Pfeifer & Reynolds LLP - Attorneys at Law

A LEGAL SAFTY NET

Article appearing in "Mortgage Banking, - The Magazine of Real Estate Finance,"
June, 1995. Written by: Michael R. Pfeifer, Esq.

Repurchase demands from buyers of loans that later go sour have long been dreaded by mortgage lenders. Until now, few have legally contested these demands. But with a wave of buyback requests descending on lenders, more are exploring what legal protection might exist to shelter them from this heavy burden.

 

WITH ORIGINATION INCOME PLUMMETING, BALANCE SHEETS HEMORRHAGING and layoffs decimating operations and management, the end of the refinance market has forced mortgage lenders to take extraordinary measures to slash expenses. More than a few are scrambling for new sources of income simply to survive. Just when it seems things couldn't get worse, many are now facing massive repurchase demands from investors on substandard loans long since sold and forgotten. Originated when quality control was stretched then during the refinance frenzy, some of these loans may involve liabilities of several hundred thousand dollars. Even with just two or three such loans, the consequences can be devastating. This is especially true for mortgage bankers because most repurchases cannot be financed with warehouse lines.

 

Evidence is starting to mount that many bad loans passed through the quality control safety net during the massive refinance boom. For example, the FBI estimates that as many as 25 percent of the federal tax returns provided by Californians seeking mortgages during 1993 had misrepresentations in them, and as much as $100 billion in mortgages originated in California in 1993 and 1994 was made to borrowers providing misinformation on loan applications, according to National Mortgage News.

 

Servicers that did not originate these loans, yet are currently servicing them, are not immune to the threat of repurchase. Many investor agreements make no distinction between seller and servicer in the representations and warranties they are required to make regarding each loan. So, when these are breached, both seller and servicer can be liable.

 

Moreover, many of the problem loans on which repurchase demands are now being made could have been worked out or refinanced if their defects had been recognized early enough by diligent servicing. In some instances, the actual loss to the investor is more the result of failure to follow required servicing practices - such as prompt commencement of foreclosure or competent handling of REO - than it is of technical defects in loan origination.

 

A changed response

A time did exist when such repurchase demands would have been honored immediately and without question because failure to do so would mean the end of a mortgage bankers seller-service relationship with that investor - and maybe every other investor in the industry. With many mortgage bankers now struggling to survive, however, and the inability of borrowers to refinance problem loans because of rising rates, ways to challenge the enforceability of repurchase obligations are suddenly being sought.

 

The sheer volume of the problem is also compelling investors to make the "no win" choice of either compromising the amount of their repurchase demands or terminating important seller-servicer relationships and prosecuting law suits against former "customers" who now may be very real candidates for bankruptcy.

 

Given these circumstances, it is important to raise some questions and seek some answers regarding repurchase demands. For example: What are the most important legal and financial issues with respect to repurchase obligations? What are the current trends in the enforceability of these obligations, and the expected pitfalls being discovered by investors, sellers and servicers as they demand or resist such enforcement? And with new legal approaches emerging to deal with these problems, what changes can be expected in the way business is done in the industry, both now and in the future?

 

The destructive potential of repurchase obligations

At first glance, it may not be easy to see why loan repurchase obligations have such enormous destructive potential. In their most basic and commonly encountered form, such obligations are nothing more than covenants in seller/servicer contracts with loan purchasers (such as Fannie Mae, Freddie Mac, private conduits or other mortgage bankers.) Pursuant to these covenants, the seller or servicer agrees to repurchase (usually on 30 days notice) every loan not originated or serviced in accordance with certain representations and warranties in the contract and accompanying "guide."

 

While these representations are warranties are often very specific and extensive, they are normally nothing more than a detailed description of what a properly underwritten, documented and serviced mortgage loan should be. Since the purchaser's ultimate objective is often to securitize the loans or at least retain the option of doing so at some future date, most if the representations and warranties focus, in one way or another, on the issue of whether a private institutional investor would have any reasonable basis for rejecting the loan as an investment.

