01 August 2013

Colorado Foreclosure Lawyers Still Dirty

The Foreclosure Law Firm Industry and Its Business Model

In Colorado, and in most states, most mortgage foreclosures are handled by a small number of law firms between them have won most of the commercial banks and other mortgage lenders in the state as clients (a more numerous but still small set of core clients), in addition to lower volume mortgage lenders who use them because they specialize in the work.  Unlike most law firms, which operate on a craft work basis, handling cases on an individualized case by case basis, these firms engage in factory style mass produced legal work with a small number of partners supervising a significant number of associates supervising an army of paralegals to produce large numbers of judicial foreclosures and deficiency judgments which are overwhelmingly routine and not seriously contested.

These firms do almost nothing else but foreclose on defaulting mortgages.  Often, if lender liability issues or other serious complications arise, the cases are transferred to another large law firm or boutique law firm specializing in lender liability and commercial litigation with a more tradition craft work business model.  They work on a fee for service basis and handle dozens, hundreds or even thousands of cases per year for each client.

Most of a foreclosure law firm's work happens in the non-adversarial non-judicial public trustee's foreclosure system punctuated by a brief, narrow summary probable cause hearing to determine if there is a default on the loan (often uncontested) called a Rule 120 hearing.  The Rule 120 hearing does not examine issues like the reasonableness of collection costs or foreclosure bids.

Institutional mortgage lenders like these firms because they know how to interact with institutional clients with a large volume of routine work, they provide consistent quality work, and their paralegal and form driven practice with routine hiccups supervised by associate attorneys with less prestigious credentials and lower hourly rates than the large law firms they use for non-routine work makes these firms very competitive with other small and medium sized firms that would do the work on a traditional top heavy craft work basis.

These firm's poor cousins, collection law firms, have similar practices that collect unsecured debts like unpaid credit card bills, store accounts, judgments and bills for professional services, typically on a contingency basis of 33%-50% of the funds recovered.

Process Serving Charge Corruption

Almost all of the leading foreclosure law firms in Colorado are the subject of an investigation by the Colorado Attorney General's office (currently Republican Attorney General Suthers) involving inflated charges for posting foreclosure notices.  Foreclosure firms claimed the costs were on the order of $125 to $150 or more for the service, but actually had affiliated process serving firms owned by their lawyers do the work for $7 a posting plus mileage, pocketing the profit for themselves and not disclosing the relationship to the Public Trustee's offices or courts.  Bona fide third party process servers typically charge $25 or so for the same service.

What is the economic impact of this practice?

While the practice generates only $100-$200 of extra revenue per foreclosure, which typically involve debts of hundreds of thousands or millions of dollars each, and is also small relative to the largely unregulated fees charged by foreclosure lawyers, the undisclosed profit received by the foreclosure lawyers from this practice at one major foreclosure law firm was $5 million a year.  This is a classic case where the bite of the practice to its primary victims is a mosquito bite to them, but a huge boon to the people who engage in it.

Who Is The Victim?

This practice defrauds property owners (1) if they pay this price when curing their defaulted mortgages, (2) if deficiency judgments are entered against them that include that amount if the an appraisal supports a foreclosure sale bid less than the value of the outstanding debt because the price of the house fell after it was purchased, and (3) if they receive less of a surplus check when the foreclosure sale bid is more than the outstanding debt.

Property owners do not bear most of the cost of this practice, however.  In the overwhelming majority of cases the mortgage default is not cured and the only bidder at the foreclosure sale is the lender who bids the amount of the debt plus collection costs, in return for title to the property that was collateral for the loan, waiving a deficiency judgment.  In these cases, the defrauded party is usually a commercial bank, or a government agency that purchased or guaranteed the loan, such as Fannie Mae, Freddie Mac, the FHA, the Veteran's Administration and other government lenders or guarantors.

Of course, nothing prevents foreclosure law firms from discontinuing this dubious practice with hidden charges and replacing it, for example, with more honest increases in the hourly rates charged by their paralegals, associates and partners, or even an arbitrary "new case fee" in addition to their hourly rates, of a similar amount.

