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Triple trouble: FHA-approved lenders face the threat of treble damages when the government decides to use the false claims act as an enforcement tool.

With the Federal Housing Administration's (FHA's) market share exceeding 3o percent, the Department of Housing and Urban Development (HUD) has placed even greater emphasis on enforcement activities in an effort to protect and preserve its insurance fund. That means heightened responsibility, accountability and liability for lenders that originate and service FHA-insured loans. * As stark evidence of ~ HUD's commitment to enforce its requirements and impose draconian penalties against lenders that violate these standards, HUD recently began teaming up with the Department of Justice (D0j) to file court actions against lenders under the False Claims Act (FCA). * These actions, based on purportedly false loan-level certifications and annual certifications, result in treble--damages Wherethe lender is liable for three times the damages sustained by HUD--plus civil penalties of up to $11,000 per transaction. * Since May 201 1, HUD and DOJ have filed and/or settled five cases against lenders based in large part upon the FCA. The settlement amounts have been staggering, ranging from $132 million to $1 billion. Clearly, the stakes have been raised.

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Background

The FCA is a federal law that imposes liability on any person who knowingly presents a false or fraudulent claim for payment or approval to the U.S. government. If HUD pays a claim for insurance benefits in connection with a loan it thinks was originated in violation of FHA requirements, HUD may use the loan level certifications made at Origination to bring an action against the originating lender under the FCA.

Further, if HUD determines a lender violated other FHA program requirements, such as quality-control standards, HUD may rely on the lender's annual certification to bring an action under the FCA as well.

Private persons, known as "relators," may also bring qui tam actions against lenders in the name of the federal government for alleged violations of the FCA. If the government proceeds with a qui tarn action, the relator is entitled to 15 percent to 25 percent of the proceeds of the action or any settlement. In fact, several of the cases discussed in this article began as qui tam actions brought by an employee or former employee of the lender.

With the FHA capital reserve ratio stuck below the congressionally mandated level, it's not surprising that treble damages would appeal to HUD. And, to be clear, no one is suggesting HUD should tolerate fraud or lenders should take a lackadaisical approach to compliance with. FHA rules. HUD, however, already has a host of alternative enforcement tools available to ensure that lenders comply with FHA requirements and to make HUD whole when it. pays an insurance claim for a loan it deems ineligible. These other tools include indemnification, civil money penalties and sanctions against lenders' officers, directors and employees.

This article provides an overview of recent HUD enforcement trends from a loan origination perspective, summarizes the recent FCA actions and settlements, and provides our observations as to how this trend may impact lenders that participate in the FHA insurance program.

HUD enforcement trends

HUD's enforcement practices have evolved noticeably over the past to to 15 years, but most dramatically in the past year and a half.

Traditionally, HUD sought reimbursement on a loan-by-loan basis through indemnification following either a Quality Assurance Division audit or a Mortgagee Review Board (MRB) proceeding. In this context, indemnification meant that the lender reimbursed HUD for the net loss remaining after HUD had paid the claim, sold the property and paid certain costs associated with selling the property.

Indemnification was originally used as a last resort in cases of fraud or misrepresentation, (Jr where objective HUD requirements were violated--for example, where the mortgage lender had actual knowledge that the borrower was a straw buyer with no intention of occupying the property or the lender knew that the down payment came from an interested party.

HUD also sometimes imposed civil money penalties, currently limited to $7,500 per violation, up to $1,375,000 for all violations committed during any one-year period.

Several years ago, HUD began to focus on underwriting (e.g., qualifying ratios and compensating factors), often engaging in Monday morning quarterbacking by focusing on early payment defaults. After a loan has gone bad, it is easy to look back and say that the loan never should have been approved, even if hundreds of other loans with similar credit profiles are performing like clockwork.

HUD will not accept as a defense that a default was due to job loss, divorce or accident; the agency takes the position that "but for" the alleged origination deficiency, the loan would not have been approved and HUD would not have taken a loss, regardless of the direct cause of the default.

