Lipson, Neilson, Cole, Seltzer & Garin, P.C.
The Mortgage News
A Mortgage Banking Newsletter

Editor: Howard A. Lax
hlax@lipsonneilson.com

 

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  December 2007 Edition

Welcome the Forty Ninth Edition of our electronic Mortgage Banking Newsletter. The current edition of our newsletter will be posted on our web site at http://www.lipsonneilson.com/news.html.  Previous editions of our newsletter are available at our web site, at http//www.lipsonneilson.com/news/archive.html. Please send an E-mail to the Editor, Howard A. Lax , at hlax@lipsonneilson.com if you have any difficulties viewing this newsletter, if your email address changes, or if you would like to be added to our newsletter electronic mailing list. Please feel free to share our newsletter with your colleagues. We ask that any republication of our newsletter must be without charge or compensation, in its entirety, and without modification. Please note the new address of our Las Vegas, NV office.  

The Editor's presentation materials from the 4th National Forum on Preventing and Resolving Mortgage Fraud sponsored by the American Conference Institute (ACI) and from the Certified Mortgage Planning Institute are now available from the sponsors. The Editor will also be speaking at the Reverse Mortgage Compliance Conference in Las Vegas on January 30, 2008, sponsored by ACI, and at a mortgage fraud conference sponsored by Michigan Association of Community Bankers in the MACB Training Center in Lansing, MI on February 7, 2008.  Of course, you are always welcome at the next meeting of the Michigan Compliance Officers Association on February 8, 2008. We hope to see you there!

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Contents
Court Decisions

Stealing Homes from the Elderly Will Cost the Title Company Dearly

Title Agency Liable to Real Property Owner for Recording Fraudulent Mortgage

Eleventh Circuit Turns Back the Clock to Culpepper I

Lender Takes the High Road, Avoids TILA Claim

One Fraudster Goes to Jail But HUD is Ripped Off Twice on the Same Property

Failing to Fix Credit Report Results in $532,000 Jury Award

Michigan Consumer Protection Act Not Applicable to Most Credit Transactions

Class Action Filed Against Bank and Real Estate Broker Alleging Sham JV

Compliance

Federal Reserve Proposes New Subprime TILA Rule

Congress Removes Insult From Top of Injury

IRS Develops New Form For 1099 Employees Who Should Be W-2 Employees

FTC Fines Broker $50,000 for Failing to Implement Information Privacy and Security Rules

Massive Closing Agent Changes Coming

Is the Fix in or is this Another Thumb in the Dike?

HUD's Hit Parade Continues

Other Stuff

How Do We Fix This Mess (Part II)

What Were They Thinking?


Articles

Stealing Homes from the Elderly Will Cost the Title Company Dearly We used to guard against people stealing candy from children and tell our kids that money does not grow on trees. Now we need to watch out for people who steal the homes of the elderly and tell our kids that money is not printed by shiny machines sticking out of the walls. In Franklyn v. Maxwell, an unpublished case, Maxwell rescued an old lady's home from foreclosure. The complaint alleged that Maxwell visited the old lady in the hospital and promised to pay off the mortgage and refinance the debt. The old lady deeded the home to Maxwell for the amount needed to redeem the home from foreclosure, and Maxwell let her live in the home for a year rent free. The problem is that the old lady had a guardian who was not told of the transaction. The guardian sued for rescission or $90,000 in the alternative. The trial court improperly held that the old lady had received a benefit from the bargain and dismissed the lawsuit. The appellate court reversed, holding that the complaint stated enough of a claim that the old lady was incompetent that the trial should go forward. The Court stated:

Michigan law has long held that a person under a guardianship is conclusively presumed incompetent to make a valid contract and that any contract made by a person under guardianship is void. Wies v Brandt, 294 Mich 240, 247; 293 NW 773 (1940); Acacia Mutual Life Ins Co v Jago, 280 Mich 360, 362; 273 NW 599 (1937); May v Leneair, 99 Mich App 209, 215; 297 NW2d 882 (1980).

Additionally, MCL 700.5134(b) and 700.5423(3) require that if the real property, or any interest in real property, of the ward is sold during the course of the guardianship, the guardian must notify all interested parties and obtain court approval. Here, the guardianship was in effect when the real estate transaction occurred between Armstrong and defendant, and there was no involvement or approval by the guardian or court. Although the trial court cited contract language and some evidence, which might suggest that Armstrong competently entered into the contract, it could not under this record resolve that issue by way of a motion for summary disposition.

The appellate court also held that the Guardian could prove that the transaction was fraudulent if she could prove that Maxwell never intended to help refinance the home when he made this promise (as if she could read his mind). This case is unusual in other respects, which may have influenced the court to send the matter back for trial. Stewart Title is a defendant which is unusual in itself. Even more unusual is that neither Stewart Title or Maxwell filed an appeal brief opposing the Guardian.

The moral of this story is that title agencies need to be much more careful about who they do business with. Title agencies should stop taking screwy deals that are just going to come back and bite them in the you know where. The uniform closing instructions proposed by the MBA (see below) will place the liability for loss on the title agency for failing to report suspicious events to the lender prior to closing. Title companies are going to stuff these cases down the title agent's throat. The proposed uniform closing instructions heighten the standard of care for closing agents, making the title agent's failure to perform due diligence on the parties and the transactions a negligent act. Title agents should realize that the new order will be "you cannot win, you cannot break even, and you cannot get out of the game."

Title Agency Liable to Real Property Owner for Recording Fraudulent Mortgage This decision should make every title agency's hair stand up in fright. In Maxwell v. Martin and Prescott Title, Inc., the title agency closed a loan for someone masquerading as Maxwell. The title agency did not check the identity of the person who signed the deed of trust, or the persons who picked up the proceeds check. When the thieves could not cash the check, the title agency wired funds into an account designated by the thieves. Maxwell sued the title agency for breach of fiduciary duty. The title agency argued that Maxwell had no relationship with the agency, the deed of trust was forged and could not be enforced, and the claim should be dismissed. The Court of Appeals held that Maxwell had a claim against the title agency for breach of a fiduciary duty, even though Maxwell was not a party to the transaction. The Court stated:

Prescott Title undertook to provide escrow services for the transaction involving the party Prescott Title believed to be Lucinda Maxfield, even though Maxfield herself was an involuntary party to the transaction. Although Prescott Title had no contact with Maxfield, it undeniably believed it had a relationship with her based on her name being used as one of the parties to the escrow. Moreover, Prescott Title recorded a deed of trust against property owned by Maxfield. Prescott Title's own actions in recording the deed of trust held the potential for direct harm to Maxfield and as part of its duty of diligence it should have confirmed her identity. The duty of an escrow agent to act with "scrupulous honesty, skill, and diligence," Berry, 124 Ariz. at 351, 604 P.2d at 615, includes the duty of taking reasonable efforts to ascertain the identity of the named parties to the transaction.

Title agencies cannot dance blithely through transactions. The errors in this case were compounded when someone other than a title agency employee obtained signatures on the deed of trust. The proposed uniform closing instructions will close any loophole that title agencies may now claim to avoid liability. Title agencies must beef up their due diligence and better train their personnel and contractors to detect fraud.

Eleventh Circuit Turns Back the Clock to Culpepper I I am cheating a little here, but this is an important decision (coming in January, 2008). In Busby v. JRHBW Realty, Inc., the Court of Appeals for the Eleventh Circuit delivered a decision proving that the Heisenberg Uncertainty Principal is a valid postulate. Last summer, we saw the Second Circuit open the door to lawsuits for post-closing fees charged by lenders before any services were provided. See Cohen v. JP Morgan Chase & Co.  In the Cohen case, the borrower had an argument that the fee was collected on a premise that services would be provided in the future (a some what dubious connection). The Eleventh Circuit expanded upon the Cohen decision to allow a lawsuit against a real estate broker who charged an Administrative Brokerage Fee. The real estate broker lowered its commission from 3.0% to 2.5% to encourage the seller to accept Busby's offer. It wanted to make up the shortfall by imposing a fee on the buyer, Busby. This is no different than the situation in HUD Statement of Policy 1999-1, in which HUD authorized lenders to pay a Yield Spread Premium (YSP) to a mortgage broker instead of making the borrower pay the entire mortgage broker fee. However, the Court rejected any comparison of the Administrative Brokerage Fee to a Yield Spread Premium. The Court distinguished the real estate broker's fee from a YSP because the borrower claimed the real estate broker did nothing at all to earn the fee. The argument that the mortgage broker did nothing to earn a fee from the lender, or the argument that the YSP duplicated the fee paid by the borrower, was rejected by HUD in its 1999-1 Statement of Policy. How the Court could twist the HUD Statement to hold that HUD really meant the opposite of what it said is beyond me. The opinion is marvelous example of scholarly legalese and obfuscation.

The Court goes even further in dicta, claiming that the exceptions to the kickback rule are nothing more than an "interpretive gloss." The Court stated:

In Culpepper v. Irwin Mortgage Corp., 253 F.3d 1324, 1330 (11th Cir. 2001) (“Culpepper III”), overruled on other grounds by Heimmermann, 305 F.3d 1257, we stated that “everything about § 8(c) suggests that it is an interpretive gloss on § 8(a) rather than a list of exemptions bestowed upon otherwise illegal conduct.” Under the logic of Culpepper III, § 8(c)(2) does not provide a “defense” to claims brought under either § 8(a) or § 8(b).