 

In referring to this requirement, the Freddie Mac contract requires the mortgage loan to be of "investment quality." as that term is more specifically defined in Freddie's "Guide." The Fannie Mae contract requires the seller to represent and warrant that the mortgage not only "conforms to all the applicable requirements in (Fannie Mae's) Guides and....Contract," but also, inter alia, that the seller:

 

knows nothing involving the mortgage, the property, the mortgagor or the mortgagor's credit standing that can be reasonably be expected to: cause private institutional investors to regard the mortgage as an unacceptable investment; cause the mortgage to become delinquent; or adversely affect the mortgage's value or marketability.

While the obligation to repurchase also may be accompanied by additional covenants to indemnify and hold the purchaser harmless from any loss or injury in connection with any loan for which repurchase may be required, all of this does not, on its face, seem to be inconsistent with normal commercial expectations. After all, in other areas of commerce, when a merchant sells a "bad" product, the usual remedy is a "refund" upon return of the defective goods.

 

What is different in the mortgage context, however, is the degree of financial leverage used by the seller - and allowed, for ostensibly public policy reasons - in creating the "product." This situation, combined with the almost total unavailability of financing to the seller in the event a loan must be repurchased, further sets apart the mortgage repurchase concept from other market place practices.

 

Funding a loan is typically done with funds borrowed from a "warehouse" line, and such borrowing is, in turn, secured by the loan. Thus, comparatively little capital is required to generate and sell millions and millions of dollars in financial obligations. The minimum capital requirement for Fannie Mae seller/servicers, for example, is only a few hundred thousand dollars, but repurchase obligations can be incurred equal to many times that amount. Also, in many instances, since the characteristics of a loan that make it a candidate for repurchase drastically affect its value, these loans are often no longer viable collateral to help a lender finance the repurchase. This is particularly true where some defect exists in the validity or priority of the mortgage lien, the enforceability of the loan documents, the accuracy of the appraisal or some material fraud committed by the borrower.

 

The inexact science of quality control and risk allocation

The problem is compounded by the fact that quality control in the origination of mortgage loans extremely difficult. The ease with which the process can break down is almost universally underestimated. Expanding consumer protection requirements, along with increasingly sophisticated fraud schemes - often enhanced by dazzling technological innovations that make detection ever more difficult - the inherent subjectivity of the appraisal process and the seemingly infinite variety of adjustable-rate products, combine to make both loan origination and servicing extremely complex enterprises.

 

Moreover, evidence of fraud or other defects in origination may not appear immediately. Not every fraudulent loan results in a first payment default, and with the volumes of loans involved, investors may be blissfully unaware of any documentation or fraud problems until an economic downturn or other unanticipated event brings about a default.

 

The quality control programs of many purchasers often are, by their own design, not comprehensive and test only samples of any given portfolio. Meanwhile, property values may decline and borrowers' ability to refinance disappear, leaving behind a mortgage "asset" that is nothing more than a mere shell of what it was gauged to be at origination.

 

As if that weren't enough, the existence of repurchase demands, depending upon the circumstances, can have a domino effect. If the repurchase erodes capital adequacy enough to result in loss of eligibility to sell or service mortgages for one investor, eligibility to continue with others may be jeopardized or lost as a result of what are now quite common covenants in seller/servicer contracts. With respect to regulated institutions that originate mortgage loans, risk based capital guidelines further complicated the picture because assets sold with "recourse" are considered off-balance sheet items requiring capital support, regardless of the regulatory reporting treatment of the transaction.

 

As a method of allocating credit risk exposure, the current structure of repurchase obligations is grossly lopsided. This action was presumably taken to facilitate the development of a "vigorous secondary market" in mortgage instruments.