HUD did, however, give lenders one break by focusing on loans originated during the previous two years. The theory was that if the loan defaulted after 24 months, the default was unlikely to be related to an origination deficiency. With regard to quality-control plans, if a lender did not have a plan or did not have a good plan, HUD generally would fine the lender about $5,000 and direct it to implement a compliant quality-control plan.

That was generally what the enforcement landscape looked like a year and a half ago. Now the same origination and quality-control issues are being used as the basis for treble damages claims under the FCA.

In this context, treble damages means three times the amount of the gross claim paid by HUD, minus the proceeds HUD received for selling the property, plus a civil penalty of up to $11,000. For example, consider a $200,000 mortgage where HUD sells the property for $80,000. Here, HUD takes a $120,000 loss but can recover $531,000 in damages and penalties under the FCA (5600,000 - $80,000 + $11,000).

Additionally, the U.S. Attorneys' Offices working with HUD have begun to employ extrapolation--examining a sample of a few hundred loans, typically early payment defaults, and extrapolating the results across all loans originated by the lender during the relevant period. As you can see, treble damages add up quickly. An action under the FCA could therefore prove lethal to a company.

Recent actions under the False Claims Act

As noted, HUD has recently resorted to pursuing lenders for alleged violations of the FCA. In May 2011, the government sued Deutsche Bank (the parties reached a settlement in May 2012); in November 2011, the government sued Allied Home Mortgage Corporation (now known as Allquest Home Mortgage Corporation), Allied Home Mortgage Capital Corporation (now known as Americus Mortgage Corporation) and two of its top executives; and in February of this year, the government announced settlements with Bank of America (for loans originated by Countrywide Home Loans), CitiMortgage and Flagstar Bank.

Several of these cases began as whistleblower suits brought by an employee or former employee of the lender. Although the details vary, the government alleged that the lenders in these cases violated the FCA by submitting false underwriters' certifications in connection with individual loans and/or false annual certifications with respect to their participation in the program as a whole.

In two of these cases, the government also brought claims under the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA). The act prohibits making false statements to HUD with the intent to defraud or deceive HUD or knowingly making false statements to FHA for the purpose of influencing FHA's actions.

FIRREA imposes civil penalties of up to $ i million per violation (for a continuing violation, up to $1 million per day, not to exceed $5 million). If the violation results in a monetary gain to the violator or a monetary loss to a person other than the violator, the civil penalty may be higher to allow the government to recover the amount of any such gain to the violator or loss to another person.

Lender certifications

In order for a lender to be liable under the FCA, HUD must have paid a claim and the lender must have made a false statement in connection with the submission of the claim. If there is no false statement, there is no false claim and no liability under the FCA. In its search for a false statement, the government has recently focused on the certifications that lenders make to HUD. The most recent FICA cases filed by the DOJ relied upon two types of lender certifications: 1) loan-level certifications and 2) annual certifications.

Loan-level certifications: Lenders must make a number of loan-level certifications in order to obtain FHA insurance. In particular, each lender must complete the Addendum to Uniform Residential Loan Application (HUD form 92900-A) for each originated loan. To complete this form, the lender must make a number of certifications, including: certifying to the integrity of the data relied upon by the lender for loans approved by an automated underwriting system; certifying that the mortgage is eligible for FHA insurance; and, in the case of manually underwritten loans, certifying that the underwriter personally reviewed the loan application and all associated documents and used due diligence in underwriting the mortgage.

Annual certifications: In addition to the certifications made in connection with each loan origination, each lender must make certain certifications on an annual basis. Only corporate officers and principal owners with authority to legally bind the lender can make the annual certification on behalf of the institution.

Among other things, according to the annual certification lenders complete online, the lender must certify that it "complied with and agrees to continue to comply with HUD-FHA regulations, handbooks, Mortgagee Letters, Title I letters, policies and terms of any agreements entered into with the department"; that it "conforms to all HUD-FHA regulations necessary to maintain its HUD-FHA approval"; and that neither the lender nor any of its senior personnel "are currently involved in, or have been involved in, a proceeding and/or investigation that could result or has resulted in a criminal conviction, debarment, limited denial of participation, suspension, civil money penalty or other adverse action by a federal, state, or local government."