Regardless, we need not reach the question. Even if § 8(c)(2) provides some sort of defense to claims under § 8(b), the result is still the same because under either § 8(b) or § 8(c)(2), the issue is whether any services were provided for the ABC Fee. Therefore, the Court concludes that § 8(c)(2) of RESPA does not require any individualized analysis.

If Section 8(c) were merely a gloss on the prohibition against referral fees, then HUD would never have issued its Statements of Policy. There is a principal in particle physics that an electron orbiting an atom on earth can be located going around the moon, and that electrons shot at a pair of slits can go through both slits at the same time. This opinion exhibits some of the same strange characteristics.

Lender Takes the High Road, Avoids TILA Claim In Greenpoint Mortgage Funding , Inc. v. Bach, an unpublished opinion, the lender erroneously excluded certain charges from the disclosed finance charge when Bach took out a home equity loan. The lender disclosed its error and offered Bach the right to cancel the transaction. Bach did cancel the transaction, and the lender returned interest paid by Bach. The lender sent a payoff letter to Bach for the loan amount less closing costs paid by Bach. The lender then attempted to arrange for return of the loan proceeds in return for discharge of the deed of trust. Bach resisted all attempts to settle the matter, so the lender put its reconveyance document in escrow with instructions to the escrow company to release the reconveyance when it received the loan proceeds. Bach demanded that the deed of trust be discharged. The lender sued Bach for the loan proceeds, and Bach claimed the lender violated TILA by not removing the deed of trust, which Bach now claimed was void.

The Court sided with the lender, holding that rescission is a process started by a request to cancel the transaction. The lender satisfied TILA by beginning the process of removing the deed of trust within the 20 day period after receiving Bach's request to cancel the transaction. The lender does not have to complete the process of rescission in 20 days unless the borrower is prepared to repay the loan proceeds immediately. Bach cannot escape the duty to repay the net loan proceeds, and the lender has a right to ask a court to modify the procedures outlined in Regulation Z to condition the removal of the lender's security interest on repayment of the loan proceeds if it appears that the lender will not be repaid immediately. The Court also held that the lender's good faith in promptly disclosing its error precluded any award of statutory damages. This case highlights the proper procedures that a lender should take in the event that it receives a late rescission request and discovers that there may be a disclosure error that entitles the borrower to cancel the transaction.

One Fraudster Goes to Jail But HUD is Ripped Off Twice on the Same Property The recent decision in US v. Luessenhop illustrates a fraud scheme that is all too common - investors ripping off HUD by buying homes at a fraction of their value and flipping them immediately for massive profits. Luessenhop submitted false applications for HUD loans on behalf of two borrowers. Both loans defaulted, and Luessenhop was charged with fraud. He plead guilty, was sentenced to jail, and ordered to pay restitution to the government in the amount of $233,000. Luessenhop argued that he was the victim of ineffective counsel when he was sentenced. The Court held that Luessenhop's counsel was not incompetent, and that the amount of restitution would not be reduced unless the government committed fraud in the sale of the properties.
 
The rest of the story is that HUD shot itself in the foot by accepting fraudulent appraisals from its contractors, and by allowing the contractors to sell the properties to investors who promised to make the property their principal residences. The investors flipped the properties within a couple months for profits of two to three times what they paid for the properties. The real crime here is that the government is so gullible that it allows investors to buy homes for a song and flip them for a handsome profit. There is an old saying: Fool me once, shame on you; Fool me twice, shame on me. HUD should be ashamed that it cannot detect the simplest fraud. This case reminds us of the massive frauds against HUD decades ago. HUD seems to have learned little by its mistakes. Heads should roll at HUD for this loss, but it is unlikely that anyone will be held accountable for this matter.

Failing to Fix Credit Report Results in $532,000 Jury Award There is an old saying that a conservative is a liberal who has been mugged, and a liberal is a conservative who has been arrested. In other words, bad experiences can cause extreme conversions. The case of Sloane v. Equifax Information Services, LLC made twelve jurors converts as they tore into Equifax for failing to fix Sloane's credit report. Sloane became an identity theft victim as she gave birth to her child. The thief went to jail, but Equifax could not straighten out the two dozen fraudulent charges on Sloane's credit report, or delete a second fraudulent credit report, over a 21 month period. Sloane's ruined credit rating resulted in several credit denials, and contributed to the failure of Sloane's marriage and other emotional damages. A jury found that Equifax violated the Fair Credit Reporting Act in numerous respects and awarded Sloane $351,000 in actual damages ($ 106,000 for economic losses and $ 245,000 for mental anguish, humiliation, and emotional distress). In addition, the court awarded attorney's fees in the amount of $181,083. Equifax appealed, arguing that there was insufficient evidence of injury to support the award. That argument usually fails, as it did in this case, because the lower court must be found to have abused its discretion in refusing to throw out a jury verdict and grant a new trial. the Court stated, 'A district court abuses its discretion only by upholding an award of damages when "the jury's verdict is against the weight of the evidence or based on evidence which is false."' The evidence did not help Equicredit's cause since  Equicredit appeared more concerned about protecting the privacy of the convicted identity thief than fixing the damage done to the victim. It also did not help that Equicredit's attorney admitted to the court that his request for reduction of the emotional damage award to $25,000 was pulled "out of the air." The Court of Appeals did reduce the emotional damage award to $150,000 (or allowed Sloane to ask for a new trial) since the only persons who were aware of Sloan's defamation were her family and creditors. The Court of Appeals also reversed the attorney fee award to allow Equifax to present its argument that the fee was unreasonable.

Michigan Consumer Protection Act Not Applicable to Most Credit Transactions In Ozormoor v. HSBC Retail Services USA, Inc., an unpublished decision, the Court rejected all of the borrower's claims against enforcement of a credit agreement. The borrower argued that imposing a late charge and finance charges when payments were not made was cruel and caused emotional damages. The Court held that this was ridiculous:

The present case involves a commercial dispute concerning the terms of plaintiff’s purchase of goods on credit. Defendants acted to enforce the terms of the credit application in assessing plaintiff late fees and finance charges when he failed to timely pay the amounts due. The circuit court did not err in determining that defendant’s alleged conduct cannot reasonably be regarded as so extreme and outrageous to support a claim of intentional infliction of emotional distress. Therefore, this claim was properly dismissed.

The Court rejected the claim that improper collection of late charges and finance charges caused intentional infliction of emotional distress. The Court also rejected a claim under FCRA since the creditor did not make a false report to a credit bureau "with malice or intent to injure." Any claim of negligent reporting would be preempted by FCRA.

More important to the credit community was the holding that consumer credit transactions are not subject to attack under the Michigan Consumer Protection Act (MCPA). The MCPA exempts any consumer transaction or conduct specifically authorized under laws administered by a regulatory board or officer acting under statutory authority of this state or the United States. Since credit transactions are governed by TILA and FCRA, and these laws are enforced and administered by the FRB and FTC, no transaction subject to TILA or FCRA is subject to MCPA. The Court stated:

Although plaintiff attempts to characterize the transaction at issue as the sale of furniture on advertised terms, our Supreme Court held in Smith v Globe Life Ins Co, 460 Mich 446, 465; 597 NW2d 28 (1999), that in determining whether the exemption applies, “the relevant inquiry is not whether the specific misconduct alleged by the plaintiff is ‘specifically authorized.’” “Rather, it is whether the general transaction is specifically authorized by law, regardless of  whether the specific misconduct alleged is prohibited.” Id. (emphasis added). The Court observed that in adopting this exemption, the Legislature “intended to include conduct the legality of which is in dispute.” Id.

In this case, the general transaction that gave rise to plaintiff’s claim was the purchase of consumer goods on credit, defendants’  enforcement of their interpretation of the terms of the sale and the terms of the credit agreement, and defendants’ reporting of plaintiff’s payment history to consumer credit agencies. The Consumer Credit Protection Act, 15 USC 1601 et seq., of which the United States Fair Credit Reporting Act (FCRA), 15 USC 1681 et seq., is part, regulates the disclosures that must be made upon extending credit to a consumer and how credit disputes must be handled, including disputes concerning the accuracy of reports made to consumer credit reporting agencies, among other things. Chapter 41 is administered by the Board of Governors of the Federal Reserve System, 15 USC 1602(b), and by the Federal Trade Commission, 15 USC 1607(c), among others. Thus, the general transaction at issue in this case is specifically authorized under laws administered by a regulatory board or officer, acting under statutory authority. Therefore, the circuit court did not err in determining that the regulated industries exemption applies and properly dismissed plaintiff’s CPA claim.

This decision effectively eliminates consumer protection claims for a wide range of credit transactions, irrespective of whether the creditor or servicer is licensed under state law. Creditors should be aware, however, that many licensing acts permit a cause of action for any violation of law in a transaction that is arguably governed by the licensing act (even against exempt creditors). Proper pleading by consumers will not allow these types of cases to be dismissed so easily. Do not let your guard down.

Class Action Filed Against Bank and Real Estate Broker Alleging Sham JV Denise Minter filed a 51 page complaint against Wells Fargo, Wells Fargo Bank, N.A., Long & Foster Real Estate, Inc., Prosperity Mortgage Corporation, and Walker Jackson Mortgage Corporation. This is the latest in a string of RESPA claims against Long & Foster that simply will not go away. The two mortgage companies were joint ventures (affiliated business arrangements) of Wells Fargo and Long & Foster. The Complaint alleges that the mortgage companies were sham arrangements for the payment of kickbacks by Wells Fargo to Long & Foster. In essence, the complaint alleges that the mortgage companies did not provide substantial services to originate loans under HUD Statement of Policy 1999-1, the loans were originated by Wells Fargo, and the fees paid to the "lender" were illegally split between Wells Fargo and the mortgage companies.
 