 

Government-sponsored enterprises (GSE's) such as Fannie Mae and Freddie Mac, that earned billions in profits in the last few years, are clearly the beneficiaries of the current system. But as risk-based capital guidelines make lenders more reluctant to retain recourse in the form of repurchase obligations, and the "bite" of those obligations drives more marginally capitalized seller/servicers out of business, the burden of credit risk exposure will inevitably fall more heavily ion both GSE's and private conduits. This situation will create an impetus for new types of mortgage products and greater resort to alternatives such as cash payments, reserve accounts, senior/subordinated participations, excess serving fees and new forms of mortgage insurance. For the time being, however, the balance is very uneven, which raises the question: Is it just a waste of time talking about defenses to mortgage repurchase demands?

 

Are repurchase demands really defensible?

In 1999, the United States Eighth Circuit Court of Appeals issued an opinion (at 870 F2d. 847) in a lawsuit filed the previous year in which Union National Bank of Little Rock, Arkansas, sought to enjoin Fannie Mae from terminating the contract under which Union had sold and serviced loans to Fannie Mae for several years. The basis for the threatened termination was Union's alleged breach of warranties and representations in the contract and subsequent failure and refusal to repurchase 11 loans having a value of approximately $493,000 upon demand by Fannie Mae.

 

Union argued that terminating the contract would effectively put Union out of business and that, among other things, Fannie Mae had engaged innumerous "predicate" acts of "economic terrorism" and "extortion" by using its superior bargaining position to accomplish its objectives, thereby violating provisions of the Racketeer Influenced and Corrupt Organizations Act (RICO). While Union's civil RICO claim was ultimately denied by both the District Court and the Court of Appeals, this case graphically illustrates the attitudes of many seller/servicers about the economic and practical disparities in bargaining power between themselves and the secondary market giants on whom they are dependent.

 

The degree of this bargaining power disparity has grown larger in recent years. Considering this fact, and the power to terminate sellers "at will," --giving Fannie and Freddie an overwhelming dominance of the marketplace -is there really any such things as a "defense" to most repurchase demands? The answer is a qualified, "yes," depending upon who you are, who is demanding repurchase and why, and what you are attempting to accomplish.

 

If your objective is to avoid repurchase obligations altogether, be prepared for vigorous and expensive litigation, particularly if the investor is well capitalized and holds a commanding market position.

 

With the potential volume of repurchases confronting them, however, even Fannie and Freddie recognize that they cannot refuse to negotiate with everyone. The bigger you are, and the more economically viable you are, the better your chances. If the reason for the repurchase demand is fraud, however, and your employees were involved, most purchasers are quick to tell you to "expect no mercy."

 

In contrast, if your objectives are more limited, it may be possible to achieve the desired results. Examples of more limited objectives might be to obtain a negotiated indemnification arrangement, to temporarily delay the repurchase requirement while seeking contribution from other "participants" (i.e. mortgage insurers, subservicers, borrowers, appraisers, escrow or title companies) or, in more desperate cases, to complete preparations for filing bankruptcy. Also, it's important to remember that if you refuse to honor a repurchase demand, significant differences in rights exist under most seller/servicer agreements if the termination is "at will" versus termination "for cause." Even if you are unwilling or unable to litigate the matter, awareness of available defenses may enable you to negotiate a termination on terms less onerous than otherwise might be the case.

 

Where to make a stand

If you decide to litigate, the remedy most likely to be sought is an injunction against enforcement of the repurchase obligation and the termination clauses of the seller/servicer agreement. Federal district courts have original jurisdiction in actions against Fannie Mae, Freddie Mac and other government sponsored enterprises. As private corporations, mortgage conduits may presumably be sued in any court of competent jurisdiction. If you are not a regulated financial institution, and seek protection through the bankruptcy laws, new amendments to the Bankruptcy Code in 1994 seem to eliminate any previous confusion about whether the automatic stay that takes effect upon filing applies to government agencies of GSE's. Now, everyone is stayed.

 

If the objectives sought y the lender permit, an infinitely better forum for resolving disputes over repurchase demands is the conference room of the parties involved or their lawyers. While achieving a negotiated result may require patience, diligent preparation, creativity and persistence, the final outcome is often far more desirable. It may even yield a foundation for future business dealings.

