Twisted sisters

Clearwater, Fla.-based Global Mortgage Inc. found itself in familiar company and surroundings when it plunged into Chapter 7 bankruptcy this past March. Business Mortgage Inc., another brokerage with identical owners, had filed its Chapter 7 papers in the same Tampa, Fla., court five months earlier. Lawyers for a third brokerage had marched into the seventh-floor courtroom in July 2007. That brokerage, Premier Mortgage Funding Inc. of Tampa, was a fierce competitor of Global Mortgage and had provided some key Global staff. Premier Mortgage claimed as its principal asset the value of a slander and tortious interference suit filed against Global Mortgage, which in turn had filed a countersuit.

Round and round it goes.

A few mortgage brokerages began to trickle into bankruptcy court in the early months of 2007, an early warning that America's housing boom was in trouble. That trickle has since become a torrent, and the waters have yet to recede.

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Even major lenders that focus on the supposedly safe prime lending market are gasping for air. One such company is Thornburg Mortgage Inc., which has been hammered by losses, compounded by margin calls on the falling value of its mortgage-backed securities. A $1.35 billion rescue package lined up in March is in jeopardy, Friedman, Billings, Ramsey Group Inc. said in a report issued in October. (Friedman Billings acted as the lead placement and financial adviser in the March $1.35 billion private placement.) On Sept. 30, Thornburg was forced to make an interest payment to senior subordinated lenders in additional notes.

Mortgage banks have failed as well, with IndyMac Bancorp leading the way. And the rot is spreading upwards. In recent months, the industry has been wracked by the closure of wholesale lending units, which are critical to home loans because they're the ones actually funding brokers and bankers. That list includes the wholesale operations of Accredited Home Lenders Inc., Homecomings Financial LLC and Irwin Financial Corp., according to data compiled by the Web site Mortgage Lender Implode-O-Meter. Irwin, for one, is attempting to restructure and faces a tough time surviving.

As the courts wade through the muck left behind by the collapse of the housing market and the mortgage industry that fed it, they can discover a pattern of entangled and now-withered ownership systems and obligations. It's true with mortgage brokerages, which originate loans, and with mortgage banks, which can both originate and fund the mortgages.

This family tree of bad and busted relationships speaks volumes about the financial meltdown. Strip away the debris, and supposed assets turn to dust. With virtually no regulatory supervision, mortgage companies could be created overnight, flourish in a flash and die just as quickly, leaving behind nothing but bad debts and on-the-hook creditors.

Those up the mortgage chain assumed they were well protected. At each step along the way, there was supposed to be some kind of guarantee, some level of insurance. Now everyone from the banks that originally funded the loans to institutions that bundled the mortgages to investors who bought securities backed by bits and pieces of the bundles are scurrying around trying to ascertain whether there's any recourse whatsoever.

"Every party along that chain is looking; where did these loans come from, did someone misrepresent something?" says William Nolan, senior managing director of corporate finance for FTI Consulting Inc. "Every part in the chain is looking at their exposure and an ability to get something back."

They're discovering that protection isn't necessarily as billed. Banks that funded these mortgages, and those that provided lines of finance to the banks, carried guarantees against defaulted mortgages or those obtained through fraud and misinformation. These safeguards, called repurchase agreements, also provided some of the succor for the entire bundling and securitization explosion. "Repurchase agreements all came out of bundling," says John Smaha, a San Diego-based attorney.

Turns out, those safeguards can be worthless.

An examination of bankruptcy court documents reveals sometimes huge caches of these repurchase demands, which also can be lumped under the more broadly termed representations and warranties. Often, these demands actually triggered the bankruptcies. In some cases, these reps and warranties could end up being held by mortgage banks such as IndyMac, which themselves went bust.

This kind of daisy chain of worthless guarantees provides more evidence why the full extent of the financial debacle is so difficult to figure.

Who owns what and with what guarantees becomes a mystery that could take months, if not years, to solve and unwind. "It's hard to establish their value," Smaha says.

As mortgage banks and brokerages now in liquidation show, it's also tough to determine who will ultimately get stuck by all these questionable loans. Mortgages were usually bundled and securitized and often insured against default by monoline insurers such as MBIA Inc. Mounting defaults mean monoline insurers eventually must pay out. But there's a long time lag--possibly years--between the point when individual mortgages began to default and when a big enough percentage of the underlying mortgages in a securitized instrument defaults to trigger the policy.