First, it is interesting that Paragraph 29 of the Complaint states that Prosperity Mortgage has loan officers, and Paragraph 52 says that Prosperity Mortgage did not have loan officers (the complaint claims that Prosperity mortgage uses "loaned employees" from Wells Fargo). Therein lies the crux of this case. Did Prosperity Mortgage perform substantial services through its employees? Who controlled these employees, and who paid them? Did these employees originate loans for any other mortgage company or bank? Paragraph 143 of the Complaint alleges that these employees had both Wells Fargo and Prosperity Mortgage email addresses. Does this mean that they worked for Wells Fargo, or that they worked for Prosperity Mortgage, or both? Plaintiffs must show that Prosperity Mortgage had no employees, not even part time employees. The complaint collapses if the plaintiffs cannot prove this. The defendants, or course, will be trying to show (through email records, etc.) that the joint ventures directed the activities of, paid compensation to, and directly benefited by the work of these employees.
 
Second, it is interesting that this lawsuit does not allege that Prosperity Mortgage illegally paid its loan officers. If, as alleged, the loan  officers were really Wells Fargo employees, then being paid to make referrals to Prosperity Mortgage might be improper. In a final rule issued by HUD on June 7, 1996 (http://www.hud.gov/offices/hsg/sfh/res/resp0607.cfm), which Congress later overturned, HUD noted:
 
Following the enactment of these [1983] amendments [of RESPA], HUD issued several informal legal opinions concerning the extent to which employers could pay referral fees to employees. The opinions stated that bona fide full-time employees could be compensated for generating business for their own employers, as this would be within the scope of their employment. These opinions also made clear that uncompensated referrals to affiliated companies were not prohibited. HUD did not, however, broadly approve compensation to employees for referrals to affiliated companies.

Where is the allegation that compensation paid to these "loan officers" is not bona fide compensation exempt from scrutiny under RESPA? Does this omission imply that the loan officers received bona fide compensation? If so, were they not providing bona fide services on behalf of these mortgage companies?
 
If anything good comes from this lawsuit, it could be a definition of what an "employee" is for purposes of RESPA. HUD has carefully avoided defining this term. In 2005, Phil Shulman published an article in  Realtor Magazine, which stated:
 
"Since RESPA exempts origination payments by an employer to its employees, you could be hired by a lender as a part-time employee; several lenders’ programs offer this type of arrangement. Only bona fide employees are covered by this exemption, however, and never in connection with FHA-insured loans.

Although HUD has never published criteria for what constitutes a bona fide employee, the Internal Revenue Service has strict standards for defining employment. Among other things, an employee must: be under the supervision and control of the employer, use the employer’s equipment, and receive a W-2 form. Under these strict criteria, it would be difficult for a sales associate to operate as an employee of the lender."

Also in 2005, the law firm of Blank Rome LLP published a newsletter article discussing the decision in Novakovic v. Samutin, 820 N. E. 2d 967 (Ill. App. 2004). The article states:
 
"As the term “employee” is not defined under RESPA, the Illinois appellate court examined the definition of employee in the Illinois Wage Payment and Collection Act. Under that Act, the term employee does not include an individual (1) free from control and direction under its contract for service with its employer and is actually free from such control; (2) that performs work outside of the usual course of business or outside of all places of business of the employer; and (3) that works in an independently established trade, occupation, profession or business.

With respect to the first exception, the Illinois appellate court found that there was an issue of fact as to whether the loan originator was controlled by the lender because, while the lender did not set a schedule or impose assignments or quotas, the loan originator attended weekly meetings with the lender and was employed under an employment contract on an exclusive and permanent basis. The court also found that an issue of fact existed as to the third exception because the loan originator operated his own commercial lending business separate from the lender but it was unclear whether the loan originator operated the business at the same time he performed services for the lender and whether he invested capital in the other business.

The case was remanded for further determination of these issues. As this case illustrates, lenders should not be cavalier about categorizing loan officers was W-2 employees and must exercise sufficient control over a loan originator so that it is considered a bona fide employee and not an independent contractor. Employers need to understand their state laws on bona fide employee attributes (as well as IRS guidelines)."

Finally, Plaintiff may be fighting an uphill battle regarding the attempt to make this a class action case. As stated in the Novakovic decision:

"As an ancillary matter, we uphold the trial court's denial of plaintiff's motion for class certification. The federal district court and court of appeals have followed HUD policy statements that the reasonableness tests and damage calculations prescribed under RESPA are transaction-specific inquiries and as such militate against class-wide adjudications. In re Old Kent Mortgage Co. Yield Spread Premium Litigation, 191 F.R.D. 155, 163-64 (D. Minn. 2000); Glover v. Standard Federal Bank, 283 F.3d 953, 965-66 (8th Cir. 2002). Because this suit involved specific inquiries into the status of specific parties and specific payments, we find that the trial court properly denied plaintiff's motion for class certification."

Does this lawsuit have legs to stand on its own two feet, or did plaintiffs just sacrifice a lot of trees? Stay tuned for further developments.

Federal Reserve Proposes New Subprime TILA Rule The Federal Reserve proposed a far reaching new rule to create a "higher cost" loan category that encompasses most, but not all, subprime loans. A vast prairie exists between prime loans and high cost loans in which the APR is between 3% and 8% above comparable treasury rates. This range of loans, known affectionately as subprime lending, has been an incubator turned boiling cauldron for financial experiments. If any news reporters are reading this, QUIT ASKING IF THE NEW FEDERAL RESERVE RULE FIXES THE SUBPRIME MORTGAGE CRISIS! We only have a proposal, not a rule. When the rule is finalized, it will be mandatory no earlier than October 1, 2008, and it will not apply retroactively. Most of the lenders who might have been impacted by this rule are out of business, or their subprime loan programs shut down. If the new rule does anything, the rule will change the moniker "subprime loan" to "HOEPA-lite loan" since the new rule is implemented under an obscure and heretofore under used provision of HOEPA, 15 USC 1639(l)(2).

The Federal Reserve proposes to implement several restrictions on these loans to make misrepresentation by lenders and financial mismanagement by borrowers more difficult:
The following protections would apply to all loans secured by a consumer’s principal dwelling, regardless of the loan’s APR:
This rule has one more really big hole - borrowers are payment sensitive, not rate sensitive. The real risk of high cost loans is those loans that carry a high payment, not a high interest rate or fees. Loans go into default because borrowers cannot afford to make monthly payments, not because the interest rate is high. The average borrower can afford to pay up to 33% of his or her gross income in principal and interest payments. Above this, the borrower either has to budget very carefully, or change his/her standard of living to shift money to home payments. Hence, the FRB would be well advised to include another trigger for this rule - any payment listed in the payment schedule, other than a balloon payment, that exceeds ~40% (we will leave the exact number to the gnomes at the FRB) of the borrower's verifiable income, should trigger greater consumer protections.

The rule also mandates more disclosures in advertisements, and prohibits deceptive practices (such as advertising the ARM teaser rate and payment without disclosing that the rate and payment can rise). Lenders will be permitted to advertise a toll free number for the consumer to obtain the complete disclosure for the advertisement. It is not clear whether the lender's disclosures are provided before or after the hard sell when the consumer calls the toll free number. The Federal Reserve is not going to stop false or deceptive advertising with its rules - there is simply no enforcement. If the government wants to get serious about deceptive mortgage advertising, the Justice Department is going to have to go after advertisers and publishers. For example, Microsoft, Google and Yahoo just settled a claim that they aided and abetted illegal online gambling by posting advertising for the online casinos. 18 USC 2 states:

(a) Whoever commits an offense against the United States or aids, abets, counsels, commands, induces or procures its commission, is punishable as a principal.
(b) Whoever willfully causes an act to be done which if directly performed by him or another would be an offense against the United States, is punishable as a principal.

The settlement will cost these online publishing services a total of $31.5 million. Think of how much money the Justice Department could wring out of newspapers, TV stations, and web sites for posting thousands of deceptive advertisements for mortgage loans. The Justice Department might even try to prosecute Internet Service Providers for allowing lenders to post web pages that do not contain all of the disclosures required by federal law, because they aid and abet intentional violations of TILA. Most people (even most prosecutors) do not realize that intentional violations of consumer disclosure laws expose lenders to criminal liability. 15 USC 1611 states:

Whoever willfully and knowingly
(1) gives false or inaccurate information or fails to provide information which he is required to disclose under the provisions of this subchapter or any regulation issued thereunder,
(2) uses any chart or table authorized by the Board under section 1606 of this title in such a manner as to consistently understate the annual percentage rate determined under section 1606(a)(1)(A) of this title, or
(3) otherwise fails to comply with any requirement imposed under this subchapter,
          shall be fined not more than $5,000 or imprisoned not more than one year, or both.

If the government sent a few people to Club Fed, the rest of the industry would wake up and smell their advertising. If the government wants to do a good job cleaning up consumer credit advertising, TILA needs to be expanded to include mortgage brokers in the definition of a "creditor."

