The litigation factor.

Author:England, Robert Stowe
Position:COVER REPORT: LEGAL ISSUES AND REGULATORY COMPLIANCE

Five years of litigation against FHA lenders under the False Claims Act has netted $5 billion in settlements for the federal government. But at what price? Some of the largest FHA lenders have curtailed or exited the business.

Five years ago, federal false claims litigation was a tiny cloud on the horizon. Since then, the clouds have filled the sky and released a relentless deluge of lawsuits and settlements on lenders that originate home loans insured by the Federal Housing Administration (FHA). [paragraph] And there's no sign it is going to slow down or stop. [paragraph] The false claims suits filed by the U.S. Department of Justice (DOJ) and Department of Housing and Urban Affairs (HUD) are brought under the False Claims Act, a Civil War-era law aimed at military contractors that defrauded the government. Its application has been expanded over the years to include fraud against Medicare and Medicaid and, more recently, against the FHA. [paragraph] For the government, a lot is at stake. The FHA insures $1,046 trillion in single-family and $105 billion in reverse mortgages in its Mutual Mortgage Insurance (MMI) Fund, according to FHA's latest annual actuarial report to Congress in November 2015. [paragraph] The toll of the federal government litigation wave against FHA lenders has been exceedingly high. "The banks have had to pay a king's ransom and then some to settle the claims," says Jeff Davis, managing director of the Financial Institutions Group at Mercer Capital, a Nashville, Tennessee-based financial advisory firm.

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In the 16 major cases brought so far, the federal government has recovered about $4 billion in settlements in 14 of those cases, according to a tally by K&L Gates LLC, a Washington, D.C., law firm that has defended lenders in some of the cases. No cases have been resolved through a trial and a court verdict.

The federal government's total recovery might soon hit $5.2 billion. That's because Well Fargo & Co., San Francisco, after a lengthy and determined effort to avoid a settlement, revealed in an early February filing with the Securities and Exchange Commission (SEC) that the bank had reached an agreement in principle to settle for $1.2 billion.

The Wells Fargo settlement will thus be the largest single settlement as of this writing, although virtually no details beyond the amount of the settlement have yet emerged.

Still to be resolved is a high-profile case against Quicken Loans Inc., Detroit. The company has refused to settle charges and has blasted the methodology used by DOJ and HUD to extrapolate claimed losses for what Quicken says are mostly minor errors that do not, in fact, affect the credit quality of the loans.

Quicken pre-emptively sued HUD and DOJ in April 2015 for pressuring the company to reach a nine-figure settlement on charges of fraud the company claims it did not commit. "The rumored amount is $300 million" for what DOJ is reportedly asking Quicken to pay in a settlement, says Guy Cecala, chief executive officer (CEO) and president of inside Mortgage Finance.

In its complaint, Quicken stated it is a target of a "political agenda under which DOJ is 'investigating' and pressuring large, high-profile lenders into nine- and 10-figure sums and publicly 'admitting' wrongdoing."

HUD and DOJ countersued a few days later, and in December 2015 the Quicken lawsuit was dismissed by Judge Mark Goldsmith in the U.S. District Court for the Eastern District of Michigan. At press time, it was not yet clear whether Quicken would appeal the ruling.

Sledgehammer?

So what happened? How did the litigation risk for false claims go from a small risk to being such a significant threat that major lenders are abandoning the FHA program to escape the potential liability?

Before 2011, false claims lawsuits were based on individual cases of deliberate fraud. However, in the last five years FHA lenders have been sued because of defective underwriting and loan-quality review procedures in their FHA lending programs.

Lenders have been charged with making false annual certifications and loan-level certifications to HUD that assert their loans submitted for FHA insurance have complied with the Direct Endorsement program rules and procedures.

As one FHA lender after another has been compelled to reach large settlements, voices of opposition have been rising against the litigation wave.

"I think they overuse [the False Claims Act], and it has had a pretty detrimental effect on lenders' willingness to do FHA loans," says Laurie Goodman, director of the Housing Finance Policy Center at the Urban Institute, Washington, D.C.

More recent cases seem to be going farther and farther afield to apply the law to an ever-diminishing supply of larger lenders, with fewer and fewer loan defects to justify the actions.

The 2015 case against Quicken Loans is a case in point. The case "makes for some fascinating reading," Goodman says. "You can see that a lot of the claims that were used to figure out the defect rate for the purposes of the False Claims Act were actually very, very minor errors," she says.

"They sample some number of loans to establish a defect rate and then use that defect rate on the entire portfolio," Goodman adds. Penalties per loan can be as high as $11,000 per claim, with potentially treble damages of those amounts.

Early success in 2013 in extracting $100 million-plus settlements emboldened the DOJ, according to Mercer Capital's Davis. U.S. Attorney General Eric Holder, who oversaw the expansion of the false claims litigation, "had an 800-pound sledgehammer he could bring into a board room," says Davis, referring to the treble damages of the False Claims Act.

While Davis concedes that underwriting was loose in the last decade, giving the government a strong basis for bringing many of the lawsuits, some of the actions that have been brought are based simply on "technical deficiencies." Besides, Davis points out, a lot of the losses suffered by FHA were inevitable in any downturn. He asks, "How could you not have losses with 3 percent down mortgages?"

Even so, FHA lenders who are convinced they are not guilty often face a losing hand if they want to fight the charges, according to Davis.

"When you see people settle before going to trial, they are thinking, T am not guilty--but if I lose, the penalties are so draconian, I'll settle and admit [wrongdoing],"' Davis says. "I think there's very much an element of that here, but how much, I don't know," he adds.

For DOJ, winning the early cases with big settlements has vindicated its approach and helped it perfect the targeting of FHA lenders for the maximum return, according to Davis.

"If Eric Holder were an investment banker, he'd be the top investment banker on Wall Street by far because he's [so] good at bringing in...

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