Add to this credit default swaps, issued to protect collateralized debt obligations further up the chain but ultimately backed by the same bundle of mortgages. So, lawyers believe, it's very possible one group of defaulted mortgages could over time trigger multiple claims.

"There are obviously lots of issues that need to be worked out," says a lawyer who works with securitization.

Mortgage abuse flourished during the property boom, and unscrupulous brokers certainly played a large role. New evidence of illegal deals is emerging all the time. For example, three individuals associated with a New York mortgage broker called AGA Capital NY Inc. pleaded guilty in October to mortgage fraud. Their misdeeds included setting up straw buyers for condos acquired with mortgages for overly inflated prices, then defaulting on the loans. What's notable is this operation's size. During a 3-1/2-year run, AGA brokered more than 1,000 mortgages and home equity lines, with a book value of at least $200 million, the U.S. government said in its indictment.

Reno, Nev.-based Cetus Mortgage Ltd. filed for Chapter 11 in July after the Nevada Department of Business and Industry ordered that it be shut down. That followed an investigation into widespread complaints by investors of fraudulent loans and forged documents.

But it's a mistake to see what's happened only in terms of fraud or predatory loans to people who couldn't afford them or even grossly overinflated real estate markets, although these are critical elements in the ongoing saga. "Brokers are the front, but they weren't the main driver," says Alys Cohen, staff attorney at the National Consumer Law Center.

It isn't just a question of unprincipled brokers and questionable mortgages, but of a system designed to shed those mortgages as quickly as possible and move them further and further away from the originator and the initial funder. "The goal was not to keep assets," says Cohen. "The real issue is the incentives. [They] pushed all loan originators to steer all borrowers to more expensive mortgages than they qualify for."

That created a system in which those that write mortgages have neither the responsibility nor the assets to make good on any problem loans. Minimal oversight of the mortgage industry combined with what has turned out to be unenforceable legal protection.

The explosion of mortgage brokerages and banks was part and parcel of the real estate boom. In what is now a well-known cycle of pass-the-problem, the brokers originate mortgages, acting as agents, or a kind of independent contractor, for banks or other financial warehouses. Brokers make their money through up-front fees. While banks kept some mortgages whole, more commonly they bundled and sold them off to other investor institutions that securitize them. Mortgage-backed securities and their collateralized debt obligation brethren now form the radioactive core of a multitrillion-dollar meltdown.

At the height of the bubble two years back, the number of mortgage brokerages topped 53,000, according to the independent mortgage-related research firm Wholesale Access Mortgage Research & Consulting Inc. The number of mortgage brokerages in the U.S. is now about 30,000, the consulting firm estimates. Christine Clifford, Wholesale Access vice president, believes that number will keep falling to 25,000 by next year.

That means more than half will have called it quits, an astounding percentage of failures. Many were mom-and-pop operations, and the majority of these, it appears, simply turned out the lights, shut their doors and walked away. Others, however, boasted extensive branch networks and eight-figure revenues. Large and small companies are now clogging up the bankruptcy courts.

From boiler-room tactics and junk fees to fraudulent applications and improper rates, mortgage broker fraud is a well-trafficked subject by now. An astounding lack of regulatory oversight certainly abetted this unsavory scene. A Miami Herald investigation earlier this year detailed more than 10,000 individual mortgage brokers in Florida alone with criminal histories. Some 2,000 were convicted felons, including bank robbers and land swindlers. Of the 51 brokers convicted of criminal mortgage fraud from 2003 to 2007, the newspaper revealed, only one had a license revoked as a result of the conviction.

State regulators aren't the only ones to blame. Only this summer did Congress impose any kind of federal oversight for mortgage brokers and ban licenses to those who had been convicted of a felony or had a license revoked previously. Before, an unscrupulous broker who was shut down in one state could easily obtain a license in another. A nationwide database began to operate earlier this year. So far, however, only 19 states representing 8,600 mortgage companies are online.