If the government wants to make sure that we do not suffer through another mortgage "meltdown," Congress needs to establish a role for the Federal Reserve to offer non-depository charters for mortgage banks. We all know that the states do not have the money or the trained personnel to adequately police their mortgage licensees. It is time for us to admit that mortgage bankers need to be well capitalized, adequately trained, and sufficiently examined to prevent the abuses that now plague our financial system. The Horatio Alger story of the bricklayer who spends two years working for a net branch, opens his own mortgage company, and makes a fortune, is inviting but not financially sound. Every city kid dreams of making it in the big leagues, but few succeed. What would our professional sports leagues look like if we allowed anyone who could come up with $25,000 in assets to field a team? That is essentially what we allow in mortgage banking.

There is another dark side of any rule promulgated under 15 USC 1639 - the penalty for failure to comply is that the borrower has the right to rescind.  That means that any mortgage containing a "unfair or deceptive" term , or a term designed to evade the provisions of HOEPA, or any refinancing of mortgage loans that the FRB finds to be associated with abusive lending practices, or that are otherwise not in the interest of the borrower (where have we heard, "My lender was unfair! I can't repay my loan!") will suddenly result in the right to cancel the loan and receive back all finance charges and closing costs as long as three years after the loan is closed. This rule may start a feeding frenzy by class action litigation attorneys in jurisdictions where rescission is permitted as a class remedy. The remedy may also disappoint borrowers who cannot rescind because they cannot obtain a refinance loan to tender back the net principal of the loan. The result may be the reverse Cinderella effect - the borrower is trapped in a loan he or she cannot afford, and the borrower's attorney gets rich. Be careful what you ask for - we live in interesting times.

Congress Removes Insult From Top of Injury Congress finally passed the Mortgage Forgiveness Debt Relief Act of 2007, and it was signed by the President on December 20, 2007. This means that IRS will no longer have to chase phantom taxes due from homeowners who have lost their principal residence and have no money to pay IRS anyway. The bill may actually save money since IRS will no longer be required to spend resources chasing taxpayers who cannot pay the foreclosure penalty. There are some caveats - the principal ones being that the home has to be the taxpayer's principal residence (investors are out of luck), and forgiveness of the tax obligation only applies to acquisition credit. Hence, anyone who used their home to finance cars and their kids' education is SOL. The amount of indebtedness forgiven has to be less than $2 million (sorry, Michael Jackson). The relief from taxes for phantom income only applies to foreclosures occurring in 2007 and later years.

The bill has a few other benefits.
Now we wait for the other 90 bills floating around Congress to see the light of day.

IRS Develops New Form For 1099 Employees Who Should Be W-2 Employees IRS is actively challenging employers who claim that they are entitled to pay their staff as independent contractors. Marketwatch reports that IRS ordered FedEx to pay $319 million in back taxes for 2002 since FedEx drivers are employees, and not independent contractors. Decisions are pending for later years taxes. Employees have been pushing the IRS in this matter so that they can claim the company failed to pay minimum wages and overtime, and have years of service credited toward social security and Medicare benefits. FedEx argued that its drivers are independent contractors because drivers purchase or lease their trucks and pay for all operating expenses, including liability insurance, fuel, and maintenance. IRS, however, found that FedEx controlled almost every aspect of their driver's conduct, from how they ran their routes to the clothes they wore. Drivers were not free to determine how they would deliver packages or in what order the deliveries would be made.

In anticipation that many employees will claim that they are entitled to overtime and minimum wage benefits, IRS developed a new form for employees,. Form 8919, Uncollected Social Security and Medicare Tax on Wages, to figure and report the employee’s share of uncollected social security and Medicare taxes due on their compensation. Mortgage lenders who have been paying loan officers as independent contractors need to be especially alert since IRS issued a Technical Advice Memorandum in 1996 stating, in effect, that loan officers were employees, not independent contractors, because they could only work for one mortgage company. IRS also issued Publication 1779 as a guide for individuals to determine whether they are employees or independent contractors This form states:

The courts have considered many facts in deciding whether a worker is an independent contractor or an employee. These relevant facts fall into three main categories: behavioral control; financial control; and relationship of the parties. In each case, it is very important to consider all the facts – no single fact provides the answer. Carefully review the following definitions.

BEHAVIORAL CONTROL
These facts show whether there is a right to direct or control how the worker does the work. A worker is an employee when the business has the right to direct and control the worker. The business does not have to actually direct or control the way the work is done – as long as the employer has the right to direct and control the work. For example:

Instructions – if you receive extensive instructions on how work is to be done, this suggests that you are an employee. Instructions can cover a wide range of topics, for example:
If you receive less extensive instructions about what should be done, but not how it should be done, you may be an independent contractor. For instance, instructions about time and place may be less important than directions on how the work is performed.

Training – if the business provides you with training about required procedures and methods, this indicates that the business wants the work done in a certain way, and this suggests that you may be an employee.

FINANCIAL CONTROL
These facts show whether there is a right to direct or control the business part of the work. For example:

Significant Investment – if you have a significant investment in your work, you may be an independent contractor. While there is no precise dollar test, the investment must have substance. However, a significant investment is not necessary to be an independent contractor.
Expenses – if you are not reimbursed for some or all business expenses, then you may be an independent contractor, especially if your unreimbursed business expenses are high.
Opportunity for Profit or Loss – if you can realize a profit or incur a loss, this suggests that you are in business for yourself and that you may be an independent contractor.

RELATIONSHIP OF THE PARTIES
These are facts that illustrate how the business and the worker perceive their relationship. For example:

Employee Benefits – if you receive benefits, such as insurance, pension, or paid leave, this is an indication that you may be an employee. If you do not receive benefits, however, you could be either an employee or an independent contractor.
Written Contracts – a written contract may show what both you and the business intend. This may be very significant if it is difficult, if not impossible, to determine status based on other facts.

Loan officers must receive instruction and training. Training is mandated by FTC rules on information security and protection against identity theft. Most states require continuing education for loan officers. Loan officers must provide certain disclosures and take applications for loans in a specific manner (these processes are built into Encompass and Calyx Point). The opportunity to pay significant expenses and suffer a loss did not sway IRS in the FedEx case. Do not expect IRS to be moved by your arguments that loan officers are independent contractors when they make much lower investments than FedEx drivers. Most loan officers also have a written contract or an employee handbook that serves the same purpose as an employee handbook. Some states permit "loan originators" to be paid as independent contractors, but this is not binding on IRS. Do not equate "outsides sales" staff that may be exempt from overtime and minimum wage requirements with "independent contractors" who do not have taxes withheld from thier paychecks. Outside salespersons are W-2 employees. If you still believe that you can pay "loan originators" on a 1099 basis, we wish you luck when the lawsuit arrives minutes after the IRS agent seizes your computer.

Previously, there was no way for IRS to distinguish employees who received tips from those who were improperly paid as independent contractors. This new form is intended for employees to snitch on their employer. You should review your company's policies and practices with your labor law legal counsel.

FTC Fines Broker $50,000 for Failing to Implement Information Privacy and Security Rules So, you think a shredder costs too much and wastes employee time? Think again. United Mortgage Company did not provide financial privacy disclosures to its customers, did not implement an information security policy, and left its trash loan documents next to the dumpster instead of shredding the documents. The FTC warned, and then fined the company $50,000. That is not the least of the company's worries. The Company has to hire a Big Brother to perform information security audits for ten years, and train all of its employees to keep information secure. The cost of compliance and oversight is going to be several times the amount of the fine. State attorney generals are getting into the act also. Ohio's AG announced that Ohio sued Randall Mortgage Services, Inc. and the company's owner (the corporate veil did not stop the AG from suing the owner personally) for abandoning loan files when it closed an office. If you think it costs too much to obtain an information security plan from your attorney, you obviously did not read the sample information security plan printed in our January 2006 newsletter. You should also review the information security tutorial for small businesses published by the FTC. If you do not have time for the tutorial, at least read the guide published by the FTC. Get going before the FTC knocks at your door, and you are the subject of a story in this newsletter.

Massive Closing Agent Changes Coming The first salvo in the restructuring of the mortgage industry began in the states, where state after state is considering and enacting new laws and regulations. The second salvo comes from within the industry. The Mortgage Bankers Association is drafting uniform closing instructions for residential loans. This massive work, now in its two dozenth revision, is up for comment until January 30, 2008. These instructions consist of a 39 pages of General Closing Instructions and 11 pages of Specific Closing Instructions. Unfortunately, these instructions are not quite ready for prime time. Some provisions are fine, but others need to be adjusted. Expect modifications to these instructions in the next year or two.

Of particular interest to closing agents are the following provisions (each comment is preceded by the section and paragraph number of the provisions discussed):
We also have a few comments regarding the specific closing instructions:
We trust that you will weigh in before these instructions are written in stone. Do not count on the MBA being as forgiving as God was when Moses broke the two tablets.  Once set in stone, you may have to live with these instructions, for good or bad, whether they be a blessing or a curse.

Is the Fix in or is this Another Thumb in the Dike? President Bush announced that representatives of HOPE NOW have developed a plan under which up to 1.2 million homeowners could be eligible for assistance.  Many individual homeowners feeling financial stress have "adjustable rate mortgages," which typically start with a lower interest rate and then reset to a higher rate after a few years.  The HOPE NOW plan is designed to help subprime borrowers who can afford the current, starter rate on a subprime loan, but will not be able to make the higher payments once the interest rate goes up.  HOPE NOW members have agreed on a set of new industry-wide standards to provide systematic relief to these borrowers in one of three ways:

1.    Refinancing an existing loan into a new private mortgage;
2.    Moving them into an FHASecure loan; or
3.    Freezing their current interest rates for five years.