Why care?

The practice itself leads to only modest harm that disclosure alone can mostly remedy.

Standing alone, the practice of using captive process servers charging inflated prices to post notices on foreclosed properties is a petty and banal case of petty corruption which, in fairness, is sufficiently subtle that it is just barely fraud at all.  Most of the people who are hurt by it would have had the economic power to insist that the practice stop if they are going to continue to use the firm's services if they had known about it.

The more diffuse class of property owners who have no economic means to stop the practice (and surely it is lawyers who defend them, and not representatives of institutional investors who brought this practice to the attention of the Attorney General's office) is suffering a modest share of the total harm caused by the practice, that is also small relative to the total losses they suffer in foreclosure cases.

Also, once the information is shared widely (as it is in many kinds of specialty legal practices like foreclosure defense through practice newsletters, internet forums, and bar association networking and continuing education programs), property owner in cases where deficiency judgments are asserted do have an adversarial court forum in which they can get a fair hearing regarding these inflated charges (although the cost of doing so over a $100 to $200 charge may not be cost effective except as a good faith basis to fight summary judgment and delay collection).  Significant surplus payments in foreclosure cases due to third party foreclosure sale bid are rare, and cures are also, alas, quite rare.

The tip of the iceberg.

The improper conduct of these foreclosure firms in the case of process serving fees, however, is really just the tip of the iceberg of the overarching and more serious problem: low level corruption that pervades the entire industry and is exacerbated when foreclosure volume is up putting a strain on these firm's resources.

Another area that the Attorney General's office is investigation, albeit on a lower profile, because the issue is more subtle and more invasive of the attorney-client privilege to investigate, is attorneys' fee bill padding by these firms.  These dollar amounts are likely considerable greater than inflated process service charges and have the same incidence and sources.  Inflation of attorneys' fees and collection costs combined can create a significant barrier to the ability of a property owner in default on a mortgage to cure the default and retain the property.

Even more problematic than inflated collection costs is the practice of using false affidavits of foreclosure firm attorneys, their staff, their clients and their process servers concerning the right to foreclose.  For example:
Attorney Toni M.N. Dale of Medved Dale Decker & Deere in Lakewood was referred for discipline last month by a federal judge for wrongly certifying that copies of a bank's promissory note — required for any foreclosure in Colorado — were "true and correct" when, in fact, she had never seen the originals at all.
Additionally, U.S. Bankruptcy Court Judge A. Bruce Campbell said in a written order that not only was Dale's certification in 2011 to the El Paso County public trustee — the overseer of foreclosures in that county — untrue, but so was her verification to the bankruptcy court about the same records.
From the Denver Post.

In the Dale case, he was caught when two different purported note assignments from one bank to the other were submitted in different stages of three different court proceedings involving a loan.  Fraud regarding the existence of original notes and deeds of trust establishing the right of a foreclosing bank to enforce it by bringing a foreclosure action, something that is part of a larger national "robo-signing" scandal was common during the period of high volume foreclosures during the financial crisis.

In all of these cases, a key issue is that the sworn statement of a lender's foreclosure lawyer or the lender's foreclosure department employee is all that stands between a person losing their home and not losing it to a lender who doesn't actually have the legal right to enforce the promissory note.  The non-judicial foreclosure process is non-adversarial, recent amendments to Colorado law prevent property owners from contesting this issue in a Rule 120 proceeding, and contesting a foreclosure in an independent injunctive relief action is an expensive option that is unlikely to prevail in cases where the borrower knows that there is only a small chance that their particular case involve a lender who doesn't actually have a right to foreclose.

Dale's case is particularly notable because the kind of forgery and lying in affidavits that he engaged in, within a firm that operates on a mass production model rather than the individualized craft work business model of most law firms, is almost certainly not an isolated incident.  The other cases may never be caught, but there are almost surely many other cases in which Dale engaged this kind of fraud, in which other employees at the same law firm engaged in this kind of fraud, and in which other similarly situated law firms in the industry in Colorado engaged in this kind of fraud.

Why would someone like Dale lie?

Dale's fraud is somewhat understandable.

