March 6, 2014
How Should the Courts Determine Mortgage Fraud Restitution?
James Lytle and Martin Valadez ran a mortgage fraud operation. They submitted falsified applications and loan documents to mortgage lenders to finance the sale of real estate to straw purchasers. For procuring the purchasers and loans, Messrs. Lytle & Valadez obtained kickbacks from the sellers out of proceeds of the sales. See Mar. 15, 2009, “Amid Subprime Rush, Swindlers Snatch $4 Million.” Benjamin Robers was one of these “straw men.” Mr. Robers signed falsified mortgage loan documents for the purchase of two homes in Walworth County, Wisconsin. Lytle & Valadez paid Robers $500 per transaction.
Robers soon fell into default under the loans. A representative of the Mortgage Guarantee Insurance Corporation (“MGIC”) testified about its losses and those of Fannie Mae regarding one of the properties. American Portfolio held the lien on the other property. Robers pleaded guilty (as did Lytle & Valadez). In Robers’ sentencing, the Federal District Court based the offset value of the real estate on the prices obtained by the financial institutions in the post-foreclosure out-sales. The court ordered restitution of $166,000 to MGIC and $52,952 to American Portfolio.
What is restitution? Restitution is the restoration of the property to the victim. The term also encompasses substitute compensation when simply returning the defrauded property is not feasible. For mortgage fraud restitution, the outstanding balance on the loan is easy to calculate. More difficult is adjusting the loan balance for the foreclosure. In a criminal case, how much of an off-set is the defendant entitled for the home when the bank forecloses on it? On February 25, 2014, lawyers argued this question before the U.S. Supreme Court. Later this term, the Court will decide how to offset the foreclosure against the loan amount. Defendant Robers argues that the proper amount is the fair market value of the property on the date of the foreclosure. The government and the victim banks maintain that it should be the price that the bank actually sells the property to the next owner.
U.S. v. Benjamin Robers:
These questions came before the Court in Benjamin Robers’ an appeal from the Seventh Circuit Court of Appeals and the Eastern District of Wisconsin. Robers argued that the Court wrongfully held him responsible for the decline in value of the homes between the dates of the foreclosure and the out-sales. He wants the Fair Market Value (“FMV”) of the property on the date of the foreclosure to serve as the proper off-set amount in the restitution award.
U.S. Mandatory Victims Restitution Act:
Under the Federal Mandatory Victims Restitution Act, when return of the property to the victim is impractical, the monetary award shall be reduced by, “the value (as of the date the property is returned) of any part of the property that is returned.” 18 U.S.C. section 3663A(b)(1). In mortgage fraud, the real estate is collateral. Usually the lender does not convey real estate to the defendant in the original sale. Rather, the defendant defrauded the lender out of the purchase money. At what point during the foreclosure process is the “property” “returned” to the victim? In oral argument, some of the Justices didn’t seem entirely convinced that the statutory return of the property language even applies. Justice Scalia observed that the banks were not actually defrauded out of money; the money went to the sellers. The banks thought they were getting a borrower who was more likely to repay over the course of the loan than he actually was.
Robers argues that since title passes to the lender at the foreclosure, that is the “date the property is returned” for purposes of calculating restitution. He argues that Fair Market Value of the property at the time of the foreclosure is the proper off-set amount. This is consistent with decisions of some federal appellate courts.
Foreclosures in Virginia:
Note that in Virginia, and in some other states also practicing non-judicial foreclosure, formal title does not pass at the foreclosure sale. That is when the auction occurs and the bank or other purchaser acquires a contractual right to the auctioned property. The bank or other purchaser disposes of the property after obtaining a deed from the foreclosure trustee.
Government Sides with Victimized Lenders:
In Robers, the Seventh Circuit Court of Appeals agreed with the government and the financial institutions. The court pointed out that banks are in the money business, not the real estate investment business: “The two cannot be equated. Cash is liquid. Real estate is not.” Obtaining title to the real estate collateral at the foreclosure sale gives the bank something that it must take further steps to liquidate into cash that can be re-invested elsewhere. As the new owner of the property, the lender must cover management, taxes, utilities, insurance and other carrying costs. Any improvements to the property likely suffer depreciation during any unoccupied period.
The Seventh Circuit observed that the Courts which adopt a contrary position ignore, “the reality that real property is not liquid and, absent a huge price discount, cannot be sold immediately.” What is the relationship between the liquidity of real estate and a Fair Market Value appraisal? Federal law contains a definition of FMV:
‘The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.’ 26 C.F.R. Sect. 20.2031-1(b), cited in, U.S. v. Cartwright, 411 U.S. 546, 551 (1973).