With such lax regulations, brokerage houses can easily evade responsibilities and liabilities. Even now, mortgage brokerages have no net worth requirements. So an individual can incorporate a brokerage, siphon off the income and go out of business if necessary, with little concern of personal loss.

"There's no accountability," says Mary Dannelley, an Irvine, Calif., attorney who has litigated against brokerages. "They can just walk away."

Instead of providing a safeguard, repurchase demands can become the reason for a quick exit. "What you may find is that after a repurchase demand or a judgment, they'll just BK [file for bankruptcy] that company and two days later start another one," Dannelley says.

Three hundred mortgage banks either failed or went out of business during 2007, according to an extrapolation of data from the Federal Financial Institutions Examination Council. Repurchase demands tripped up these banks as well, bankruptcy lawyers say.

As long as banks had access themselves to funding, so-called warehouse lines, they could take back defaulted loans, pay off whoever had acquired them and eventually resell them for a discount as so-called scratch-and-dent. But if their funding sources dried up as well, they had no way to make good.

That was the case with EquiPoint Financial Network Inc., which filed for Chapter 11 in June. EquiPoint was the creation of Oaktree Ventures Inc., a small venture capital group, which rolled up two mortgage banks and two mortgage brokers beginning in late 2003.

In its bankruptcy court schedule of unsecured claims, San Diego-based EquiPoint Financial lists pages upon pages of contingent repurchase demands. In bankruptcy documents discussing the collapse, attorneys for EquiPoint cited not only the loan purchase requests on the books, but also "the inability of debtor to quantify what further repurchase requests may occur in the future."

"It was the presence of these demands that drove them into Chapter 11. They were issued at the same time as the loss of warehouse lines," says Smaha, who's acting as debtor counsel and attempting to reorganize EquiPoint. He adds that EquiPoint's situation is anything but unique. "I've seen this with several others."

The amounts of these demands can be staggering. Aegis Mortgage Corp., a once-huge operation 81% owned by Cerberus Capital Management LP's Madeleine LLC affiliate, filed for Chapter 11 in July 2007. At the time of its filing, Aegis estimated repurchase requests would top $400 million by the end of 2007. Aegis just filed a reorganization plan this October. The plan indicates recovery of repurchase-related claims will range from 5% to 15%.

In its Chapter 11 bankruptcy filing, Fieldstone Mortgage Co. said it faced more than $100 million of such repurchase demands. During its heyday, Fieldstone Mortgage employed 1,000, boasted 70 offices and originated $7 billion in mortgages as both a wholesaler and retailer, virtually all of which were sold on to either its former real estate investment trust parent or third parties. By the time it declared Chapter 11 bankruptcy in November 2007, its funding had dried up and it had laid off pretty much the entire staff.

Fieldstone is also reorganizing. The debtor and creditors agreed to allow $35 million of the repurchase agreements as claims. But that's pretty much an accounting exercise, because distribution amounts to 3%, or about $1 million.

A few liquidations have yielded "more assets than anyone thought," says Ira Kharasch, a Los Angeles-based partner at Pachulski Stang Ziehl Young & Jones LLP. Kharasch cites the bankruptcy of Ownit Mortgage Solutions Inc., a large subprime lender of which Merrill Lynch & Co. owned 20%. When Ownit filed for Chapter 11 in early 2007, it showed few assets on its balance sheet. But the estate eventually collected about $35 million, says Kharasch, who acted as debtor counsel. These assets included mortgages Ownit had been forced to repurchase.

At the height of the real estate bubble in 2006, the value of residential mortgages issued was about $2.7 trillion. That is expected to drop to $1.9 trillion this year, according to the Mortgage Bankers Association, although that estimate seems wildly optimistic. Even in terms of the current marketplace, however, mortgage brokers are getting less business. Wholesale Access projects mortgage broker market share will have dropped from 58% of total origination in 2006 to 38% this year.

Just about anyone could become a mortgage broker and with minimal capital, since the whole idea was to write them up and get them out the door as quickly as possible. Bankruptcy records reveal an astounding mismatch between assets and liabilities. Take East West Mortgage Co. of Vienna, Va., for example. In January, First Mariner Bancorp sued it, detailing 16 loans it alleges were made through false, misleading, altered or forged documents. First Mariner sold the loans but was forced to buy them back after they defaulted. First Mariner claims it lost $5 million from the repurchase and sued for $15 million.

