Many of the country's largest banks received $6 billion in kickbacks from mortgage insurers over the course of a decade, according to a previously undisclosed investigation by the Inspector General of the Department of Housing and Urban Development.

The allegations, since referred to the Department of Justice, stem from lenders' demand that insurers cut them in on the lucrative business of insuring the mortgages they produced during the housing boom.

In exchange for their business, companies such as Citigroup Inc, Wells Fargo & Co, SunTrust Banks Inc. and Countrywide allegedly required reinsurance partnerships on generous terms that violated the Real Estate Settlement Procedures Act, a 1974 law prohibiting abusive home sales practices.

During a two-day presentation in the summer of 2009, HUD's team presented DOJ attorneys with a thick binder of evidence that major banks had engineered a decade-long kickback scheme, people familiar with the investigation say.

Documents from the investigation show that the inspector general's staff concluded that banks and insurance companies had created elaborate financial structures that had the appearance of reinsurance but failed to transfer significant amounts of risk to their bank underwriters.

Some of the deals were designed to return a 400% profit on a bank's investment during good years and remain profitable even in the event of a real estate collapse.

Making matters worse, banks allegedly forced unknowing consumers to buy more insurance than they needed and failed to properly disclose the reinsurance agreements, another RESPA violation.

HUD's acting inspector general, Michael Stephens, worked on the case before being appointed to head the inspector general's office last year. He acknowledged the investigation's existence and expressed frustration that the case had not yet produced a settlement or prosecution.

While Stephens said he was still "hopeful" that prosecutors would bring a case, "this thing has been going on for too damn long."

PUNISHING INSURERS

Market observers, analysts and ratings agencies long questioned the reinsurance deals, but banks and insurers publicly maintained they met the standard for arms-length transactions set out in a 1997 policy letter circulated by HUD. The deals, they said, were not the result of coercion.

What those companies may have believed in private is another matter.

Wells Fargo and Bank of America Corp. have settled class action cases alleging the same sort of misconduct flagged by HUD, and internal documents show that banks and insurers viewed the arrangements as a thinly veiled pay-to-play scheme. Even as insurers complained they couldn't afford the escalating cost of the reinsurance payments, banks threatened or punished companies that balked at providing them, documents obtained by American Banker show.

Wells Fargo & Co told one insurer that it should consider giving Wells such deals if it wanted business referrals. After insurer MGIC Investment Corp. announced plans to cut back on banks' share of premiums in 2003, Countrywide executives complained to an MGIC executive and told him that they were shifting Countrywide's business to MGIC's competitors.

"I think we should continue to decrease there [sic] share again," former Countrywide business operations executive Mitch Turley wrote in an email to colleagues that was later obtained by investigators and reviewed by American Banker. (B of A bought Countrywide in 2008, after the alleged wrongdoing occurred; Turley no longer works for B of A and did not respond to an interview request from American Banker.)

Noting that the mortgage industry was in dire shape when investigators handed their case to prosecutors, the inspector general's office proposed that much of the penalty should be stayed. Even still, the proposed settlement would be the most aggressive action ever pursued under RESPA, requiring banks to pay hundreds of millions of dollars in fines and restitution.

Although HUD's investigation was referred to the Justice Department last year, people familiar with the case say that prosecutors have done little to advance it. Contacted by American Banker, a spokeswoman declined to discuss the case.

Prosecutors had agreed the case was well worth taking when it was first referred to them, said former HUD Inspector General Ken Donohue and others.

"I'm bewildered by why this wasn't pursued on an aggressive basis," Donohue said.

"NO BONA FIDE PURPOSE"

HUD's case began far from its Washington headquarters. Around 2007, Special Agent Julien Kubesh of the inspector general's Minneapolis field office teamed up with the Minnesota Department of Commerce in a review of the insurance on home loans, people familiar with the investigation say.

Mortgage insurance, often required for borrowers without sizable down payments, is a substitute for equity that serves to protect a loan's owner in the event of a borrower default. Banks typically choose the insurance carrier, but borrowers pay for the coverage in the form of higher net mortgage payments. In the industry's early years, there were no financial ties between banks and the insurers.

