In light of a number of bankruptcies among mortgage loan originators, participants in the secondary market for residential mortgage loans have become increasingly aware of potential assignee liability and mortgagor set-off rights under the Truth in Lending Act ("TILA") and the Real Estate Settlement Procedures Act ("RESPA"). Both purchasers and lenders, who before relied almost exclusively upon originators' representations and warranties and repurchase and indemnification obligations to ensure that they were protected from losses due to TILA or RESPA violations, have found their asset pools less valuable due to potential mortgagor offsets and have incurred affirmative expenses due to the assignee liability provisions under TILA.
Moreover, when mortgage loan originators file for bankruptcy protection, assignees may become substitute targets for class action plaintiffs alleging violations of TILA or RESPA and seeking defendants with deep pockets. Therefore, secondary market participants must find tools which are not cost prohibitive to mitigate the risks associated with acquiring and/or financing assets subject to TILA and RESPA.
Potential Liability Under Truth in Lending Act and Real Estate Settlement Procedures Act
Under TILA, loan originators and assignees may be held liable for failure to make required disclosures. Remedies for TILA violations include rescission, damages and equitable relief. With respect to mortgage loans which are not purchase money mortgage loans created to finance the acquisition or initial construction of the borrower's principal dwelling, within three years following loan consummation, a borrower may rescind such loan if the TILA disclosure requirements were not properly made.
An assignee who acquires such a loan is subject to rescission claims to the same extent as the loan originator. A borrower who successfully exercises the right to rescind is entitled to a refund of all amounts paid to the mortgagee (including points, interest, insurance premiums and paydowns on the loan principal) and release of the mortgagee's security interest on the mortgaged property within twenty days. Moreover, if a borrower's action to rescind a loan is successful, the loan originator or its assignee may be liable for the mortgagor's costs and attorney's fees.
Within one year of a TILA disclosure violation, a borrower may assert a claim for damages against the loan originator or an assignee of the loan originator. TILA distinguishes between Section 32 or "high cost" mortgage loans and other mortgage loans. A Section 32 or "high cost" loan is defined as a mortgage loan not obtained for purchase or initial construction and exceeds certain trigger points as defined by the Home Ownership and Equity Protection Act of 1994 (HOEPA).
For non-Section 32 loans, assignee liability is limited to disclosure violations "apparent on the face of the disclosure documents." For Section 32 loans, an assignee may be held liable for all TILA disclosure-related damages unless the assignee can demonstrate that it was not apparent from the disclosure statement that the loan was a Section 32 loan. In either case, a borrower may be awarded actual damages, statutory damages equal to twice the amount of the finance charge (but not less than $200 or more than $2000), and costs and attorney's fees. In a class action, liability reflecting actual damages plus penalties of the lesser of $500,000 or 1% of net worth, plus costs and attorney's fees may be imposed upon the loan originator or assignee. Claims for damages must be asserted by the borrower within one year, and by state attorneys general within three years, following the date of the TILA violation.
At any time following a TILA violation, a borrower may assert the violation as a defense in an action to collect the debt. An assignee who attempts to foreclose a mortgage loan is subject to the same recoupment and set-off defenses as the loan originator. Thus, an assignee's recovery in an action to enforce the loan may be limited if the borrower successfully relies upon a TILA violation to limit or preclude collection of the debt.
Courts may extend the limitations period for monetary damages for reasons of equity, which must typically involve some type of fraudulent concealment on the part of the creditor. The statute of limitations for rescission actions, however, may not be prolonged beyond the three year statutory term. Finally, borrowers may assert TILA violations as a defense to an enforcement action (e.g., foreclosure) after the expiration of the one year period without judicial permission.
Under RESPA, anyone providing "settlement services" for federally-related mortgage loans may be held liable for failure to adhere to its disclosure requirements and provisions regulating fees, insurance and escrow payments. RESPA exempts bona fide secondary market transactions and, consequently, assignees who take part in secondary market activities are exempt from liability under its provisions. However, RESPA defines the settlement services it regulates broadly. As such, "table" or "wet" funding mortgage loans in the secondary market is deemed a settlement service and may subject the acquiror to RESPA disclosure requirements.
It should be noted, however, that no federal case since 1979 has imposed liability for RESPA violations upon an assignee with no involvement in the origination of the acquired mortgage loans.
