What you don't know about closing protection letters could come back to bite you. uybacks are not going away. Worse yet, they will likely increase in the months and year ahead. As Brian Levy , of counsel with Katten & Temple LLP in Chicago , wrote in his September 2013 Mortgage Banking article, "the buyback era is far from over," for a variety of reasons. U Inside Mortgage Finance hosted a webinar focused on buyback risks in November where it was noted that Fannie Mae's and Freddie Mac's stepped-up reviews of tens of thousands of loans, even performing loans, has generated more than $250 million in buyback requests for loans made in 2012 and 2013. This means lenders will face more than double the risk of buybacks than they did from 2010 and 2011 closed loans. H While much has been written about the most obvious causes of buyback demands, scant attention is being paid to the other possible causes for repurchase demands. Moreover, a significant number of lenders might be quite surprised to discover that they have little to no coverage for this additional exposure. Over the past two years, I have heard from a number of lenders and lawyers representing lenders about buyback demands due to defective titles, inaccurately executed closing documents, and the settlement agent's failure to follow instructions. A good example comes from Eugene McCullough , a partner in Title Experts and Management Services (TEAMS), McKinney, Texas , a title insurance consultant and expert witness firm, and former president of several regional title insurance underwriters for more than 30 years. McCullough was recently retained by several lenders to provide expert witness testimony regarding the scope of coverage in a number of closing protection letter (CPL) cases. In one case filed in 2013, the lender sustained a loss and filed a claim under the CPLs issued in each transaction, but once the claim was denied the lenders were forced to file suit to recover under issued CPLs. In that case, the secondary market purchaser of the loans had forced the originating lender to buy back seven loans once it was determined that the mortgage broker and title agent had conspired to have loans secured by straw borrowers who had submitted on fraudulent loan applications. The title agent and mortgage broker were tried and convicted on criminal charges. The CPLs in each case stated that the lender would be indemnified for losses in the event of "fraud or dishonesty of the issuing agent or approved attorney in handling your funds or documents in connection with such closings." The original funding lender was caught in the middle. Initially it innocently relied on the loan application documents (which were subsequently determined to be fraudulent) secured by the mortgage broker before it funded the transactions. Then, years after the sale of the loans, the broad recourse provisions in the Correspondent Loan Purchase Agreement with the secondary market purchaser resulted in the loans being forced back to the innocent originating lender. The lender thought it had coverage for losses arising from the acts of the criminally convicted issuing agent, but found coverage was disputed and has been forced to file suit to determine if the CPL provides any coverage at all. The fact patterns are not surprising. What is surprising is the frequency of occasions when a lender finds itself without adequate coverage. The lenders in these instances often learn a surprising and expensive lesson: CPLs and title insurance provide less coverage than they think, and they are more at risk for loss than they realize. What you don't know can hurt you The CPL isn't something most mortgage lending companies and banks lose a lot of sleep over. This is unfortunate, because their lack of worry may be based on a false sense of security-one that can quickly lead to a nightmarish scenario if things go wrong. As far as CPLs go, the reverse of that old saying, "what you don't know can't hurt you," is true. What you don't know can definitely hurt you with CPLs. There's another old saying that also applies: "The devil is in the details." Sadly, this succinctly sums up the problems with CPLs. Even worse, it can be extremely difficult to determine what any given CPL does and doesn't cover. It's a matter of reading between the lines, instantly spotting what the details are conveying and what they're not covering. And it can be anything but clear. All too often, long after the loan has been closed and sold upstream to a larger warehouse lender or even to the secondary market, the shortcomings of the typical CPL can come back to haunt the original lender. Far too frequently, the mortgage lender turns to the issuer of the CPL only to discover that, by the terms of the instrument itself, it's the lender-and not the title insurance company-that is exposed to any number of errors or acts of malfeasance. Don't get the wrong idea. CPLs certainly have their place. They're necessary, even essential, for providing much-needed protection. And that's why lenders require them as a condition to close a loan. But-and this can't be emphasized enough- CPLs