So-called vulture investors perched atop the mortgage market's gaping valley are no doubt salivating at this given moment. Whole loans and mortgage-backed securities are trading at hugely deep discounts, monetary and fiscal policy is bent on providing support and stability, and mortgage-related debt shares the same risk characteristics of other secured debt instruments (credit, collateral and interest rate risks).
Experienced fixed income investors are likely to conclude that the moment of opportunity is fast approaching.
The reality is different.
The mortgage market differs from all other fixed income markets – even other consumer credit markets – due to the amount and complexity of consumer protection laws and regulations. Losses from credit and collateral are capped by the investor's basis – nonperforming loans are worth no less than the value of the underlying home (less some added costs to foreclose).
Violations of consumer protection laws, however, can result in fines, penalties and civil damages that can exceed the original principal balance of the loan. There are also additional reputational risks associated with charges of predatory and discriminatory lending, and investors – including anyone in the chain of title for whole loans and the securitization trust for securities – can be liable, even though the violator was the broker or originating lender.
What's that smell?
The risk that a loan violates consumer protection laws is not insignificant. Consider that 83% of FDIC-regulated institutions examined in 2005 had been cited for "significant" violations of basic federal consumer protection laws.
Eighty-five percent of those institutions cited for significant violations were, oddly enough, rated by the FDIC to have "strong" or "generally strong" compliance controls.
It's noteworthy that FDIC-regulated institutions are exempt from most of the consumer protection laws applicable to a majority of subprime originators. State licensed lenders, who were responsible for originating 52% of subprime mortgages, are subject to a much broader patchwork of state regulation.
According to a study by Navigant Consulting Inc., the number of subprime-related cases in the first quarter of 2008 increased 85% over the next busiest quarter on record. Additionally, subprime-related cases surged from 181 in the final six months of 2007 to 170 in the first three months of 2008, according to the study.
A 15-month span ending March 31, 2008, found subprime-related case filings totaled 448, up from 287 previously reported at the end of 2007, according to the study.
Non-compliant loans easily escape secondary market detection. The secondary market relies mainly on seller representations and warranties that loans comply with all applicable laws. Therefore, an investor may force a seller to repurchase a loan back if it is subsequently found to violate law (and if the seller is still around – something not at all frequent in distressed debt sales).
However, the investor is often still liable. Due diligence firms, which analyze the quality of mortgage loans for whole loan investors and issuers, will customarily review a 10% to 20% sample of a loan pool for compliance with some basic consumer protection laws.
But the quality of these reviews varies dramatically among providers, and there are allegations that certain issuers routinely ignore issues. Loans with issues are called "exception loans," and some due diligence firms cite figures for these in the 50% to 80% range.
Rating agencies are not intended to provide much protection here. The due diligence results are delivered to the issuers and rating agencies expressly avoid verifying information provided by issuers who, of course, foot the bill for their services.
Of course, not all exception files have regulatory violations, but discerning investors will be suspicious of lenders that underwrote so many loans that are now in default. It is hard to imagine that lenders that made reckless credit decisions took greater care in the way they treated borrowers.
All this makes regulatory risk management rather important for investors. But investors will do well to appreciate that regulatory risk management is not only about protecting against loss. Understanding consumer protection laws can also improve pricing and risk/return characteristics.
A TILA tequila
When considering consumer protection laws, mortgage investors are mostly concerned with losses from regulatory fines and litigation. However, in some cases, borrowers have a right to rescind the loan, essentially voiding the transaction.
The Truth-In-Lending Act (TILA) provides a stark example. TILA imposes significant liability on lenders when they fail to provide accurate disclosure of the APR and finance charge. (The finance charge includes all interest the borrower is obligated to pay to the lender, as well as certain fees the law vaguely describes as a condition to the loan).
TILA imposes liability not only for intentional violations, but also for innocent or careless mistakes. Furthermore, the liability for a lender's mistake can pass through to an assignee, thus making the purchaser of the mortgage loan (including a securitization trust) liable for mistakes made by others. In some cases, this liability may arise even if the investor does not know – and could not know – of the disclosure mistake made by the lender.
It is easy to violate TILA. Consider that TILA violations occur where the disclosed APR falls under one-eighth of 1% percent of the actual APR. (For certain irregular transactions, TILA permits a tolerance of one-fourth of one percent). Violations also occur where the disclosed finance charge is more than $100 less than the actual finance charge.
However, in certain circumstances, the tolerance for the same mistake may fall as low as $35.
TILA violations are particularly significant in option adjustable-rate mortgages (ARMs) and loans with negative amortization. The problem is that the growing variability of such products, particularly in the nonprime segment, ran far ahead of the ability for many production systems and compliance controls to keep up.
