During the lending frenzy of the Millennium Boom, lenders aggressively solicited subprime borrowers unable to obtain conventional financing to accept adjustable rate mortgage (ARM) loans yielding high-interest rates. In the chaos, some loan brokers and unscrupulous mortgage bankers, also called warehousing lenders and wholesale lenders, arranged loans for subprime minority borrowers with higher loan fees than would be arranged for similarly qualified Caucasian subprime applicants. These brokered loans were then fed to other mortgage bankers, as well as commercial banks and thrifts. The lenders funding these defective loans then resold them in bulk to bankers on Wall Street. Wall Street bankers bundled the loans into mortgage-backed bonds (MBBs) for purchase by bond market investors.

As the loan passed from hand to hand, the logical question arose: could the lender who funded a loan packaged and originated by a corrupt mortgage banker or loan broker be liable for their improper conduct?

The United States Justice Department recently made an example of two mortgage banking subsidiaries of the Wall Street investment bank American International Group, Inc. (AIG).  Due to a breach of fair lending laws in the arranging and packaging of mortgages they funded, the AIG subsidiaries must pay $6.1 million in restitutions to minority borrowers who were charged excessive loan fees. Both mortgage banking subsidiaries must also pay $1 million towards consumer financial education programs.

The moral of the story: whoever funds the loan is liable for defects in its origination. Mortgage bankers who aggregate loans must ensure the loans are compliant with fair lending laws, otherwise they will be left holding the bag. The hope is that forcing mortgage bankers to be more vigilant about fair housing practices of those who take loan applications, package the documentation and arrange loan terms and charges for the loans they eventually fund will result in less corruption.

However, the precedent set by the Justice Department has inevitably sparked great contention within the mortgage lending community which persists in claiming that mortgage bankers should not be liable for illegal acts performed by others prior to loan funding. The mortgage banking industry expresses fear that this precedent will make the large lenders who ultimately purchase loans, such as Wall Street bankers, unnecessarily paranoid and wary of dealing with loan originators, and thus decrease the number of players competing to make loans within the mortgage market – driving up fees for all who remain involved.

first tuesday take: Perhaps a quick review of how mortgage bankers function in the real estate market would be instructive.

The mortgage banker, who does not need a Department of Real Estate (DRE) license as does a real estate broker, is responsible for processing and reviewing all of the documentation in a loan package. Mortgage bankers have extensive lines of credit which they use to fund the loans transmitted to them by DRE-licensed loan brokers. Brokers are the primary source of the loans funded by mortgage bankers.

However, mortgage bankers are not the permanent lenders of these warehouse-funded loans and have no intention of holding the loan for the long term. Mortgage bankers conduct business by funding and collecting the loans fed to them by loan brokers (and those handled entirely in-house) and selling them in bulk to larger lenders for permanent funding. Typically, the loans are further disbursed into the MBB market, a process called securitization.

Essentially, mortgage bankers sandwich themselves between the originator of a loan (the broker) and the ultimate investor in the Wall Street bond market pool. Thus, mortgage bankers are primarily middlemen who are financially supported by another entity – the Wall Street banks or large lenders who end up purchasing the wholesaled loans, then bundle them for purchase by investors in the MBB market through securitization.

The above situation is precisely what Real Estate Settlement Procedures Act (RESPA) lenders sought to avoid under the Secure and Fair Enforcement for Mortgage Licensing (SAFE) Act. The SAFE Act is designed to reduce fraud and enhance consumer protection by pointing the “finger of blame” at loan brokers who solicit and funnel applications and loan packages to mortgage bankers, who must now register with the federal government. The parachute of the SAFE Act is not unfurling as expected, and the registration and endorsement of RESPA loan broker licensees and federal regulations for packaging loan applications has made all real estate brokers and agents the class of victims now tangled in the cords.

In re: “Obama administration adopts get-tough stance on mortgage bias,” from the Los Angeles Times