 

Defenses based on the contract

The legal enforceability of any contractual repurchase demand rests on the ability of the party demanding repurchase to demonstrate: 1. unambiguous contract terms binding on the two parties exist that require purchase under specified circumstances; 2. those circumstances are present in this case; 3. the party demanding repurchase has complied with all of its obligations under the contract; and 4. there is now, or, with the passage of time, will be damage, loss or injury if the repurchase demand is not honored. Unless all requirements are met, a solid argument can be made that repurchase is not required.

 

It is important to determine who the actual parties to the contract containing the repurchase covenant are. The Fannie Mae, Freddie Mac and GNMA seller/servicer contract are clear. But given the merger, acquisition and consolidation frenzy in recent years among private conduits, and the proliferation of subsidiaries and affiliates, which may once have existed as "divisions" of other companies, along with the frequent name changes and assignments and re-assignments of whole loans and servicing rights that have occurred, the party currently demanding repurchase may not even have rights in the subject contract due to some legal defect in all of the transfers of assets and liabilities. The same concerns apply regarding the party against whom the repurchase demand is made.

 

Enforceability of particular contract terms

What are the actual contract terms that apply in these situations? The correct answer may not be as obvious as it seems. To the extent that any seller/servicer contract or "guide" has been materially modified since the date the loan was sold, the current terms (which somehow are always more onerous) may not be enforceable with respect to that loan. Such modifications may not only be made by express revision, but in some cases implied from changes in actual practice or procedure.

 

Moreover, a fundamental legal question exists about the enforceability of any contract term or condition -- including repurchase covenants-to the extent the provisions are contained in a guide or some other document incorporated by reference that can be modified at will by the other party. Such contract terms are often referred to as being "illusiory" or lacking in "mutuality."

 

Even where the actual terms and conditions of the repurchase obligation are specified, their meaning and application may fall short of being clear and unambiguous. Grounds for dispute may exist, for example, over the meaning of the term investment "quality" under the circumstance, or what is really required for a mortgage to be an "unacceptable investment. "These are both key terms in the Fannie May and Freddie Mac contracts.

 

Nonperformance by the purchaser

Another relevant question to raise to whether the party demanding repurchase has performed all of its obligations under the contract. Nonperformance by the party demanding repurchase often occurs in the critical area of post sale and default servicing. This is particularly important when loans are sold servicing-released and the party with the repurchase obligation has little or no influence over how the loan is serviced one it is sold.

 

While seller/servicer contracts often attempt to make third-party servicers "independent contractors," a court may nevertheless construe them to be an agent of the purchaser. Even if they are not agents, usually express or implied duties of supervision exist concerning such third parties that the purchaser cannot escape or ignore. If the loan is not properly serviced by a third party, whether or not this results in a loss on t he loan, if the purchaser is held responsible, its own "nonperformance" of all material terms of the contract may prevent a repurchase obligation from being legally enforceable.

 

Nonperformance by the seller/servicer

Is there, in fact, a breach of the contract by the seller/servicer, or of any of the warranties and representations that give rise under the contract to a duty to repurchase the mortgage? This is an intensely factual matter; one very critical element of which is whether the party being asked to repurchase was, in fact, the cause of the alleged breach or otherwise responsible for it. In some instances, the seller/servicer is not required to purchase unless it had actual or constructive knowledge of the alleged defect.

 

Many circumstances can give rise to a repurchase obligation. They vary in both large and small measure from contract to contract. The following excerpts from the Freddie Mac single-family seller/servicer guide illustrate this.

