When should a basketball-like “no harm, no foul” rule apply to the long litany of loan-level representations, warranties or certifications made in connection with the insuring, selling or securitizing of residential mortgage loans by, to or with a federal government agency or sponsored enterprise?
This question is top of mind for many of our clients that often ask us to identify the material risks of entering into an “agency” mortgage banking business. A common, unpopular answer was that the respective agencies have broad remedial powers to reallocate the risk of loss back to the originator, seller or servicer of the mortgage loans depending on the applicable mortgage insurer or loan purchaser, based on allegations of faulty underwriting. While this material risk remains, it has diminished in light of the agencies’ initiatives in some cases to limit their remedial powers. We thought it might be useful to highlight the ways that the Federal Housing Administration (“FHA”) and Fannie Mae and Freddie Mac (each, a “GSE”) are handling this issue.
Absolute perfection in the “manufacturing” of a residential mortgage loan is a laudable goal that often unintentionally is not achieved. Imperfections in the loan manufacturing process can lead to inaccurate loan-level representations, warranties or covenants, which in turn could lead to a variety of adverse consequences for the maker. These consequences range from demands for loan repurchase or indemnification, rescission of mortgage insurance, termination of agreements or imposition of monetary and non-monetary governmental sanctions.
These consequences certainly were the case in the fallout from the financial crisis. Consider, among other consequences, demands by the Department of Justice (“DOJ”) for triple damages under the False Claims Act or claims for indemnification by the FHA in either case in connection with alleged origination violations of FHA rules and requirements for insured loans. Or, consider demands by a GSE for repurchase of loans based on allegations of breaches of selling, loan-level representations and warranties. Such claims were substantial in number and dollar amount.
But not all origination “defects” are created equal; some may impact the value or enforceability of the loan or the compliance of the loan with applicable legal and underwriting requirements, while others may be relatively inconsequential. Over the years, there has been a lively debate over a sense of proportionality in doling out remedies. Should the “punishment” or remedy in respect of an inaccurate representation, warranty or certification be limited by the severity of the resulting consequence? Or, on the other hand, should the punishment or remedy exceed the actual harm or negative consequence, either as a deterrent to future wrongful acts or omissions or simply to allocate risk away from the counterparty that itself did nothing wrong? Of course, this also plays out in private purchases and sales of mortgage loans where the question is whether a breach occurred at all or, if so, whether the breach had a material adverse effect on the value of the loan or the interest of the purchaser—a common standard for loan repurchase in a private whole loan sale or securitization agreement.
In this regard, last fall, FHA announced proposed amendments to its loan-level certifications and updates to its mortgage origination “Defect Taxonomy” in response to this years-long debate. By coming down on the side of proportionality in these documents, the FHA to some degree followed the initiatives Fannie Mae and Freddie Mac started in 2013 to limit their available remedies with respect to alleged inaccuracies of selling representations and warranties pertaining to underwriting the loan.
FHA’S DEFECT TAXONOMY AND LOAN CERTIFICATIONS
On October 24, 2019, FHA issued a new version of its “Defect Taxonomy.” In connection with the origination of FHA-insured residential mortgage loans, the Defect Taxonomy, originally published in 2015, created a method of identifying loan-level origination defects under FHA rules and regulations, categorizing those defects and identifying their sources, causes and severities. FHA’s revised Defect Taxonomy reflects an effort to achieve more predictable review outcomes and identify penalties that align with the severity tiers. The revised Defect Taxonomy includes nine defect areas for underwriting—borrower income, borrower credit, loan-to-value and maximum mortgage amount, borrower assets, property eligibility, property appraisal, borrower eligibility, mortgage eligibility, and lender operations. There are four potential severity tiers for each finding, depending on the size and nature of the deviation from FHA’s requirements.
Tier 1 and 2 violations reflect unacceptable deficiencies to which the lender must respond to the FHA, and may result in penalties including indemnification, refunds or principal reductions. Tier 3 and 4 violations reflect immaterial deficiencies to which a lender response is not required. FHA’s revisions to the Defect Taxonomy clarify that Tier 3 and 4 violations do not impact the original eligibility of the loan for insurance and that, while lenders are not required to respond to them, optional responses from lenders will be accepted. Importantly, Tier 1 is reserved for instances of fraud or material misrepresentation about which the lender knew or should have known, violations of which generally result in life-of-loan indemnification. The addition of penalties draws a clear line between indemnifiable offenses (Tiers 1 and 2) and violations that do not rise to the level of indemnification (Tiers 3 and 4).
