In 2007, the pages of mortgage industry publications have been dominated by sobering reports on how the subprime market has affected the industry. As with any major trend, the troubles associated with the rise in loan defaults have created a ripple effect that has everyone's attention, from mortgage professionals to home buyers to the U.S. government.
First, it was the lenders who saw increases in their REO portfolios and felt the effect of the origination downturn. Next, mortgage originators felt the effect of the market shift. As these groups adjust to the market it has become common to see reports of subprime divisions closing or brokerages going out of business, leaving a number of those originators looking for work. Now, the problem has migrated to an area many subprime mortgages go to after being sold on the secondary market: Wall Street.
Mortgage lending to subprime borrowers has always been risky business. However, with the rising home prices in cities across the country, lenders saw it as a risk worth taking: In the first seven years of this decade, Wall Street has created more than $1.8 trillion of securities backed by subprime mortgages.
The process ran smoothly until the housing market experienced a sharp rise in mortgage delinquencies and defaults, which hurt the value of the bonds. In turn, the reactions of investors drove down the bond prices even further.
Wall Street firms deal with risk every day, but, in the current market, mitigation has to play a more dominant role with subprime mortgages. The key to risk mitigation is a quality due diligence review. The review is an opportunity for a buyer to get the full story on the pool of loans under consideration for purchase and use that information to make the best possible decision. This can only happen if the review is based on looking at the loan's entire story and determining if that story makes sense.
A quality due diligence review is more than studying a spreadsheet and plugging in numbers. The underwriter must re-verify everything to ensure that it makes ‘working’ sense. Looking at the loan from the perspective of the borrower's financial history is the best approach.
One of the keys to a review is understanding the borrower's ability to repay the loan. How long has this person been with their current employer? What is the debt-to-income (DTI) ratio? Are they living beyond their means?
These questions are important not only at the time that the loan is funded, but also during the review because based on the type of loan, the interest rate may adjust, and the borrower may no longer be able to afford the monthly payments. This approach allows the underwriter to make projections and provide the client with information on the likelihood of the loan going into default.
Another key area of the review is the credit history. Look for a change in the FICO score. The borrower may have closed the loan and then maxed out all of his or her credit cards by buying furniture or purchasing an expensive car to fill that new garage. Once that happens, the borrower could have a new DTI ratio that makes it very difficult to pay all of his or her bills on time.
This change can be found in an updated credit report. Then, on the flip side, extremely high credit scores are also a red flag. There are not many people with credit scores of more than 800, so that could be an indication of fraud.
Also, a person's financial history goes beyond credit cards and auto loans. It's important to review the borrower's previous mortgage history. More due diligence review clients are requesting this information because a borrower's past ability to make mortgage payments is an indicator of their future actions.
At the end of the review, the underwriter should be able to put together a reasonable, seamless story about the loan's ability to perform. This is especially important considering the large number of option adjustable-rate mortgages (ARMs) and interest-only loans out there. With stated-income loans, the underwriter must establish if all the necessary documents of the loan are present, and the underwriter must determine if they fit together.
If holes are found, it could be a red flag that requires further investigation. For example, a borrower who is 22-years-old and states that his annual income is $100,000 seems unreasonable without backup documentation to support the salary, type of job, etc. At this point, the underwriter should conduct further research, and if a logical reason cannot be determined, the client should be alerted.
Use of outside sources
As an underwriter raises questions about a borrower's information, it sometimes becomes necessary to go to outside sources to get answers. Web sites that provide salary ranges for different parts of the country are important tools because an underwriter often does not have that information at hand or may not be familiar with the area in which the property is located. These Web sites are extremely valuable when considering the reasonableness of a borrower's stated income.
Military Web sites are also available for verifying job titles, corresponding salaries and housing expenses. This extra step can be the difference between a buyer purchasing a loan based on an inflated salary and the buyer rejecting a potentially nonperforming asset.
The use of outside resources is also vital with respect to the appraisal report. Valuation fraud is an increasing problem in the U.S. For the last few years, this fraud has taken the form of more and more cases of appraiser identity theft. Appraisers are extremely vulnerable to identity theft because they often work in offices where it is easy to gain access to another appraiser's personal information. In many cases, a fired appraiser will continue to work under a former co-worker's license.
In addition to identity fraud, sometimes appraisal reports are also tampered with when sent electronically. As a result, underwriters should check the license number to verify that the appraiser is licensed by the state and in good standing.
Evidence of valuation fraud can also be detected by doing background research on the appraiser and the location of the property. In October 2006, The Appraisal Foundation hosted a symposium on valuation fraud, and one of the suggestions offered by attendees was that mortgage professionals learn to recognize potential red flags on appraisal reports.
For example, how often has the property been sold? How far is the property from the appraiser's office? Has the appraiser completed an unusually high number of reports?
A growing number of buyers are requesting that underwriters provide the appraiser's name, license number and location for each loan. The buyer may even put together an exclusionary list of appraisers. If the appraisal was performed by one of these appraisers on the list, the loan is rejected by the buyer.
Furthermore, buyers are now setting strict variances between the original appraised value and the value found by other valuation sources. If the variance is too high, more investigation is being required.
New training, old style
Over the past few years, underwriters have been trained to use automated underwriting systems, whereby the raw data entered from the loan documents is used to determine conditions that need to be met, credit decision levels, etc. While the data may be a good foundation with which to start, it is now necessary for an underwriter to go back to the ‘old school’ method of analyzing all of the documents in the file, looking for red flags, confirming that everything on the 1003 loan application is accurate and making sure that there are no missing pieces to the puzzle.
More in-depth training is required today for underwriters to analyze the loan file and data to determine if the buyer is truly purchasing a good asset. Targeted training is necessary and should include activities such as reading appraisals, calculating self-employed borrower income, looking for red flags, learning how to use outside resources to validate loan application information and, most importantly, gaining the ability to make a good decision by being able to put all of the pieces of the loan together and determining that they make sense.
Much of this can be done with personal training that involves going through sample loan documents and looking for red flags and areas where more research is needed. Due diligence companies should ensure that their underwriting staff is always up to date on compliance changes and industry trends so that everyone is armed with the necessary information needed to review the loan and make a good decision.
The mortgage industry is extremely dynamic. Companies must adjust their procedures and requirements to take advantage of the best practices that are available. The rise in loan delinquencies and defaults has affected industry professionals at all levels. A more robust due diligence review that includes further analysis and the use of outside resources will result in a complete loan story. This story provides the investment buyer with the knowledge necessary to make a decision that will yield the desired result; a well-performing loan.
Will Wenck is underwriting operations manager at MDMC, where he is responsible for due diligence policy management for central underwriting at the company's Sussex, Wis., headquarters. He can be reached at will.wenck@mdmc.com.