This resulted in a big investment gap between new product introductions and the related enhancements to risk management systems required for their support.
TILA violations also often occur because the lender or settlement agent misidentifies a closing or pre-closing fee. Occasionally, TILA classifies some fees – like closing agent fees – as finance charges, but allows the lender to exclude the fee from the finance charge in some situations.
A processing clerk may not understand the complexities of TILA and make an erroneous judgment about how to identify such fees in a particular transaction. Such a mistake can arise for several reasons, which can be a simple oversight or carelessness.
Unfortunately, TILA imposes strict liability. Likewise, closing agents regularly add fees at the settlement table. Hence, even where the lenders disclosures are perfectly accurate, a $101 fee (and, in some cases, a $36 fee) can result in a violation.
In addition to statutory damages and attorneys' fees, a mistake in disclosures may give rise to a borrower's right to rescind the loan. Borrowers often only find out that the creditor made a TILA mistake when they fall behind on their payments, or face collection or foreclosure actions.
In many cases, these same borrowers seek bankruptcy protections. If the mortgage is rescinded, the mortgage loan may essentially become an unsecured obligation of the debtor in bankruptcy, subject to satisfaction at pennies on the dollar – or, worse still, discharge.
Consumer protection laws not only pose regulatory and litigation risk, but they are also an important factor in pricing mortgage assets. Consider prepayment penalties. The borrower's right to prepay makes mortgages and mortgage securities callable debt.
Accordingly, investors rely on statistical prepayment models that consider the basic determinants of prepayment behavior: seasonality, burnout, seasoning and interest rates.
There has been little need previously for these models to explicitly consider prepayment penalty enforceability. The regulatory environment, however, has changed remarkably. Clearly, whether a 1% to 10% prepay penalty is enforceable or not has dramatic consequences to cash flow, even when loans are trading at such deep discounts.
TILA and predatory lending laws apply equally to all loans, though requirements differ based on loan characteristics and terms. Yet, when it comes to prepayment penalties (as with most other consumer protection requirements), there is an added layer of regulatory complication. Knowing what laws and regulations to apply depends not only on loan characteristics and terms, but also on the licensing or charter authority of the originating lender.
Some lenders operate under the licensing regimes in all the states in which they lend. Most states have multiple licenses that grant lenders the authority to make loans. Each such license imposes different substantive requirements governing loan terms.
For instance, certain licenses allow subordinate lien loans while others govern loans with higher interest rates. In some states, more than one license will authorize the lender to make the same loan, though subtle differences in the consumer protection requirements apply to the loan terms.
Thus it is critical to identify under what license the originating lender made the loan – and to make certain the lender was indeed properly licensed and in good standing – in order to know the applicable consumer protection requirements, including what prepayment penalty plans are enforceable.
Other lenders are chartered financial institutions, such as state banks, national banks and federal savings banks. Banks and thrifts are subject to different regulatory requirements. For instance, most chartered institutions "export" interest rates from their home state to the target state in which the loan is made.
This results in a complex synthesis of both the home state's and target state's consumer protection laws. Prepayment penalties are an exportable fee, meaning that the home state's laws governing them apply no matter where the loan is made. But certain other consumer protection laws of the state in which the loan is made will also apply.
It is difficult enough to obtain all the required loan terms and fees required to perform a regulatory analysis. Where the counterparty to a transaction is not the originating lender, or where the loan is part of a securitization, tracing the license or charter authority of the originating lender is especially challenging.
Once the lender's license or charter authority is known, as well as its elections, the review must consider the specific transaction terms – such as the APR, interest rate, loan balance, lien position, occupancy type, etc. – to determine which out of the several laws that might apply to the lender is the one that governs a particular mortgage loan.
The silver lining
But the complex patchwork of regulations and authority described above also presents mortgage lenders with a diverse set of regulatory strategies to pursue. The question posed, then, is not simply "What can't a lender do?" but also "What options are available to particular lenders?"
The differences in regulatory requirements applicable to different licenses and charters means that some lenders in certain circumstances can make loans with more favorable cash flow characteristics without any increased compliance risk.
Not only can certain lenders avail themselves to friendlier prepayment penalty regulation, but they may also enjoy advantages when it comes to such things as acceptable late-fee and grace-period terms, permissible day-count methodologies and the flexibility to charge higher interest rates. These regulatory permissions follow the loan through the secondary market chain of title.
Often, though, these sorts of loans are priced cheap. This is because, at some point along the way, a person or tool that did not account for license or charter nuances mistakenly concluded that a law was violated. A clever investor capable of performing a more precise regulatory risk evaluation than its counterparty can purchase these loans at a deep discount without taking on any compliance risk.
Louis Pizante is chief executive officer of Mavent Inc. Irvine, Calif. He can be reached at firstname.lastname@example.org.