In the vast majority of cases, lenders do have their paperwork in order, so affidavit signing lawyers or bank employees tend not to be vigilant as they mass produce this routine and dull paperwork for hours on end for large packages of defaulted mortgage loans.

In the cases where the lenders don't have their paperwork in order, it is usually because some mid-level bureaucrats at a loan transferring institution in the byzantine secondary mortgage market process by which mortgage originators sell their loans to other lenders or mortgage loan investors in large packages of loans failed to dot their i's and cross their t's property in the course of implementing a deal already reached at the executive level, or because bureaucrats at this level simply made a clerical mistake.  The customer service level loan servicing process often works from the high level package of loan transfer process of engaged in by the executives rather than back room documentation of the mid-level bureaucrats involved in the transfer, so problems in transferring the physical loan documents can easily go unnoticed until the loan goes into default.  In the case of the vast majority of loans that never default and are released without physical copies of the notes as special rules applicable to release by institutional lenders permit them to do, the problems never have any impact at all.

But, the bottom line is that when the loan transfer paperwork isn't in order it is costly and time consuming to correct the problem and the vast majority of the time, there is no bona fide dispute between the parties to the transfer of the loan concerning who owns the loan.  Indeed, this appears to have been the situation in Dale's case where the loan transfer documentation irregularity was ultimately sorted out and the foreclosure was ultimately completed.

When it is factually true that a borrower is in default, and it is factually true that the foreclosing lender really is the owner of the loan entitled to foreclose, but the paperwork documenting the fact that the foreclosing lender has that right was screwed up by someone earlier in the mortgage transfer process, it is tempting for a foreclosure lawyer to see a lie, or even a forgery that covers up the bureaucratic screw up in connection with the loan transfer to be a mere "white lie" that cuts down on busywork paperwork and delay that would provide a windfall benefit to an undeserving defaulting mortgage borrower, rather than a material misstatement of fact that constitutes a morally blameworthy "black lie."

There are cases where lenders who have no right at all to foreclose on a loan, rather than merely a right to foreclose in which the paperwork needs to be cleaned up happen.  There was a famous case where that happened in Florida a few years ago at the height of the financial crisis.  But, these cases are vanishing rare, because in those cases there is hell to pay in an easily proven case from a property owner who can easily prove that the loan was paid off with bank records, or from another lender whose right to collect on the loan was converted from them by the wrongdoer.

The trouble is that if "white lies" by people like Dale are not punished severely, an entire system that depending on banks and their lawyers being honest about the amounts owed on loans, the existence of a default, the amount of collection costs incurred, the accuracy of the notices that they give, and the lender's ownership of a loan, none of which are subject to a meaningful adversarial challenge, could go of the rails and become seriously abusive as a matter of routine.

Petty corruption by foreclosure lawyers about process service fees, the number of hours of legal work involved in a foreclosure, the accuracy of mailing lists, the accuracy of a bank's loan payment history, the existence of documentation establishing that the foreclosing party owns the loan, and the sincerity of the appraisals backing up deficiency claims all undermine what if utilized in good faith with extremely high standards of care and honesty can be a very low cost and efficient way for banks to collect their unpaid debts which lowers the cost of mortgage lending and benefits borrower's who fulfill their obligations while proportionately and accurately punishing borrowers who default on their loans.

An Aside On The Economically Most Significant Issue In The Foreclosure Process: Overstated Deficiency Claims And Thin Foreclosure Sale Markets

Outside of the cure situation, when deficiency judgments are sought by banks foreclosing on properties that are upside down (i.e. worth less than the outstanding debt), however, even inflated collection costs and carrying costs for the property are relative minor issues.  The two main sources of economic harm to property owners and people who guaranty their loans are overstated deficiency claims and thin foreclosure sale markets.

Low Ball Foreclosure Appraisals

In cases where a lender believes that foreclosed property is worth less than the debt owed, the lender can obtain an appraisal, bid the appraised value of the foreclosed property rather than the full amount of the debt owed, and sue for the deficiency.

