REQUIRED READING: Last year, some people assumed that wholesale lending was dead in the water. Today, however, resurgence in the wholesale channel is possible, and it could be just what the industry needs to get back on the road to recovery.
The problem, however, is that mortgage bankers remember the trials and tribulations they faced in their broker channels as the bottom fell out of the industry. That's why many are hesitant to revisit the idea of third-party originations (TPOs). By taking a best-practices approach to due-diligence enhancement, mortgage bankers can assuage their concerns about TPO integrity, compliance and profitability, and recommit themselves to this burgeoning channel.
In April, the Department of Housing and Urban Development (HUD) issued a memo on TPO management that may offer lenders a good place to start for developing a new set of due-diligence best practices. The memo outlines 10 recommendations on how lenders can determine whether their TPO partners are following Federal Housing Administration (FHA) requirements, and if they are qualified to originate FHA-insured loans. Using these recommendations as a starting point, lenders can create an effective TPO due-diligence strategy.
Specifically, HUD recommends that lenders establish procedures to do the following:
- Manage the execution of due diligence;
- Address potential issues with TPO operations, practices and/or customer service;
- Validate TPO compliance with all governing federal, state and local requirements;
- Ascertain the TPO's current license status via the National Mortgage Licensing System, per the Secure and Fair Enforcement for Mortgage Licensing Act of 2008;
- Verify that TPOs are not ‘suspended, debarred or under a limited denial of participation in HUD's Credit Alert Interactive Voice Response System, or on the Federal Government's Excluded Parties list’;
- Evaluate the TPO's financial capacity; and
- Create enhanced quality-control plans for evaluating TPO originations.
The recommendations also advise lenders to create internal guidelines and systems for initiating and maintaining TPO relationships, monitoring loan quality and managing the ongoing renewal processes of TPOs to ensure they continue to meet lenders' approval standards. However, as with most government recommendations, the guidance on execution of these recommendations is vague and open-ended – and HUD is quick to point out that these are merely recommendations, not requirements. HUD also conjectures, ‘No doubt many mortgagees already have such procedures, protocols and systems in place.’
Although this statement may be true, it is not enough to simply have a procedure in place. To create a truly robust due-diligence strategy, the processes behind the procedures must allow for a continual re-evaluation of all these areas to alert lenders of changes that could indicate potential issues with a TPO. This is the most basic component of any due-diligence strategy and, at the very least, something that all lenders should already be doing.
Yet this is the step that causes lenders the most headaches and, therefore, is the least likely step that lenders will engage in on a regular basis. Aggregating the information necessary to thoroughly investigate a potential TPO partner on the front end of the relationship is onerous enough.
Consequently, many lenders only execute a point-in-time review and fail to continually follow up on the initial information gathered to verify that the TPO is still a solid bet. As a result, lenders often get burned later on, when brokers that seemed trustworthy at the outset of the relationship suddenly go bad.
Past as prologue
While the checks HUD recommends are certainly important, lenders must dig deeper into a TPO's background to truly determine the trustworthiness of that TPO. As the saying goes, the past is a good indicator of future performance.
Among the information lenders should examine, a particular focus should be placed on licensing status and loan-performance history. Many lenders would view credit history as also being a critical area to investigate, yet given the current state of the market, examining credit history alone provides a skewed view of a TPO's trustworthiness.Â
But finding a broker with a completely unblemished credit history after the subprime meltdown is an extremely tough challenge, and lenders may miss out on engaging in profitable relationships with reputable TPOs that may have simply hit a run of bad luck.
Licensing and loan performance provide a much more accurate portrait of a TPO's integrity. Lapses in licensing and a history of early payment default, first payment default and/or fraud should be red flags for lenders and indicate that a more thorough TPO examination is necessary. Should a TPO pass this initial inspection, this information should be reviewed on at least a quarterly basis to ensure continued fidelity on the part of the TPO.
Where HUD's recommendations also fall short is in addressing the pain points that lenders experience in performing due diligence, as well as with the issues created by the current due-diligence strategies employed by most lenders. The next step lenders must take in creating due-diligence best practices is to identify the glitches in their current due-diligence systems and the items hindering them from taking their due-diligence strategy to a higher level.
Historically, automated due-diligence systems have primarily focused on identifying fraud in the origination and underwriting process. The benefit of hindsight tells us that collusion often plays a large part in the perpetration of fraud, and in many cases, the broker was more than likely aware of, if not directly involved in committing, the fraud taking place. Yet many lenders fail to apply the stringent, systematic approaches they take for fraud identification to the due diligence they perform on TPOs.
Imagine the following scenario. You're hosting a party at your home, and some ‘characters of ill repute’ are identified as being in attendance. Rather than following them around all evening to ensure nothing sinister takes place, wouldn't you want to simply stop them at the door?
Good reason and common sense would indicate that the right answer is yes. However, this idealized outcome falls short of reality for many lenders, and it is due to the fact that lenders are not keeping up-to-date on information about their TPO partners. Lenders would never dream of conducting a fraud review of their pipeline once, but beyond the initial application process, most lenders don't bother to authenticate that their TPOs are legitimate.
In addition, the lack of information lenders have regarding a TPO's track record with another lender inhibits all lenders from prohibiting unsavory characters to continue to burn other lenders. Traditionally, lenders' attempts to perform due diligence on mortgage brokers or TPO took place with very little collaboration occurring amongst lenders. Further complicating the issue is the manual nature of the due diligence most lenders perform, which makes information-sharing next to impossible.
Therefore, it's all too easy for a bad broker to jump from one lender to the next, leaving a trail of burned relationships and losses along the way. Ultimately, a combination of organization, standardization and transparency is key when it comes to performing sophisticated TPO due diligence.
HUD's memo is a clear indication that the responsibility for TPO management falls squarely on the shoulders of lenders. To effectively mitigate the risk while reaping the benefits of TPO origination, lenders must develop a superior due-diligence strategy based on industry best practices, as it is through best practices that the industry can create a standardized and, therefore, effective process.
Greg Schroeder is president of Comergence Compliance Monitoring, based in Orange, Calif. He can be reached at greg@comergence.com.