Good luck.

East West filed for Chapter 7 in March. First Mariner's lawsuit was stayed.

What's more, East West listed assets of only $181,000, most of which were rent and utility deposits. Among the other creditors: IndyMac.

Some of these mortgage brokerages exhibited a missile-like trajectory. In five years, Premier Mortgage Funding went from nothing to 750 branches, through a kind of franchising that created an affiliate network with independent mortgage brokers. Revenues in 2006 totaled more than $200 million. Assets were about $12 million.

Its descent was even more rapid. In a year, more than 600 branches either closed down or dropped out of the network. Monthly income fell about 99%. The company filed for Chapter 11 in July 2007.

Even Chapter 11 couldn't be sustained. After it filed, Premier Mortgage became so strapped for cash it couldn't pay either an attorney or the trustee's office.

In April, the company converted into Chapter 7 and is now being liquidated.

Of Premier Mortgage's $2.6 million in declared assets, the lawsuit against Global accounted for $2 million. An examiner into Premier Mortgage's affairs concluded the claim was "exaggerated," especially since the supposed slanderous allegations, most notably over Premier Mortgage's mounting financial straits, turned out to be absolutely spot-on.

Any victory for Global Mortgage is Pyrrhic, however. The Chapter 7 trustee maintains Global was insolvent for a year before its bankruptcy filing in March and was hit before filing with at least 18 lawsuits. Add to that a lawsuit the trustee has since filed against owners Scott and Debra Losch, alleging preferential transfers of at least $1.2 million into their personal accounts. They are fighting the charge and couldn't be reached for comment.

In 2006, Global Mortgage claimed gross income totaled $51.3 million. In its prime, Global Mortgage boasted of more than 2,200 employees spread across 38 locations throughout the U.S. It filed in Tampa as well. When Global Mortgage filed for Chapter 7, it listed its only assets as furniture and computers valued at a wildly optimistic $900,000. By then, the California Corporations commissioner had pulled Global licenses and barred Scott Losch from any role as a lender or broker.

Global was subject as well to consent decrees in Pennsylvania and Connecticut.

The Losches' other mortgage company, Business Mortgage, went down in flames as well. Business Mortgage filed for bankruptcy after losing an antitrust and false advertising lawsuit. It was one of several mortgage companies a California jury found guilty of conspiring to strike American Interbanc Mortgage LLC from a Web site after American Interbanc accused them of bait-and-switch tactics. Each is on the hook for the $42 million judgment, plus interest.

American Interbanc won't get much from Business Mortgage. According to court documents, Business Mortgage listed assets as worth $10,000 for computers and office equipment, and that's being generous.

Among the other defendants in the American Interbanc suit is NovaStar Home Mortgage. Last month, creditors put Kansas City, Mo.-based NovaStar Mortgage Inc. into Chapter 7 involuntary bankruptcy. NovaStar, both mortgage broker and lender, bundled its loans into securities and sold them on, retaining some ownership stake. NovaStar defaulted on about $80 million worth of unsecured notes used to finance its mortgages.

NovaStar says it no longer originates loans. It claims the loans on its books have a value of about $18.5 million. The extent of its repurchase agreements -- and entanglements -- isn't yet known.

Only this year did it appear that state authorities began to step in and corral even the really egregious brokers. The Minnesota commerce commissioner shut down a broker called Centennial Mortgage and Funding Inc. after it found evidence of "financial irresponsibility or incompetence." A prominent Centennial Mortgage sign still adorns the top of an office building just west of the Minneapolis-St. Paul International Airport in suburban Bloomington.

But some of those license revocations show that the agencies were about a year too late and that operations had long since ceased.

Banks should have known something was amiss long before. Take the case of Mark Karwisch, who owned Cincinnati-based Amerigroup Mortgage Inc. The company opened for business in August 2005 after Karwisch and a partner closed another mortgage company. Amerigroup didn't last two years. It filed for Chapter 7 in March 2007. Karwisch had his home foreclosed. The bankruptcy estate eventually conducted an auction for the house. Turns out Karwisch hadn't paid principal or interest on his own home loan since May 2006.

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