REQUIRED READING: Over the course of the past several years, the mortgage meltdown has given rise to a new risk management landscape. Mortgage quality control that has historically taken place in the specially designated operations centers of lenders has now become a complex series of legal issues playing out in local, state and federal courts.Â
This once-benign review process, long considered standard operating procedure by purveyors of residential mortgage portfolios, has become a multimillion-dollar industry of risk expertise. Mortgage bankers – many of whom grew accustomed to the requisite 10% post-funding sample review process as the final step in the exit strategy for bulk and flow production – are now scrambling to implement new credit policy oversight. However, their thinly-stretched resources are being allocated to review nonperforming closed loans for inconsistencies, thus putting them at risk for large-scale legal actions should issues be missed.Â
As we have seen by a recent convergence of legal actions, the dust has not yet settled on defining loan quality. Â
Due diligence is an affirmed operational process structured to conduct stress tests for key credit policy points governing the origination and sale of residential mortgages. During the reviews, key data elements are verified using a checklist-based process and completed as a condition of the buyers' and sellers' representations and warranties for securitization or sale.
It is often stated that due diligence ensures the ‘i's’ are dotted and the ‘t's’ are crossed. Originators are required by the agencies and private insurers to maintain written quality control plans documenting components of the reviews that guarantee the contents and credit quality of each unit presented for investment.  Â
Today, regulators and industry leaders are debating the criteria for defining a qualified residential mortgage. Without definitive standards, the legal fallout from newly imposed lending regulations, coupled with the enforcement of consumer and securities laws, has created a firestorm of mortgage litigation.
Starting with the federal government and trickling all the way down into local courts, the active growth in today's industry belongs to the attorneys. Private investors are suing for mortgage-backed securities (MBS) losses due to misrepresentation of critical credit data and servicing violations. The federal government has issued injunctions against banks large and small through consent orders aimed at evaluating the procedures behind the origination and funding of mortgage loans from the last decade. Locally, distressed homeowners facing foreclosure are now savvier than ever, engaging counsel to defend their claims that the loans they can no longer afford were predatory in nature and were not underwritten in accordance with consumer and industry laws.Â
This litany of unanswered questions has given rise to multitudinous new case law, and a cottage industry of due diligence firms specializing in the forensic due diligence auditing process.
The roots of chaos
The economic life of a mortgage begins when the borrower executes the final loan documents. This loan is then subjected to years of follow-up verifications of information, including everything from a borrower's employment history to the proper execution of the Truth in Lending disclosure.
Liability for the accuracy of information relied upon to make each loan is governed by unique, detailed representations and warranties and other agreements between brokers, lenders, insurers, servicers and investors. Each party has specific contractual requirements to uphold when processing its phase of the lifecycle, ensuring to each of the other parties that it fulfilled all obligations. Each lender has its own underwriting criteria for its particular lending programs. Every MBS has its own Securities and Exchange Commission registration that includes unique representations and warranties, pooling and servicing agreements, and other contracts that govern the underlying loan product acceptability.
However, the profligate amount of gray area underlying each deliverable has the causal effect of clogging our courts and impeding the return to business as usual in the mortgage industry. Licensure, assignment and satisfaction of mortgage and unfair and deceptive practices are the most prevalent local and appellate filings.Â
Over the past couple of years, an increasing number of players have become involved in this matter. The state attorneys general have attempted to get their collective arms around mortgage fraud, while a federal mortgage fraud task force formed in January 2012 by the U.S. Department of Justice is now vetting a backlog of misconduct complaints against MBS packaging and sales. Indeed, it often seems unusual if a day passes without any announcement of new litigation or agreements by lenders to settle lawsuits.
The allegation of widespread fraud requires the review of thousands of individual residential mortgage loan files. Each of these actions requires a complex level of expertise around the underwriting, credit policy and contractual issues that give rise to these indictments. And this is where forensic due diligence comes in.
Enter the experts
Forensic, by definition, means the application of a broad spectrum of scientific disciplines used to resolve legal issues pertaining to the courts. Forensic due diligence thereby applies a multidimensional, investigative approach to examining each layer of the mortgage transaction.Â
Concentrated areas of expertise have evolved within the industry, whereby individual elements of the process are examined in great detail. Other auditing methods encompass every phase of the lifecycle, from borrower solicitation legalities through property types securitization.Â
Industry vendors providing services such as credit reporting and valuation utilize technology to automate components of the investigation, while other pieces take on a true CSI level of extensive detection work. The overarching standard forensic due diligence strives for is a legal summary and expert witness opinion on the materiality of the information obtained. Â
Each case involves underlying mortgage loans, but that is where the similarity ends. Forensic due diligence auditors must evaluate the individual merits of each transaction, including the parties involved, in order to establish unique processes for investigating and documenting findings in a manner acceptable to the supervising court.Â
Specifics of the case help define audit methodology. For example, wherein the plaintiff is the New York state government or a mortgage insurer seeking an injunction on a claims payout, loan pools may be reviewed for measurable underwriting deficiencies such as excessive debt ratios or overinflated valuations. In cases of securities fraud where the plaintiff is the U.S. government, thousands of pages of legal contracts specific to the credit quality of the deliverable must be interpreted and audited against the closed loan product for breaches of contractual liability, including misrepresentation.Â
Down at the county court level, these cases often involve foreclosures that require research into land title issues, insider collusion and forgery. No two cases are the same, aside from the auditing firm working hand in hand with the courts to ensure the findings are documented and presented in a manner allowable to the prosecution.
Expertise in this area is relatively new and very costly. As with all service providers, the onus falls on the solicitor to perform due diligence before engaging individuals or firms claiming to be experts in forensic due diligence. Knowledge, experience and references are key to verifying the quality of work output.Â
Complaints have been filed against due diligence firms for so-called ‘robo-audits’ that utilize standard form-based reporting and law citings without taking into account jurisdiction, state compliance and other critical factors. Accounting firms have recently become a commodity to the forensic community. Their knowledge of accounting practices lends a practical advantage when cases involve lengthy tax returns and other financial documents, but can fall short in mortgage underwriting expertise and can exceed billing rates double the industry average.Â
Other licensed specialty services utilized by accomplished firms include the Federal Bureau of Investigation or other handwriting analytics, historical property valuations and document fraud examiners. Basic law enforcement training in interviewing techniques and chain of custody documentation for evidence should be requisite for firms engaging in expert witness report preparation presented for trial.Â
Unlike a mortgage quality control review, the forensic process requires an intensive understanding of the legal process in addition to credit policy and fraud detection. At risk are not only the investments of time and cost to complete the audit, but also the lasting reputational damage and legal implications – which can be far more devastating if the right due diligence auditing partner is not selected.
Cindi Dixon is CEO of Mela Capital Group, based in Sunrise, Fla. She can be reached at (877) 633-7992.
(Photo courtesy of Xfinity Comcast)
