Bankers weren't exactly singing ‘Happy Days Are Here Again,’ but their relief was palpable after the Senate rejected a measure in May that would have given bankruptcy judges broad discretion to modify home mortgage loans.
The celebration of cramdown's defeat may be premature, however. Although the Senate vote – 51 to 45 – was definitive, industry analysts agree that the measure will almost certainly resurface if current initiatives to halt the rising foreclosure tide are not successful. And even without the threat of a bankruptcy cramdown order, the pressure on lenders and servicers to modify loans to help borrowers avoid foreclosure is intense, and it is coming from several directions.
Relentless media reports of homeowners losing their homes are producing a continuing drumbeat of negative publicity for an industry whose image has already taken a huge beating from the financial meltdown. Meanwhile, federal homeowner assistance programs are requiring some lenders to offer modifications and providing incentives to encourage all lenders and servicers to do so. ‘Helping Families Save Their Homes,’ the anti-foreclosure act signed into law by President Obama, addresses one perceived obstacle to those efforts: establishing a ‘safe harbor’ protecting servicers who modify loans from suits filed by investors.
Significantly, the safe harbor targets only suits filed by investors; it does not prevent suits filed by borrowers. And it is the threat of borrower litigation that is likely to create the strongest pressure on lenders and servicers to modify existing loans. Homeowners faced with foreclosure, not surprisingly, are doing all they can to hang onto their homes. Many are taking their battles to the courts, meeting foreclosure notices with counterclaims against their lenders.
In one increasingly common tactic, borrowers are exercising their right of rescission on refinance transactions, citing alleged disclosure violations by lenders as the basis for this claim. Court decisions in these cases have varied but provide some cause for lender concern.
In a 1992 decision, Williams v. Homestake, a district court held that the rescission right established under the Truth in Lending Act (TILA) was ‘automatic’ and the relinquishment of the lender's claim could not be conditioned on the borrower's return of the loan proceeds. The 11th Circuit Court of Appeals subsequently overturned that decision, holding that while the process outlined in TILA and its implementing regulations make rescission automatic if the lending violations are proven, the courts, in fact, have the power to modify the rescission process in order to ensure equity between the parties.
However, this court went on to say that, in determining whether and how to modify the rescission process, judges should consider ‘traditional equitable notions, including such factors as the severity of [the bank's] TILA violations and whether [the borrower] has the ability to repay the principal amount.’
To understand why this guidance should make lenders nervous, consider how the rescission process might play out in a bankruptcy proceeding. Typically, the borrower would move to rescind the loan simultaneously with the bankruptcy filing. If the disclosure violation is proven, the bankruptcy judge could determine – and many have – that the rescission extinguishes the creditor's lien, leaving the mortgage lender with what amounts to an unsecured claim. A bankruptcy judge who follows this path would have considerable leverage to ‘encourage’ lenders to modify loans, even without the cramdown measure.
Potential problems are emerging for lenders outside of the bankruptcy arena. Although the courts in most jurisdictions have been loath to recognize a ‘duty of care’ for lenders – removing a prerequisite for negligence claims against them – this area of the legal landscape may be changing, too, influenced in no small measure by the subprime lending abuses that triggered the financial meltdown.
The sweeping mortgage reform legislation approved recently by the U.S. House of Representatives contains a provision directing the Federal Reserve to adopt regulations requiring mortgage lenders to ensure that borrowers have a ‘reasonable ability to repay’ a first mortgage, and to verify that a mortgage refinance transaction provides ‘net tangible benefits’ to the borrower.
Those standards, presumably, would apply only prospectively, but not necessarily. The Massachusetts Supreme Judicial Court (SJC) recently upheld a lower-court decision requiring a lender (Fremont Investment & Loan) to obtain the approval of the state attorney general before initiating foreclosure actions against subprime borrowers. The SJC affirmed the lower court's conclusion that the targeted loans had features that, in the court's view, made the loans ‘presumptively unfair.’
It is possible, and probably more likely than not, that courts and regulators in other states will agree that loans originated without regard for the borrower's ability to repay them are, by definition, unfair and deceptive.
In another Massachusetts action that is likely to rattle windows far beyond the state, Goldman Sachs Group agreed recently to fund a $50 million loan modification program to settle an investigation into whether the company ‘may have facilitated the origination by others of 'unfair' loans.’ This appears to be the first successful action to hold a syndicator responsible for loan violations, but it is unlikely to be the last.
Lenders, servicers, syndicators and investors should be concerned about where this train is heading and the speed at which it is traveling. It is not a question of whether borrowers, state regulators or both will file countersuits to block foreclosures; the only questions remaining are when and where those suits will be filed, in what numbers and what violations they will allege.
The threat of litigation is, by no means, the only reason to modify a loan. But the threat of a successful lawsuit that could cost considerably more than a modification provides strong incentive for lenders and servicers to negotiate with some borrowers rather than fight with them.
All modification requests are not equal; some loan restructurings will be more or less viable than others. Similarly, all litigation threats are not equally potent; some borrowers will have stronger claims than others. With this in mind, lenders and servicers need to be able to distinguish among the suits.