After the payment of billions of dollars to the DOJ to settle False Claims Act charges based on allegations of defective FHA-insured loan originations, many banks reduced their footprint in FHA-insured lending. In part, this reduction was driven by a belief that the DOJ wrongfully focused on originating lenders’ immaterial alleged violations of FHA’s eligibility requirements for loans to be insured by the FHA.
On October 25, 2019, FHA published proposed changes to the loan-level certifications required of lenders in FHA transactions. In every FHA loan transaction, the lender and borrower use a Uniform Residential Loan Application (“URLA”) and FHA/VA Addendum to the URLA (Form FHA-92900-A), which currently contain numerous loan-level certifications, to make the application. FHA’s proposed revisions would simplify the lender’s loan-level certifications. Instead of having to certify to a variety of statements regarding the lender’s adherence to broad references to FHA guidelines, the lender instead would certify generally to the loan’s compliance with FHA requirements pertaining to the final underwriting decision and post-closing and endorsement.
Among other changes, the proposed changes would add a qualifier to the certification regarding the loan’s compliance with FHA underwriting requirements such that only defects that rendered the loan ineligible for insurance would cause the certification to be inaccurate. Specifically, the certification would state, in relevant part: “This mortgage complies with SF Handbook 4000.1 Section II.A.4.e Final Underwriting Decision (TOTAL) to the extent that no defect exists in connection with the underwriting of this mortgage such that it should not have been approved in accordance with FHA requirements” (emphasis added). A similar statement applies to the manual underwriting and closing compliance certifications. The newly proposed language is more narrowly tailored to FHA’s standards regarding loan origination and whether a loan is in fact eligible for FHA insurance. Thus, the loan-level certifications presumably would form the basis of False Claims Act litigation only when the loans ultimately are deemed ineligible for FHA insurance and not merely when defects immaterial to the loan approval decision are identified.
In addition, the proposed certifications add a materiality qualifier to all of the statements in the loan-level certifications. Specifically, the lender and/or its underwriter would certify that its statements “are materially correct.” This standard goes to the underwriter’s intent when he/she signed the certification, which could create a defense against an allegation that the certification statement was false and may create an opportunity to provide loan-level defenses regarding the underwriter’s intent.
The proposed certifications expressly refer to the Defect Taxonomy as the standard by which FHA will evaluate any inaccurate certification statements. Specifically, the certification would state that: “[i]n the event HUD elects to pursue a claim arising out of or relating to any inaccuracy of this certification, HUD will interpret the severity of such inaccuracy in a manner that is consistent with the FHA Defect Taxonomy in effect as of the date this mortgage is endorsed for insurance” (emphasis added). As discussed above, given the recent amendments to the Defect Taxonomy to add penalties for the various severity tiers and make clear that only Tier 1 and 2 violations constitute indemnifiable offenses, the proposed certification language and revised Defect Taxonomy together would provide more clarity regarding what underwriting violations might render the loan-level certification statement inaccurate, expressly or implicitly relying on the materiality of the violation to determine the outcome.
THE GSEs REPRESENTATIONS AND WARRANTIES’ ENFORCEMENT AND REMEDIES FRAMEWORKS
Sellers that sell eligible residential mortgage loans to a GSE are required to make “selling” representations and warranties with respect to each sold loan. If a GSE identifies a breach of a selling representation or warranty (an “Origination Defect”), it has a variety of remedies available to address the breach. One remedy is indemnification against losses. The immediate repurchase of the mortgage loan or the acquired property in respect of such mortgage loan, or the remittance of a make whole payment if the GSE already has liquidated the acquired property, are other remedies available to the GSE for what is essentially a breach of contract claim.
Each GSE qualifies its rights in respect of Origination Defects in one of three ways. First, it may limit the applicability or scope of the applicable representation or warranty, which effectively means that no breach has occurred. Second, based on the timing of the purchase of the loan and the performance of the loan, the GSE may elect to bind itself in advance not to assert remedies that otherwise would be available to it; in other words, a loan may qualify for relief from enforcement, notwithstanding a breach of certain selling representations and warranties. Third, each GSE has reserved certain remedies, such as repurchase or make whole, to Origination Defects that, in effect, constitute material breaches of the selling representations and warranties.
