WHEN Gregory and Paula Sherman wanted to refinance the mortgage on their ranch-style home in Chattaroy, Wash., near Spokane, in June 2003, they went to a local mortgage broker.
Or so they thought. The good-faith estimate that the federal government requires mortgage brokers to give to all customers said that was the deal. But at the closing, the Shermans were handed loan documents for an adjustable-rate mortgage with a higher initial rate, of 8.625 percent, that would reset in two years.
They reluctantly signed the documents because they had pressing commitments to pay debts and home renovation contractors. It was only later that they discovered that their mortgage broker was paid a commission of $5,344 by NovaStar to put them into the riskier and more expensive loan. That commission added $200 to their monthly mortgage bill.
The Shermans filed suit in 2005 against NovaStar, a lender based in Kansas City, Mo. The suit is now part of a federal class-action lawsuit accusing the company of bait-and-switch practices that increased borrowers’ costs. NovaStar, founded by a pair of entrepreneurs who rode the real estate wave hard by specializing in financing risky borrowers, faces litigants next month when the lawsuit goes to trial in federal court in the Western district of Washington.
Documents in the case show a raft of NovaStar customers accusing the company of using hidden commissions as early as 2003 to generate high-cost loans that may have run afoul of state consumer protection rules.
As NovaStar fights that courtroom battle, it has become Exhibit A for anyone interested in understanding how loose the lending was among some upstart mortgage companies in the great real estate run-up of this decade. The company’s troubles also reveal how willingly investors, regulators and much of Wall Street overlooked mortgage companies’ questionable practices.
NOVASTAR jolted its investors in February when it disclosed that loans made in 2006 were defaulting at a torrid rate. A highflying stock paying a handsome dividend that made it a favorite among small investors, NovaStar lost 42 percent of its value in one day.
But while problems at NovaStar, one of the nation’s top 20 mortgage issuers, seemed to crop up suddenly, they were evident enough from 2002 to 2004 that a big mortgage insurer and two Wall Street banks stopped doing business with the company.
NovaStar’s financial performance in those years was blinding. With Scott F. Hartman as co-founder, Mr. Anderson built NovaStar as a low-cost, low-overhead lender that relied on as many as 16,400 independent mortgage brokers across the nation. After issuing shares to the public in 1997 at a split-adjusted price of $9, the company had explosive growth. NovaStar made $2.5 billion in mortgage loans in 2002; by last year the annual figure had risen to $10.23 billion. The stock hit $70.32 in March 2004; it now trades at $5.
As is often the case when an industry is booming, working at NovaStar was a frenetic blur, some former employees said. The founders, who met at Saxon Mortgage in the mid-1990s, a subprime lender now owned by Morgan Stanley, complemented each other. Mr. Anderson, NovaStar’s deal maker, took a freewheeling approach to the lending business, while Mr. Hartman was buttoned down, paying more attention to detail and acting as the company’s relationship manager with Wall Street, former employees said.
The combined loan-to-value ratio in its mortgages, a measure of risk that compares the size of the total loan on a property to the underlying collateral, averaged 81.2 percent in 1998. By 2006, that figure had jumped to 87 percent. A minimum loan-to-value of 80 percent is considered prudent.
Like other lenders, NovaStar also eased up on the required documentation of a borrower’s income during the boom. In 1998, some 35 percent of the company’s mortgages did not have full borrower documentation attached to them; last year, almost 53 percent did not.
It is perhaps not surprising, then, that NovaStar’s early payment default rate for loans underwritten in 2006 reached 8.19 percent, up from 5.61 percent in 2000.
Until recently, though, few investors seemed concerned about NovaStar’s lending practices. Perhaps they were lulled by its earnings, which grew to $132 million in 2005 from $32 million in 2001.