The dominant economic concern of borrowers in this situation is that these deficiency bids are routinely based on artificially understated appraisal of the foreclosed property that for one reason or another third party foreclosure sale bidders did not exploit.  Appraisers who are hired by banks in these situations know the score and produce low valuations within the range of possible appraised values (something that is more art than science) so that they get repeat institutional lender customers.

This is a core litigated issue in deficiency judgment cases brought against borrowers and their guarantors, but the presumptive validity of a deficiency bid which a contesting borrower has the burden of showing was unreasonable, is challenging for someone who has just lost a valuable property to overcoming in sometimes expensive litigation.  As often as not, borrowers fight these claims be reaching a settlement based upon inability to pay, or by going bankrupt, rather than by resolving the question on the merits in a deficiency judgment lawsuit that they lack the resources to fight once deprived of their valuable property in foreclosure.

This is also a situation where an asymmetric playing field is unfair to borrowers.  The deficiency bids of lenders supported by appraisals are presumptively valid and can be used to get more than the property from the lender on a basis that is not market tested.  In bankruptcy under Chapters 11 and 13, second home borrowers and commercial real estate borrowers can do essentially the same thing, using an appraisal to "cram down" the amount of a mortgage lender's loan that survives bankruptcy to the value of the property that is collateral for the loan without any market test of that appraised value.  But, residential mortgage borrowers aren't entitled to cram down in bankruptcy and must either surrender a personal residence (in which they have a non-economic stake that can't be share with the bank) that is worth less than the loan, or turn over the personal residence to the bank and move out.

Lenders and their attorneys often pursue deficiency cases aggressively even when in a large share of cases this leads to nothing but a pennies on the dollar settlement in or out of bankruptcy, or to no meaningful recovery at all, often after forcing a borrower or guarantor to go bankrupt.  There are some substantial recoveries in these cases, but they aren't particularly common even in big dollar commercial cases.

The Thin Foreclosure Sale Market

The other hugely problematic feature of the foreclosure system is that foreclosure sale bids rarely command anything close to the full fair market value that could be secured in an ordinary arms length, undistressed realtor negotiated sale of the collateral.

The moment that a property enters the foreclosure process, buyers collectively lower their offering prices because they know that the seller is distressed.

Foreclosing lenders are never required to bid more than the amount of their debt to obtain the collateral even if their loan is worth far less than the property foreclosed upon.

Third parties are allowed to bid at foreclosure sales, and sometimes they do, but a variety of factors conspire to prevent third parties from making anything other than low ball bids except in the case of properties which obviously have lots of equity.

Foreclosure bidders have far less information about the property being purchased than an ordinary commercial real estate purchaser and have to suspect the worst because the current owner didn't find a third party buyer for the property prior to the foreclosure sale.  So, they discount their offering price accordingly, factoring in a higher expected profit margin in each transaction to compensate for unexpected surprises in a few deals. Sometimes the owner doesn't come to terms with reality because the property has little equity, but equally often, the owner fails to act because the owner does not personally have the capacity (often at a time of general personal and financial distress) to be together enough to take the steps necessary to conduct a pre-foreclosure sale, especially if the complications involved in trying to negotiate a short sale are involved.  Also, the lender can always refuse to cooperate with a short sale, leaving the borrower's only recourse to solicit people to make cash bids at a foreclosure sale without knowing what appraised price the lender will be offering.

The fact that a foreclosure bidder has to promptly pay cash in a time frame to short between the purchase and the time that full payment is due to arrange commercial financing for the property prevents the vast majority of people ultimately interested in purchasing a foreclosed property from bidding.

The lender has no interest in soliciting people to bid at the foreclosure sale, because once they regain possession they can arrange at their leisure for a more lucrative commercial sale of the real estate in the ordinary course and secure a full market price rather than a distressed seller, cash only sale price.  Any potential buyer the lender is aware of at the time of the foreclosure sale can be contacted after the lender secured title to it.

Artificially low foreclosure sale auction prices inflate the deficiency judgments owed by borrowers when properties are upside down, and cause them to arbitrarily lose equity in their foreclosed property in cases where the lender's debt is fully satisfied out of the collateral.