 

"In addition to any other remedies it may have at law or in equity for any Mortgage it purchased, Freddie Mac may require the Seller or Servicer to repurchase Freddie Mac's interest in a Mortgage if the Seller or Servicer has

• not complied with a requirement, term or condition of the Purchase Documents, or
• breached any agreement in the Purchase Documents, or
• been unable to supply satisfactory evidence of compliance with the Purchase Documents, or
• been unable to supply satisfactory evidence of compliance with the Purchase Documents, or
• not underwritten and/or documented a Morgage at the time of origination in accordance with the requirements of the Purchase documents or
• failed to provide Freddie Mac with information that is true, complete and accurate concerning the Mortgage, or
• violated or failed to comply with any applicable law designed to protect the health and safety of the Mortgaged Premises' occupants (including failure to take any action available to the Seller or Servicer that would relieve the Mortgage holder from liability under such law or regulation).... Freddie Mac may also require the Seller or Servicer to repurchase Freddie Mac's interest in a mortgage if The Borrowers or any other party in the Mortgage transaction has made false representations in conjunction with such transaction, whether or not the Seller or Servicer was a party to or had knowledge of such false representations, or
• the MI cancels coverage and/or denies a claim under such coverage due to fraud, misrepresentation or omission of a material fact, or for any other reason related to the eligibility of the Mortgage for Mortgage insurance. (The Servicer's reimbursement to Freddie Mac of the amount of the claim denied by the MI is not an acceptable substitute for repurchase of Freddie Mac's interest in the Mortgage.)...."

 

Damage, loss or injury

Is there now or, with time will there be damage, loss or injury as a result of the alleged breach? If there is no loss or damage, a demand for repurchase may not be justified, and instead, a promise of indemnity warranted. And even where there is a loss (or ultimately will be), knowing the amount of it makes a great difference in whether a repurchase obligation can be avoided or some substitute arrangement negotiated.

 

Three consideration in this area of defense are: 1) calculating the amount of loss, if any; 2) determining whether any breach of the representations, warranties or other covenants is the actual and "proximate" cause of the claimed loss (causation); 3) determining whether, and to what extend, the purchaser has taken reasonable steps to mitigate the loss.

 

In calculating the amount of loss, the repurchase price specified in the contract or guide is not the issue but, instead, the degree to which the investment value of the loan is impaired. It is therefore, critical to find out whether the mortgaged property has actually been liquidated through foreclosure and resale of the REO, or whether the claimed loss is only an estimate, based on appraisals or other projections. Until foreclosure is complete and the property resold, the reality and amount of loss are uncertain, and this may provide a basis for at least delaying a repurchase deadline or negotiating an indemnity agreement.

 

In determining causation and loss mitigation, it is also extremely important to find out whether the purchaser, and/or its agents, has done everything reasonably possible to prevent loss of investment value on the loan. For loans sold servicing-released, have all servicing obligations - including communications with the borrower and prosecution of the foreclosure - been performed on a timely basis and in the required manner? If not, could the loss have been avoided altogether by better servicing?

 

The assets any borrower may have to satisfy a deficiency can change or be given to other creditors. Property values can change or be given to other creditors. Timeliness is, therefore, crucial in default servicing. If there have been delays or other mistakes beyond the seller's control, the burden of repurchase obligations may have shifted to the third-party servicer. This creates a dilemma for any seller of loans servicing-released who wished to avoid not only repurchase obligations, but also a negative reputation of looking for scapegoats for bad loans.

 

It is important to know whether errors were made in the foreclosure process by the purchaser or third-party servicer, particularly in calculating the bid price. Moreover, in some states, such as California, a "full credit bid" at a foreclosure sale may be held to create a conclusive presumption that the beneficiary's loss has been fully compensated by recovery of the property, even if the actual value of the property is less than the loan amount. If foreclosure by a full credit bid has been completed before the repurchase obligation must be satisfied, a strong argument may exist that the purchaser has suffered no loss or damage whatsoever, and that there is, therefore, no basis for requiring repurchase.

 

Were there unnecessary waivers of deficiency rights? Were there errors in the management or sale of the REO? The latter is a particularly vulnerable area because market price is a matter of expert opinion and is sometimes subject to reasonable dispute. Were there opportunities during the servicing process to have discovered origination defects in time to remedy the situation before any loss was incurred?