But Kubesh, a former IRS agent, found that the insurers had taken out reinsurance from subsidiaries of the banks that had produced the loans. Virtually all major lenders had established such ventures, which supposedly shared insurers' risk in exchange for a portion of the insurance premiums.

Kubesh was skeptical of the captive reinsurance agreements, which were entrenched in the mortgage insurance market but at best grudgingly tolerated by HUD in other areas. In a May 2007 settlement, for example, HUD slapped Beazer Homes for using a captive subsidiary to share in the proceeds of title insurance. "There is almost never any bona fide need or business purpose" for captive title reinsurance, HUD noted at the time, adding that the deals' outsized profitability was "strong evidence there is a sham arrangement" to circumvent RESPA.

Banks' captive mortgage reinsurance ventures were little different, Kubesh and his colleagues came to believe.

While designed to look like reinsurance, the deals weren't built to perform like it. The problem was how they split up the risks and rewards of insuring homeowners' mortgages.

When it comes to insurance, "if I get 50% of the profits, I have to take 50% of the risks," said Herman Thordsen, a California attorney who defends companies accused of RESPA violations. "If they're not doing that, then there's likely a violation. And disclosure has to be there, absolutely."

Banks fell far short of both those standards with their captive reinsurance schemes, investigators and the companies' own records suggest. Over the course of two years, Kubesh and other investigators concluded that captive mortgage reinsurance had devolved into a way to hide illegal business referral fees.

THE $0 RESERVE

For a reinsurance agreement to be legitimate, it has to transfer risk from an insurer to a reinsurer. One simple way to do that would be for the insurer and the reinsurer to each collect a portion of the insurance premiums and each pay a similar portion of the insurance claims. In reinsurance, this is called a "quota share" structure.

A different way to split the risk is what's called an "excess of loss" arrangement, in which the insurer has to pay all claims up to a certain point, when the reinsurer steps in. Figuring out how to divide the premiums is now harder, because in the event of a loss the insurer and the reinsurer will no longer bear the load evenly — if the losses are modest, the reinsurer might not have to pay anything at all.

Still, so long as both the insurer and reinsurer hire actuaries and bargain for their own interests, the resulting agreement should make the reinsurer's reward proportionate to its risk.

Banks started demanding the excess-of-loss reinsurance deals in the mid-1990s. Unlike in the example above, however, the two parties didn't have equal leverage.

The mortgage insurers' entire business depended on keeping the banks happy, and HUD investigators concluded that they gave banks reinsurance deals that would be profitable in virtually every circumstance.

This was partly because the initial terms of the deals were generous — the reinsurance vehicles collected 40% of the premiums, but were responsible for a maximum of 10% of the losses — but also partly because insurers let banks tweak the terms of deals in their favor.

According to investigators, the contracts gave banks a large cushion before they would have to start paying claims. The partnerships excluded high-risk loans from the reinsurance coverage. And the deals were "self-capitalizing," meaning that a bank could fund its stake with incoming premiums. If the deal went bad, the bank could walk away and leave the insurer to cover its losses.

Conceptually, such arrangements are analogous to letting a gambler with $10 in casino chips place a $100 bet at a blackjack table on the assumption that he'll win. A 2003 Standard & Poor's analysis modeled the most popular type of deal and found that in the event of high claims, the reinsurance vehicle's funds wouldn't be enough to cover the losses it was supposed to take on.

"The captive is unable to pay its full contractual exposure," S&P wrote.

The deals had yet another unusual sweetener, investigators alleged.

Each of a bank's reinsurance vehicles was legally separate not only from the bank's main reinsurance subsidiary but also from all the other funds. If a reinsurance deal didn't have enough money to pay its obligations, the bank could abandon it and leave the mortgage insurer with the unpaid bill.

To carry on the casino analogy above, it would be as if the gambler with $10 in chips were allowed to make that same $100 bet at ten different blackjack tables, collecting on the winning bets and renouncing the losers.

Documents reviewed by American Banker suggest banks may have agreed they were not taking on significant risk.