The applicable GSE Selling Guides do not really describe what constitutes a “breach” of a selling representation or warranty, other than to refer to an allegation that the representation and warranty is untrue. Generally speaking, applicable GSE rules make knowledge of the breach by the seller irrelevant unless the particular representation and warranty is explicitly qualified by seller’s knowledge. The representations and warranties themselves do not generally have materiality qualifiers. Thus, a breach of a representation and warranty generally does not depend on knowledge or materiality, and any notice and cure provisions that may exist lie on the enforcement side, not on the definition of a breach.
While there are many different elements to the GSEs’ so-called “Enforcement Relief Framework,” for purposes of this Legal Update, we have chosen to highlight two aspects. The first is a seasoning requirement. Commencing with respect to loans purchased on or after January 1, 2013, each GSE elected not to exercise repurchase remedies with respect to loans that purportedly breached selling representations and warranties related to the underwriting of the loan but performed for 36 months after the purchase of the loan by the GSE. Certain limited delinquencies are permitted, which vary depending on when the GSE purchased the loan.
The applicable underwriting representations and warranties are those pertaining to:
- the borrower, which includes the lender's assessment of the borrower’s loan terms, credit history, employment and income, assets and other financial information used for qualifying the borrower for the loan;
- the subject property, which includes the lender’s analysis of the description and valuation of the property to determine its adequacy as collateral for the mortgage transaction; and
- the project in which the property is located, which includes the lender’s analysis of the condo, co-op or PUD project in accordance with the GSE's requirements.
Enforcement relief is not extended to eligible loans where the breach involves a “life-of-loan representation,” such as those pertaining to Charter Act compliance, title defects, and pattern and practice fraud or misrepresentation.
Second, even if a loan is not an eligible loan for purposes of the Enforcement Relief Framework, for loans purchased on or after January 1, 2016, each GSE has limited its ability to impose certain types of remedies based on the type of breach, regardless of the seasoning of the loan. Under their “Remedies Relief Framework,” the GSEs generally reserve the remedy of repurchase for breaches of selling representations and warranties that rise to the level of a “significant defect.” This is defined as a defect that results in the loan being unacceptable for purchase had the true and accurate information about the loan been known at the time of purchase. In determining whether there is a significant defect on a loan covered by the Remedies Relief Framework, each GSE must give due consideration to the severity of the defect. Among other types, the defect must relate to one of the following:
- the underwriting of the borrower’s creditworthiness and capacity;
- the borrower’s eligibility and qualification; or
- the property appraisal or the physical condition of the property.
Whether the GSE agrees not to assert a repurchase demand in respect of breaches of underwriting representations under the Enforcement Relief Framework or the Remedies Relief Framework, the result is the same. The presence of a “significant defect” is not relevant to the determination of whether a breach occurred in the first place. Rather, the GSEs have announced that they will not exercise available repurchase remedies in respect of that breach—a good example of a “no harm, no foul” approach. In this regard, GSE forbearance from the enforcement of the repurchase remedy for breaches of loan-level underwriting representations and warranties other than those that rise to a “significant defect” in many respects mirrors the course of dealing in the private whole loan market for trades between two private parties.
The role of materiality in determining the occurrence of an alleged act, error or omission and, if so, the proper response is a debate that has gone on far longer than the age of any of the readers of this Legal Update. In the aftermath of the financial crisis, this issue was front and center in both civil and governmental disputes involving the making, servicing, selling and securitizing of residential mortgage loans. The FHA’s willingness to tier the severity of violations for indemnification purposes and its focus on insurability of a loan as the test for an inaccurate loan-level compliance certification are helpful. Similarly, the GSEs’ forbearance from exercising repurchase demands based on loan seasoning or the significance of an Origination Defect is a positive step. The actions of the FHA, Fannie Mae and Freddie Mac certainly do not resolve the issues of materiality or proportionality, but at least they have provided some needed guidance to the industry as lenders evaluate the potential financial risks associated with participating in agency mortgage origination and secondary market programs.