First, it is important that we understand that this is not President Bush’s program, and no legislation will be proposed to implement this plan. Loan Servicers will voluntarily freeze rate changes for some adjustable rate mortgage (ARM) loans with the consent of bondholders. The criteria for who will receive assistance were developed by the American Securitization Forum, a trade group representing the interests of bond issuers, major investors, law firms, accounting firms, and others involved in secondary markets for secured bonds. See the Executive Summary, the Q & A, and the press release.

This plan will not solve the current credit crunch any more than WIN buttons helped President Ford revive the sagging economy. Were it so simple, we would have seen peace in the Middle East decades ago. The difficulties of implementing a rate freeze are evident from the qualifications that are imposed on this plan. The many who will not be helped by this plan should at least understand why they will not qualify to be saved.

1.  Why was this plan developed?

One of the principal goals of this plan is to keep a few houses off the market to stabilize prices. There is a general expectation that housing prices will continue to drop, especially in areas where housing is least affordable and areas where local economies are weakest. Keeping a few more houses off the market may slow the rate of descent of housing prices and preserve the value of mortgage investments held by lenders and bondholders. The hope is that incomes will increase substantially, and home values will appreciate (at least to the level they were at before the current crisis hit), so that borrowers will be “inflated” out of bad loans and mortgage bonds will recover their value. This is a very speculative assumption, based largely on the expectation that mortgage bond investors will resume purchases of these securities and increase the availability of subprime mortgage loans. However, the alternative is to require financial institutions to admit that many more of the loans they own or the securities they own are in default or will default, requiring the financial institutions to decrease their net worth. This could cause additional financial institutions to be insolvent or fail.

A second major goal of this plan is to justify the market value of certain loans held by banks. If an ARM loan borrower defaults when the interest rate rises, and the mortgage is foreclosed, the bank may be forced by accounting rules to classify the loan as a worthless (non-performing) asset. When the home is eventually sold after foreclosure, the recovery is added to income. A problem exists between default and recovery. If too many loans go into default at once, the write-down of asset value could result in technical insolvency, triggering all sorts of bad things (such as the FDIC closing the bank and liquidating its assets). If the interest rate does not change, the borrowers can continue to make payments, and the market value of the loan may actually increase. The increase in value may offset losses on other loans in the bank’s portfolio. One of the issues that still needs to evaluated is whether the servicer may freeze the interest rate without forcing the investor to classify the loan as a non-performing asset. Downey Financial, for example, recently announced that Statement of Financial Accounting Standards No. 114 required it to classify modified loans as non-performing loans since the modifications were performed without a new credit analysis and appraisal. I do not know if the same rule would apply to loans for which the rate is frozen. A loan is not modified when the rate is frozen. The lender simply does not notify the borrower of rate increases and, therefore, the rate cannot change.

The HOPE NOW alliance selection criteria for interest rate relief are amoral (see #4 below). For example, anyone who stated that their home was their primary residence may be eligible for help, even if they lied to the lender. Some critics of this plan call this a bailout for the reason that it is may save lenders from liability to bondholders for originating fraudulent loans. Others who struggled with payments, sacrificed other needs, and followed all of the rules, may find that they did too good of a job handling their finances to obtain any assistance. For this reason, some borrowers may be tempted to skip a credit card payment or two to drop their credit score to be eligible for a rate freeze. However, the damage to one’s credit score, and the potential for increased credit card and auto loan interest rates, should deter individuals from trying to “game the system.”

Consumers need to realize this is a temporary fix that only delays the day of reckoning for borrowers in trouble. After the five year interest rate freeze, interest rates and payment amounts will reset. The amount owed on these loans will not decrease. The interest rate on second mortgages and lines of credit will not be affected. If you owe more than your home is worth, that is your problem. If you default in your payments, your loan will be foreclosed. Foreclosures will not be delayed, nor will this program reduce the interest that borrowers may owe to redeem their homes.

Many people do not want to speculate on inflated incomes and housing prices because they lost this bet once. Some homeowners are contemplating a short sale of their home to get out of their mortgage to enable them to purchase a new home at a distressed price. Trading homes may be a better solution than refinancing for many borrowers since it eliminates debt that the borrower cannot afford. The problem with the plan is that someone has to take a loss, and suffer the consequences of that loss. Neither lenders or borrowers want that loss to nest in their back yard.

Since foreclosure typically occurs when a borrower is at least three months behind in payments, and the borrower typically has six months to redeem the foreclosure, you can expect the number of properties for sale to increase throughout 2008 and into 2009. The real estate market may temporize for a few months until these foreclosed properties are offered for sale by the lender. At that time, lenders will dump the homes at distressed prices (before the value decreases further).

Housing prices will be further depressed in 2009 by a second wave of payment resets starting late in 2008, when negative amortization of Pay Option ARM loans end and payment amounts may double. The HOPE NOW Alliance has no answer for these borrowers, since the interest rate resets early in a Pay Option ARM loan, and amount the borrowers owe increases if the borrower is paying less than the full amount of interest. In many, if not most, Pay Option ARM loans, the balance owed will significantly exceed the value of the home. A payment reset (not an interest rate reset) occurs when the negative amortization feature causes the principal balance to push up to a cap (between 110% and 125% of the original value of the home). The reset terminates the negative amortization feature and the full principal balance must be repaid in the remaining term at the then current interest rate. Pay Option ARM loan defaults will have a double whammy effect – banks that hold these loans have been counting the full amount of interest on these loans as income, even though they did not collect this amount. The warning not to count your chickens before they hatch was ignored. These lenders will be forced to recapture the profits they were not paid as Pay Option ARM borrowers default or ask for permission for short sales.

2.   Can I demand that my initial interest rate be frozen?

Borrowers can beg and plead, but not demand, relief from rising interest rates. The sad reality is that there is no entitlement to an affordable home loan. The plan to freeze ARM loans at the low teaser rates that attracted borrowers to these loans is not enforceable. Few investors who purchased bonds backed by these loans want to lose money on their investment, and the government is powerless to force investors to give up the benefits of their bargains. Mortgage loans are enforced by state laws, not Federal law. Article 10, Section 1, Clause 1 of the US Constitution states, “No state shall… make any ex post facto Law, or Law impairing the Obligation of Contracts….” A contract is unconstitutionally impaired by legislation which alters its terms, imposes new conditions, or lessens its value. A contract is “substantially impaired” when legislation detrimentally affects the financial framework which induced the bondholders originally to purchase the bonds. Cutting off the rights of bondholders to receive some of their income without their consent substantially impairs the bargain they made. Hence, the servicers that are participating in this program will not modify any loan unless the servicing agreement with the bondholders permits the modification, even if the borrower meets the conditions established for interest rate relief. Any attempt to force a rate freeze would be thrown out by a court as fast as the lawsuit could be filed. Furthermore, imposing a prohibition on increasing interest rates will surely undermine the integrity of the secondary mortgage market and corrode the availability of funds for future residential and commercial real estate loans.

3.  Who may this program help?

Anyone can ask for help. To the extent that counselors are available to provide advice, you can pick their brain on how to get out of a bad financial predicament. However, the promise of a rate freeze was only held out to a few of the many ARM loan borrowers. Estimates of those who may be assisted range from 7% to 20% of the subprime borrowers facing an ARM loan payment increase. Furthermore, the qualification criteria selected by the HOPE NOW Alliance for interest rate relief is designed to minimize losses by bondholders rather than help those who need help the most. Those with too little income to make payments under current interest rates and those with enough income to make payments after interest rates adjust are not eligible for an interest rate freeze.

Most state governors are getting behind this bandwagon to make sure that servicers live up to their commitment to help those who can be helped. For example, Governor Granholm of Michigan announced that she met with representatives of several servicers located in Michigan. The press release states:

Among the servicers who met with Granholm this week are Flagstar, Countrywide, GMAC, and Option One. Under the protocols discussed, the companies will:
- provide Michigan homeowners with alternatives to foreclosure;
- proactively reach out to borrowers in advance of their mortgage rates being reset to work out alternatives to foreclosure;
- for people who are in their homes and making timely payments at their original interest rate on a subprime loan but who cannot make the payment after the interest rate resets, the servicers will attempt to keep them at an affordable interest rate for up to five years;
- streamline the process for determining what borrowers qualify for loan modifications because they cannot reasonably be expected to make the higher reset mortgage payment;- work with the state and the federal HOPE NOW program to implement home preservation programs and assist distressed borrowers who are behind in their payments to work out a plan going forward, if possible;
- work with the state to conduct outreach efforts to inform borrowers with subprime adjustable rate mortgages that they should contact their servicers if they believe they are at risk of losing their home because they cannot afford the higher interest rate payments on their ARM;
- work with the state to proactively identify methods to address issues surrounding those vacant and/or abandoned properties over which the lender or servicer has assumed ownership or control, including but not limited to ensuring that such properties remain in compliance with relevant property maintenance codes and appropriately streamlining the foreclosure process where necessary to avoid neighborhood blight.

Recent statistics released by the MBA indicate that some borrowers are being helped. It will be a tight race to rescue the rest before their interest rates explode. There is also the possibility that interest rates will drop enough to limit the effect of rate adjustments, and further forestall resets for option ARM loans.

