Pub. 2 2013 Issue 5

l e a d i n g a d v o c a t e f o r t h e b a n k i n g i n d u s t r y i n k a n s a s 12 A small rural bank “opened” a loan production office in a large city. The bank entered into a contract with an “employee” who was to run the loan production office. The employee had previously headed a loan production office at the same location for another bank. The employee was to be paid a minimum-wage salary plus 50 percent of all income after all expenses for the branch. The employee had predicted that the bank would earn about $500,000 annually under this arrangement. In other words, a hotshot mortgage broker needed to use the bank’s name to have access to sell mortgages to the secondary market and was willing to pay 50 percent of the profits his business would earn for use of the bank’s name. The bank put few controls in place to audit the activity of the loan production office. For the first two years, things appeared to be going very well. The bank earned a profit of more than $500,000 annually from the mort - gage loans the employee produced and sold. The employee earned a similar amount as commission. He now had a large home and a luxury car with large monthly payments. Criteria then became stricter to qualify for mortgage loans. The loan production office did not make money for several months, but then slowly began making money again, though much less than in previous years. Suddenly, the bank started receiving letters demanding that the bank buy back loans as required by the contracts between the bank and the loan purchasers. An investigation revealed that in order to continue to produce loans, the employee had been providing inaccurate financial statements, false tax filings and even altered property appraisals. The employee admitted he did these things to make the loans appear to qualify under the stricter requirements. He explained that he couldn’t get by on a token salary and that it was impossible to produce enough valid loans to make a profit. He said he had to start fudging so he could produce more loans. The bank promptly closed the loan production office. Because by contract the bank had warranted to the purchasers that the loans met the required criteria, the bank was required to buy back more than $40 million in questionable-quality, long-term mortgage loans. The bank was then forced to sell the nonconforming loans for about 65 percent of face value, losing about one-half of the bank’s total capital. This put a severe long-term financial burden on the bank. Two lessons can be learned. First, when someone has a deal for you, you must understand the risks. If the person traveled past others to find you, you should question why the others turned him down. When a bank’s name is used to sell mortgages, the bank can make a profit only if everything is done correctly. Errors, whether intentional or not, might trigger buy-back provisions in the contracts with the mortgage packagers. An employee who is changing financial information and tax returns, either in collusion with a customer for kickbacks or just to get more loans approved to receive a larger commission, can trigger buy-back provisions. Insurance would likely apply when the employ- ee is receiving a kickback from the customer. When the benefit to the employee is only commissions, insurance is not likely to protect the bank. The risk to the bank is often many times larger than the possible profit the bank can make by producing and selling conforming mort - gage loans to mortgage packagers. Second, when an employee’s earnings are based almost solely on commissions, (whether for mortgage loans or any other kind of prod- uct), a change in circumstances can place considerable pressure on the employee’s personal financial situation. When faced with a sudden reduction in personal income, it becomes easier for many people to mentally justify acts which they would not consider under other circumstances. When a loan officer is paid a commission based on making loans, this can easily result in a huge potential loss to a bank. Every bank should have procedures in place to strictly control mort- gage-producing employees, especially commissioned employees, so that no loan is made and sold which might later trigger a buy-back provision. For more information, please give us a call at (785) 228-0000. SECURITY OFFICER’S BY-WORD MORTGAGE PRODUCTION COMMISSION INCENTIVES SPELL TROUBLE By Charles M. Towle, Senior Vice President Kansas Bankers Surety Company