At one point, Countrywide's Balboa Insurance division crunched the numbers to determine how much it should reserve for potential losses from the deal. The answer, the actuaries concluded, was "$0," according to a reserve analysis obtained by investigators and cited in a report to the Department of Justice.

All the same, banks persuaded state insurance regulators to sign off on the structures. To judge whether the reinsurance agreements were fair, state officials relied in part on actuarial analyses submitted by the banks and insurers.

"Review of these opinions has found them to frequently contain significant defects and omissions which render them inapplicable to the actual reinsurance agreements executed," HUD investigators later concluded.

"DEEP CEDE"

With state regulators blessing the deals, the captive mortgage reinsurance business was off to the races. Not everyone involved was thrilled about it.

Mortgage insurers, which had initially used reinsurance deals as a marketing tool, were unpleasantly surprised to find that banks demanded an ever-increasing share of the premiums.

Banks considered the insurers to be interchangeable, and companies like Wells Fargo made it clear as early as 2000 that they wanted "deep cede" deals in which their captives would receive as much as 40% of the insurance premiums in return for providing reinsurance.

In letters to insurer Triad Guaranty from the beginning of the last decade, Wells demanded that Triad "demonstrate a willingness to discuss a captive reinsurance structure with a 40% net ceded premium" in order to receive Wells' future business, according to a HUD investigators' report submitted to the Department of Justice. Further clarifying its demands, the company wrote that "consideration will be given to enhancement of our returns."

Triad is now in liquidation.

Wells Fargo said in a written statement to American Banker that risk was split equitably under its contracts with mortgage insurers. It further denied that its captive mortgage reinsurance arrangements had ever been under HUD investigation.

"It is simply not true that Wells Fargo has ever been the subject of a HUD investigation involving either our captive reinsurance programs or our relationships with any private mortgage insurance company," the statement says.

"FEEDING THE BEAST"

Over time, the insurers came to realize that offering banks a taste of their profits only increased their demands for further financial concessions.

The aggressive revenue sharing was ruining insurers' profitability and emboldening lenders to demand even more outlandish deals in a cycle GE Capital Mortgage Insurance called "feeding the beast," a dour 1999 presentation to CitiMortgage noted.

The insurer — which eventually split from General Electric to become Genworth — was pressing Citi to restrain its demands. Ratings agencies and analysts were already flagging reinsurance deals as legally dubious, the insurer warned in a PowerPoint presentation obtained by HUD investigators, and "the MI industry and lenders won't be able to defend/sustain these structures."

Genworth declined to discuss the presentation.

"Captive reinsurance and excess of loss reinsurance structures have been a feature of the insurance industry for decades," a Genworth spokesman said in a written statement. "Genworth's arrangements with lender-affiliated reinsurers were structured in compliance with guidance from HUD."

Genworth further argued to American Banker that claims paid by the captive reinsurers in the wake of the mortgage industry's collapse proved the legitimacy of the financial structures. The captive reinsurers to which Genworth ceded premiums have covered a total of $850 million in claims, the company said.

But, as HUD's inspector general reported to the DOJ in 2009 — and as one investigator confirmed to American Banker recently — the fact that captive reinsurers paid claims does not mean the structures were unprofitable for the banks.

At least some of the deals were so generous that banks would still turn a profit even in the event of catastrophic claims, a Moody's Investors Service analysis cited by investigators found.

Because banks profited from selling their borrowers insurance, they sold it aggressively. In a presentation to the Department of Justice, the inspector general's investigators claimed that banks forced borrowers to buy more expensive policies than they needed.

"Nearly all loan files reviewed show borrowers with excessive coverage placed on their loan," the presentation concluded.

Most of the time, lenders did not tell borrowers in advance that their captives were reinsuring the deals, HUD investigators reported to the DOJ. In some cases, banks allegedly told customers that the charge for the reinsurance was "none."

Banks and insurers that spoke to American Banker denied that they had sold unnecessary or improperly disclosed insurance.

