REQUIRED READING: For the past couple of years, it has become a fairly common practice for lenders and servicers to employ forensic loan audits on pools of mortgages, with the goal of uncovering patterns of noncompliance with federal and local regulations, the presence of fraud and/or the testing of high fee violations. Unfortunately, for these same lenders, the practice of forensic loan auditing has slipped over to the consumer side of the market and is now being used against the lenders themselves.
Homeowners, many of whom are facing foreclosures, have begun hiring forensic loan auditors to review their loan documents, and if violations are found, they are hiring attorneys to bring their case against the lenders. What do they hope to gain? At the very least, the homeowners are trying to forestall a foreclosure, push for a loan modification or, at the end of continuum, try to get the loan rescinded.
‘The forensic loan review as we know it today came about two years ago, when the mortgage market started to melt down,’ explains Jeffrey Taylor, co-founder and managing director for Orlando-based Digital Risk LLC. ‘The idea of the forensic review was to look for a breach of representations and warranties so the investor or servicer could put the loan back to the originator. This is when you had all the big banks reviewing nonperforming assets to see if there was any fraud material or breaches so as to put them back to the entity that sold the loan.’
Originally, and still today, most forensic loan reviews are done by institutions on nonconforming assets. Starting in about 2008, the concept morphed into a kind of consumer protection program. Forensic loan auditing companies have since sprouted up like weeds, and many advisors are now advocating the program as a best practice and the first step before bringing a lawsuit against the lender to get a ‘bad’ mortgage rescinded or force a loan modification.
‘Every constituent along the way is looking for their own get-out-of-jail-free card,’ observes Frank Pallotta, a principal with Loan Value Group LLC of Rumson, N.J. ‘I've been seeing this for the last two years. It started with banks that bought loans from small correspondents, and when those loans were going down, they would look for anything in the loan documentss to put it back to the person they bought the loan from. Fannie and Freddie are doing it, too. Now you have borrowers going to the banks to see if they have all their documents in place; they want their own get-out-of-jail-free card.’
In some regards, lenders should be worried, as a swarm of potential lawsuits could fly in their direction. These might not always be hefty lawsuits, considering they mostly represent individual loan amounts, but they are annoying and the fees to defend the institution from these efforts can mount up very quickly. In addition, if homeowners are successful in the bids to rescind a loan, the lender has to pay back all closing costs and finance charges.
The industry should also be concerned because experts in mortgage loan rescissions say it is very hard for a bank to mount an effective defense against people who can prove that their loan contained violations.
‘It is extremely difficult for lenders to defend against a lawsuit when they face a bona fide rescission claim,’ says Seth Leventhal, an attorney with Fafinski Mark & Johnson PA in Eden Prairie, Minn., who often works with banks.
Additionally, in this age of securitization, many banks don't own the loans they originated, but, says Leventhal, this is not a defense. ‘If they don't own the loan anymore, they are going to have to get in touch with the servicer who does,’ he says.
On the other hand, the homeowner's cost to arrange a loan audit and hire an attorney can be prohibitive, so there is some balance.
Jon Maddux, principal and founder of Carlsbad, Calif.-based You Walk Away LLC, started one of the first companies offering forensic home loan audits for homeowners back in January 2008.
‘We found that about 80% of the loans we audited had some type of violation,’ he says. ‘And we thought it was going to be a great new tactic to help the distressed homeowner.’
However, it wasn't. Homeowners would take the audit findings to their lender or servicer, only to find themselves pretty much as ignored as they were before they made the investment in the audit.
‘We found lenders weren't really reacting to an audit,’ says Maddux, adding that lenders and servicers would only react to lawsuits based on audit information.
An audit by itself is not some magical way to make everything go away; it's just the beginning, adds Dean Mostofi, the founder of National Loan Audits in Rockville, Md.
‘Borrowers who contact lenders with an audit don't get too far,’ he says. ‘It's in their best interest to go in with an attorney.’
The problem is, Mostofi states, that the first point of contact is the loss mitigation department, and ‘those people typically have no idea what you are talking about. To get past them sometimes requires lawsuits.’
The forensic loan audit lets the homeowner know if the closing documents contain any violations of the Truth In Lending Act (TILA) and Real Estate Settlement Procedures Act (RESPA), or if there was any kind of fraud or misrepresentation.
