One might argue that consumer protection and overregulation are just sauce for the goose these days. Yet a serious overhaul of mortgage regulation is under way, and it promises to snap the secondary market's overstretched and outmoded approach to compliance.
If you want to discredit the mortgage industry, looking at how the secondary market ensures loans comply with consumer protection laws is a good place to start. Typically, investors perform some loan-level due diligence, but this generally involves post-purchase audits of a small sample of loans for compliance with a small number of regulations.
Investors rarely have access to the loan information required to perform a compliance evaluation pre-purchase, and it is equally rare for investors to obtain the required information electronically on the data tapes sellers provide. Accordingly, investor due diligence is highly manual, costly and limited to a small sample of loans purchased.
For the most part, secondary market regulatory compliance relies heavily on seller representations and warranties (reps and warrants) that loans comply with all applicable laws. If a compliance violation is identified, the investor can force the seller to repurchase the loan.
The seller, in turn, may be relying on the reps and warrants of another, less creditworthy party from which it purchased the loan.
Not surprisingly, compliance issues are seldom identified until a loan goes sour – in other words, until the investor looks for a reason to put the loan back to the seller, which is about the same time the borrower is seeking a defense to foreclosure.
Essentially, the rep and warrant reduces regulatory compliance risk to a credit decision: Can the seller's balance sheet absorb expected repurchase demands? The reason for this is can best be understood in its historical context.
The rep-and-warrant model is a holdover from the last great mortgage mess. Prior to the savings-and-loan crisis, existing regulatory and accounting rules allowed lenders to treat secondary market transactions as a sale, even though the purchaser had recourse to the seller for credit losses.
Consequently, investors relied on the seller's balance sheet rather than on the quality of the underlying loans.
Consumer-protection regulation was uncomplicated, and its risk was considered nominal. Accordingly, sellers – already on the hook for credit losses – favored broad reps and warrants that loans complied with all applicable laws over the legal costs of attorney due diligence.
Regulation responding to the savings-and-loan crisis forced a change in how the industry accounted for secondary market transactions by requiring that all recourse obligations be treated as ‘on balance sheet’ financing transactions, not as sales. The industry responded by taking advantage of the recently passed real estate mortgage investment conduit legislation. Because secondary market transactions had become nonrecourse, investors shifted their focus from the creditworthiness of the seller to the quality of the underlying loans.
This spurred the development of sophisticated technologies and models to assess loan quality, particularly borrowers' creditworthiness and collateral valuations. This required sellers to provide investors with data tapes containing information necessary for investors to make credit, collateral and pool stratification decisions.
Regulatory compliance risk, though, remained relatively benign. Because most regulatory violations arose from a demonstrable ‘pattern or practice’ observed over a large universe of loans, performing compliance checks on a loan sample remained an effective means of identifying noncompliant patterns or practices.
Generally, the vestigial compliance rep and warrant continued to be the most economically favorable allocation of regulatory risk between sellers and investors.
Eventually, as the market for subprime mortgages evolved, consumer advocates lobbied successfully for greater consumer-protection regulation. Over the past 10 years, mortgage lenders have become subject to a rapidly growing patchwork of federal and state laws. In several states, shorthanded regulators made mortgage investors (including securitization trusts) liable for compliance violations made by the originator, effectively turning the secondary market into a de facto police force.
Investors responded by investing more in compliance risk management. However, most of this spending was wasteful, as it involved throwing more dollars at the same increasingly costly, highly manual, post-purchase diligence approach. This approach to compliance was designed for a far simpler, more benign regulatory environment.
What was needed was a smarter approach that leveraged automation to perform ‘lights out’ compliance on every acquisition. This would ensure higher rates of compliance for a cheaper total cost.
The problem with is approach is that it required sellers to deliver more loan data to investors. It was a seller's market, and requiring any additional data – especially in order to kick out loans – made an investor's bid less competitive. The simple choice for most investors was to continue relying on the rep-and-warrant model or exit the market.
As Warren Buffet once said, ‘When the tide goes back out, then we'll see who is wearing their bathing suits.’ As delinquencies began to spike, hidden compliance liabilities and other loan-quality issues reared their ugly heads. Investors soon found the reps and warrants upon which they'd relied were not worth the paper on which they were printed.
New rules
The current mortgage lending meltdown has resulted in distinct and far-reaching regulatory changes. There are two main features of these new rules.
The first is a flurry of new regulation that greatly expands consumer-protection regulations – most notably, the new breed of ‘higher rate’ laws that reduce the financial triggers that cause loans to be noncompliant. At the federal level, substantial changes to the Truth in Lending Act (TILA) and Regulation Z, which became effective in October, include the introduction of higher-priced mortgage loans, a new category of mortgages defined by annual percentage rate (APR) thresholds that are much lower than those for the Home Ownership and Equity Protection Act (HOEPA) high-cost loans.
