Mortgage Meltdown

Calculating Losses For Mortgage Fraud Under The Federal Sentencing Guidelines

In 2006, Toby Wayne Goss, a mortgage broker, was convicted in federal court of 19 of mail fraud, wire fraud, and money-laundering charges for submitting false documents like verifications of rent, W-2 Forms, and Social Security benefit letters in order to obtain mortgages for clients.  Goss was sentenced in August 2007.  One of the main issues for sentencing in a federal fraud case under the now-advisory sentencing guidelines is the amount of financial loss to the victims -- in this case, the lenders who provided mortgages in reliance on the falsified documents.  Goss was sentenced to 57 months in prison after the district judge concluded that the amount of financial loss to the victims was the full amount of the loans at issue, which should not be reduced by the value of the collateral - the real estate - pledged for the loans.

The Fifth Circuit reversed the district court's calculation of the financial loss under the federal sentencing guidelines.  Although the guidelines are now only advisory in nature, district courts are still required to properly calculate the guideline sentencing range in deciding the sentence to impose.  For assessing financial losses, a court should use the greater of the "actual loss" or the "intended loss."

Actual loss means the "reasonably foreseeable pecuniary harm that resulted from the offense."  Intended loss means the pecuniary harm intended (even if it all of it is not realized by the victim), including damages that would have been impossible or unlikely to occur, such as in a government sting operation or an insurance fraud where the claim exceeded the insured value.

The court held that Goss did not intend for lenders to lose the full amount of the loan, because the loans were backed by the real estate that secured the loans.  Accordingly, actual loss should be used, and therefore the value of the real estate at the time of sentencing should have been off-set against the loans when considering the actual loss.  The court also required the district court to estimate a fair market value for each property to determine this off-set.

Quote of note: "[T]he relevant losses in the case at hand are actual losses; and, on remand, the district court shall conduct a loan-by-loan inquiry to explore the factors discussed [in the opinion], as well as others it deems relevant.  After making the necessary findings of fact with respect to the collateral's likelihood of recovery and its fair market value at the time of the initial sentencing, the district court, for its loss calculation, should: deduct the fair market value of collateral likely to be recovered from the total value of the loans, using the court-determined value of that collateral; and obviously, should not deduct the value of collateral not likely to be recovered." The opinion is available here. 

FBI Issues Mortgage Fraud Report -- Staggering Increase

The Federal Bureau of Investigation recently released its "Financial Crimes Report To the Public Fiscal Year 2007," (available here) which contained an extensive summary of the staggering increase in mortgage fraud prosecutions, investigations, and incident reports for the last government fiscal year (October 1, 2006 to September 31, 2007). Here are some highlights:

--The extensive securitization of mortgages that were the hallmark of the subprime lending era "has created opportunities for organized fraud groups" and "the sale of the mortgages [in the secondary market] in many cases conceal or distort the fraud, causing it not to be reported."

--Reports of potential mortgage fraud increased from 35,000 in 2006, to 46,000 in 2007, to an estimated 60,000 reports in 2008.

--80 percent of all reported fraud losses involve collaboration or collusion by mortgage industry insiders, and so the FBI focuses its resources on these cases rather than borrowers committing "fraud for housing."

--Pending mortgage fraud cases in the courts nearly doubled from 2005 to 2007

--The top 10 mortgage fraud states for 2007 were Florida, Georgia, Michigan, California, Illinois, Ohio, Texas, New York, Colorado, and Minnesota.

--The report also notes in the Insurance Fraud section, the increased incidents of distressed homeowners, property flippers, and/or real estate investors have resorted to arson to avoid foreclosure.

Jurors' Views Of Already Pending Litigation May Be Influenced By Effects Of Subprime Mortgage Problems

Newspapers and the internet are filled with accounts of mortgage foreclosures, predatory lending, failure by brokers and lenders to fully disclose the terms and impact of adjustable rate mortgages and other creative lending vehicles, and the overall detrimental effect that the problems in the credit industry are having on the American economy and general public. Because of this, the problems in the mortgage industry and with subprime lending are not only generating a wave of new litigation, they may also be impacting jurors' decisions in already pending litigation.

For example, as reported here, a jury in Jackson County, Missouri (near Kansas City) handed down a verdict against three mortgage lenders, imposing punitive damages of $99 million, about 20 times the amount of actual damages. The trial court declined to reduce the punitive damages as being excessive.

The case involved a suit by borrowers in Missouri who obtained loans from a company called Mortgage Capital Resource Corporation under Missouri's Second Mortgage Loan Act, which limits the types and amounts of fees that can be charged by a lender for second mortgages. Interestingly, plaintiffs' lawsuit was not brought against Mortgage Capital, the originating lender, but instead was brought against three different secondary purchasers of the mortgages from Mortgage Capital – Residential Funding Co. LLC, Household Finance Corp. III, and Wachovia Equity Servicing LLC. These secondary purchasers argued that they were entitled to rely on Mortgage Capital's representations and certifications that the loans they were purchasing complied with state and federal law, and therefore could not be held liable for violations of the act. The plaintiff class argued that Residential Funding, Household, and Wachovia "stood in the shoes" of Mortgage Capital and also were aware of Mortgage Capital's fraudulent conduct. Whether the borrowers could reach past the originating lender and place liability on the secondary purchasers of the mortgages was a crucial issue in the case because Mortgage Capital was out of business, and its principal previously had been sentenced to 57 months in prison for defrauding other banks.

The court permitted the claims to go forward against the purchasers of the Mortgage Capital mortgages. Residential Funding, which is owned by GMAC Mortgage Group, was hardest hit by the verdict. It was ordered to pay $4.3 million of the $5.1 million actual damages award and $92 million of the $99 million punitive damages award. Residential Funding said it plans to appeal.

