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HuffPo: HUD IG Finds Servicing Fraud

posted by Adam Levitin

Shahien Nasirpour at Huffington Post has broken a story that HUD's Inspector General has conducted an audit of FHA-insured loan foreclosures by the big 5 servicers (BoA, JPM, Wells, Citi, Ally) and concluded that they have been defrauding the government by filing for FHA insurance payments to cover losses "on foreclosed homes that sold for less than the outstanding loan balance using defective and faulty documents."  Shahien reports that the HUD IG has referred the matter to the Department of Justice for potential False Claims Act (defrauding the government) suit.  

Three things are worth noting here. First, the HUD IG seems to have been able to conduct a much more thorough review of foreclosures than any of the bank regulators.  The HUD IG's office has a small staff. Compare this with the enormous examiner teams at the disposal of the OCC and Fed. Yet somehome the HUD IG has been able to accomplish a much more insightful review than the federal bank regulators. The clear implication here is that regulatory motivation matters in investigations. HUD has its own money (the FHA insurance fund) on the line. HUD doesn't want to be defrauded. Compare that to the OCC, which makes its money by chartering banks. The OCC wants to keep the banks happy. And that means looking the other way. Regulatory incentives matter. Makes one wonder what the AGs or CFPB will turn up (shudder) if/when they get into the mix.  

Second, the all-clear sounded by the OCC and Fed on the servicing front just isn't credible. This is a major problem for the US financial recovery. Financial regulators are the guarantors of the credibility and soundness of the US banking system. The financial system is built on trust. In fall 2008, that trust disappeared and there was paralysis until the US government substituted its own credit for those of the major banks. But that's a situation that no one wants to continue indefinitely. To ween ourselves off of the government, however, the market must be confident in the quality of the banks' books. And that's where the federal bank regulators' credibility comes into play.

If it looks like the OCC and the Fed are sweeping the problem under the carpet here, why should markets feel any more confident about the stress tests or anything else about the US banking system? The banks' paperwork problems are proving hard to paper away. The banks' failure to do their paperwork correctly because it was cheaper not to might well be the most serious source of systemic risk in the US financial system at present. 

Third, it's worth noting that irrespective of whether DOJ pursues the HUD IG's findings under the False Claims Act, HUD has a major disciplinary tool at its disposal:  FHA lender eligibility.

Irrespective of the existence or outcome of a False Claims Act suit, HUD can at its sole discretion declare any or all of the financial institutions in question ineligible for making FHA-insured loans. It could do so permanently or temporarily. But that's some pretty powerful leverage, given that FHA is now doing 15% of the market

If anyone's interested in the legal mechanics, here's how they work. In order for a lender or mortgagee to get FHA insurance on its loans, it must be approved by HUD, which requires meeting various eligibility requirements.  Two of these requirements are particularly pertinent:  

 To be eligible, a lender must not:

(3) Be subject to unresolved findings as a result of HUD or other governmental audit, investigation, or review;

(4) Be engaged in business practices that do not conform to generally accepted practices of prudent mortgagees or that demonstrate irresponsibility;

...

(7) Be in violation of any other requirement established by the Secretary.

24 C.F.R. 202.5(j)(3)-(4), (7).  The "other requirement" provision can bootstraps in all of FHA and GNMA's servicing standards, etc. (24 C.F.R. 202.5(e) does so directly, however.) 

Approval must be recertified annually and may be terminated by the HUD Secretary (in accordance with the contract-which I haven't examined for this) with 5 days notice. 24 C.F.R. 202.3.  If the termination is due to fraud, it relieves FHA of liability on the insured mortgages. And that means the credit risk would go right back onto the fraudster bank. (Of course, if the bank actually failed, the risk would move over to the rest of us, which is a pretty sad state of affairs.) 

HUD's decision would be subject to judicial review, but under a very deferential standard, and the likelihood of a preliminary injunction is remote.  So, at the very least, HUD could make these banks ineligible for a while and hold their feet to the fire.  It could probably make them ineligible prospectively, and it might even be able to get out of its current insurance liability from them. 

Whether HUD is willing to use this leverage remains to be seen. That's a political decision that probably rests in the White House, not at HUD, and I could see Treasury in particular being very adamant that the US housing market is too fragile to stand any of the big 5 being shut out of the FHA sector.  (Never mind that the fragility is in substantial part because Treasury is unwilling to bite the bullet on negative equity.) But if DOJ pursues a False Claims Act and HUD does not revoke eligibility, isn't that a sign that we've truly succumbed to too-big-to-fail syndrome? 

Comments

Do you really believe that Justice will pursue a False Claims Act? I've lost all trust in Holder, I guess.

I don't think US regulators have the stomach to play chicken with the big five. According to all the consultants they are too big to fail, sue, or reprimand.

Can't thank you enough for staying on top of this, Professor.

I'm almost certain that a sternly worded letter is being drafted this very moment.

I wonder if the compliance of the smaller banks is likely to be superior to the big 5's. Because, if there isn't a better-complying lender to step up to fill the market share of an excluded lender, there isn't any real compliance gain from excluding any of these lenders. One could argue a deterrent effect, but I suspect that the deterrence might just drive volume down so the sector just shrinks because the cost of strict compliance eats so far into margins on the product that it renders it an inferior use of bank capital. Regulators and prosecutors would then have to consider the potential net reduction in housing finance relative to the exercise of any sanction.

Has anyone taken a look at (Townsend v. BAC Home Servicing LP SD Tex)?

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