Penalties for RESPA disclosure violations may include actual damages, additional damages up to $1000, and costs and attorney's fees. In a class action, liability for additional damages (not including actual damages, costs and attorney's fees) is limited to the lesser of $500,000 or 1% of net worth. RESPA neither provides borrowers with a private right of action nor renders a loan void or voidable for violations of its provisions. However, borrowers may obtain an offset for monetary damages stemming from RESPA violations, which in turn could have a negative effect on the value of the loan or the income stream from the affected mortgage loans.
Steps to Mitigate Risk of Liability
As indicated above, participants in the secondary market who acquire residential mortgage loans could face liability under TILA to the extent that the seller of the mortgage loans has not indemnified them for such liability or to the extent that the seller is no longer solvent. Less obvious however is the risk faced by lenders who secure the loans that they make to their counterparties with residential mortgage loans as collateral.
Such lenders, relying upon their counterparties to repay the indebtedness, may not have assessed the potential risk that their collateral may be tainted by TILA or RESPA claims or set-off rights. Such lenders rely upon the collateral to mitigate their exposure to their counterparties' credit, but the value of their collateral may be reduced due to this taint. Magnifying the problem is the fact that while it may be easier to justify extensive due diligence of mortgage loans in connection with acquisitions of mortgage loans, it is less justifiable to conduct the same due diligence when the lender is not actually acquiring the mortgage loans.
To the extent that one hundred percent due diligence is cost-prohibitive, a lender or secondary market purchaser must seek other ways in which it can mitigate its risk of exposure to TILA or RESPA liability. To that end, set forth below are some techniques for conducting due diligence which are targeted towards uncovering potential problems while there may still be time to avoid liability. The choice of technique will naturally vary according to the unique circumstances of each situation. However, use of one or more of the techniques described herein should assist lenders and secondary market participants in identifying problems before they are exposed to liability which can no longer be mitigated.
Representations and Warranties
Do not rely solely upon representations and warranties. Unless the counterparty has a creditworthiness for which the purchaser or lender would be comfortable making a loan on an unsecured basis, representations and warranties as to the worthiness of the mortgage loans should not be the sole comfort regarding the quality of the mortgage loans. Although representations and warranties in a purchase or lending context are useful, they become meaningless once the counterparty who made them is insolvent.
Review form documents. If the counterparty has deviated from using standard Fannie Mae or Freddie Mac forms, review the counterparty's forms to ensure that they have proper protections and comply with applicable law.
Conduct extensive due diligence at the outset. At the beginning of a new relationship with a counterparty, conduct extensive due diligence on the mortgage loans it originates and its origination procedures.
Conduct Random Due Diligence
Conduct due diligence at sporadic times, either by spot-checking the counterparty's operations, or by conducting a random sampling or re-underwriting of mortgage files to ensure integrity of originations. Consider including in such review the following:
- Confirm whether required disclosures and notices appear to have been properly and timely prepared (including recalculating the various numerical disclosure items);
- Confirm whether required disclosures and notices appear to have been in the proper form;
- Confirm whether required disclosures and notices appear to have been timely and properly delivered;
- Compare the signatures on the file copies of the mortgage/deed of trust and note with original signatures on the compliance documents;
- Determine if the signatures are apparently the same or obviously different;
- Confirm whether the acknowledgements on the mortgage/deed of trust indicate they were signed before the notary, or the signatories were only personally known/identified to the notary; verify that the notary's commission had not expired prior to the execution of the mortgage/deed of trust;
- Analyze whether suspiciously different dates on the note, mortgage/ deed of trust and compliance documents indicate potential "back dating" of some signatures; and
- Confirm whether charges for items/ services shown on the disclosure documents differ from the cost for the same charges on other documents in the file.
Conduct Due Diligence Upon Any Organizational Change or Acquisition
Often if there is a significant organizational change or acquisition, there will be changes that affect the origination and/or underwriting of loans. In particular, in cases in which the counterparty has acquired a new branch or office, a secondary market participant or purchaser may consider visiting or conducting diligence on such branch or office to ensure that loan originations are made in accordance with the standards that it has relied upon for such counterparty.
Conduct Increased Diligence At the First Sign of Trouble
At the first indications of trouble with a counterparty, whether it is failure to make or remit payments on a timely basis, failure to deliver table-funded documents on a timely basis, or breach of financial covenants, a secondary market lender or purchaser should consider increased due diligence. Experience has demonstrated that there appears to be a correlation between an increase in TILA and RESPA problems for loans and a counterparty's increasing financial difficulties. Intuitively, it is easy to conclude that a company which is in need of money will use every effort to increase originations of loans in order to sell them in the market faster; this in turn could lead to at best, carelessness, and at worst, fraud, in connection with loan originations.