit report at the closing of the subject mortgage loan since it takes a few days for a lender to initially report a new mortgage loan to the credit bureau. Accordingly, the Originator of the subject mortgage loan would have no way of knowing about the other closing or closings. Also, credit bureaus sometimes show a mortgage, or other debt, more than once on a credit report. Problems can also arise if an error is made by MERS, the Mortgage Electronic Registration System.
● Misrepresentation of Assets
This should be a moot point for any stated asset loan, such as a SISA loan where the Originator is not required to verify a borrower’s assets.
● Misrepresentation of Cash Assets
This should be a moot point for any stated asset loan, such as a SISA loan. Because cash moves into and out of bank accounts, it is sometimes difficult to make sense of where a borrower actually stands on cash. If the loan program requires a verification of cash, then a standard Fannie form 1006 Verification of Deposit must be sent and received back prior to the closing of the mortgage loan.
● Misrepresentation of Down Payment
This situation sometimes takes the form of excessive seller contributions at closing. Sometimes these payments from the Seller are not paid for the benefit of the Buyer but rather to clear up past obligations of the Seller, such as past due Homeowners’ Association fees, past due property taxes, and other similar items. Any debt that was owed by the Seller and that is being paid by the Seller at closing should not be included as funds being paid for the benefit of the Purchaser. If someone else has paid all or a part of the down payment for the buyer, then whereas that might not meet the requirements of the particular mortgage loan program under which the loan was originated and approved, the reality is that it only helps the borrower’s financial position since they have more cash than they would have had if they had paid the full down payment.
● Misrepresentation of Credit Standing
How this claim is handled depends on the nature of the alleged misrepresentation. There are many instances where discrepancies may appear on a borrower’s credit report due to errors on the part of the credit bureaus, or the timing of when payments or payoffs of debts are reflected on the credit report. Each case must be examined in order to determine its possible causes.
● Misrepresentation of Outstanding Judgments
The most common problem in this area is that sometimes judgments are paid off at the closing of the subject loan, so the judgments will still appear on the borrower’s credit report that was pulled prior to the closing.
● Misrepresentation of Appraised Value
This potential problem typically is one with the appraiser rather than a problem with the borrower since the borrower does not generate the appraisal or contribute towards the data used by the appraiser in formulating the value of the property. Criticisms also relate to the proximity and appropriateness of comparables, but there are situations where there truly are no nearby comparables that can be used in the appraisal. My experience has been that Originators make sure that the appraisal is performed by an appropriately certified licensed appraiser, and rely upon the expertise of the appraiser.
● Misrepresentation of Insurance of the Mortgage Loan
If the payment of the mortgage insurance premium was included on the HUD-1 at closing, and the insurance later rejected or terminated for whatever reason, then certainly it is unreasonable to expect the Originator to know this at closing since it had not happened at that point in time.
● Pre-Purchase Review
Purchasers often charge for a Pre-Purchase Review, which indicates that they have indeed performed a review of the loan file before they purchase the loan. In these cases, it is reasonable to think that the Purchaser would discover at the time they purchased the loan any problems that they allege the Originator should have discovered while underwriting and closing the loan.
● Review before Sale to Fannie, Freddie, Ginnie or Another Investor
Likewise, it is reasonable to expect that the Purchaser would review the loan file after they purchase it and before they sell it to Fannie, Freddie, Ginnie, or any other investor.
● Review before the File was Sent to the Mortgage Insurer
It is reasonable to expect that the mortgage insurance company would review the file before they issue mortgage insurance coverage, and that any problems found by the mortgage insurance company during their underwriting would be communicated to the Originator. If the mortgage insurance company did not find the alleged problems, then it is unreasonable to expect that the Originator would.
● Review before the File was Sent to FHA for Guarantee Approval
It is reasonable to expect that FHA would review the file before they issue an FHA guarantee, and that any problems found by FHA would be communicated to the Originator. If FHA did not find the alleged problems, then it is unreasonable to expect that the Originator would.
● Some Underwriting Methodologies Cited by the Purchaser are Arbitrary and could not be Anticipated by the Originator
For example, I have seen Purchasers allege after the fact that underwriting erratic income should take into account a longer income period than that used by the Originator. Arbitrary determinations such as this by the Purchaser are unforeseeable by the Originator.
● Situation of a borrower that had previously successfully made larger payments than those required by the present financing.
General Comments that Apply to All Loans
1. It is highly likely that a great but immeasurable portion of the damages that the Purchaser may feel it sustained in loan losses were in fact due to the overall economic situation experienced in the country over the last few years, including unusually high unemployment that always leads to income loss and borrowers’ inability to make mortgage payments that but for the loss of their employment they would be able to make.
2. This situation has caused a steep drop in real estate values nationwide, and of course, some areas are affected more severely than are others, but all geographical areas have been negatively impacted.
3. These above-mentioned factors are outside of the Originator’s control.
4. If the Purchaser modifies a mortgage it purchased from an Originator, then it is an industry standard practice that the mortgage loan with a changed risk profile cannot be put back to the Originator.
5. Many of the repurchase demands that I have seen were initiated simply because the investor - such as Fannie or Freddie – that the Purchaser had sold the loan to had demanded that the Purchaser repurchase the loan. In many of these cases, the repurchase demand made to the Purchaser was unreasonable, and the Purchaser should have refused the investor’s repurchase request rather than simply accepting their demand and then trying to force a subsequent repurchase on the Originator.
