Buy-Backs: Keeping Lenders On The Hook
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Did you ever wonder what happens to lenders when mortgages fail, when someone gets foreclosed? Lenders know, and for them there are lots of sleepless nights.
“When loans go bad borrowers can be foreclosed. Meanwhile, investors such as pension funds, insurance companies and others who own loans can lose money,” say James J. Saccacio, Chairman and CEO at RealtyTrac, the largest marketplace for foreclosure properties. “But there’s another party that can also lose: the original lender who found the borrower, took the loan application and got fees and commissions at closing can often be forced to buy back the loan.”
In today’s mortgage world a large percentage of all loans are routinely sold and resold. The buyers include insurance companies, pensions as well as purchasers such as Fannie Mae and Freddie Mac.
To some extent selling a mortgage is a lot like selling a shirt. A purchaser has certain expectations and if the shirt is not up to par the buyer can bring it back for a refund.
With mortgages, the same arrangement applies with each mortgage sale. If a loan is not up to snuff, the seller — meaning the lender who originated the loan in the first place — can be forced to buy back the mortgage.
Clothing stores know that relatively few shirts will be returned and they also know something else: Paying for a few shirts will not bankrupt the company.
The situation with mortgage loans is different because mortgages are big-ticket items. A conventional, everyday loan today can easily be worth more than $400,000. Return a few of these and you’re out big money — perhaps more than $1 million.
That’s a problem because many of the businesses most people see as “lenders” do not actually fund mortgages with their own dollars. They’re middlemen who obtain loans from the wholesale marketplace and then resell those loans at retail to borrowers. If there’s an unacceptable loan default, our “lender” may not have enough capital to buy back one mortgage much less three or four. Rack up enough problem loans and lenders facing buy-backs — even big lenders — can quickly go broke.
According to David Reed, with the Austin, Texas, firm of CD Reed Mortgage Bankers, there are three general kinds of loan defaults.
With a “universal” default the borrower never makes a payment. Not one. If the loan was sold to an investor the original lender will usually be required to take back the loan — but not always. Reed, author of Mortgage Confidential, says he had one borrower who died before the first payment was due. The loan was in default but there was no issue with fraud, there was nothing wrong with the loan, so there was no demand by the investor to buy back the loan.
Original lenders are usually required to buy back loans if borrowers quickly default, say within 120 days of closing. After 120 days the original lender — the lender who took the loan application — is typically no longer responsible for the debt, except in one situation: if the loan involves fraud.
If the original loan application involves fraud then the clock never stops. The original lender is on the hook until the entire debt is repaid.
Looking at the marketplace it’s clear that most loans are not a problem to lenders because more than 120 days have passed. But what about fraudulent loans, loans where borrowers (or lenders) inflated income, downsized debts or claimed employment that did not exist?
“If there are a lot of fraudulent loans out there then large numbers of lenders may ultimately be forced to buy back loans,” Saccacio said. “But how many fraudulent loans are there? No one knows for sure, but recent studies suggest the problem may be far larger than imagined.”
Figures from the FBI show that mortgage fraud reached $946 million in 2006 — more than four times the 2003 level.
However, the FBI says “a significant portion of the mortgage industry is void of any mandatory fraud reporting. In addition, as initial mortgage products are repackaged and sold on secondary markets, the sale of the mortgages, in many cases conceal or distort the fraud, causing it not to be reported. Therefore, the true level of Mortgage Fraud is largely unknown. The mortgage industry itself does not provide estimates on total industry fraud. However, based on various industry reports and FBI analysis, Mortgage Fraud is pervasive and growing.”
Lenders have access to tax records through the IRS Form 4506 provided by borrowers, a form that allows lenders to review past tax records. In testimony before the Federal Reserve, Steven Krystofiak, President of the Mortgage Brokers Association for Responsible Lending, says his group compared the income figures for 100 stated-income loans with IRS records. What did they find?
- Ninety percent of the stated-income loan applications showed earnings that were exaggerated by at least 5 percent.
- Almost 60 percent of the stated amounts were exaggerated by more than 50 percent.
“We usually think of foreclosures in terms of people who lose their homes,” Saccacio said. “But we also have an unknown number of fraudulent loans which will need to be bought back. These loans will keep lenders on the hook for years to come — and bankrupt more than a few.”
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Published originally by RealtyTrac.com during February 2007 and posted with permission.
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