Although it is unclear how the jury reached the punitive damages award and what specific evidence it considered, it will be interesting to see if the punitive damages award is upheld on appeal in light of the U.S. Supreme Court's punitive damages jurisprudence, which has reined in punitive damages awards in State Farm Mutual Automobile Insurance Company v. Campbell, 538 U.S. 408 (2003) and Phillip Morris USA v. Williams, 549 U.S. __, 127 S.Ct. 1057 (2007). In the State Farm case, the Court wrote, "We decline again to impose a bright-line ratio which a punitive damages award cannot exceed. Our jurisprudence and the principles it has now established demonstrate, however, that, in practice, few awards exceeding a single-digit ratio between punitive and compensatory damages, to a significant degree, will satisfy due process." Based on the news report of the case, I believe that it may be difficult to sustain punitive damages in an amount 20 times greater than the compensatory damages against the secondary purchasers of mortgages from a company that may have been the primary wrongdoer.

Seller Carry-Backs: The Role of Forgivable Carry-Backs in the Subprime Mess

First, what is a Seller Carry-Back?  It's an agreement where the seller provides part of the financing for the buyer to purchase the property, often as a second (or third) mortgage.  The purpose of the seller carry-back is to help the buyer get financing so that he can purchase the seller's property. 

In the past few years, however, we have seen seller carry-backs (or rather forgivable carry-backs) become another tool for mortgage fraud schemes.  Generally, the scheme works like this: Seller wants to sell his property to buyer, but buyer cannot get lending for the full amount needed to purchase the property.  Rather than doing a traditional seller carry-back, in which the seller would finance part of the purchase price, the seller (often with the help of the broker and an appraiser) inflates the value of the property.  The seller then provides a "forgivable" carry-back for part or all of the inflated portion of the purchase price – with the understanding that all or part of the carry-back will be "forgiven."  The borrower can now obtain financing from the bank because the bank believes the loan is being made for less than the value of the property.  The seller gets paid, the broker gets a higher commission, and the buyer gets the home he wanted and the financing needed.  The bank (or investor if the loan was securitized), however, is left holding the note when the borrower defaults and it realizes the property is worth far less than the mortgage. 

This is not to say that seller carry-backs are a bad thing.  Today, with financing more and more difficult to obtain and sellers unable to find buyers who can get financing for the full asking, seller carry-backs are actually becoming more popular.  Sellers desperate to sell their home are providing incentives in the form of low-interest to no-interest carry-backs for 5-20% of the purchase price.  For their part, financial institutions are being advised to do more to ensure a proper appraisal of the property's value to avoid problems of over-valuation and forgivable carry-backs.  This trend will add an interesting dynamic to home lending, as more and more average Americans become mortgage lenders. 

What is a Subprime Mortgage?

If you listen to the mainstream media, you'd start to believe that subprime loans include anything with an arm, adjustable interest rate or affected by declining home values.  You might also start to believe that "subprime" and predatory lending are the synonymous. This is not the case.  The confusion isn't limited to journalists and politicians.  Even those in industry seem to disagree and be confused as to how exactly to define subprime loans. 

Traditionally, a subprime mortgage is a loan provided to someone with "subprime" credit – either because of bad credit or too little credit history.  Although competing banks have different lending criteria, generally anyone with a credit score below 650 could only qualify for "subprime" lending.  In the past few years, however, the types of loans considered to be "subprime" have increased to include: (1) persons with a high debt to income ratio – generally above 35%; (2) high loan to value ratios – generally above 80%; and (3) certain loan programs – such as interest only loans.  Although purists would not include these in the definition of "subprime loans", it would be difficult to discuss the current state of the home mortgage market without such a broad definition of subprime. 

It is important to remember that "subprime" does not mean predatory lending or a bad lending decision.  Subprime loans made it possible for people with lower credit scores to own their own home.  Some individuals took out subprime loans to purchase a larger home than they would generally qualify for (with the idea that they would grow into their home) or to purchase an investment property.  Predatory lending, on the other hand, often involves brokers lying to prospective home buyers about interest rates or other terms of the mortgage. 

What Are the Issues in this Mortgage Meltdown?

The term "subprime mortgages" is often used as the catch-all phrase to describe the various problems plaguing the mortgage lending industry.  These problems, however, go far beyond loans made to people with less than good credit.  Instead, problems like mortgage fraud, depreciating property values, rising interest rates, and securitization of loan portfolios extend to both prime and subprime mortgages.  That said, it is important to understand how these problems affect the prime and subprime mortgage markets differently.

For example, mortgage fraud is not restricted to subprime markets.  Identity theft, falsified employment and credit information and taking out multiple mortgages with different lenders at the same time are all types of fraud affecting both the prime and subprime markets.  That said, fraud is more prevalent in subprime loan programs.  Why?  One reason is a common subprime loan practice that allowed borrowers to state their income and/or assets without requiring proof and or verification by the loan officer.  These are known as "no-doc", "low-doc" or SISA (stated income, stated asset) loans.  Critics of this practice also call these "liar loans" because many borrowers and their brokers lied about income and assets in order to qualify for the loan. 

Similarly, declining property values and increasing interest rates affect borrowers of both prime and subprime loans.  The greater impact, however, is on subprime mortgages, which were more likely to have an adjustable rate, started at a higher interest rate and include a greater percentage of people with a high debt to income ratio. 

So, next time you talk about the troubles surfacing in the mortgage lending industry, remember that there are often differences between the prime and subprime markets that need to be understood and appreciated in order to face the challenges ahead.