4.  What criteria distinguish the lucky few who will win this interest rate lottery?

Eligible borrowers must satisfy all of the following criteria:

A.  The loans must be in securities pools serviced by members of the HOPE NOW Alliance. Nobody will come to your rescue if your loan is owned by a local bank or mortgage company, or it is serviced by a non-member of the Alliance. The only servicers who are participating at this time are:
•    AIG / American General Financial Services, Inc.
•    Aurora Loan Services, Lehman Brothers
•    Carrington Mortgage Services
•    IndyMac Bank
•    Litton Loan Servicing
•    Morgan Stanley Home Loans
•    Ocwen Loan Servicing
•    Wilshire Credit Corporation, Merrill Lynch Home Loans

B.  The loan must be an adjustable rate loan originated between January 1, 2005 and July 1, 2007, and the interest rate cannot have already adjusted before January 1, 2008. If your payment amount for principal and interest went up, or will go up, before February, 2008, you are not eligible for help. According to studies by Credit Suisse, there is a huge bulge of ARM loan resets beginning in December, 2006, that peaks in November, 2007, and then decreases gradually through 2008.  The HOPE NOW alliance will not reverse an interest rate increase if the loan already reset.

C.  If you are eligible to refinance your loan into an FHA insured loan or a prime loan, you are not eligible for an interest rate freeze. Generally, anyone with a credit score of 660 or more, or who increased their credit score by more than 10%, is deemed eligible for refinancing. Borrowers who are on the cusp of qualifying for a refinance loan will find that lenders are reluctant to offer easy credit. If, for some reason, the borrower is not eligible to refinance, but the borrower’s credit score is higher than the 660 threshold, the servicer will determine whether the borrower can afford higher payments when the interest rate resets and may offer an interest rate freeze. If you fit into this category, please apply for rate relief as soon as possible, since servicers will have few employees available to process these requests, and your interest rate might reset while you wait for relief. Refinancing may increase your interest rate, and result in the borrower paying significant closing costs. The borrower may not be able to make these payments, and may not be eligible for an interest rate freeze.

D.  If you have more than 3% equity in your home, you are deemed eligible to refinance and this program will not freeze your interest rate. The one saving grace is that the 3% equity threshold may be based on the current value as determined by the servicer, and not the original appraisal (if you can get the servicer to perform a valuation analysis before your rate resets).

E. Your financial situation cannot be so bad that you are more than a month behind in your mortgage payment, or that you have been two months behind more than once in the past year. Those borrowers who are too sick to save will be thrown overboard.

F.  If you have a second mortgage or a home equity line of credit, the holder of the second mortgage must agree to the senior modified ARM loan. Junior mortgage holders will approve this program since it does not prejudice the junior loan and it does not modify a loan secured by a junior mortgage.

5.  Do I need to ask for help or will someone contact me?

Someone may contact you, but it may be too late to obtain help by then. If your loan is scheduled to reset to a higher interest rate in 2008, you should call your lender and the HOPE NOW hotline (1-888-995-HOPE), and keep calling until you are offered assistance. Counselors from Consumer Credit Counseling Services (CCCS) in Atlanta are supposed to be available 24 hours a day, but borrowers are likely to experience lengthy wait times or dropped calls. Reuters reports that the hotline received 45,000 calls in three days after President Bush announced the HOPE NOW program. CNNMoney reports that the foreclosure hotline is overwhelmed, and housing counselors are giving top priority to those already in default (those not eligible for a rate freeze). Borrowers may also contact CCCS on the Internet at http://www.995hope.org. Counselors are available to “chat” with borrowers online at any time after borrowers provide an email address and choose a password to start an online counseling session (select the “Click here for…Live Help Chat” feature at the upper right corner after you login for an online counseling session). If a borrower calls his (or her) lender to ask for a reprieve, the borrower may find himself in "voice mail hell" as described by one housing counselor in a Parmus Post story.

6.  Why are we helping those who were financial irresponsible?

The rate freeze means that interest owed to investors will not be paid, with no penalty on the borrowers. Many people object to rewarding financially irresponsible persons with a rate freeze. We could develop a system to refinance ARM loans using money from bonds sold by state and federal governments. Borrowers could be given the opportunity to refinance at payment amounts they can afford, with the remainder of their debt paid as their income increases or as they realize other income and capital gains. However, the structure of such a system would rival Hillary Clinton’s ill fated universal medical insurance coverage proposal. Other people are afraid of the cost of a government bailout, even though past government loan and deposit guarantees successfully rescued a failing business and a failing industry (Chrysler Corporation and the savings and loan industry). We simply do not have the time, the obligation, or the resolve as a nation to consider any plan to sweep away these loans and replace them with fiscally sound alternatives.

7.  Is there a better solution?

There are many possible better solutions, if we had the time and the manpower to implement a fix. It took us three years of lending to get to this point. Any comprehensive solution would take three years to back out of this mess. We do not have three years, or even three months, to resolve these loans. The best that can be done in the short term is put as many borrowers as possible who may be saved into stasis for five years, and pray that a cure is found in the future. It is unnerving for the rest of us that we must depend on a thumb in the dike to hold back a greater breach that might swamp our communities.

HUD's Hit Parade Continues First American Title Insurance Company (FATIC) continues to pay through the nose for its now closed affiliated business arrangements set up by the company and its agents. The paperwork was all good, but HUD alleged that the joint ventures did not perform any real work, and the joint ventures were under-capitalized. The joint ventures relied heavily on the title company and title agencies to provide services in the name of the joint venture. The latest settlement, out of Florida, requires FATIC to pay $5 million to HUD and shut down eighty some joint ventures. In addition, HUD laid out the conditions it expects joint ventures to operate under to avoid future liability:

1.  The joint venture must have working capital similar to other title agencies in its market area.  The joint venture's capital must be sufficient to conduct all work and provide all services of a typical title agency in the market area.
2.  The title company or title agency partner in the joint venture may exercise control typical of the majority owner, but it should not manage the day to day affairs of the joint venture.
3.  The joint venture should have its own physical office with an address, entrance and signage identifying the joint venture.
4.  The joint venture must pay fair market value for any goods and services purchased, especially when the goods and services are purchased from one of the owners.
5.  The joint venture must employ, compensate and manage its own employees who work exclusively for the joint venture. This is a departure from the established practice of having one title agent work part-time for two title agencies.  We have yet to see whether HUD intends to impose this requirement solely for its settlement agreements, or whether this will be a broad standard for all joint ventures.  In theory, an individual should be able to work for two title agencies if the individual works distinct time segments for each agency, and receives paychecks from the separate title agencies.
6.  The joint venture must perform all core title services.  The joint venture cannot be paid to duplicate services already provided by one of the owners of the joint venture.
7.  The joint venture must actively market its services to real estate brokers, builders, lenders, and others in the community.  It cannot rely solely upon referrals from the owners to generate all of its business.  This settlement does not include the 30% outside business requirement that we have seen in prior settlements.  HUD is requiring the joint venture to make a good-faith effort to market its services to a broader client base.

FATIC also must pay for compliance monitoring of its joint venture activities for a period of one year.  Prior settlement agreements, especially with the FTC, require compliance monitoring for 10 years.  The cost of compliance monitoring often exceeds the cost of implementing compliance measures.  Perhaps HUD has a soft spot in its heart after all. In the meantime, FATIC's competitors are sweeping in to pick up the pieces and set up replacement joint ventures with the survivors of this market downturn. Hopefully, everyone will learn a lesson from this sad state of affairs and listen to experienced RESPA counsel before jumping into another joint venture.

How Do We Fix This Mess (Part II) In our last newsletter, I proposed that we split the balance owed on mortgage loans into two portions - one that borrowers could afford, and one than hung like an anvil on borrowers' necks to be paid from future increases in earnings. While the vision of old Marley's ghost talking to Scrooge (from A Christmas Carol) comes to mind, the plan would have the benefit of keeping homeowners in their homes while forcing homeowners to repay the debts that they incurred. This proposal is not a true bailout, and would more or less accomplish the goals of leveling out the marketplace.  There are successful precedents for government assistance, such as the loan guarantees given to Chrysler Corporation lenders, and Federal Reserve assistance for banks that are facing liquidity crises. What we did not provide in the earlier article is objective evidence that a plan is needed. This evidence was highlighted in a recent Op-Ed article from Paul Krugman, a regular contributor to the New York Times. He points out:

How will it all end? Markets won’t start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won’t happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years.

A similar observation was posted in a Fortune article:

"What we're seeing now is a valuation crisis," says Sylvain Raynes, a former Moody's analyst and principal at the structured finance consultancy R&R Consulting. "Wall Street is a big wheel that is moving the same losses in a circle and only postpones the ultimate reckoning and makes it much worse." 

A resolution to the current crisis that allows the problems of financial institutions and borrowers to fester for years is simply unacceptable. If you look at the REO properties owned by Countrywide (just as an example), there are over 14,400 properties in inventory for sale. That number is increasing monthly - there is no sign that the number of homes in Countrywide's inventory will level off. Where are most of these homes? Nobody is surprised that almost 4000 homes are in California. We were surprised that Michigan came in at number 2, by a wide margin, with more than 1600 homes owned by Countrywide (a third of which are in the City of Detroit). Number 3 is Florida, with over 800 homes in Countrywide's inventory. Prices for Detroit properties start at $1.00, and most of the others have been reduced, drastically. Nevertheless, there are few buyers. Michigan lost population last year. People who lost a home to foreclosure are packing up and moving out of Michigan. Anyone moving into Michigan has their pick of dozens of fine empty homes.