Further, to the extent that the foreclosure sale auction process is not providing a meaningful check on abuses on inaccurate bidding and lenders windfalls from over secured loans in the foreclosure process, the foreclosure process imposes strong moral hazards on lenders to routinely unreasonably bend the rules in their favor that are hard to test in an adversary process.

How Badly Broken Is The Foreclosure Sale Process?

In short, the concern is that foreclosure sale prices are too low.  Nobody is seriously claiming that foreclosure sale prices are too high and are cheating the lenders and foreclosure bidders at those sales.

The indirect measure of the extent to which the foreclosure sale process is flawed by underpricing foreclosed real estate is the extent to which lenders and third party foreclosure sale purchasers are making profits from property purchased at foreclosure sales.  The bigger the profits lenders are making from the REO sales and the bigger the profits third party foreclosure sale purchasers are making from their purchases, the more badly the foreclosure system is broken.

The fact that surplus payments to borrowers are rare, even in cases that don't involve recently closed, low down payment loans also supports an inference that the foreclosure sale process is flawed, although less decisively, because market wide declines in real estate prices, which have been recently experienced in many markets, can also have that effect.  A poorly cited study by Whitney from 2003 cited in Wikipedia states that bulk REO sales are typically for 40% to 60% of the actual fair market value of the properties.

A 2008 study in the Cleveland market found that lenders take losses on a large share of their lowest price REO sales, although subsequent buyers from commercial banks make significant profits of these very low priced REO sales.  The lenders apparently see foreclosure as a way to cut their losses a little, while placing a premium of getting out of the business of owning real estate quickly even if that comes at significant opportunity costs to the lender.  Part of this may be motivated by tax disincentives for lenders associated with REO profits.  Rather than chase borrowers for deficiency judgments, these lenders bid the amount of their debts in the case of low value real estate, quickly dispose of the property in a fire sale, and let someone else secure incremental profits involving activities like fixing up foreclosed properties and marketing them that are outside their core business competencies.

Another metastudy from 2012 that was jointly sponsored by several federal reserve banks looking at several studies conducted since 1985 found that in U.S. markets discounts in foreclosure sales varied by market and property type from just 1-2% to 47%, with a foreclosure discount in the vicinity of 22% being typical nationally.  Recently, studies have also focused on the concerns of local governments about neighborhood level distress caused by a wave of foreclosures in the same neighborhood.

The foreclosure sale auction market is also not monolithic.  Most foreclosure bidders are geared towards purchasing very low priced properties either for personal use or to fix and flip (or just to flip).  Empirical studies have shown few big players with foreclosure bidders who purchase large numbers of properties making up only about a fifth of REO purchasers in the Cleveland market, for example.  The pool of potential foreclosure bidders for high end residential real estate and commercial properties, where the risks associated with imperfect information are greatest and the number of sales each year is smallest, is particularly thin.

In short, the empirical evidence supports the claim that foreclosure sale prices are artificially low, but there are few strong indications that REO sales are a big profit center for lenders who tend to leave money on the table in these transactions, or that the market is lucrative enough to attract large numbers of repeat players who consistently make big profits over time on these transactions.  So, while this system is broken, something, probably the ability of borrowers to make distressed sales or secure hard money loans while foreclosure proceedings are pending, mitigates the extent to which this process is abused when property owners risk losing large dollar amounts of equity in a foreclosure sale itself.


Anonymous said...

It's nice that you are covering the subject and you raise many valid points. However, to correct something, the bank usually does not own the note and the custodian for the bank, like cash, should be able to account for the whereabouts of the original Note and Mortgage, 100% of the time. The Note is "owned" by the trust who securitized that obligor's cashflow contribution; the Note is always sent to a vault with locks and staff supervising what goes in and out.

Also, it's not the bank hired lawyers who get paid 35% to 50% for collecting on a mortgage. The bank, who pretends to have ownership, has a contract with the GSEs (Fannie Mae) giving them as a Servicer the right to keep the first 27% of the collected proceeds from a foreclosure. After all of this is collected that same servicer goes to the GSE to make up the full balance due from our Federal government.

sirking said...

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