6. I have seen many instances where the Purchaser did dispute with the mortgage insurance company the bases of some of the mortgage insurance rescissions; but then having lost their rescission request, the Purchaser turned around and demanded that the originators repurchase the loans for the same reasons that they had argued against rescission of the mortgage insurance in the first place. Of course, this severely weakens the Purchaser’s case against the Originator when they make the same claims against the Originator that they argued against with the mortgage insurance company.
7. Sometimes, it is unclear how the Purchaser calculates the interest charges it includes as alleged damages. In any event, it is an improper methodology to accrue interest charges for an extended period of time that is a function of the Purchaser’s inability to properly manage and market its foreclosed properties, and then add that inflated interest amount to the claimed damages. I have seen some foreclosed mortgage loans where the interest accrual period is in excess of 500 days. In effect, the Purchaser wants to reward itself for failing to properly market its REOs in a timely manner.
8. Likewise, I have noticed many instances where the Purchaser accepted some REO sale and short-sale offers that were well below a reasonable market value. In these instances, the Originator should cite some evidence that indicates that a higher sales price should have been achievable for the REO.
9. Even though a Net Present Value analysis is often used in determining REO sales strategies and the acceptability of potential sales prices, many Purchasers fail to utilize this approach.
10. No damages should be shown by a Purchaser for loans that have not yet been foreclosed. I have seen many alleged damages estimates by Purchasers for mortgage loans that are current!
Damages Factors Affecting Individual Loans
● The Purchaser should not claim any damages for mortgage loans that are not in default or foreclosure.
● REO sale proceeds. Accepting a purchase offer that is well below market value. Net present value estimate methodology.
● In the case of a second priority mortgage loan, if it appears likely that there is equity in the property over and above what is owed on the first mortgage, it sometimes makes sense for the second lien holder to buy in the property at the foreclosure of the first mortgage rather than have their second lien position wiped out by the foreclosure of the first mortgage.
● Excessive time to market REO.
● Excessive interest accrual period.
● Excessive expenses.
● Excessive REO expenses.
● Excessive late charges.
● Lost servicing fees for the period that the Purchaser will not be servicing the mortgage loan.
● Other collateral, such as certificates of deposit, liens on other property, etc.
● Mortgage insurance proceeds or a refund of the mortgage insurance premium if the coverage was rescinded. Of course, any mortgage insurance proceeds received or any mortgage insurance premium refunded should be applied to reducing the balance of the mortgage loan or the REO balance.
1. It is an unrealistic economic business model and an unacceptable bargain that the Purchaser can knowingly and intentionally prohibit the Originator from verifying certain underwriting items, yet later claim (usually after a problem develops with the loan) that the Purchaser has an unlimited ability to require the Originator to repurchase the mortgage loans that the Purchaser purchased from the Originator, and base the repurchase demand on information that the Purchaser precluded the Originator from verifying. In addition, in many cases, the Purchaser charged for and performed a Pre-Purchase Review before it purchased the loan, which provided the Purchaser with an opportunity to notice any of these alleged defects when they received the loan file as well as when they sold the loan and shipped it out to an investor. To grant what the Purchaser asks, one would have to accept that the Purchaser is entitled to the highest of yields due to the nature of SISA and SIVA mortgage loans and high yields even on many full documentation loans that it purchased even though the Purchaser is assuming no risk whatsoever on any of the loans it purchased. In many cases, the Purchaser unrealistically expects the highest investment returns on these investments with the lowest government securities risk characteristics, i.e., no risk.
2. In my professional opinion, it is financially impractical for the Purchaser to realistically expect an Originator to have the financial capability to repurchase a large volume of loans such as Purchasers demand the Originator repurchase in some instances I have seen. The Purchaser would have known this at the outset of this relationship.
3. It is my professional opinion that many of these Purchasers failed to take any actions to mitigate any losses it may think it sustained, and instead mistakenly relied upon its flawed misconception that it could dispose of all of its alleged loan problems by putting them back to the Originators.
4. It is my professional opinion that the Originator would have no way of knowing about and no actual or constructive knowledge of many, if not all, of the alleged borrower misrepresentations claimed in many of these litigations that I have seen.
5. It is my professional opinion that in many of these cases I have seen, the Purchaser failed to observe good faith, fair dealing, ordinary care, honesty in fact, and reasonable commercial standards in its dealings with the Originator, as explained above.
6. It is my professional opinion that in many of these cases I have seen, the proximate cause of any losses that the Purchaser alleges from these mortgage loans were the Purchaser’s mortgage investment program design, its failure to examine mortgage loans when they are purchased, its failure to examine mortgage loans when they were sold and shipped to an investor, it’s unrealistic and non-standard repurchase expectations, and its own actions and inactions in terms of corrective and remedial actions.
© 2012 by Don Coker.
ABOUT THE AUTHOR: Banking and Lending Expert Witness Don Coker
Expert witness and consulting services. Over 500 cases for plaintiffs & defendants nationwide, 120 testimonies, 12 courthouse settlements, all areas of banking and finance. Listed in the databases of recommended expert witnesses of both DRI and AAJ. Clients have included numerous individuals, 75 banks, and governmental clients such as the IRS, FDIC.
Employment experience includes Citicorp, Ford Credit, and entities that are now JPMorgan Chase Bank, BofA, Regions Financial, and a two-year term as a high-level governmental banking regulator.
B.A. degree from the University of Alabama. Completed postgraduate and executive education work at Alabama, the University of Houston, SMU, Spring Hill College, and the Harvard Business School. Called on by clients in 31 countries for work involving 61 countries. Widely published, often called on by the media.
Copyright Don Coker
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.