Ed. #57: A Tale of Two Decisions

I really do try to keep discussion about legal case law decisions to a minimum in these Musings. Unfortunately, sometimes the machinations of our justice system have such a huge impact on the mortgage business that I am compelled to share my thoughts. I will try to keep this at an level all non-lawyers will understand. With that said, February 3, 2023, was an interesting day to say the least for mortgage banking lawyers.

“It was the best of times, it was the worst of times.”[1]

By now, most readers will have heard that after years of litigating[2], the CFPB’s “envelope pushing” fair lending case against Townstone Mortgage was shot down like a Chinese spy balloon (and took almost as long). US District Court judge Franklin Valderrama dismissed the case against Townstone and told the CFPB in no uncertain terms that their vehemently held, but poorly supported interpretation about Reg B/Equal Credit Opportunity Act applying to “prospective applicants” was wrong. At this time, we do not know if CFPB plans to appeal the decision to the 7th Circuit Federal Court of Appeals.

What you may not have heard about, however, was that the same day, the 8th Circuit issued a decision against Primary Residential Mortgage, Inc. (PRMI)in the last remaining case in the long-running disputes[3]with RFC’s bankruptcy liquidator, the Res Cap Liquidation Trust over mostly pre-meltdown stated-income loan losses. Any chance of successful appeal of that 8th Circuit decision seems highly remote. So, while Townstone had compliance lawyers and other professionals giving each other social media high-fives on the fair lending front[4], on the same day, mortgage company owners, CEOs and CFOs got a gut punch from the RFC/PRMI decision about bet the company litigation, loan sale agreement repurchase and indemnification liability and the importance of reading and negotiating contract language and terms before signing.

Because I have written frequently about fair lending issues and Townstone in particular, I will start with my thoughts on that, but the implications I see for the RFC/PRMI decision may loom just as large for the industry. Nevertheless, the risks posed by the RFC/PRMI decision are still much easier to avoid than to execute fair lending compliance because fair lending is alot more than just a matter of contract between commercial parties.

Townstone Decision: CFPB gets forked

Last April, I was hopeful that CFPB Director Rohit Chopra would do more to limit CFPB’s overreaching interpretations, but, especially in the fair lending arena, CFPB’s enforcement staff pressed their interpretations beyond the limit. For example, the CFPB’s enforcement efforts to challenge mortgage company marketing efforts in reliance on the “prospective applicant” interpretation played a starring role in the Trident Mortgage consent order[5](see my discussion of that at https://mortgagemusings.com/f/ed-50-trident-gets-forked)

To be clear, no one previously had the resources[6]and/or will to take the federal government to court over a fair lending enforcement challenge. All other enforcement actions ended in settlements and consent orders. So, despite decades of aggressive fair lending enforcement premised on the CFPB’s “prospective applicant” interpretation, no court had ever ruled on whether ECOA actually says that prospective applicants are protected. With Townstone, however, finally, a judge has told the government that its expansive view of ECOA extending to prospective applicants is unsupported by the law (federal judges have the final say in interpreting federal laws, not administrative agencies[7]).

Despite using words like “thus” and “therefore”, the key point of Judge Valderrama’s Townstone opinion is easy to understand,

“The plain text of the ECOA thus clearly and unambiguously prohibits discrimination against applicants, which the ECOA clearly and unambiguously defines as a person who applies to a creditor for credit. 15 U.S.C. §§ 1691(a), 1691a(b). The Court therefore finds that Congress has directly and unambiguously spoken on the issue at hand and only prohibits discrimination against applicants.”

A victory for the rule of law

In his decision dismissing the case against Townstone, Judge Valderrama also recounted many of the statements made by Townstone’s owner on his radio show that were alleged by the CFPB to discourage African-American prospective applicants from applying for mortgage loans from Townstone. Those statements, however, were irrelevant to Judge Valderrama’s simple legal conclusion.[8] Simply put, Judge Valderrama told the CFPB that he doesn’t agree with the CFPB’s interpretation of Reg B applying to “prospective applicants”. Rather, he told CFPB that ECOA only applies to ‘applicants” and that means whatever someone says on a radio show that may be discouraging or even whatever lending patterns and advertising may or may not exist doesn’t matter under ECOA unless CFPB can show how it impacted applicants.

