Thursday, March 7, 2013

Securities, Mortgages, and Good Faith and Fair Dealing

According to The Washington Post, in 2012, the government began suing banks for reckless and fraudulent mortgage lending practices that cost the it hundreds of millions of dollars- namely Wells Fargo. Subsequently, some of these banks went into foreclosure.  Wells Fargo and many other banks made bad loans to struggling homeowners. So when the homeowners stopped making payments, the loans defaulted leaving the government to pay huge insurance payouts to the bank. 

But the issue turns on whether the banks acted knowingly and without good faith when making and issuing these loans. To act fraudulently is to knowingly misrepresent or lie in the circumstance. However, within core business dealings, in the common law of the United States anyway, there is an inherent and underlying duty to act with good faith and fairly deal (GFFD). This GFFD standard is especially to be upheld when a financial scanter, such as a bank institution, works with a non financial scienter such as the common home buyer. 

Of course the Government and any other government sponsored entities (GSE) (like theFederal Housing Financing Agency, Federal National Mortgage Association, or the Federal Home Loan Mortgage Corporation) who purchased certificates issued in hundreds of residential mortgage backed securities (MSB) offerings will allege that the banks knowingly made fraudulent misrepresentations, and thus, acted in bad faith when making and issuing mortgage loans to the home buyers.

Naturally, the banks will argue that they acted in good faith as prudent and responsible lenders in compliance with the federal housing rules of the GSEs. But can this argument stand when there is direct evidence of paying bonuses to staff? Remember when President Obama’s Financial Fraud Enforcement Task Force brought five similar lawsuits against CitiMortgage for mishandling money. Or when the Obama Administration rescued Wall Street and other banks? This was known as the bailout, in which one entity gives a loan to a company that faces serious financial difficulty or bankruptcy.   

Confused yet? Well let’s look at what happens to your mortgage when you sign the dotted line? 

1.       You, (the borrower) work with a broker or directly with a lender to get a home-purchase loan or a refinancing.  The borrower gets the financing needed to purchase a home or cash from refinancing. If the loan goes bad the house can be repossessed.

2.       The broker finds a lender who can close the loan. They usually have a working arrangement with multiple lenders. The broker takes fees for doing the preliminary sales and paperwork and may get cut from the lender’s approved broker list.

3.       The lender often funds the loan through a ‘warehouse’ line of credit from an investment bank. Then sells the loan to the investment bank. He takes his fees upfront for making the loan. He can also be forced to take the loan back if there is an early default or documentation is questionable. 

4.       The Investment Bank packages the loans into a mortgage-backed bond deal often known as a securitization (aka the mortgage-backed security). The investment bank (IB) now sells the securitization sorted by risk to investors. Lower-rated slices take the first defaults when mortgages go bad, but offer higher returns. The IB collects fees for packaging the loans into a bond deal. It may push back the loan to the lender or be forced to eat any loss. 

5.       The Investors choose what to buy based n their appetites for risk and reward. The lower the risk the lower the reward and the higher the risk, the higher the reward. The investor earns interest on the bonds and absorbs any gain or loss in price of the bond. May have legal recourse against bank if they can show the quality of the loan or loan documentation was misrepresented.

As the outline lists, many of these financial scienters have access to your paper work and get a fee for the work that is done in connection to acquiring your loan after you sign that dotted line. So there is a lot of room for that GFFD to go out of the window. Of course, if that occurs, you will not know about it until you default on your loan, but even then, it may be difficult to pin point who did what and when.  Therefore it is very important to do your financial research before you sign the dotted line.

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