REQUIRED READING: Before the housing bubble burst, the most important elements of quality control (QC) in the mortgage business were the credit quality of the borrower and the expectation of loan performance. When lenders thought about QC and risk management, they always viewed it on a loan-by-loan basis.
In retrospect, by being overly focused on the trees, the industry lost sight of the forest. The result was a massive inferno of bad loans, and we're still trying to put out that fire today.
More recently, there has been a new way of thinking about QC. The industry has slowly learned that the credit quality of one particular loan cannot offset material defects in the loan origination process. If required information on a loan application is not verified properly and all eligibility requirements are not met, the system will have failed – regardless of the applicant's credit quality.
New government requirements have put a renewed emphasis on loan data verifications right up to the closing – and in the post-closing period. All parties, from the lender to the investor, want more assurance that a later repurchase will not be necessary.
Both originators and secondary market investors are now placing a higher priority on their QC procedures than on the quality of the individual loan itself. They are demanding that loan documentation and disclosures be done correctly. This means that the loans need to be underwritten and closed according to the standards demanded by the secondary market.
What is needed in our industry is a focus on ‘manufacturing quality’ – which is no different than what is commonplace in other major industries. It is a routine, mechanized and technology-driven approach that has been successfully used for decades in making everything from automobiles to refrigerators. From a mortgage banking perspective, it means making sure that loans originated, packaged and sold to investors or Fannie Mae and Freddie Mac meet the quality standards that they are representing in their disclosures.Â
To accomplish the goal of getting residential mortgages to pass QC tests, individual loans and pools of loans must be put through an intense process that ensures origination practices meet or exceed investors' specifications. If you imagine this process as being similar to a manufacturing plant's assembly line, you will understand how it works, with ongoing QC examinations tracking the loan from start to finish.
Obviously, there is a difference between originating a loan and building a refrigerator. But the basic principles of assembly, testing, inspection and packaging share a common goal: to ensure the product does not have any defects. Otherwise, it will not be released.
The LQI change
It has been a little more than a year since Fannie Mae launched its Loan Quality Initiative (LQI) to mitigate expensive putbacks and generate higher-quality loans. On Dec. 1, 2011, Freddie Mac did the same with its new QC requirements. On one hand, these new ground rules represent a dramatically different and new approach to risk management – one that has permeated the entire mortgage industry.
On the other hand, they also represent the much-ballyhooed ‘back to basics’ approach that many mortgage bankers spoke about in the aftermath of the 2008 tumult. However, these QC standards are much tighter than in the pre-housing bubble years – clearly, no one in Washington wants to risk a reprise of the ‘quantity-instead-of-quality’ mantra that derailed the industry.
As part of the LQI, originators are required to perform QC reviews prior to funding – not just in post-closing. This is being done to prevent closing on mortgage loans that have significant defects, such as misrepresentations, inaccurate data or inadequate documentation. The lender's QC process must include a review of potential red-flag messages or alerts that spot critical defects in loans, and the lender must ensure that all potential red-flag messages have been addressed and documented.
Lenders must also establish an audit process to ensure that QC processes and policies are effective and being followed, and that the results are being reported to senior management in a timely way. Moreover, the LQI requires that loan aggregators take responsibility for the QC processes of their third-party correspondent originators.
Perhaps what is just as important as the QC process itself is what to do with the information. The sooner deficiencies are discovered, the sooner corrective action or process improvements can be put into place.
Investors want to know immediately whether there is a critical deviation in a loan. Previously, they had to wait a month or a quarter to get this information. In today's QC systems, however, email alerts are automatically generated to both the originating lender and the investor for any item that could create a problem in the loan. Deviation trends are transmitted in real time back to the areas of responsibility during the origination process.
The origination team's managers see these trends and have the ability to set up action plans to fix them and prevent future errors. Once the action plan is in place, the risk management team can compile trending analysis to see if the frequency of these deviations is diminishing. If deviations are going away, then the action plan was effective.
The whole purpose of QC programs is to provide an earlier focus on deviations. Even before loans are closed, lenders can start monitoring, sampling, performing trending analysis and creating reports as part of an overall QC workflow system. The QC findings are useless unless you use them to make changes and address potential problems quickly.
Underwriting involvement
In effect, this approach allows QC employees to communicate directly with the origination department. Traditionally, there was a significant communication gap between the origination side and the QC side. Now, the QC people are much more involved in the origination side of the business.
If a lender's post-closing team can identify pre-funding conditions that were definitely linked to early payment defaults or other unsellable qualities, then some loan buybacks can be prevented. The idea is that if you identify a problem, it saves the lender from writing a bad loan or having to buy it back later.
The payoff from having a QC-oriented system is enormous. Lenders that use such a system report an 80% reduction in loans with material defects.
In the 2006-2007 period, loans that defaulted had a material-defect rate of 60% to 70%. By 2010, that figure had mercifully dropped to a rate between 10% and 15%.
Similarly, early payment defaults for wholesale conforming conventional loans were between 30% and 40% in 2007 – that level plummeted to less than 10% in 2010. Meanwhile, the speed of the post-closing QC process has been cut from a previous span of 60 to 75 days to real-time communications on a daily basis.
There is still a long way to go, of course. Despite the plethora of new rules, regulations and requirements, there is still a lack of uniformity and standards on how to measure quality in the mortgage industry.Â
However, it certainly seems like the mortgage banking industry is on the right path, thanks – in large part, to the understanding that future dividends will be reaped from an elevated focus on QC processes. In manufacturing and in loan origination, the final product must meet specs, perform as advertised and endure a life cycle that is worthy of the advanced billing it gets.
David O'Malley is president of ACES Risk Management Corp., based in Fort Lauderdale, Fla. He can be reached at (954) 202-5606 or domalley@armco.us.