"Wells Fargo provided disclosures to consumers regarding its captive reinsurance programs along with the ability to opt out of reinsurance arrangements," a Wells spokeswoman told American Banker.

"CitiMortgage provided disclosures to borrowers and they were offered the choice to opt-out, which many did," a spokesman for Citigroup wrote. "This choice has no impact on the premiums charged to the borrower."

SunTrust declined to comment.

PASSING THE BATON

HUD Inspector General Ken Donohue — and his deputy, Mike Stephens, who succeeded him last year — were confident that they had a case. Initially the project of one regional investigator, the captive mortgage reinsurance probe drew the attention of senior officials in the inspector general's office as well as the RESPA enforcement staff elsewhere in HUD.

In the summer of 2009, Kubesh and Minnesota Department of Commerce staff came to Washington to present their findings to the Department of Justice.

The DOJ said it wanted take the matter on, according to Inspector General Stephens and others. Six months later, HUD's attorneys formally referred its case to prosecutors, effectively ending the housing agency's involvement. Investigators believed a speedy settlement in the hundreds of millions of dollars was likely, and HUD's investigators even suggested that the proceeds should be used to pay for mortgage counseling for borrowers who were allegedly victims of kickback schemes.

Major banks deny that their reinsurance agreements were illegal, but they have not been eager to defend them in court. In July, Bank of America spent $34 million to settle a RESPA class action suit accusing Countrywide of taking the same mortgage insurance kickbacks alleged by HUD investigators.

In court filings prior to that settlement, Countrywide's attorneys argued that eventual payouts made by the company's captive reinsurance vehicles demonstrated that they had taken on real risk.

A Bank of America spokesman made the same argument to American Banker.

"[W]hen loan default rates are low — there would be limited or no reinsured losses; and in other years — when loan default rates are high — there would be significant reinsured losses and, correspondingly, significant reserves," he wrote.

Court filings show that Countrywide paid zero reinsurance claims between 2000 and 2006. What losses Countrywide might have later sustained from the deals, however, is not in the public record.

Under an agreement between Countrywide and the plaintiffs' attorneys, case files documenting the company's alleged behavior — as well as how much it earned from reinsurance deals — were sealed by Judge Paul Diamond of the Eastern District of Pennsylvania.

Wells Fargo has also reached a preliminary settlement with the same law firm, Kessler Topaz Meltzer & Check LLP, in a case alleging "a secretive conspiracy to circumvent RESPA's prohibition on kickbacks and unearned fees." A Wells spokeswoman said the company's decision to settle the case does not mean that the allegations had any merit.

"GETTING KICKED AROUND"

More than a year and a half after the Department of Justice took over the case, no settlement has been reached and there is serious doubt as to whether the case even remains active.

Bank of America has not received any HUD inquiries on the subject of Countrywide's captive mortgage reinsurance since 2008, according to a company spokesman, and is unaware of any current review of its deals.

People familiar with the case believe it may have stagnated because demonstrating that the captive reinsurance amounted to kickbacks would require accounting expertise that the Department does not possess.

HUD staffers who initially put the case together have moved on to new jobs. Just last month, HUD's authority to enforce RESPA expired, and its responsibilities were transferred to the new Consumer Financial Protection Bureau.

The bureau declined to address questions from American Banker about whether it intends to pursue the matter.

The agency has hired at least two former enforcement officials from HUD who are familiar with the case, however. Both referred questions to the CFPB's press office.

"While we continue to build and staff our enforcement program, the CFPB is capable of exercising its RESPA enforcement authority now," says a CFPB official.

If the Bureau doesn't take the case, there is also the possibility that Minnesota officials or another state would readopt it, Acting Inspector General Stephens and other people familiar with the case said.

"This thing is getting kicked around," Stephens said, arguing that a lack of enforcement on such matters has eroded consumers' faith in the process of buying a home.

"The mortgage companies … are responsible for those people feeling that way," he said.

Editor's note: This is the first of a two-part series. Next up: How regulators, the government-sponsored enterprises, mortgage insurers, and trial attorneys allowed banks to collect a decade of alleged kickbacks, and the deals' effect on lending standards.