What this means is that there is no market, nobody knows what these properties are worth and, therefore, there is no reasonable financing available. This is evident from the foreclosure auctions in California. The Modesto Bee reports that lenders are cutting their bids at foreclosure sales, by almost half in some cases, in the hope that some investor or first time buyer will buy the home (even if the lender takes a huge loss). Even at these levels, there are no bidders. The Modesto Bee also reports that 1,336 properties were offered to the highest bidder on the courthouse steps in Modesto, Merced and Stockton in November, 2007, but only 17 received bids from someone other than the lender. The San Francisco Chronicle reports that the number of homes reposessed in California in the fourth quarter of 2007 were up 421% over last year. These homes were not just in lower cost areas. San Francisco Bay area foreclosures are up 482%. The Milwaukee Journal-Sentinel reports that there were 2800 foreclosures in Milwaukee last year (a 60% increase), but another 1000 were filed in the first ten days of 2008. About a third of all foreclosures are cancelled due to bankruptcy, and lenders purchase 92% of the properties at sherrif sales. There are few buyers for homes. Lenders may try begging next.

An article in CNNMoney reports that almost all economists and other prognosticators were wildly optimistic in their housing projections for 2007, and there is no reason to believe any of the predictions for 2008. The best guess for the course of housing prices may be the housing futures contracts in the Chicago Board of Trade that correctly predicted a 5% to 7% drop in housing prices in 2007. These futures predict a drop of 4% to 14% in 2008. A 14% drop in prices would be a disaster, reducing the equity in many homes to the price of a loaf of bread. Think about it - a 6.7% drop in home prices on average in 2007, and another 14% drop in 2008? The value of home equity loans, HELOCS, and the piggyback second mortgages is wiped out. Who wants to keep paying when you are not protecting any equity? Homeowners who thought that they were building up equity find themselves simply renting. Worse yet, all HELOCS have a clause allowing the lender to cease advancing new money if the price of the home drops significantly. See 12 CFR 226.5b(f)(3)(vi)(A). Nobody thought that this clause would ever be enforced. Think again. How are your kids going to pay for college?

The mortgage mess started as a tropical depression, and quickly became a tropical storm. We need to break the big wheel that is moving losses in a circle before the circle gains speed and breadth, and turns into a catastrophic hurricane. This can only be done by refinancing the bad debt into soundly structured obligations to get rid of the bonds that threaten our financial system. Refinancing the debt will free up residential financing, boost investor confidence in mortgage bonds, and end the downward spiral of housing values. We need to recognize that some people mortgaged their future, not ours. This is their problem, and they need to repay it, even if it takes the rest of their lives to repay the debt. Those that invested in the bad debts are not going to get a windfall, and may have to suffer some losses. At the same time, we need to recognize that you cannot get blood out of a turnip, and this has turned into our problem, not just theirs. The NIMBY principal does not work for real estate values. We also need to realize that new investors willing to step forward to buy the new bonds need to be rewarded for doing so, principally by government guarantees of payment. Governments needs to remember that they work for the people, not the other way around. Governments also need to recognize that subprime loan products are essential for first time home buyers. Governments are going to have to give up some tax revenue on the new investments to keep the cost of refinancing a ton of bad debt within the means of the individuals who are stuck holding the bag.

What Were They Thinking?

Where Have All the Losses Gone, Long Time Passing... An interesting tidbit appeared in an AP story that appeared in CNNMoney and in Zibb on FNMA losses. It turns out that good, honest, hard working people with prime loans in Michigan and Ohio are FNMA's problem children, and not subprime borrowers. The news story states:

Fannie said its single-family credit losses through September were largely concentrated in the Midwest, led by losses of $185 million in Michigan and $101 million in Ohio. The two states combined account for 6 percent of Fannie's business. Meanwhile, losses in California and Florida, which combined account for nearly 23 percent of the company's business, totaled $51 million.

When  you look at ARM loan statistics in terms of foreclosures by year of origination (see the study by the Milken Institute), there are significant foreclosures in ARM loans that have not yet reset, and the foreclosures are not limited to subprime loans. Another study by the Milken Institute found that of all the 2/28 and 3/27 subprime loans in foreclosure as of July 2007, 57% and 83%, respectively, had not yet undergone any upward interest rate adjustment. A similar study by the Mortgage Bankers Association states that of 166,000 foreclosures started in the third quarter of 2007, 90,000 ended in repayment plans, and 13,000 ended in modified loans. The remaining 50,000 foreclosures most likely occurred "due to the traditional reasons for default, loss of job, divorce, illness or excessive debt burden relative to income, not just the impact of rate resets, thus eliminating any possible benefit of a rate freeze."

A story in Chicago Tribune points out that the fastest growing county in Illinois, with many new, affordable homes, has the highest foreclosure rate. What does this tell us? First, that Florida Condominiums (which are an alternate spelling for "mortgage fraud"), overpriced homes, and real estate speculators in Florida and California that were financed with these hybrid loan products are not eating FNMA and FHLMC alive as they claim in mortgage fraud seminars. Second, James Carville (President Bill Clinton's strategist) was correct -  it's the economy, stupid. Let me add that it is the economy almost everywhere that is a problem. Countrywide owns more homes in Las Vegas than Detroit, and the Palm Beach Post reports that the foreclosure rate tripled in Palm Beach County, FL over a year ago (the foreclosure rate in Palm Beach is almost five times the national average). As pointed out in a recent blog, the number of good paying jobs is declining and the number of poor paying jobs is increasing. Jumping up and down about the number of new jobs created is foolish if many of these jobs pay near the poverty level. We need information about what the new jobs pay, not how many of them there are. Frankly, any new full-time job paying at or near minimum wage should not count as a new job since is it only a temporary job anyway. Either the worker will be cut when the work dries up or goes overseas, or the worker will find a better paying job because peanut butter and jelly or noodles every night for dinner gets tired.

What Would You Give Your Right Arm For? In Barnhill v. Kovach, the trial court dismissed Barnhill's malpractice lawsuit against her attorney because Barnhill would not raise her right hand when she affirmed that she would tell the truth in court and at depositions. She objected to raising her right hand on religious grounds. The Court of Appeals reinstated Barnhill's case, reading the law as not requiring any ceremonial hand raising to affirm that a person would tell the truth (under penalty of perjury). There was a long dissent arguing that state laws required the ceremonial hand raising, and that there was no constitutional impediment to requiring the ceremonial hand raising. This begs the question of whether paraplegics, persons who have suffered strokes, and other handicapped persons are not permitted to testify in court. It also raises the issue of whether the dissenter would prohibit telephone testimony since nobody can see whether the witness is raising a hand or not. The dissenter was evidently never admonished "not to stand on ceremony."

Paradise Lost Allan Sloan writes in Fortune "Why the Federal Reserve has lost its mojo." The Federal Reserve has not lost its influence, or mojo. The Federal Reserve simply has not grown at the rate that wall street and banking institutions have grown. We have all been so concerned about the size of government that we overlooked the fact that the industries regulated by government have grown exponentially in size, with the largest institutions growing more rapidly than the rest of the pack. Consider that the FDIC bank insurance fund holds only $50 billion dollars. That is a thimble full in terms of the size of some of our largest banks and wall street firms. Wall street firms paid bonuses of $23.9 billion in 2006 according to a story in the New York Times. Think about it - the bonuses for Wall Street firms (and that does not include banks) were half of the size of the fund that insures all of our bank deposits. A million dollars is needed for a person to retire comfortably. It takes more than a billion dollars to get on the Forbes 400 list of the richest Americans. Not even some companies that insure municipal bonds would make the Forbes list. Fortune also reports that ACA Financial Guaranty Company only has $650 million to insure a ton of bonds. None of the other bond insurers have sufficient capital to cover expected losses. The Fortune article speculates that the banking industry could write down $200 billion of the value of its collective assets. Why should we think that the FDIC bank insurance fund is any better off than bond insurers? No, the Federal Reserve has not lost its mojo - it is just working with the same equipment that it had twenty years ago. It will take a really big stick to make an impression on the ten ton gorillas roaming our financial system today. We just need to provide that stick so that the Federal Reserve can walk tall.

Statistics Do Not Lie; People Using Statistics Lie Statistics are like a gun. A gun is not dangerous sitting on a shelf with a lock. Take away the lock, insert ammunition, put the gun in an untrained hand, and you have a jail cell waiting to be filled. Statistics sitting by themselves are not dangerous. Using statistics irresponsibly to prove a predisposed position should be a crime. A study by the Milken Institute reworked figures used by the Center for Responsible Lending (CRL) to support the assertion that subprime lending created a net loss of home owners in the US. It turns out that CRL was making an assumption that 25% of subprime loans were made to first time home buyers, and the data for foreclosures used by CRL was for all subprime loans. If you compare all purchase-loan foreclosures to the same types of loans to first-time home buyers, the foreclosures do not approach the figures quoted by CRL. Nevertheless, both organizations assume foreclosure rates that are simply too high. Perhaps we will get good data after the hype dies down.

