Managing Director
Lenders Compliance Group
I am often asked if there are significant
compliance risks involving third parties in mortgage banking. The answer is:
without a doubt! In providing some insight, I will just mention three of the
many types of third parties that pose such risks: mortgage brokers, mortgage
lenders, and mortgage servicers.
Let’s be clear at the outset: managing
third-party risk is critical for providers of consumer financial products and
services. This is because financial institutions (“FI”) can be and often are themselves
held liable for the practices of third parties acting on their behalf. Where
there is contact with the public by third parties, directly or indirectly, on
behalf of the FI the risk is substantively greater. From the point of view of
technological factors, service providers may be integrated into an FI’s
business operations. As such, this can lead to enforcement actions in which
certain violations of consumer protection laws are alleged against the service
provider and the FI itself!
It is the case that regulators have affirmed
their intention to hold companies strictly liable for conduct of their agents.
The legal principal invoked is usually the theory of “vicarious liability.”
Just a few years ago, in October 2015, the Department of Housing and Urban Development
(“HUD”) proposed rules to formally codify third-party liability standards under
the Fair Housing Act, including strict vicarious
liability for acts of an institution’s
agents, as well as direct liability for negligently failing to correct
and end discriminatory practices by those agents.[i]
Consider the risk posed by mortgage brokers.
For many years, an area that has seen a lot of fair lending enforcement and
class action litigation has been the wholesale mortgage lending industry. Since
mortgage lenders close loans originated by independent mortgage brokers, regulators
and private litigants have brought enforcement actions and lawsuits alleging
that lenders have failed to monitor and control discretionary mortgage broker
pricing and product selection practices. In these cases, it has been alleged,
under the disparate impact theory, that the mortgage lenders have violated the
Equal Credit Opportunity Act (ECOA) due to pricing disparities disfavoring
racial and ethnic minorities.
In fact, since 2010 there have been several Department
of Justice (DOJ) and Consumer Financial Protection Bureau (CFPB) enforcement
actions, as well as lawsuits filed by cities, against wholesale mortgage
lenders under this theory.[ii]
Most of the mortgage pricing fair lending
enforcement actions to date have focused on conduct that predates April 2011,
when regulations by the Federal Reserve on loan originator compensation first
took effect. I have written extensively on the features of the loan originator
compensation requirements that went into effect on April 6, 2011, if you are
interested in reading more about these rules.[iii]
The loan originator compensation regulations prohibit compensation to mortgage
loan originators based on, among other things, discretionary loan pricing or
product steering by a broker based on a financial incentive to a product not in
the consumer’s interest.[iv]
Although these changes in the law have reduced
pricing’s influence on fair lending risk, they have certainly not eliminated
the risk entirely. For instance, in December 2015, the DOJ brought an
enforcement action against Sage Bank in Massachusetts relating to disparities
in revenue earned on retail mortgage loans to minority borrowers compared to
that on mortgage loans to non-minority borrowers. What is notable about this
action is that it was the first pricing discrimination enforcement action that focused
on loans made after the loan originator compensation rules took effect in 2011.
Obviously, it demonstrated that regulators are continuing to focus on mortgage
pricing discrimination issues.
But fair lending is not the only compliance
risk associated with wholesale lending. Other risks include Unfair, Deceptive,
or Abusive Acts or Practices (referred to collectively, “UDAAP”) and related
areas. In fact, the CFPB issued guidance on UDAAP in its Supervision and Examination Manual of October 2012.[v] With
the benefit of time, litigation, guidance, and examinations, among other
things, we can say that these risks arise because mortgage brokers play a key
role in marketing, discussing product benefits and terms with applicants and
guiding their product choices, providing disclosures, completing applications,
and gathering documentation in support of the loan applications. It stands to
prudent reasoning that, in addition to fair lending, oversight of an FI’s
mortgage broker network is critical for mitigating UDAAP risk and managing
other compliance requirements.
When we move from a consideration of risks
associated with mortgage brokers to those posed by mortgage lenders the risk
profile is neither better nor worse, but, as the saying goes, it is different. Much risk tends to congregate
around fair lending in secondary market transactions. For instance, in the case
Adkins v. Morgan Stanley, plaintiffs
alleged that the policies and procedures of Morgan Stanley, which had purchased
loans from subprime loan originator New Century Mortgage Company, had created a
disparate impact on African-American borrowers. If as alleged, this would be a
violation of the Fair Housing Act (FHA), ECOA, and state law.[vi] Although
the court dismissed the ECOA claims as time-barred, it allowed the FHA claims
to proceed, holding that plaintiffs’ allegations were sufficient to state a
claim of disparate impact discrimination. In the ruling, the court stated that
the FHA expressly applies to secondary market purchasing of mortgage loans. It
further emphasized allegations relating to Morgan Stanley’s warehouse lending
commitments, on-site due diligence of New Century loans, demand for loans with
alleged “high-risk” features, and instructions to originate no-documentation
loans when it appeared that the applicant could not afford the loan. In its
conclusion, the court noted that the evidence was sufficient to support claims
that Morgan Stanley’s policies “set the terms and conditions on which it would
purchase loans from New Century” and that these terms and conditions had
resulted in a disparate impact when they caused New Century to issue toxic
loans to the plaintiffs.
In the case In re Johnson, a Chapter 13 debtor alleged that a loan originator
had targeted minority borrowers for predatory loans, and that the purchasers
and assignees “were involved in this enterprise of selling toxic loans and
targeting vulnerable minorities” because the loans were originated with
securitization as the ultimate goal.[vii]
Although the court dismissed the complaints on the ground that the plaintiff
had not alleged sufficient facts to support the claims, it did not summarily reject
the proposition that a secondary market purchaser could be held liable under
ECOA or the FHA.[viii]
My point is that fair lending scrutiny of not
only mortgage lenders, but also their investors, will likely increase in the
coming years as new Home Mortgage Disclosure Act (HMDA) reporting requirements,
finalized in October 2015, will provide greater insight into the role of
investors in the loan origination process.
