A recent opinion written by Chief Judge Gregg out of the Western District of Michigan has given at least one bank a wake up call about trying to make debtors shoulder its prior negligent lending practices.

In Flagstar Bank, FSB v. Stricker (in re Stricker), Case No. 07-80217, the court was asked by Flagstar Bank to rule that a couple could not discharge their remaining $214,000 mortgage debt after the home was sold.  The couple had entered into the mortgage via a shady real estate broker, who fabricated numbers and forged documents. Flagstar asserted the couple had conspired with the shamster, and for that reason the debt shouldn't be dischargable.

But the court found that the documents the shamster submitted to Flagstar to support the mortgage were so blatantly unreliable that there's no way the bank could have reasonably relied on them. These documents included leases for property the couple was occupying, bizarre gift letters, and unsigned account balance verifications, all aimed at boosting the couple's modest income.  

Despite the obvious red flags, the court found that Flagstar was more concerned about getting the loan through the loan evaluation “engine” to ensure that an investor could take this loan as part of a package. The testimony established that Flagstar was concerned with the ultimate marketability to “package” the loan rather than the responsibilities of the borrowers and the broker.  The court referred to this as the "greedy easy-money loan-now-ask-questions-later mentality of the market place at that time. . . Flagstar ignored numerous red flags and relied upon documents . . . that would not have fooled a literate high school student."

The court rejected the notion that the couple had somehow defrauded the bank to its loss. The only evidence at trial of any misrepresentation by the couple was their stated intent to use the home for their primary residence, when they actually intended to resell it.  But that didn't justify the bank's nearly gross negligence, or have any direct connection with the bank's substantial loss.  Instead, the court found that Flagstar had allowed the shamster to apply the proceeds of the home towards his personal loans after he had sold it with a forged deed, rather than applying it towards the couple's mortgage balance. Flagstar was then able to recover the home in state court via a foreclosure and get a double recovery. Had Flagstar applied the proceeds towards the couple's mortgage, there would have been no damage.

The court then summarized its concern over lending institutions bringing this type of case in light of their careless lending practices:

Now that the dancing at the banks and the Wall Street music has been temporarily stopped by the current financial crisis, this judge is concerned that when some borrowers are forced into bankruptcy because of imprudent loans, the same profit focused lenders, or their assignees, will decide to “nit pick” the loan applications created by themselves and their brokers and seek to hold lower and middle class borrowers solely accountable. Banks, who relied on the brokers, so both would make a healthy profit, should not be permitted to spin the facts and later claim that ordinary, financially strapped citizens were attempting to defraud them. 

The mortgage lenders (and others) invented a system (Flagstar’s “engine”) where the more loans they made and immediately turned around and sold, the more money they “earned.” Lenders such as Flagstar abandoned even the pretense of knowing a borrower or relying upon a specific borrower’s statements. The mortgage lenders almost exclusively depended upon mortgage brokers to sell their “products” to almost anyone. Under these types of circumstances, bankruptcy courts should undertake a careful and precise review of lender nondischargeability claims arising out of a flawed system created, or at least ratified, by those plaintiff-lenders.