The Townstone decision is a great example of a legal decision highlighting what lawyers mean by a victory for the rule of law. As noted previously, CFPB has a penchant for overreaching in its interpretations to move the law in the directions it desires, but often doesn’t want to go through the Constitutionally and Congressionally required hoops to do that correctly. We’ve seen this frequently in the fair lending arena, but it was also key to the decision of the DC Circuit in the PHH case involving RESPA. This imperious kind of government agency behavior is what civil libertarians often decry when they speak about the “administrative state”. To be clear, however, for all of his lost reputation and business opportunity and money spent on legal defense, Townstone's owner gets nothing back from the government. Not even an apology. This win only helps other mortgage lenders, so he and lawyers who worked on this case deserve the industry's gratitude.

Townstone's impact

Assuming it is not successfully appealed by CFPB, Townstone will set a new course for fair lending compliance, reversing the CFPB’s positions in many recent settlements. For example, claims such as those in the Trident Consent Order regarding the lender’s lack of marketing and outreach will likely be significantly different post-Townstone. Yet as noted by Judge Valderrama in a footnote,

“the Court does not analyze whether the ECOA’s prohibition on “discrimination” encompasses “discouragement.” The Court likewise does not reach Defendants’ argument that the CFBP is attempting to create affirmative obligations with respect to marketing and the hiring of loan officers, nor its arguments under the First and Fifth Amendments"

That said, Townstone also doesn’t address any alleged violations of the Fair Housing Act (or state law) which were also raised in Trident and are typically enforced by other prosecutors. In that regard, it is notable that the Justice Department declined to prosecute Townstone for the claims noted in the CFPB’s pleadings. That said, Townstone is not the end of fair lending risk by any stretch. Fair lending enforcement remains a huge priority for both the Justice Department CFPB and many state attorneys general, and it remains to be seen whether the CFPB will appeal. Besides, the housing industry still has alot of work to do to address racial homeownership gaps.

PRMI gets forked

Meanwhile, the relief offered by the Townstone decision last Friday was counterbalanced by the tragedy of the RFC/PRMI decision. There you have a mortgage company who, after years of litigating, is now faced with a final order to pay over $5 million in loan related losses with another $16 million in legal fees, costs and interest. Brutal.

As I said to Rob Chrisman, there is no way to sugar coat this case for a mortgage originator who sells loans on the secondary market. It means that contracts signed by commercial parties mean what they say, and you don’t get point out later that the deal was terrible for you[9]as if you are a consumer who is entitled government protection from an unscrupulous business practice. Mortgage originators should read this and understand they are unlikely to get much sympathy from a court of law for bad agreements they sign.

I’m going to skip the entire history of this litigation against many in the industry because 8th Circuit Judge James Loken did that in outstanding fashion in the opinion. In fact, I highly encourage every mortgage banking lawyer to read Judge Loken’s entire decision before providing legal counsel in connection with mortgage banking loan sale agreements going forward. Nevertheless, I am going provide a summary of some key loan sale agreement issues in order to explain how this could happen and what can be done.

Loan Sale Indemnification Basics

Most loan sale agreements for mortgage loans sold on the secondary market were drafted by high-priced East Coast lawyers[10]well before the subprime meltdown on behalf of loan purchasers to protect those buyers and to enable securitization of loans from various sources. That means these agreements are very one-sided in favor of loan purchasers. Sellers rarely seek (or are unable) to negotiate the terms of these agreements which have pages and pages of representations and warranties about the loans that they sell. These agreements further require sellers to indemnify[11]the buyers for any losses due to defective[12]loans. Trillions of dollars of mortgage loans have been sold and securitized under the terms of these kinds of agreements, including loans securitized by Fannie, Freddie and GNMA.

