A&B Abstract:

According to a recent edition of Inside Mortgage Finance, correspondent lending is the only lending channel that posted gains in Q3 2023. While it is always nice to see gains, it should also serve as a reminder to take a fresh look at your risk management program to ensure it is calibrated to address the unique risks of correspondent lending.

To level set, we define a correspondent lender as one who performs the activities necessary to originate a mortgage loan, i.e., takes and processes applications, provides required disclosures, and often, but not always, underwrites loans and makes the final credit decision. The correspondent lender closes loans in its name, funds the loans (often through a warehouse line of credit), and sells them to an investor by prior agreement.

The risk that correspondent misconduct poses to an investor falls broadly into three categories:  legal risk, reputational risk, and credit risk. Legal risk refers to the risk that the investor will be subject to legal claims based on the misconduct of the correspondent, or that the correspondent misconduct somehow will impair the investor’s rights under the loan agreements. Reputational risk refers to the risk of damage to the company’s reputation among investors, regulators, the public at large, counterparties, etc. Credit risk refers to the risk that correspondents will fail to conform to the investor’s underwriting guidelines or credit standards. We include fraud within this category.

In this post, we provide, in our assessment, an overview of the types of claims that pose the greatest legal risks, as well as best practices to mitigate such risks.

Theories of Liability on Assignees

The following laws and/or legal theories, in our assessment, pose the greatest risk of either vicarious liability or economic risk to assignees for the misconduct of correspondents:

• Holder in Due Course:  Under the Uniform Commercial Code, if an assignee or “holder” of a mortgage loan rises to the level of a Holder in Due Course, it can enforce the borrower’s obligations notwithstanding certain defenses to repayment or claims in recoupment that the borrower may have against the original payee. If Holder in Due Course status is never attained or is lost, the purchaser of a mortgage loan will be subject to certain defenses to payment and claims in recoupment that the mortgagor may have against the original payee.
• Truth-in-Lending Act (TILA): An assignee may be exposed to civil liability for a TILA violation that is apparent on the face of the disclosure statement.  In addition, for certain violations of TILA, a consumer may have an extended right to rescind a loan for up to three years from consummation. The consumer may exercise this right against an assignee. Moreover, amendments to TILA pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) expand the liability of assignees in connection with certain TILA violations, including violations relating to the TILA-RESPA Integrated Disclosure or TILA’s ability to repay, loan originator compensation, and anti-steering provisions.
• Home Ownership and Equity Protection Act (“HOEPA”) / Section 32 “High Cost” Loans: Subject to certain exceptions, an assignee of a HOEPA loan is subject to all claims and defenses with respect to the mortgage that the consumer could assert against the original creditor.
• Equal Credit Opportunity Act (“ECOA”): ECOA’s broad definition of “creditor” may place liability on assignees for the statute’s anti-discrimination and disclosure requirements where the assignee “regularly participates” in the credit decision.
• State and Local Anti-Predatory Lending Laws: A number of states have passed anti-predatory lending laws that contain assignee liability provisions similar to those found in HOEPA with triggers that may differ from HOEPA. An assignee of a loan covered by such a state law will be subject to certain claims and defenses with respect to the mortgage that the consumer could assert against the original creditor.
• Aiding and Abetting: Under the common law theory of aiding and abetting, loan purchasers and other parties can be held responsible for the acts of the lender that originated the loan, particularly if they (i) knew that the originating lender was engaged in “predatory” practices, and (ii) gave substantial assistance or encouragement to the originating lender. The Dodd-Frank Act also imposes aiding and abetting liability.
• State and Federal Defenses to Foreclosure: Certain state laws expressly provide that a violation of the law may be asserted by a borrower as a defense against foreclosure, either as a bar to foreclosure or as a claim for recoupment or setoff. In addition, courts may invoke UDAP or UDAAP statutes or equitable remedies to prevent an originator or assignee from foreclosing on a loan that the court views as abusive or unfair.  Finally, as noted above, violations of TILA’s ability to repay, loan originator compensation, and anti-steering provisions may also be raised defensively to delay or prevent foreclosure.
• State Licensing and Usury Laws: Certain state laws provide for the impairment of the mortgage loan if the originating lender was not properly licensed or the loan exceeded state usury limits.
• Challenges to Ownership: Plaintiffs are increasingly raising concerns about investors’ or servicers’ authority to foreclose when the investor cannot produce original loan documents or otherwise verify ownership of the loan, although this risk is lessened when an investor acquires the loan directly from the original creditor.

The list above reflects the laws and legal theories that are most commonly used to impose liability on assignees and/or that we believe will be of increasing prominence going forward. There are other federal and state laws that might also expose assignees to liability, either expressly or by implication. There are also claims against an assignee based on the assignee’s own misconduct in connection with the origination of the loan. An example of a direct claim against an assignee related to loan origination would be a claim under fair lending laws that the underwriting criteria that the assignee established and provided to its correspondents violated fair lending laws. Of course, there are plenty of other risks that the assignee may need to manage, such as the risk of loss from fraud perpetrated against the assignee by borrowers or correspondents; the risk of correspondents’ non-compliance with the investor’s underwriting criteria; or the risk of liability from servicing violations.

Best Practices to Mitigate Correspondent Lending Risk

A financial institution should consider adopting the following best practices to mitigate against the legal, reputational, and credit risks presented by correspondent lending relationships, to the extent the institution has not done so already:

• Ensure that its compliance management system reflects the legal and regulatory requirements relevant to correspondent lending activity and the risks presented by correspondent lending relationships, that the company has in place monitoring, testing, and audit processes commensurate with such risks, and that the company’s compliance training includes material relevant to the management of correspondent lending relationships and their associated risks.
• Prepare written policies and procedures that explain comprehensively the steps the company takes to minimize the risk that it will be subjected to liability for violations by correspondents.
• Conduct due diligence reviews to ensure that correspondents are properly licensed, particularly in those states in which the failure to be licensed could impair the enforceability of the loan.
• Conduct company-level due diligence reviews of correspondents to assess whether the correspondent is willing and able to comply with applicable laws and avoid engaging in practices that might be considered predatory. This might involve reviewing the company’s policies and procedures, examination reports prepared by regulators (to the extent that such reports are not confidential), repurchase demands made against the correspondent, internal quality control reports, complaints received from consumers and regulators, and information about litigation in which the company is involved.
• Interview correspondents regarding their policies and procedures designed to prevent predatory sales tactics and other predatory lending practices.
• Question correspondents regarding the measures they use to oversee and monitor the brokers with whom they do business.
• Perform loan-level reviews to ensure that loans (1) do not exceed HOEPA and state/local high cost loan law thresholds, (2) exceed state usury limits (particularly in states in which the failure to comply can impair the enforceability of the loan), (3) either are not covered by state or local anti-predatory lending laws or comply with the applicable restrictions under those laws, (4) comply with state usury restrictions, and (5) do not contain other illegal terms or predatory features.

Takeaway

With correspondent lending volume on the rise, now is a good time to review and possibly refresh your risk management approach to ensure it is commensurate with the risks presented by correspondent lending relationships.

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