If FHA Wants to Bring Lenders Back, It Will Need to Clarify Their False Claims Act Liability
On May 9, the Federal Housing Administration (FHA) announced changes to clarify how it would enforce its underwriting rules. In this blog post we describe why the changes were needed and how they could be improved.
Facing a rising tide of insurance claims following the crisis, FHA and the Department of Justice (DOJ) stepped up enforcement efforts against lenders that had made mistakes in their underwriting of FHA-insured loans, levying more and larger fines, requiring more indemnification, and, for the first time, bringing claims of fraud under the False Claims Act. This aggressive turn generated confusion among lenders, in part because they had little experience with enforcement actions before the crisis and in part because the rules weren’t being applied consistently or predictably.
Many longtime FHA lenders, especially large, well-capitalized ones, responded by pulling back on their FHA lending, sometimes dramatically. This initially led to a contraction in FHA lending and then to a shift in the counterparty mix for FHA as newer, often less-well-capitalized lenders stepped in to fill the vacuum. The figure below shows the lender composition for FHA, the US Department of Veterans Affairs, and conventional borrowing.
The resulting reconfiguration has made the FHA market less durable, as some of the more thinly capitalized lenders that have stepped into the breach are likely to fail or pull out as defaults rise. This will leave FHA unable to play the critical countercyclical role as effectively as it did during the previous downturn. It also creates significant counterparty risk to Ginnie Mae, which guarantees the securities backed by these loans and thus must step in to manage the servicing obligations of any lenders too thinly capitalized to survive a downturn.
Understandably concerned, FHA has made several attempts to provide the clarity needed to draw lenders back in, but to date it has been unsuccessful. FHA’s recently announced steps are intended to address the remaining uncertainty by clarifying what lenders attest to when they submit a claim to the FHA for payment and by creating a taxonomy of remedies that reflects the relative significance of different kinds of lender mistakes.
This is the right approach, as there are two problems here: clarifying what the rules are and clarifying how they will be enforced. Although the first should be self-evident, the second is equally important, as the lack of distinction between the treatment of egregious mistakes and small ones has been one of the key drivers of lender retreat. Since it is difficult to avoid making smaller mistakes in processing loan files that often run hundreds of pages long, many lenders have chosen to control their risk by reducing the probability that they have to file an insurance claim with FHA in the first place. They do this by refusing to offer FHA loans to many of the higher risk borrowers it is FHA’s mission to serve.
When submitting an insurance claim to FHA, a lender must certify that it has followed FHA’s rules in underwriting the loan (loan-level certification). FHA proposes to clarify the loan-level certification by stating unequivocally that the lender is certifying to compliance with all of the rules in the FHA Handbook and then clarifies how it will handle failure to comply with these rules by outlining remedies in a defect taxonomy that ranks categories of mistake by severity.
Again, this is the right approach, as it’s critical for FHA to clarify both what lenders are certifying to and what FHA will do if they make a mistake. The problem is that it doesn’t address what DOJ will do if a lender makes a mistake, thus leaving unaddressed the biggest, most uncertain source of liability of all: the False Claims Act.
Making matters worse, FHA’s clarification of the lender’s exposure to enforcement action by FHA appears to expand the lender’s exposure to enforcement action by DOJ. FHA clarifies that lenders must certify to compliance with all of FHA’s rules when they submit a loan for insurance, and then narrows the lender’s exposure to enforcement actions by FHA through the taxonomy. But the lender’s exposure to DOJ arises from the first, not the second. DOJ brings an action for a violation of the False Claims Act where a lender has certified to information that later proves untrue, not to mistakes that happen to fall into certain categories in the taxonomy. By clarifying that lenders are certifying to perfect compliance with FHA’s thousands of rules, FHA is clarifying that lenders are exposed to False Claims Act liability for any and all mistakes, irrespective of substance, size, intent or where it falls in the taxonomy.
In the face of that remaining uncertainty, it is hard to imagine that any lender that pulled back from FHA over enforcement uncertainty would return in response to these recent changes. To expand their proposal in a way that would accomplish such a market shift, FHA would need to either narrow what a lender certifies to or narrow the kind of mistakes that can give rise to liability under the False Claims Act.
It could narrow what a lender certifies to by narrowing the lender’s attestation at critical points throughout the document. For instance, rather than requiring the lender to certify that “All conditions of approval have been satisfied,” as they would do under the proposed Loan Level Certification, FHA could require that the lender certify that, “to the best of mortgagee’s knowledge, all conditions of approval have been satisfied in all material respects.” Thus, the lender would no longer be subject to treble damages for small mistakes of which it was not aware and that have no bearing on the risks to FHA, as the former version of the provision implies. This kind of line-by-line narrowing is the approach that we and many others have suggested before, and many will likely suggest again.
By narrowing the lender’s commitment in the loan-level certification to give them a reasonable chance to avoid mistaken attestations, lenders will have an incentive to control their legal risk by improving their quality control, rather than by simply avoiding borrowers who pose greater risk of default. The challenge with this approach, however, is that the changes needed are numerous and it only takes one poorly placed ambiguity to leave us roughly where we started. Given the now long record of differing interpretations that lenders, FHA and DOJ all bring to key passages, there is reason to be skeptical that any revisions would provide adequate clarity.
A more effective way to address the uncertainty at issue is by tying False Claims Act liability to the taxonomy, stating explicitly in the taxonomy that a claim under the False Claims Act is a possible remedy for specific categories of more severe mistakes and only these categories. This would require joint action by FHA and DOJ, as both have a role in applying the False Claims Act to FHA-insured loans. By integrating False Claims Act liability into the taxonomy, FHA and DOJ would finally create a more coherent, integrated, and comprehensive enforcement regime and leave lenders with an incentive to control their legal risk by improving their quality control, rather than by abandoning many of the very borrowers FHA is designed to serve.
The bottom line is that if the administration wants to attract back into the FHA market those lenders scared off by uncertainty over how FHA’s rules are enforced, it will have to provide some certainty over when and how the False Claims Act will be used. Either of the approaches we suggest could made to work, and there are no doubt others. But any approach that leaves out this critical piece of lender liability will inevitably fall short.
Photo by TDKvisuals/Shutterstock.