A lender does not want to learn for the first time from a borrower's complaint or a bankruptcy judge's rescission ruling that it failed to provide one of the required TILA disclosures. Servicers need to know before a rejected modification triggers a lawsuit or a bankruptcy filing what is in its loan files and what is missing from them. Servicers and lenders want know where, if at all, they are vulnerable to a borrower's claims and where, if at all, the borrower may be vulnerable.
Risks and red flags
A perfect loan file does not exist. Industry studies have found that 83% of mortgages, on average, contain one or more errors. On a regular basis, audit companies find major and minor violations of lending laws and regulations by lenders, and often enough to be worth noting, there is evidence of fraud by borrowers.
For lenders and servicers looking for borrower weaknesses, stated-income loans are a definite red flag. There's a reason these are known as ‘liar loans.’ In most cases, the only reason for failing to document a borrower's income is because it is not high enough to support the loan.
Borrowers may insist, ‘The devil (or the broker) made me do it.’ They may claim they were misled, unconscious, drunk or all of the above. But at the end of the day, borrowers sign the loan application, and they know – or they should know – what is on it. Evidence that the borrower lied will not negate valid claims of lender violations, but it will affect the weight a court is likely to give the arguments on both sides and may strengthen the lender's or servicer's hand in pre-bankruptcy/modification negotiations.
Aside from misstating their income, serving knowingly as a ‘straw’ in a sham home purchase transaction or otherwise perpetrating fraud, there are not many things borrowers can do wrong. For lenders, on the other hand, the possibilities for missteps are endless. TILA, the Equal Credit Opportunity Act, the Fair and Accurate Credit Transactions Act, the Real Estate Settlement Procedures Act and state consumer protection laws create a labyrinth of procedural rules and disclosure requirements over which lenders could potentially stumble.
Some violations are more serious than others, but all offer potential legal fodder for borrowers seeking to block foreclosures and/or demanding modification of their loans.
The most common complaint is that the lender failed to provide one or more of the required disclosures. This could be a serious problem, but only if the claim is true – and it is relatively easy to refute. If the loan file contains a copy of the disclosure and evidence of ‘constructive receipt,’ showing it was delivered, borrowers can claim they lost the disclosure form – which would be unfortunate – but they cannot claim it wasn't provided, which would be a violation of lending laws.
Unfortunately, disclosure violations are all too common. During the housing boom, when loans and paperwork were flying, loan originators were not always as conscientious as they should have been about providing and documenting the required disclosures, and the disclosures they provided were often inaccurate.
The complexity of some mortgage products made annual percentage rate and monthly payment disclosures particularly prone to error. The mistakes may have been inadvertent, but the disclosure violations they produced will almost certainly provide the basis for litigation.
Where's the note?
Documentation, or the lack of it, has already become a major problem for lenders pursuing foreclosure actions. Judges in several jurisdictions have delayed or halted foreclosure actions when the servicers were unable to produce the original mortgage note or provide evidence that the originating lender had assigned it. A Web site offering free legal documents for consumers reports that the template most in demand is one asking lenders to produce the original mortgage note.
The New York Times reported recently that a legal aid attorney in Florida is training consumer lawyers nationally in how to litigate these cases, and if that doesn't make lenders nervous, how about this: In a recent speech, U.S. Rep. Marcy Kaptur, D-Ohio, described the inability of lenders to produce the mortgage note on demand as a good thing for borrowers facing a foreclosure action.
Her advice: ‘I say to the American people, be squatters in your own homes.’
Do you know where your mortgage notes are? Make sure you can answer that question before initiating a foreclosure action and before deciding how to respond to a modification request. If the note isn't in the file, modifying the loan and producing a new note that you will be able to find is a strategy you might want to consider.
Additional suggestions for coping with the likely surge in modification requests and consumer litigation include the following:
- Expect modification pressure, borrower lawsuits and state anti-foreclosure actions (like those in Massachusetts) to continue for the foreseeable future. Two points here: (1) monitor federal modification and foreclosure prevention programs, the rules and incentives for which are changing regularly; and (2) track litigation trends. Court decisions in one jurisdiction will not set precedents in others, but they may influence the thinking of other judges, highlight arguments borrowers may use and suggest defenses that lenders might use.
- Be proactive. Lenders should review loan files before borrowers request modifications or initiate suits. When identifying violations, correct them, if possible; where appropriate, reach out to borrowers before they come after you.
- Approach modification prospects with an open mind and a long-term perspective. Assess the benefits and costs of modifying a loan against the potential risks (including the threat of litigation) if foreclosure is chosen.
- Practice ‘safe modifications.’ If servicers cannot offer – or are not willing to offer – terms that improve the borrower's repayment prospects, a modification should not be offered. Redefaults are not in anyone's best interest, and failed modifications, as much as a failure to halt the foreclosure trend, will bring stronger anti-foreclosure measures, including an almost certain revival of the bankruptcy cramdown bill.
August Blass is the founder and CEO of National Loan Auditors, which provides quality control, auditing and risk assessment. Blass can be reached at firstname.lastname@example.org.