Recent lawsuits and settlements

The government's allegations

The certifications outlined here are at the heart of the recent FCA cases. Each case was based on allegations that the lender made false loan-level certifications in connection with certain loans and/or made false annual certifications.

In two of the cases, the government's allegations were twofold. The government asserted that these lenders: 1) failed to implement an adequate quality-control plan, yet certified annually that they complied with all HUD/FHA requirements; and 2) endorsed loans for FHA insurance without conducting the required due diligence, yet certified to HUD that such diligence had been performed. These actions, the government argued, resulted in signif-icant losses to the FHA insurance fund.

With respect to quality control, the government argued that the lenders did not implement quality-control plans that complied with HUD/FHA requirements. In particular, the government alleged that:

* The lender did not review all early payment defaults (i.e., loans that go into default within the first six payments);

* The lender did not devote adequate staff to the quality-control process;

* The lender did not provide adequate guidance to its quality-control personnel;

* The lender failed to address problems in the quality-control process that were reported to senior management;

* he lender did not review the findings letters prepared by the vendor it hired to conduct its quality-control reviews;

* The lender failed to report findings of fraud and other serious deficiencies in its loans to HUD; and/or

* The lender's business units were encouraged to pressure the quality-control unit to reduce the number or severity of its quality-control findings.

Had these lenders implemented compliant quality-control plans, the government argued, they could have prevented many of the underwriting deficiencies that resulted in defaulted loans and losses to the FHA insurance fund.

With respect to underwriting deficiencies, the government alleged that, in certain cases, the lenders:

* Failed to document gift funds properly;

* Failed to develop a credit history for a borrower without an established credit history;

* Failed to verify and document a borrower's cash investment in a property;

* Failed to verily properly the borrower's employment and/or income;

* Failed to verify the source of an earnest money deposit that appeared excessive in relation to the borrower s savings;

* Failed to examine irregularities arid resolve conflicting information in the borrower's file;

* Completed a streamline refinancing even though the file indicated that the mortgage being refinanced was delinquent; and/or

* Allowed verification forms to pass through the hands of a third party.

As a result, HUI) accepted allegedly ineligible loans for FHA insurance protection. Many of these loans defaulted, resulting in significant losses to the FHA insurance fund.

Of the remaining three FCA cases filed and/or settled to date, one was based solely on alleged underwriting deficiencies similar to those described here. The other two presented more unique fact patterns, involving use of unapproved branch offices and "underwriting assistants" that had not been approved as Direct Endorsement underwriters.

Settlement terms

As noted, four lenders have entered into settlement agreements to resolve the FCA claims made by the government. Under these settlement agreements, the lenders have agreed to payments of $132.8 million, $158.3 million, $202.3 million and $1 billion in damages. Under the terms of the $1 billion settlement, the lender must pay 5500 million to the government up front and use the other $500 million to fund a loan-modification program for underwater borrowers.

One lender also agreed to a monitoring program under which its compliance with all HUD/FHA requirements will be monitored by a third party for at least one year. If the lender's Credit Watch compare ratio is unacceptable, HUD may extend the monitoring period for a second or third year. This lender also agreed to implement a training program to educate its employees about HUD/FHA origination and underwriting requirements.

Finally, we note that three lenders, as part of the settlement, publicly admitted, acknowledged and accepted responsibility for certain conduct, including failing to comply with HUD/FHA requirements and submitting false certifications to HUD. One lender also agreed to certify to HUD that certain individuals in senior leadership positions are no longer employed by the lender.

The remaining case is still being litigated.

Implications for FHA participants

The wave of FCA cases discussed here should serve as a serious wake-up call for FHA-approved lenders. HUD has delegated to lenders the responsibility for analyzing an applicant's creditworthiness and making a decision on the loan. Despite HUD guidelines, this process is largely subjective.