are not all-inclusive in their coverage. It's important to know the areas where you're most vulnerable with CPLs. Areas where experts see most likely exposure Too narrow "Some CPLs are written so narrowly that they're essentially worthless as instruments to protect lenders," according to Marx Sterbcow , managing attorney with the Sterbcow Law Group LLC , New Orleans . This is a problem he's seen time and time again in his practice, which involves litigation on mortgage fraud issues involving CPL coverage issues, as well as when representing lenders that are performing third-party agent due-diligence processes. Another problem is that CPLs not only differ from state to state, but the coverage protection often changes over time. In other words, what is covered in a CPL today may not be covered in a CPL tomorrow. "The standard language in CPLs has varied slightly in form, but significantly in coverage, over the past 30 years," says McCullough. " The American Land Title Association [ALTA, Washington, D.C. ] has adopted various forms as the ALTA closing protection letter, which has become the lender's default requested form. The version used for many years was the 1987 version, but the standard letter was amended in 1996 and again in 2011. Not surprisingly for a document that is given away for free in most states, the coverage afforded lenders narrows significantly with each successive revision. And to make the issue even more confusing, title underwriters often continue to issue the older version after a new version is adopted or even make special modifications to the ALTA form that has been recently adopted. The exact coverage can only be determined by reading the form that was actually issued in each transaction." Sterbcow adds, "A lender [that] is issued a CPL must closely review the coverage it is actually receiving from the title insurer's CPL in order to adequately assess whether it should choose that title insurer's policy. Of course, this is a time-consuming and expensive process, but failing to review opens the door to expensive litigation because the title insurance underwriters often seek to further limit the CPL coverage in the court." Short-term According to J. Bushnell Nielsen , a partner with Milwaukee -based law firm Reinhart , Boerner, Van Deuren SC, the terms of a CPL can vary by state and by issuer. By and large, however, the variation is fairly minimal. He points out that on most CPLs, some closing instruction violations are protected against. However, he also notes that many CPLs require that any claims be submitted within 30 to 180 days of the closing. In many cases, it can take months or even years, rather than days, to even discover that a loan instruction has been violated. This is usually long after the coverage of a CPL has expired. "Though the CPL was initially offered by title insurance underwriters to mortgage lenders as an inducement to require title insurance for their mortgages, they had become a fundamental requirement for risk management and provided a measure of protection relied upon by the lender. The timing of the presentation of a claim on the CPL, the requirement for lien-priority losses as well as other definitional distinctions have narrowed the CPL's effectiveness as a protective tool for the lender," says Edward Krug , industry veteran and former vice president and counsel with Stewart Title (1997-2001). He was president of ServiceLink from 2001 to 2005 and since then has been president of The Law Offices of Edward Krug , Moon Township, Pennsylvania , representing title insurers and agents as well as lenders and title claims. Fraud, theft and defalcation An equally unfortunate but common assumption is that CPLs cover all acts of fraud, theft and defalcation. They don't. McCullough suggests looking closely at the coverage afforded under a standard 1987 ALTA CPL form, as changes have been made to the fine print since then. For instance, he says, some CPLs read: "When title insurance of ABC Title Insurance Co. ('the company') is specified for your protection... the company hereby agrees to reimburse you for actual loss incurred by you in connection with such closings when conducted by an issuing agent... and when such loss arises out of fraud, dishonesty or negligence of the issuing agent or approved attorney in handling your funds or documents in connection with such closings." However, he adds, this standard clause No. 2 in the 1996 version of the ALTA CPL form was changed to read as (additional limiting coverage provisions in italics): "fraud, dishonesty or negligence of the issuing agent or approved attorney in handling your funds or documents in connection with such closings to the extent such fraud, dishonesty or negligence relates to the status of the title to said interest in land or to the validity, enforceability and priority of the lien of said mortgage on said interest in land." The truth is, most CPLs only cover "lien-related matters." Needless to say, this also narrows the scope of their protection considerably. Nielsen notes that one of the greatest shortcomings of most CPLs is fairly