 

A lender facing a repurchase demand also should ask whether errors were made by the mortgage insurer in evaluating the loan that may have contributed to the loss. Were there any waivers of rights by the purchaser against the mortgage or pool insurer that should not have been made, or on which there might have been made, or on which there might be reasonable grounds to differ? Some seller/servicer contracts purport to leave the decision of whether to prosecute a mortgage insurance claim entirely to the purchaser. In other instances, the decision of the insurer is treated as final. Such contract provisions may not be enforceable as knowing waivers by the seller/servicer of the right to an independent determination about mortgage insurance coverage.

 

Miscellaneous contract defenses and offsetting claims

In addition to the above, a variety of affirmative contract defenses, depending on the circumstances of any particular case, may be applicable. These could include claims that the contract terms were the subject of a modification, express or implied; that there was some kind of waiver or estoppel; or that the statute of limitations had expired. But a detailed discussion of these potential defenses is beyond the scope of this article.

 

Very careful consideration should be give, however, to the question of whether the seller/servicer has an offsetting counterclaim against the purchaser for affirmative economic loss. While this situation might not necessarily excuse a repurchase obligation, it may very well help in negotiating an indemnity agreement or an overall settlement. As illustrated by the Union Bank of Little Rock case, supra, claims based on cutting edge legal theories, such as violation of the RICO statutes or interference with contractual relations, are not likely to have as much impact as, for example, claims for breach by the purchaser of an earlier forbearance or indemnity agreement that is now being trashed by the purchaser.

 

Defenses based on suretyship laws

Almost no case law exists on the issue of whether mortgage repurchase obligations are subject to defenses normally available to sureties or guarantors. Yet if such defenses are found to apply, they hold enormous potential for creating revolutionary change in the mechanism for risk allocation embodied in the current system.

 

In essence, such a defense would be based on the notion that a seller/servicer that is contractually obligated to repurchase a mortgage loan when the borrower's default is likely is really a guarantor of the borrowers performance. In many states, a guarantor, which in the words of the California surety statute is nothing more that "one who promises to answer for the debt, default or miscarriage of another,' is entitled to special statutory and common law defenses and protections. These protections can include not only the ability to require beneficiaries to exhaust their collateral before seeking recovery on the guaranty, but also can result in complete exoneration of the guarantor if the underlying obligation is altered in any respect without the guarantor's consent, or the remedies or rights of the beneficiary are in any way impaired or suspended - even by the beneficiary. If recognized as a "guarantor," a seller/servicer would thus have many special defenses today assumed to be nonexistent by most purchasers.

 

The availability of such defenses would necessitate major modifications of seller/servicer contracts and guides to provide appropriate waivers that, if not obtained, could result in a total loss of the repurchase remedy under the above circumstances. In states having anti-deficiency laws, status as a guarantor could have even greater significance because the protections of those statutes may also be available to guarantors. (See, for example, the landmark California case of Union Bank v. Gradsky (1968) 265 CA2d 40, 71 CR 64.) This means that in states where a nonjudicial foreclosure sale bars the prosecution of a deficiency judgment against the borrower, completion of such a sale on a loan otherwise subject to repurchase could completely exonerate the seller from having to perform that obligation.

 

There are cases holding in a commercial loan context that a third party's agreement to purchase notes given as security for advances under a line of credit constitutes a "put," and not a guaranty. (See, for example, United California Bank v. THC Financial Corp.(1977) 557 F2d. 1351.) However, case law also exists for the proposition that a mortgage company's written contract to repurchase mortgage loans sold to a bank in event of the borrower's default constitutes a "guaranty" under applicable suretyship statutes. (See for example, Bank of America v Lane Mortgage Co. (1937) 18 CA2d 431, 63 P.2d 1189.)

 

Which of these conflicting lines of authority is ultimately embraced by the majority of courts in the country will determine just how durable the suretyship defense may be. Until them, however, nobody should simply assume that the powerful protections of suretyship law and the antideficiency statutes are unavailable to defeat a repurchase demand.

