Repurchase demands from buyers of loans that later go sour have long been dreaded by mortgage lenders. Until now, few have legally contested these demands. But with a wave of buyback requests descending on lenders, more are exploring what legal protection might exist to shelter them from this heavy burden.
WITH ORIGINATION INCOME PLUMMETING, BALANCE SHEETS HEMORRHAGING and layoffs decimating operations and management, the end of the refinance market has forced mortgage lenders to take extraordinary measures to slash expenses. More than a few are scrambling for new sources of income simply to survive. * Just when it seems things couldn't get worse, many are now facing massive repurchase demands from investors on substandard loans long since sold and forgotten. * Originated when quality control was stretched thin during the refinance frenzy, some of these loans may involve liabilities of several hundred thousand dollars. Even with just two or three such loans, the consequences can be devastating. This is especially true for mortgage bankers because most repurchases cannot be financed with warehouse lines.
Evidence is starting to mount that many bad loans passed through the quality control safety net during the massive refinance boom. For example, the FBI estimates that as many as 25 percent of the federal tax returns provided by Californians seeking mortgages during 1993 had misrepresentations in them, and as much as $100 billion in mortgages originated in California during 1993 and 1994 was made to borrowers providing misinformation on loan applications, according to National Mortgage News.
Servicers that did not originate these loans, yet are currently servicing them, are not immune to the threat of repurchase. Many investor agreements make no distinction between seller and servicer in the representations and warranties they are required to make regarding each loan. So, when these are breached, both seller and servicer can be liable.
Moreover, many of the problem loans on which repurchase demands are now being made could have been worked out or refinanced if their defects had been recognized early enough by diligent servicing. In some instances, the actual loss to the investor is more the result of failure to follow required servicing practices--such as prompt commencement of foreclosure or competent handling of REO--than it is of technical defects in loan origination.
A changed response
A time did exist when such repurchase demands would have been honored immediately and without question because failure to do so would mean the end of a mortgage banker's seller-servicer relationship with that investor--and maybe every other investor in the industry. With many mortgage bankers now struggling to survive, however, and the inability of borrowers to refinance problem loans because of rising rates, ways to challenge the enforceability of repurchase obligations are suddenly being sought.
The sheer volume of the problem is also compelling investors to make the "no-win" choice of either compromising the amount of their repurchase demands or terminating important seller-servicer relationships and prosecuting lawsuits against former "customers" who now may be very real candidates for bankruptcy.
Given these circumstances, it is important to raise some questions and seek some answers regarding repurchase demands. For example: What are the most important legal and financial issues with respect to repurchase obligations? What are the current trends in the enforceability of these obligations, and the unexpected pitfalls being discovered by investors, sellers and servicers as they demand or resist such enforcement? And with new legal approaches emerging to deal with these problems, what changes can be expected in the way business is done in the industry, both now and in the future?
The destructive potential of repurchase obligations
At first glance, it may not be easy to see why loan repurchase obligations have such enormous destructive potential. In their most basic and commonly encountered form, such obligations are nothing more than covenants in seller/servicer contracts with loan purchasers (such as Fannie Mae, Freddie Mac, private conduits or other mortgage bankers.) Pursuant to these covenants, the seller or servicer agrees to repurchase (usually on 30' days notice) every loan not originated or serviced in accordance with certain representations and warranties in the contract and accompanying "guide."
While these representations and warranties are often very specific and extensive, they are normally nothing more than a detailed description of what a properly underwritten, documented and serviced mortgage loan should be. Since the purchaser's ultimate objective is often to securities the loans, or at least retain the option of doing so at some future date, most of the representations and warranties focus, in one way or another, on the issue of whether a private institutional investor would have any reasonable basis for rejecting the loan as an investment.
In referring to this requirement, the Freddie Mac contract requires the mortgage loan to be of "investment quality," as that term is more specifically defined in Freddie's "Guide." The Fannie Mae contract requires the seller to represent and warrant that the mortgage not only "conforms to all the applicable requirements in [Fannie Mae's] Guides and...Contract," but also, inter alia, that the seller:
knows of nothing involving the
mortgage, the property, the
mortgagor or the mortgagor's
credit standing that can
reasonably be expected to: cause
private institutional investors to
regard the mortgage as an
unacceptable investment; cause
the mortgage to become
delinquent; or adversely affect
the mortgage's value or
While the obligation to repurchase also may be accompanied by additional covenants to indemnify and hold the purchaser harmless from any loss or injury in connection with any loan for which repurchase may be required, all of this does not, on its face, seem to be inconsistent with normal commercial expectations. After all, in other areas of commerce, when a merchant sells a "bad" product, the usual remedy is a "refund" upon return of the defective goods.
What is different in the mortgage context, however, is the degree of financial leverage used by the seller--and allowed, for ostensibly public policy reasons--in creating the "product." This situation, combined with the almost total unavailability of financing to the seller in the event a loan must be repurchased, further sets apart the mortgage repurchase concept from other marketplace practices.
Funding a loan is typically done with funds borrowed from a "warehouse" line, and such borrowing is, in turn, secured by the loan. Thus, comparatively little capital is required to generate and sell millions upon millions of dollars in financial obligations. The minimum capital requirement for Fannie Mae seller/servicers, for example, is only a few hundred thousand dollars, but repurchase obligations can be incurred equal to many times that amount. Also, in many instances, since the characteristics of a loan that make it a candidate for repurchase drastically affect its value, these loans are often no longer viable collateral to help a lender finance the repurchase. This is particularly true where some defect exists in the validity or priority of the mortgage lien, the enforceability of the loan documents, the accuracy of the appraisal or some material fraud committed by the borrower.
The inexact science of quality control and risk allocation
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