The FMV of property, “. . . is not determined by a forced sale price.” 26 C.F.R. Sect. 20.2031-1(b) The price to liquidate property immediately would be a forced sale, and hence not represent FMV. An appraisal seeks to value real estate in cash terms. If the seller makes dramatic compromises on price to sell a property immediately, that same is not a good comparable sale in a FMV approach.
The Seventh Circuit decided that “Robers, not his victims, should bear the risks of market forces beyond his control.” A bank agrees to accept real estate as collateral for a loan on the premise that the loan application is not fraudulent. A bank is in the real estate investment business when it lends money under these circumstances. The risk that it may become saddled with a foreclosure property later is managed in its underwriting process. In the case of fraud, the “you asked for collateral, now you get collateral” defense is not appropriate. Participants in organized mortgage fraud will not be deterred if the restitution award includes no more than a deficiency judgment awarded in a civil case.
The Seventh Circuit equates “FMV at the foreclosure date” with “liquidation at the foreclosure date.” However, the FMV approach seeks to avoid the downward pressures on price associated with compelled liquidation. The Seventh Circuit does not discuss the FMV method in detail. They likely inferred that the financial institution lenders would incur carrying costs between the foreclosure and the future date when the market allows the property to be sold for near FMV. When a neighborhood suffers from a rash of foreclosures, appraisers may struggle finding useful comparable sales that aren’t short sales, deeds-in-lieu or foreclosures.
Daniel Colbert, blogger for the American Criminal Law Review, points out that the bank has greater control over how market changes affect the out-sale price than the defendant’s fraud. Nov. 26, 2013, Foreclosing Restitution: When Has a Lender’s Property Been Returned? If the victim still owns the foreclosed property at the time the court sentences restitution, does it get both the house and the full restitution award? Such a result seems unlikely with most institutional lenders. Justice Breyer suggested that in such a case, the court would require an appraisal if the lender doesn’t want to sell within 90 days after sentencing.
Interest of Mortgage Investors in U.S. v. Robers:
Unfortunately, mortgage fraud schemes like Lytle & Valadez’s occurred in Virginia as well. Financial institutions holding mortgages on distressed properties cannot wait upon the outcome of a mortgage fraud prosecution. They must timely represent the interests of their investors. When to foreclose and re-sell the property is a business decision. A Supreme Court decision in favor of the government would strengthen mortgages as an investment. Tougher restitution awards would deter perpetrators of mortgage fraud. Mortgage investors can mitigate their losses in mortgage fraud cases by documenting the expenses they incur as a result of the fraud. To the extent such a borrower has any ability to pay, he will heed a restitution sentence more than an ordinary deficiency judgment.
photo credit: Marxchivist via photopin cc
February 5, 2014
They Might Be Mortgage Giants: Fannie & Freddie’s Tax Breaks
On January 3, 2014, the U.S. Consumer Financial Protection Bureau published a request for input from the public about the home mortgage closing process. 79 F.R. 386, Docket CFPB-2013-0036. The CRPB requested information about consumers’ “pain points” associated with the real estate settlement process and possible remedies. The agency asked about what aspects of closings are confusing or overwhelming and how the process could be improved.
The settlement statement is an explanatory document received by the parties at closing. The statement lists taxes along with other charges. The settlement agent sets aside funds for payment of both (a) the county or city’s property ownership taxes and (b) transfer taxes assessed at the land recording office. The property taxes are a part of a homeowner’s “carrying costs.” The recording taxes are part of the “transaction costs.” Typically, neither the buyer nor the seller qualify for a recording tax exemption.
The federal government advances policies designed to increase consumers’ access to affordable home loans. The Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”) provide a government-supported secondary market. They purchase some home mortgages from the lenders that originate them. The Federal Housing Finance Agency regulates these chartered corporations. In 2008, FHFA imposed a conservatorship over Fannie Mae & Freddie Mac.
In the years leading up to the crisis of 2008, Fannie and Freddie used their government sponsorship to purchase some of the higher-rated mortgage-backed securities. See Fannie, Freddie and the Financial Crisis: Phil Angelides, Bloomberg.com. As the secondary-market purchaser of these home loans, Fannie and Freddie have foreclosure rights against defaulting borrowers and distressed properties. These corporations participate in the home mortgage process from origination, through purchase post-closing, and, in many cases, subsequent foreclosure-related sales.