In 2002, however, the PMI Group, a leading provider of mortgage insurance to issuers, terminated its relationship with NovaStar Home Mortgage. A PMI spokeswoman declined to say why. But after NovaStar sued PMI in federal court in 2003, seeking payment on insured loans that had defaulted, the insurance company countersued, accusing NovaStar of misrepresenting borrowers’ stated incomes on loans. The companies settled in 2005; terms were not disclosed.
And in 2003, the ABN Amro Mortgage Group, a big mortgage lender that had bought what it said turned out to be bad NovaStar mortgages, sued the company, accusing it of fraud, breach of contract and negligence involving so-called straw borrowers and inflated appraisals.
A Lehman Brothers unit, among Wall Street’s largest packagers of residential mortgage loans that it sells to investors, terminated its relationship with NovaStar Home Mortgage in 2003. It found numerous red flags on more than half the NovaStar mortgages in a batch that it reviewed. Court documents show that the Lehman unit, Aurora Loan Services, found problems that ranged from misrepresentations of employment by the borrower to overstated property values and unsubstantiated payoffs at closing.
One loan involved a property in Ohio bought for $20,000 in August 2002 and sold two months later to NovaStar borrowers for $77,500. The average sales price in the neighborhood was $31,685 at the time.
IN 2003, problems at NovaStar Home Mortgage’s branch system began turning up when it became clear that the company had not received licenses to operate in some states. That October, Massachusetts filed a cease-and-desist order against NovaStar for not having a license in the state. Nevada followed with its own order in early 2004.
In September 2004, the office of inspector general for the federal Housing and Urban Development Department found violations of HUD rules such as the company’s hiring of independent contractors as loan officers and its practice of allowing its employees to make investments that might compete with the company.
The HUD report said that NovaStar’s branch system was meant to shift risk away from the company to the federal government. The inspector general recommended that NovaStar pay penalties in the case.
Mr. Anderson rejected all of the audit’s conclusions but said the company had been closing down the branch system anyway. He said he had not heard from HUD since then and that the company had paid no penalties as a result of the audit. NovaStar shut down its Home Mortgage branch system in mid-2006.
While NovaStar’s practices appear to have been lax, some former customers tell of what they call deceptive practices that resulted in higher-cost loans than they could have received elsewhere.
Among the sheaf of papers they signed at the closing for their refinancing through NovaStar, they did not notice one listing a commission of $5,344 paid by the company to the mortgage broker. They would learn later that it was for persuading the couple to take out a loan at a higher interest rate. In industry parlance, the commission is known as a yield spread premium.
The Shermans’ lawyer, Ari Y. Brown of Bergman & Frockt in Seattle, said an examination of hundreds of NovaStar loans showed the company was still not providing accurate information in good-faith estimates. Mr. Brown said at least 1,000 NovaStar customers in Washington State could be members of the class.
While that figure may seem small, NovaStar faces a potentially larger problem. Under the terms of many loans packaged by Wall Street and sold to investors, misrepresentation could allow the holders of those mortgages to force NovaStar to buy them back, according to a regulatory filing by the company.
In theory, yield spread premiums are meant to let borrowers pay a higher interest rate over time rather than pay a big sum in closing costs. But Ira Rheingold, executive director of the National Association of Consumer Advocates, said that this was not how they worked.
Four years ago, officials at HUD recommended requiring greater disclosure of commissions and other fees in loans, but the proposals were attacked by lobbyists and were never instituted. A spokesman for HUD said it hopes to introduce new rules soon, but declined to say when.
Widespread concerns about subprime lending have already battered the company. In February, NovaStar said it would not likely generate any taxable income in 2007. And in late March, it announced that it would lay off 17 percent of its work force.
Last week, Fitch Ratings placed NovaStar’s Mortgage Servicing unit on alert for a possible downgrade. The company’s “ability to fund its ongoing servicing operation and maintain servicing quality could come under pressure,” Fitch said.
Now, the go-go atmosphere at NovaStar’s Kansas City headquarters is gone. Next to online job postings for loan officers are those seeking specialists in modification of problem loans and litigation.
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