The risk allocation idea with these indemnification provisions is that the originating seller is in a better position to prevent the risk of loan losses than the purchasing investor and thus should be charged with ensuring loan underwriting quality, consistency for securitization and data integrity. But, is that loss prevention idea true of all losses? E.g., do origination defects have anything to do with job losses in a down economy?

Unfortunately, based on the language in the RFC/PRMI agreement, the 8th Circuit determined that under Minnesota law, none of the following types of defenses mattered:

· Were proper default/loss mitigation servicing processes used?

· Why did each loan go into default?

· How much was the loss on each PRMI loan?

· Was the loan product itself defective?

· Did the investor have knowledge of the loan defects or were they negligent themselves?

· Is it enforceable to allow one party “sole discretion” to determine loan defects?

· Is it fair to have a loan seller be responsible for losses of a buyer that far exceed the value of the loans that were sold (including the buyer’s attorney’s fees and interest on that amount)?

So, rather than look to see what the loss was on each defective loan, damages were determined based on an allocation formula looking at the entire loss to the Res Cap Trust. Res Cap had agreed to globally settle all of the claims in its bankruptcy proceeding for a discount which the court found to be reasonable in that case. RFC’s damages expert then just applied an allocation formula to Res Cap’s total loss back to each originator, including PRMI's $5.4 million.

PRMI was the only lender who never settled with Res Cap. All of the others who settled previously should read this decision and be grateful for their settlements which no doubt seemed like a bad deal at the time. But, more than that, the mortgage industry needs to come to grips with the problems this case highlights in contracts for sale of loans that create moral hazards for loan purchasers to act irresponsibly in loss mitigation and pose contingent liability issues for originators that accountants are unable to accurately capture for reserve and balance sheet protection.

What is the lesson of RFC/PRMI?

The same loan sale agreements that were in place before the subprime meltdown continue to be signed today, and in many respects have become even worse for originators. Fannie and Freddie have, however, adjusted their defect taxonomy and dispute resolution process for the better, but repruchase claims are beginning to climb again. That said, if in 2008, instead of conservatorship and 15 years of subsequent profitable operation, Fannie and Freddie had been put into bankruptcy like RFC instead of seeking damages loan by loan, I imagine that every mortgage lender would have been put out of business.

I raised similar issues previously in the early days of the pandemic when it seemed that we were heading for another meltdown which could result in massive losses getting passed back to originators. Fortunately, and surprisingly, real estate values did not decline during the pandemic, forbearance flexibilty and a rising market prevented foreclosures, and full employment returned quickly, so that tragedy was averted.

Nevertheless, these loan sale agreement indemnification provisions pose extinction level risk to mortgage originators. While indemnification for fraud and truly egregious origination practices leading to losses should remain unlimited, mortgage banking owners, securitizers and attorneys should seek a new risk allocation balance on the scope of loan loss indemnification for origination errors.

[1]The full first paragraph of the book reads, “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way—in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.” Reminds me of every time ever.

[2] No doubt the parties were engaged in negotiations for a much longer time frame.

[3]ResCap sued dozens of lenders beginning in 2013 and again with a second round in late 2016. All of those defendants have either settled or lost in court. PRMI was the last company left standing.

[4]Specifically, Rich Horn and Marx Sterbcow, mortgage industry attorneys who’s names have been mentioned in previous Musings, deserve high praise for their work on Townstone.

[5] As s reminder, a consent order is just a settlement of a dispute. It doesn’t reflect any legal precedent or statement of the law.

[6] Among other attorneys, Townstone was represented by the Pacific Legal Foundation.

[7] See, US Constitution, Article II.

[8] I offer no opinion on why Judge Valderrama felt it was nevertheless important to recount those statements in his decision.

[9]Hindsight is 20/20

[10]Not me, of course. I’m a Midwest attorney.

[11] Indemnification is essentially an agreement to cover someone else’s damages. Basically its another way of saying “insure”. There are other remedies besides indemnification, such as repurchase obligations, but that’s not important to my discussion.

[12]Loans that do not comply with the representations and warranties.