‘We go through the important documents – in particular, the applications – TILA disclosure, Department of Housing and Urban Development forms, the note, etc., making sure that everything was disclosed properly to the borrower and that borrowers knew what they were getting into,’ says Mostofi. ‘We also look at the borrower's income to see if everything was properly disclosed. If the lender didn't care about the borrower's income, then we look further for other signs that it might be a predatory loan.’
According to August Blass, CEO and president of Walnut Creek, Calif.-based National Loan Auditors, a forensic loan audit is a thorough risk assessment audit performed by professionals who have industry and legal qualifications to review loan documents and portfolios for potential compliance or underwriting violations, and provide an informative, accurate loan auditing report detailing errors or misrepresentations.
Some elements of a forensic loan audit, says Blass, should include: a compliance analysis report based on data from the actual file; post-closing underwriting review and analysis; and summary of applicable statutes, prevailing case law and action steps that the attorney or loss mitigation group may chose to act upon.
TILA's statute of limitations extends back three years, so most people who end up on their lender's doorsteps are people who financed or refinanced during the boom period of 2005 through early 2007. If serious violations are discovered, the borrower can move to have the mortgage rescinded.
Not everyone appreciates the efforts of the forensic loan auditors working the homeowner side of the business.
‘It began with a bunch of entrepreneurial, ex-mortgage brokers who learned how to game the system the first time, then started offering services to consumers to teach them the game,’ Digital Risk's Taylor says.
A year ago, most people didn't know what a forensic audit was, but ‘now almost everyone knows,’ says Mostofi. ‘The problem that we are having is that the banks are coming back and telling borrowers that everyone who is offering some kind of service to help them is a crook because they are charging a fee.’
Indeed, fees for a forensic audit often fall into the $2,000 to $5,000 range – but a hefty sum for someone facing foreclosure.
This could all be a desperate attempt to get a loan rescinded, but in regard to loan rescissions, there's bad news and good news.
‘Yes, it's tough for lenders to defend themselves,’ says James Thompson, an attorney in the Chicago office of Jenner & Block LLP who represents banks and finance companies. But, he adds, there is an exception: the plaintiff in this kind of lawsuit has to essentially buy back the loan, which means the plaintive (borrower) has to get new financing.
‘The borrower has to be able to repay the amount he borrowed,’ explains Thompson. ‘If the property is underwater, as many of these are, the borrower can't go out and get a replacement mortgage that would give him the entire amount he would need to repay the lender.’
In some court cases, as part of the initial lawsuit, the plaintiff needs to prove that he or she is capable of getting a refinancing. What happens if the court grants a rescission but the consumer can't find financing? Oddly, no one knows, because court cases haven't gotten that far.
‘Every one of these cases gets resolved,’ says Thompson. ‘The borrowers are struggling to get the attention of the overworked loan servicers, who are scrambling with as many loan modifications and workouts they can come up with. You can get to the head of the line sometimes if you show up with an attorney and forensic loan examination, saying, 'Here is a TILA violation; we want to rescind.'’
‘I don't see very many of these litigating,’ National Loan Auditors' Blass concurs. ‘It brings the settlement offer to the table a little faster. It's not as if the lender would not have brought an offer to the table without the audit. It just seems to fast-track the process a little bit more.’
Forensic loan audits expose mistakes and unscrupulous lending practices that will assist the borrower in negotiation efforts, Blass adds. ‘Federal-, state- or county-specific lending violations and the legal guidelines for remedy, can pave the way to successful and expedient modification.’
Perhaps, the bigger nightmare of all is not the lawsuits brought by individual homeowners, but the big law firms finding all these individuals and bringing them together for a class action suit.
‘The plaintiff bar is as active as ever. They have these big dragnets, trying to capture all the misdeeds of mortgage bankers, going after them with class-action lawsuits,’ says David Lykken, president of Mortgage Banking Solutions in Austin, Texas.
This just aggravates the situation, adds Lykken. ‘I have not seen one class-action lawsuit bring about any positive change. Punitive damages just drain the cash-out of already cash-strapped companies.’
Steve Bergsman is a freelance writer based in Mesa, Ariz., and author of "After The Fall: Opportunities & Strategies for Real Estate Investing in the Coming Decade," published by John Wiley & Sons.