simple. "There has been little interpretation by courts of the measure of loss payable under a CPL, and most CPLs do not state how a loss is measured," he says. Title agency closing Sterbcow points out an additional shortfall. "Another problem with CPLs takes place when a title agent closes his or her doors and the lender hasn't been given a copy of the CPL. I have seen cases [where], when asked by the lender to produce the CPL issued, the title insurer will either respond that the CPL doesn't exist or it will refuse to provide one because it's not in the underwriter's best interest to provide one to facilitate a claim," he says. Sterbcow also notes that the protection afforded by a CPL generally dies if the title insurer goes out of business as the result of agent fraud. Enough is enough The truth is, we live in an age when mortgage lenders expect more from the closing agent at settlement. These expectations are detailed in closing instructions as well as master service agreements. However, it is also a time when CPL coverage has been narrowed, leaving lenders all to often to face real exposure in an area where they had mistakenly believed themselves to be protected. TWo years ago, a lending company that was a client of ours suffered a significant loss. The lender had originated scores of loans with a settlement services firm that, it was later discovered, had embezzled a significant amount of money. That firm subsequently went out of business. The lender's out-of-pocket exposure was tens of millions of dollars. The lender filed a claim with its title insurance company to cover this loss, only to discover the CPLs covered only the liens being paid through the transaction and not the cash out (which was tens of thousands of dollars per loan) or other disbursements, such as homeowner insurance premiums. As a result, the lender lost several million dollars as well as significant legal fees. None of this was ever recovered. This situation is not an everyday occurrence by any means. However, for this lender it was a very real and nearly catastrophic experience. When talking with other lenders about Settlement agent risks, I hear stories of a wide range of experiences, and the central theme is that they suffered a loss they thought was covered. I have been in this business for 22 years, and in truth, shared a similar lack of understanding as to what CPLs truly covered. It was not until I began to see and hear of some of our customers' experiences that I began to learn more and became concerned with the vulnerability lenders were facing because of the inadequate coverage of CPLs and the lack of awareness of the areas where they were exposed. That's why I believe there needs to be a way to make this problem a thing of the past. Fixing the problem Here are a few things that can be done to make that happen. Know what most CPLs cover and don't cover. This can sound simple, but it is often anything but simple to know exactly what CPLs cover (see Figure 1). Levy says this is the one key piece of advice he would give to lenders. "It is important to understand the risks and what is covered in both title insurance, in CPLs, and how that relates to your secondary market obligations," he says. Bulk up closing and post-closing quality controls. Lenders should not ignore the CPL and the coverage it provides, especially around the execution and delivery of the closed loan documents. The secondary market is placing more focus on the lender's quality control and underwriting, with inadequate quality creating the real possibility for repurchase demands. Lenders should heighten their focus on risk management issues involving CPLs from a loan buyback perspective, because it's likely the secondary market will require a greater focus on CPL coverage in the future. Inadequate or limited protections afforded in a CPL may generate a lot of concern for lenders because if they accepted a CPL without proper protections, it could cause a possible buyback issue. Fannie Mae and Freddie Mac are expecting higher-quality loans in the loans they purchase. Settlement agents can and should play a pivotal role in ensuring the quality of the loans they deliver. "Lenders see buybacks and compliance becoming synonymous," says Sterbcow. "Quality is now of the utmost importance going forward, and lenders will want to be sure title agents have standards in place that prevent something coming back and biting them later on." Based on our company's experience reviewing lender postclosing quality issues, as much as 80 percent of those issues can be prevented by a diligent and quality-focused agent. Lenders should expect more from their agents than just a title policy-they need to be looking for the type of quality Sterbcow speaks about. It would be prudent to expect that agents take an active role in ensuring the quality and accuracy of the loan before it is closed and funded. For example, the same review processes lenders employ on closed loans before funding or shipping can be incorporated into the settlement agent's pre-closing and closing processes. In addition, as part of their vetting processes of