For example, if a borrower's income/expense ratios exceed certain thresholds, the lender may still qualify the borrower if certain compensating factors are present. The underwriter must analyze all the information in the file and make a decision based on his or her experience.

HUD itself has stated that underwriting is more of an art than a science. Given the nature of the process, lenders and HUD are bound to disagree about certain underwriting decisions. Whereas such disagreements historically might have resulted in loan-by-loan indemnification deals, lenders now have reason to wonder whether such disagreements might result in an action under the FCA.

The annual renewal process, too, has taken on increased significance. As described here, the annual certifications are incredibly broad. Among other things, each lender must certify that the lender is in compliance with all HUD/FHA requirements. If this statement may be used as the basis for an action under the FCA, any instance of noncompliance with any requirement, no matter the significance or extent of such noncompliance, theoretically could be used to seek treble damages against the lender.

Nevertheless, there are certain steps lenders can and should take before HUD or DOJ shows up at their front door. Based on the actions and settlements announced to date, it is apparent that effective quality control and internal controls are more important than ever.

At a minimum, lenders should ensure that they have a comprehensive quality-control program that is independent of origination and servicing channels. Each lender must 1) measure performance; 2) identify deficiencies; 3) take corrective action; and 4) document and track its corrective actions.

It also doesn't take a rocket scientist to figure out that if HUD and DOJ are focusing on particular deficiencies, lenders should have controls in place to ensure that they are in full compliance with those requirements.

In our experience, the top to most common origination-related HUD allegations involve:

1. Sources of funds--improper documentation of the source of funds, including the earnest money deposit, gift funds and large deposits to bank accounts;

2. Borrower credit--imprudent judgment regarding a borrower's ability to repay a loan, including unwise decisions regarding general creditworthiness, failure to consider non-purchasing spouses' liabilities, failure to verify properly Social Security numbers and failure to document borrowers' ability to handle increased payments in connection with interest rate buydowns;

3. Qualifying ratios and compensating factors--failure to have sufficient, documented compensating factors to justify loan approval to borrowers with high qualifying ratios;

4. Income and employment documentation--failure to document properly gaps in employment and/or non-taxable, part-time or overtime income;

5. General data integrity--failure to ensure that file documentation supports information entered into an automated underwriting system;

6. Quality control--failure to maintain and/or implement a compliant quality-control plan;

7. Late submission of upfront mortgage insurance premiums failure to remit upfront mortgage insurance premiums to HUD within 10 days of closing or funds disbursement;

8. Late submission of endorsement packages to HUD for FHA insurance--failure to submit loans to HUD for endorsement in a timely manner;

9. Maximum mortgage amounts--failure to calculate the maximum mortgage amount correctly, thereby resulting in an overinsured loan; and

10. Net branching--failure to adhere to FHA's branch office requirements, such as ensuring the FHA-approved lender is responsible for all branch operating expenses.

So, unless you want your mother to pick up a newspaper and read about penalties imposed against your company, you need to make it your business to be sure to originate and service loans in accordance with FHA requirements. That means taking all certifications you make to HUD seriously and training your personnel on the latest handbooks, Mortgagee Letters, circulars and frequently asked questions (FAQs) to ensure that their knowledge of FHA requirements remains current.

Most of all, ensure that your company implements a top-notch quality-control program. While there are no guarantees, taking these steps could mitigate your company's enforcement risk and should certainly result in a stronger, more compliant FHA lending program. In the end, that should be everyone's goal.

Phillip L. Schulman is a partner and Kathryn M. Baugher is an associate in the Consumer Financial Services Group of K&L Gates LLP in Washington, D.C. They can be reached at phil.schulman@klgates.com and kathryn.baugher@klgates.com.
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Title Annotation:Enforcement
Comment:Triple trouble: FHA-approved lenders face the threat of treble damages when the government decides to use the false claims act as an enforcement tool.(Enforcement)
Author:Schulman, Phillip L.; Baugher, Kathryn M.
Publication:Mortgage Banking
Date:Jul 1, 2012
Words:3126
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