Banking Law

It's easy to see the chickens coming home to roost when you live inside the coop. That's why those of us coop-dwellers who represent banks and thrifts who engage in mortgage banking have been warning for the last several years (for example, here and here) about the threat to not only the bottom line, but to capital, posed by "buy-back" obligations. A recent lawsuit by one institutional mortgage banker against an originator over allegedly fraudulent underwriting practices is a sign of the times.

Reeling from losses on mortgage loans, First Mariner Bank has filed a $15 million lawsuit against Virginia mortgage broker East West Mortgage Co., claiming the firm falsified mortgage loan documents sent to the bank.

The Baltimore bank alleges in a Jan. 25 lawsuit that in 2004, East West agreed to submit mortgage loan applications to First Mariner, which would review and fund the loans.

But First Mariner claims that to get the loans financed, East West created false credit references for borrowers, faked documents related to borrowers' employment and income and obtained home appraisals for more than the properties were worth. On one $310,000 loan made in June 2006, East West allegedly gave First Mariner two faked credit references and a false document verifying the income in the borrower's account, the lawsuit says.

[...]

Many of the borrowers had no idea East West was forging documents related to their loans, the suit says. Many defaulted on the loans shortly after closing, and First Mariner, which had sold the loans to investors, had to buy them back, the bank claims. First Mariner says it has lost more than $5 million because of East West forging loan documents.

Since the upheaval in the mortgage market began, many mortgage lenders that have found that loans were based on inaccurate data have demanded that the broker or loan originator buy the loans back, said J. Steven Lovejoy, of law firm Shumaker Williams, who is not involved in the First Mariner case.

If the facts turn out to be as alleged, outright fraud was involved. That's an easy basis on which to support a claim for breach of representation and warranty claim and/or a tort action. Yet, the extensive representations and warranties contained in most standard residential mortgage secondary market agreements make even less egregious "glitches" in the loan origination process fodder for investors to demand loan repurchases and to recoup damages from loan sellers. Obviously, investors have had people parsing the nuances, looking for loopholes, and hoping to put back every bad loan they can. It's not a recent phenomenon, but the First Mariner case highlights the problem.

A crucial issue for a mortgage banker such as First Mariner Bank is the financial capability of the originator to perform its buy-back obligations. Even if First Mariner wins the suit, if East West doesn't have "the scratch," it might be a hollow victory. There's nothing in the article to suggest that East West doesn't have that ability, but the time to worry about it is when the relationship was originated, not when it turned sour. It's the same issue with any contract that contains risk allocation provisions. If the other isn't financially capable of honoring its obligations, you've got a pretty package but an ugly core. It's your earnings and capital that will take the hit.

Obviously, hindsight is a wonderful capability. On the other hand, when mortgage originations were "blowing and going," I represented some smart bankers who anticipated the risks and required security to back the buy-back responsibilities, such as the funding a reserve account or otherwise pledging of readily marketable collateral. Others will learn the hard way, and will be better prepared in the future. If they stay in the game, that is.