settlement agents, lenders can focus more attention on understanding exactly how the agent executes its closings and manages quality. Agents with best practices can show the risks in the settlement processes and how they mitigate them through their processes and controls. "As the [requirements] of Dodd-Frank [Wall Street Reform and Consumer Protection Act] become reality through enforcement by the [ Consumer Financial Protection Bureau ], the mantra of the mortgage lender has shifted from cheaper, faster and better, to best practices. This continued emphasis will focus deeply on the settlement service provider's ability to promote and support best practices by attention to quality as well as enhancements to risk management," Krug explains. "I have seen time and time again that there is a direct correlation between the liability the lender is exposed to and the quality of the settlement agent. The higher the quality of the settlement agent, the less risk there is for the lender. In today's regulatory environment, this cannot be overemphasized. Loan officers need to do their due diligence and be sure they truly understand who they are doing business with. The Consumer Financial Protection Bureau has made it perfectly clear that lenders are responsible for the quality of the work of third-party vendors they utilize for real estate financial transactions," Krug adds. Levy added to this line of thinking, saying, "Lenders today are responsible for all the vendors they work with, especially those that come in direct contact with the consumer. There is a whole new level of due diligence required. The days of 'I play golf with this guy, so he is good' are long gone." Seek other forms of insurance risk-mitigation products beyond the CPL that could provide: * Coverage that, unlike a typical CPL that expires in months from the closing, would allow a lender to register claims for years after the closing. * Additional coverage specifically designed to protect the original mortgage lender and the investor from a range of dosing instruction violations, as well as many acts of fraud or dishonesty in the implementation of escrow funds. * Coverage with the capability to protect lenders throughout the correspondent/warehouse stream from many grounds for buyback demands that could ultimately prevent a buyback. * Coverage that names the lender as an additional insured in the policy, allowing that lender to make the claim directly to the insurance company. * A far broader definition of "wrongful acts" that are protected against, ultimately taking into consideration ways a settlement agency could fail to perform and not prevent quality issues that would result in buybacks. Krug agrees that additional forms of insurance should be provided. "Lenders need to look for ways to enhance coverage," he says. "CPL coverage has been narrowed. It is not the automatic coverage it is assumed to be, and accordingly leaves gaps or holes." Sterbcow's advice reinforces the same message: "Go find someone who will cover the gaps that CPLs leave you exposed to," he says. Be sure that you understand where you are exposed and you are working with a quality settlement agent who understands the risks involved, as well as what is covered and not covered. "If all aspects-both from an origination standpoint and organizational standpoint-of settlement agents are not being audited and vetted extremely well, lenders are leaving themselves exposed," Sterbcow advises. Once you have this understanding, you can work together with your agent to plug the holes so you are protected and your portfolio doesn't come back to bite you. W It's important to know the areas where you're most vulnerable with CPLs. An equally unfortunate but common assumption is that CPLs cover all acts of fraud, theft and defalcation. They don't. Lenders should not ignore the CPL and the coverage it provides, especially around the execution and delivery of the closed loan documents. Lenders should heighten their focus on risk management issues involving CPLs from a loan buyback perspective. James K. O'Donnell is president of East Providence, Rhode Island -based Equity National Title and Closing Services Inc. , a national title and settlement services company. He is a Rhode Island -licensed attorney and a licensed title agent in 30 states. He can be reached at firstname.lastname@example.org . James O'Donnell Jim is president of Equity National Title and Closing Services Inc. He is a Rhode Island -licensed attorney and licensed title agent in 30 states. He is an active participant in the industry, serving as a board member or committee member of many associations, most notably chairing the legislative committee of the Rhode Island Mortgage Bankers Association (RIMBA) from 2003 to 2010, during which time he earned RIMBA's Distinguished Service Award three times. Jim spends his spare time coaching his twin sons in baseball, and passionately shares stories from the dugout with anyone who listens. He and his wife are lifelong Rhode Island residents, where they raise their four children.
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