Congress exempts Fannie Mae and Freddie Mac from state and local taxes, “except that any real property of [either Fannie Mae or Freddie Mac] shall be subject to State, territorial, county, municipal, or local taxation to the same extent as other real property is taxed.” 12 U.S.C. sections 1723a(c)(2) & 1452(e). Which local real estate taxes does this exception apply to? The ownership tax, transfer tax, or both? The statute does not specifically distinguish between the two. Fannie and Freddie concede that they are not exempt from the tax on property. However, they decline to pay the transfer taxes assessed for recording deeds and mortgage instruments in land records. This is one advantage they have over non-subsidized mortgage investors. Local governmental entities and officials from all over the U.S. challenge Fannie & Freddie’s interpretation of the exemption statute since it represents a substantial loss of tax revenue. This blog post focuses on two recent opinions of appellate courts having jurisdiction over trial courts sitting within the Commonwealth of Virginia.
Virginia:
Jeffrey Small, Clerk of Fredericksburg Circuit Court, attempted to file a class action against Fannie & Freddie in federal court on behalf of all Virginia Clerks of Court. Small v. Federal Nat. Mortg. Ass’n, 286 Va. 119 (2013). Mr. Small challenged their failure to pay the real estate transfer taxes. The Defendants argued that the Clerk lacked standing to bring the suit for collection of the tax. A Virginia Clerk of Court’s authority is limited by the state constitution as defined by statute. In the ordinary course of recording land instruments, the Clerk’s office collects the transfer tax at the time the document is filed. One half of the transfer taxes go to the state, and the other half goes to the local government.
To resolve the issue, the Supreme Court of Virginia found that if the taxes are not collected at the time of recordation, then the state government has the authority to bring suit for its half, and the local government to pursue the other half. The Virginia clerks do not have the statutory authority to bring a collection suit for unpaid transfer tax liability. Because they lack standing, the court dismissed the clerk’s attempted class action against Fannie and Freddie for the transfer taxes.
Maryland & South Carolina:
Montgomery County, Maryland and Registers of Deeds in South Carolina brought similar federal lawsuits challenging Fannie and Freddie’s non-payment of recording taxes. See Montgomery Co., Md. v. Federal Nat. Mortg. Ass’n, Nos. 13-1691 & 13-1752 (4th Cir. Jan. 27, 2014). The Fourth Circuit also hears appeals from federal Courts in Virginia. This case proceeded further than Mr. Small’s. The Appeals Court found that:
- Property taxes levy against the real estate itself. Recording taxes are imposed on the sale activity. The federal statute allows states to tax Fannie and Freddie’s ownership of real property. The statute exempts Fannie and Freddie from the transfer taxes.
- Congress acted within its constitutional powers when it exempted Fannie and Freddie from the transfer taxes, because this may help these mortgage giants to stabilize the interstate secondary mortgage market.
- The exemption does not “commandeer” state officials to record deeds “free of charge,” because the states are free to abandon their title recording systems. By this analysis, the exemption is not a federal unfunded mandate on state governments because the decision to include a land recording system as a feature of property law is not federally mandated.
Some federal courts in other parts of the country have reached analogous conclusions. e.g., Dekalb Co., IL v. FHFA (7th Cir. Dec. 23, 2013)(Posner, J.). This legal battle wages on in the federal court system, but the results so far favor Fannie and Freddie.
Discussion:
Is abandoning the land recording system a realistic option? In Greece and other countries lacking an effective land recording system, property rights are uncertain and frequently brought before the courts for hearing. See Suzanne Daily, Who Owns This Land? In Greece, Who Knows?, New York Times. Like Fannie & Freddie, land recording systems advance the policy interests of stabilizing private home ownership.
Fannie and Freddie aren’t required to pay locally collected recording taxes. Their “share” of the overhead for maintaining the land recording system come from other sources. This includes the recording fees paid by ordinary parties in real estate closings across the country. Does this give the mortgage giants an unfair competitive advantage over other institutional investors in the re-sale of foreclosed homes?
Are these differing tax treatments properly considered in the CFPB’s discussion about the “pain points” in closings? Settlement statements provide clarity regarding the charges listed. The transfer and property taxes assessed in real estate closings are confusing and overwhelming, in part because they represent hidden costs. These hidden costs include the exemptions afforded Fannie Mae and Freddie Mac. The purpose of these institutions is to help mortgage consumers. Should the tax loophole should be closed or the hidden costs be disclosed to consumers? Perhaps one of these change would advance the CFPB’s “Know Before You Owe” initiative.
photo credit: J.D. Thomas via photopin cc. (not particular to any of the cases discussed herein)