Similar regulations are being promulgated at the state and local levels under various names, such as higher-rate, higher-risk, higher-priced, subprime, nonprime and rate-spread loans.
These regulations include tough provisions relating to disclosures, foreclosure, predatory practice and assignee liability. Unlike general discriminatory or deceptive lending laws from which the rep-and-warrant model was developed, a borrower or regulator can show that a lender has violated these new laws without needing to demonstrate that the violation is part of a ‘pattern or practice.’ This makes sampling less effective, unless your point is to measure unidentified violations outside the sample.
The accelerating proliferation of these new laws is akin to the outbreak of high-cost or predatory-lending laws from earlier this decade, except the larger number of loans that are covered makes material losses more likely. But perhaps more troubling than their broad applicability, many higher-rate laws encroach substantially on underwriting by requiring that creditors establish a borrower's ability to repay the mortgage.
Unfortunately, guidance on how to go about establishing this is vague at best. Current market circumstances compel reasonably stern and homogeneous underwriting. Yet as the market recovers, government-mandated underwriting will surely shape product and channel strategies.
All of this is expected to be further complicated with the Department of Housing and Urban Development's (HUD) overhauling of RESPA, which goes into effect Jan. 1, 2010. It is unclear whether these rules will be amended or appealed, as there are pending and expected lawsuits against HUD for allegedly overstepping its congressional authority; however, all efforts to scuttle the changes have so far failed.
Among forcing other important changes, these rules – by consolidating origination fee disclosures – will inflate APRs and increase the number of loans triggering HOEPA as well as high-cost and higher-rate mortgage thresholds.
The second feature distinguishing the new rules is who bears the economic risk of loss for their violation. Several regulatory changes expressly provide for assignee liability. This means that the purchaser of a mortgage loan can be liable for mistakes made by the originating lender.
While assignee liability presently exists in HOEPA and some state high-cost laws, the inclusion of similar provisions in the expansive group of higher-rate laws – such as TILA's new higher-priced mortgages – presents significant new risks to investors. Some of these laws contain due diligence safe harbors, which cannot be met by reps and warrants.
It is important that institutions understand the regulatory exposure and marketability associated with these loans. For example, Fannie Mae and Freddie Mac have announced that they will not purchase or securitize certain mortgage loans that meet the definition of high-cost or high-risk home loans in New York.
The trend is clearly toward further expanding liability for investors and securitzers. Both the House and the Senate have introduced mortgage reform bills that include assignee liability provisions that are broad in scope and applicability. While neither bill is expected to pass this year, further federal mortgage reform is a certainty, and these bills reveal much about lawmakers' views on how to best police the market.
Even more troubling, where assignee liability is not expressly stated, it is increasingly implied. For instance, a leading Wall Street firm in May agreed to pay up to $60 million to settle a Massachusetts probe into whether its subprime mortgage securitization business had encouraged unfair loans.
When it comes to the new rules, the rep-and-warrant model is sort of irrelevant. Far more loans will trigger consumer-protection laws. And, even if an investor is able to put back a noncompliant loan, it cannot extinguish the liability.
New game
On the positive side, new rules mean the game has changed. Those institutions first to implement successful strategies will enjoy great economic success.
Given the new rules, a winning strategy must incorporate two features. First, investors must require, and sellers must provide, loan information in an electronic format required for performing automated compliance reviews on all acquisitions. Second, investors should distribute their automated compliance engines to sellers so as to provide the latter the means to fund salable loans, similar to how automated pricing and underwriting engines are presently used.
Investors require greater transparency and information in order to manage regulatory compliance risk. Investors can reduce costs and materially improve compliance risk management practices by requiring sellers to provide data required to perform automated compliance reviews.
Sellers should have to rep and warrant to the data's integrity. Many sellers will argue that the data are not available. This is a red flag that should prompt investors to question a seller's controls, if not its intent.
Sellers also require greater transparency and information in order to better ensure they are funding marketable loans. Sellers can improve secondary executions by submitting their loans on a real-time, pre-funding basis to the same automated compliance engines utilized by their investors.
This approach offers several important advantages. First, it provides investors significantly greater assurance that they are purchasing compliant residential mortgage loans. What's more, it provides investors access to valuable industry data to more easily identify fraud, recognize trends and develop predictive analytics (e.g., detailed HUD-1 fee data by product type and ZIP code).
For sellers, greater transparency and automated tools reduce compliance-related repurchases. Greater execution certainty will not only enhance loan-level profitability, but, if properly implemented, could also permit sellers to reserve less capital against contingent liabilities.
Overall, this approach to the new game harmonizes business goals with consumer-protection requirements – an accord the mortgage industry sorely needs.
Louis Pizante is CEO of Mavent Inc., based in Irvine, Calif. He can be reached at lou.pizante@mavent.com.