 

Indemnity claims against third parties

Apart from the issue of whether any defense exists to a repurchase demand, the recipient of such a demand also may have a claim for indemnity or some other form of loss reimbursement from another party in the transaction. Where repurchase is sought from a seller or servicer, either may have a claim for loss reimbursement not only from the other, but against a subservicer, or the mortgage or pool insurer, in addition to the borrower, and possibly the broker, escrow, title company and/or appraisal company. The process of originating servicing and securitizing loans involves many participants along the way, any one of which may bear some causal responsibility for the subject loan eing, or becoming something less than an "investment quality" asset.

 

The availability of such recourse against third parties depends on whether they have a legally recognized duty of care or performance with respect to the party making the claim for reimbursement. This duty can be based in contract, tort or even codified in statute. In most instances, the existence of such a duty will depend on how foreseable it was that the third party's performance (or non-performance) would affect the claimant. Case law on this subject, in the context of mortgage repurchase obligations, is virtually nonexistent. So before assuming nobody else is available to share the financial burden from a repurchase obligation, examine carefully the conduct of other participants in the process.

 

Bankruptcy

When all else fails, the automatic stay that descends upon the filing of a bankruptcy petition may provide some relief - at least temporarily- from the burdens of too many repurchase demands. It also may provide a window of time within which the liability of third parties with respect to a repurchase obligation can be established. However, it is not entirely clear whether the repurchase obligations under a seller/servicer contract will be construed to fall within the specialized exception under section 559 of the Bankruptcy Code. That exception allows "rep participants" in certain circumstances to sidestep the automatic stay in causing "the liquidation of a repurchase agreement." On close analysis, this exception, enacted to facilitate the smooth functioning of the securities markets, would not seem to apply to mortgage repurchase obligations incurred as part of a portfolio sales and servicing agreement, but arguments could be made to the contrary.

 

Assuming the automatic stay is available to halt action on a repurchase demand, a downsizing seller/servicer, not barred by statute from filing bankruptcy, may be able to salvage through Chapter 11 at least some of its investor relationships from the domino effect described earlier. By assuming the executory (i.e. ongoing) contracts on investors with whom it wants to continue doing business, and rejecting the contracts of those with whom it does not, some viable business may be able to emerge from the ashes. However, full and continued performance is required of all obligations under every seller/servicer contract assumed, and rejection of a contract does not erase liability on preexisting repurchase obligations. Nor may seller/servicer eligibility continue under a contract that has been rejected.

 

All of the consequences, however, of filing bankruptcy on a seller/servicer's liabilities under a repurchase agreement are impossible to determine because of the absence of any well established body of case law on the subject. And, despite the various theoretical options that a bankruptcy may afford, it would be extremely difficult as a practical matter for most seller/servicers to salvage anything in the way of a mortgage business after going through bankruptcy. The public image obstacles might be too great to overcome.

 

Nevertheless, in dire circumstances, the threat of bankruptcy may have real value in negotiation to get a party making demands to back off - at least for a while. This action may be particularly effective if indemnification or other payments have been made with the preceding 90 days to the purchaser, which might have to face voidable "preference" issues and the possibility of having to return such payments if a bankruptcy is filed. A credible threat of bankruptcy may thus permit settlement of all repurchase obligation liabilities on terms that are more acceptable than could otherwise be achieved.

 

The absence of an established body of case law defining the rights and obligations of parties to mortgage repurchase agreements allows for no certainty about what the legal limits are on their enforceability. This circumstance leaves open to speculation which defenses to such enforcement might work and which ones will fail. Until recently, no one has even thought of contesting them.

 

Nor is it possible to rely with any confidence on the implicit assumption made by the securities markets that repurchase obligations in seller/servicer agreements are somehow different from garden-variety suretyship contracts in such a way as to make them immune to all of the infirmities and special limitations and conditions on such agreements that have grown up over years of litigation.

 

The only thing that can be said with certainty about mortgage repurchase agreements is that sooner or later the markedly disproportionate economic consequences of the present system will generate powerful motivation for change. And from every indication that process has already begun.

 

Michael R. Pfeifer - Author
Mortgage Banking Magazine
June, 1995