No Brotherly Love in Baltimore for Wells Fargo.... In a new twist on an old game, CNNMoney reports that the City of Baltimore is suing Wells Fargo for discriminatory lending. Baltimore's government is pissed that foreclosures are ruining its tax base, and increasing its costs of taking care of its citizens. Wells Fargo claims that it does not take race into account when making loans. This is one of those cases that the Judge cannot win because one side has to lose. Baltimore does not have standing to sue for discrimination in private transactions under FHA. However, Baltimore may have an ordinance banning discrimination in lending and authorizing the City to sue. Wells Fargo is forgetting that credit practices that cause a statistical imbalance in the terms of credit offered along some protected classification is illegal if some less discriminatory means of achieving the lender's legitimate business goals was available. Do not wait to tune in to this heavyweight battle until the twelfth round. There may be a technical knockout early in the fight.

.....or in Cleveland The Baltimore lawsuit against Wells Fargo beat the filing in Cleveland of a lawsuit against 21 investment banks. Perhaps seeing that a lawsuit under the Fair Housing Act would be difficult, Cleveland took the approach that these lenders (or their loans) were a public nuisance - a claim that cities file all the time to condemn properties. The gravamen of the Complaint states:

64. The Defendants are liable to the City of Cleveland for public nuisance for their respective roles in proliferating toxic sub-prime mortgages within its borders, under circumstances that made the resulting spike in foreclosures a foreseeable and inevitable result.

65. The City suffered damage as the direct and proximate result of the Defendants’ unlawful conduct, including (a) the cost of monitoring, maintaining, and demolishing foreclosed properties, and (b) decreased tax revenues resulting from the depreciated value of the affected homes and all surrounding real estate.

How long will it take for the remainder of America's major cities to file similar actions? Probably not long. There are a ton of personal injury attorneys out there who are starving after states passed tort reform and after courts cut back on premises liability claims. Any one of them would be happy to file such a lawsuit for a percentage of whatever settlement they can wring out of Wall Street. Grab a seat and watch the show unfold.

Good Grief, Charlie Brown A story in Reuters reports that housing counselors are suffering from the shock and awe of seeing their case load triple. Counselors cannot do anything to help many in foreclosure except feel their pain. Non-profit housing counseling agencies may soon need to employ grief counselors and psychologists for their employees to avoid Post Foreclosure Stress Syndrome. CNNMoney reports that lenders pledged $4.6 million to hire 45 additional counselors in California (there are three hundred mortgage counselors in the state). This may be just a drop in the bucket based on the number of recent foreclosures.

2007 Lexicon We coined new terms in 2007, such as "NINJA Loans" (No Income, No Job, or Assets), "Jingle Mail" (the sound made when shaking a letter from the borrower that contains the keys to the secured residence), and "inside-out" (the result of a disgruntled evicted homeowner removing the fixtures from his home). "Subprime" was announced as the Word of the Year by the American Dialect Society ("Plutoed" was last year's choice, meaning to be demoted). I cannot wait to see what 2008 holds. Perhaps phrases like "one year free rent" (the period between mortgage default and move out after eviction) will be a sign of the times.

A Vote of No Confidence Middle class Americans are not the only ones with no confidence in 2008. America's CEOs are a gloomy bunch, according to statistics from The Conference Board. The last time there was this much CEO gloom, the 2001 recession was just coming over the horizon. I can see many CEOs shouting, "Check please!" It may be time to leave before the band from the Titanic starts playing.

The New Subprime Borrowers Talk about getting a taste of their own credit, Reuters reports that Merrill Lynch will receive a $6.6 billion cash infusion from foreign investors - at a 9% interest rate, and a 17% conversion premium over the reference stock price. That is quite an adjustable rate loan. It dwarfs the cost of credit extended by Bank of America to Countrywide, and it is several hundred basis points above prime. Wall street banks may soon be asking for a rate freeze - for their own debt.

Chinese Fortune Cookie Says: Financial Firms Joined at the Hip Should Not Argue Which Way to Jump A recent Bloomberg article points out how Merrill Lynch's margin call on Bear Sterns' managed hedge funds resulted in the bankruptcy of the funds and $7 billion in losses for Merrill Lynch. The Merrill Lynch margin call seems typical of the vast number of repurchase demands, warehouse line margin calls, and other assaults on mortgage bankers by industry participants joined at the hip in the subprime market. We all knew that the representations and warranties demanded of loan originators were beyond the pale, and we all knew that enforcement of these clauses would sink the ship. Agreeing to these terms was the price of entry into the market, but nobody ever thought that these terms would be enforced. Enforcement of representations and warranties, liquidity clauses, and other terms by counterparties in the industry killed the producers on whom the counterparties depended for their living. If you deliver milk for a living, do not slaughter the cow that produces the milk. If you drill a hole in someone else's lifeboat, make sure that you are not sitting in the boat at that moment.

Merchant Processing Company Made Money Through Fraudulent Charges Most servicers make money by collecting payments. The FTC accused Your Money Access, LLC of making money by imposing big charges when it's merchant customers charges were rejecting by banks. Your Money Access is accused of servicing a host of fraudulent merchants. A third of the electronic debits processed by this firm were rejected by banks. The servicer made a lot more money on these rejected debits than it did on valid debits. The FTC accused this firm of essentially being an accomplice of the fraudulent merchants. This was not a small potatoes operation - the servicer processed over $200 million in debits, including many that were deemed fraudulent in prior FTC actions. I predict that this will be another case of trying to close the barn door after the horses are gone. It is unlikely that the FTC or the consumers who suffered will collect more than a fraction of the money made by fraudulent transactions.

Just in Time for Data Privacy Day The Milwaukee Journal Sentinel reports that the State of Wisconsin sent out mail to its Medicaid program recipients that included their Social Security Number on the address label. This is the second time that the state made this mistake - last year it sent out tax forms with Social Security Numbers on the address labels. Identity theft is really easy if all you have to do to get a social security number is peek in someone's mailbox. To all of the Medicaid recipients in Wisconsin, have a Happy Data Privacy Day January 28, 2008.

Oh HUD! You've Done It Again! We once had a nice, if a little old fashioned, web site known as HUDClips, in which HUD posted all of its publications. You could browse or search any portion of the publications. For example, if I just wanted to search Mortgagee Letters for the word "assignment," I could do so. HUD took this website down and folded the documents unto its website. We can no longer search any particular area of HUD publications. The search feature goes through all of HUD's documents, and sometimes returns lots of extraneous material. Way to go HUD!

Be Still My Heart! It looks like someone important is reading our newsletter and other stuff I send to email addresses at mich.gov. Governor Granholm announced that she will ask state lawmakers to approve a supplemental appropriation of $1.4 million funded by fees to add 34 mortgage industry regulators overseeing the industry, including 19 examiners and additional enforcement staff to ensure that consumers are being protected in the mortgage lending process. That is a good start, but hardly sufficient. The Massachusetts Division of Banks announced that it is hiring 25 new bank examiners at a starting salary of $39,686.92. Last time I looked, Michigan had a little over 10 million residents, and Massachusetts had a little under 6.5 million residents. Which state should be hiring more bank examiners?

Northwest Airlines - The Subprime Carrier My trip to Washington DC on January 22 to speak at a seminar turned into a marathon - at the airport. Northwest Airlines flight 228 from Grand Rapids to Detroit, which continued on to Washington DC, ran into weather delays. The flight arrived an hour and a half late. However, instead of sending the flight on to Washington when it arrived, Northwest canceled the flight, citing the "weather." The real reason for the cancellation was probably the fact that the morning flight to Washington and the afternoon flight to Washington were each half full. I believe that "weather" was a convenient excuse to avoid admitting the economic reason for the cancellation. Did you know that if a few people are bumped from a flight they are entitled to compensation, but if you bump all of the people on the flight there is no right under law to be compensated? You would think that Northwest would put me on the next morning flight if they were desperate to save the little good will they retain, but that flight was overbooked. I discovered this as I waited in vain for a standby seat that did not exist. I got a lot of exercise running from gate 30 to gate 11 to gate 64, with my luggage. Now I understand how Tom Hanks studied for his role in the movie Terminal - he booked a couple of Northwest flights.

Complaining to Northwest did not help since the "Customer Care" line is overwhelmed and the Northwest phone system kicks you into telephone menu hell. Northwest employees at the airport told me right up front that the Customer Care line is rarely answered, and that the next time I call the customer service line it will probably be answered by Delta. I was a fool to waste my cell phone battery on the call - Northwest had canceled the flight and rebooked my ticket for a mid-afternoon flight before they ever told me that my morning flight was canceled. The standby ticket was likely a ruse to keep me from complaining too much while the staff at the original gate made their getaway. The afternoon flight could have been renamed the Grey Lines Tour as it taxied for an hour to the airplane wash and to the runway at the other end of the earth, and finally lifted off an hour late. I wondered what adventures the trip home would bring, and whether Northwest flies to Kazakhstan. Fortunately, the trip home was only late by  about 45 minutes, which is on time for Northwest.

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This newsletter is produced and distributed without charge by Howard A. Lax of the law firm of Lipson, Neilson, Cole, Seltzer & Garin P.C. 

Howard A. Lax is a corporate law attorney with Lipson, Neilson, Cole, Seltzer & Garin, P.C. His practice concentrates on financial institutions consumer compliance and regulatory affairs, and real property law. Mr. Lax earned his J.D., cum laude, from Wayne State University's School of Law and holds a bachelor's degree from the University of Michigan. Active in the legal community, he is a member of the State Bar of Michigan's Business Law Section and is a member of the governing council of the Michigan Real Property Law Section.

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