In early January, the American Dialect Society held its annual meeting to decide what recent addition to the American lexicon most accurately reflected the national zeitgeist in 2007. Many suggestions were considered, including ‘facebook’ (as a verb) and ‘green’ (as a political stance). However, the society decided on ‘subprime.’
The choice reflects the pervasive nature of the country's current financial crisis that started with subprime loans but has now expanded to include all credit. Much of what has occurred has been blamed on rampant speculation in the secondary market. Whether this was a cause or an effect of an unstable financial structure is a debate best left to the economists, but the subprime debacle has taken center stage in the public consciousness and thus in political journals and stump speeches. New legislation is on the horizon. The question is what form it will take.
After the stock market collapse of 1929, President Herbert Hoover turned to Andrew Mellon for advice. "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate�purge the rottenness out of the system," Mellon said.
Thankfully, our current government is not nearly so brash. However, when the economy is in serious trouble, the government invariably steps in and exerts control. Currently, regulation is passing through the House of Representatives Financial Services committee, led by Rep. Barney Frank, D-Mass., which would drastically increase borrowers' ability to seek restitution from lenders, and even from those involved in the secondary mortgage market.
The stance of regulators is clear: The institution whose money backs a loan is responsible for the loan and all associated regulatory requirements that go along with it. A secondary market player bears a compliance responsibility no matter how transient ownership of the loan may be. This responsibility includes compliance with all anti-predatory and fair lending laws.
Fair lending laws impose strict rules around borrowing practices and explicitly make it illegal to discriminate on the basis of race, gender, age, income or any of the other "protected class" designations.
In the past six months, extensive media coverage has highlighted that a disproportionate number of the subprime borrowers facing foreclosure are minorities, and accusations of discrimination have ensued. Last summer, the NAACP sued a dozen of the country's biggest mortgage lenders, claiming the firms discriminated against black borrowers, steering them toward high-cost loans while white borrowers were offered more favorable interest rates.
The high-profile nature of the subprime fallout and the media's lack of providing context for pricing and product decisions have resulted in intense public scrutiny of individual lenders' underwriting patterns and the industry as a whole. The findings and assertions made by regulators in the first 60 days following the collapse of New Century Financial Corp., perhaps the most prominent casualty of the new mortgage market, garnered more media attention on the subject of fair lending than it has seen in years.
Since 2004, when the transparency of Home Mortgage Disclosure Act (HMDA) pricing data greatly expanded, watchdog groups have claimed lenders' current pricing policies discriminate against protected-class borrowers. While there does appear to be more visibility of pricing data, other key data are missing from analysis being performed by external parties. Without credit scores, loan-to-value ratios and other important decision and pricing data points, the full story cannot be told.
Regulating agencies are also aware that many eyes are on these data, and the pressure is on to carefully review for any seemingly significant high-pricing clusters. The results of their scrutiny will be more onerous fair-lending exams and an imperative to reveal the policies, procedures and monitoring used by lenders to prevent fair-lending violations.
Even though mortgage-backed securities traders had no say in the original provisions of the loan, the loan's acquisition means that this risk is now entirely the responsibility of the firm that's brought the loan into its portfolio.
And with the public demanding answers to past lending practices – and the mass scrutiny of mortgage origination pricing data – new technology solutions to monitor risk are now necessary in the secondary market. The goal of such technology is both to identify and proactively prevent unjustified disparate treatment and impact from entering into the loan portfolio.
Stronger focus
Identifying potential fair-lending issues is best done through rigorous statistical analysis. A properly constructed regression test that factors in underwriting policies will immediately identify the protected-class loans that lie outside the normal decision or pricing patterns. Once identified, the institution should conduct a comparative file review identifying the most similar unprotected-class loans with decision or pricing within the predicted ranges. These reviews are critical to making the decision as to whether or not there is a pricing issue.
Manual overrides for both decisions and pricing are widely used throughout the mortgage industry, even by institutions using automated underwriting technologies. Recent lawsuits resulting in multimillion-dollar settlements are a clear message that it is no longer enough to be familiar with accepted policy. A fair-lending risk manager and general counsel must understand the impact of any exceptions and whether these exceptions are being applied equally across protected and unprotected classes.
Today's fair-lending challenges and trends require portfolio controls and analysis. From shifting accountability to front-line personnel to achieving full transparency of fair-lending risk to proactive management of third-party originating channels, the proper application of automation and analysis tools is critical to a successful fair-lending risk-management program.
A good starting point for creating an effective enterprise program for fair-lending risk management is to develop a comprehensive fair-lending plan. Cost-effectiveness is a key consideration. Even modest efforts can produce significant gains in identifying and managing risks for an institution without any review or monitoring.
But it's also possible to develop an overly extensive methodology where the cost is unwarranted relative to the risk, especially in the secondary market, where ownership is fleeting. For example, a sophisticated statistical modeling approach for monitoring mortgage lending may not be cost-effective for an institution with low mortgage trading volume and a structured mortgage security acquisition process that leaves little to judgment.
In this environment, the cost of developing and maintaining a statistical program could outweigh the risk. Secondary market players need to carefully think through where their largest risks lie and identify the most appropriate and cost-conscious approaches for managing them.
Specifically, instituting controls in the trading process that proactively identify proposed loan purchases with pricing above statistically predicted norms is the strongest step to prevent acquiring fair-lending risk. If issues are caught at the time of acquisition, it is possible to intervene in real-time and prevent an overpriced loan from entering the portfolio.
Key to the evolution of such a program is to avoid interrupting the trading process. Traders, after all, are in the business of buying and selling, and any solution addressing fair-lending risk must not inhibit or slow revenue.
An integrated, automated, real-time fair-lending review based on proven statistical methodology and informed with specific underwriting guidelines allows traders to prevent potentially discriminatory decisions and pricing without slowing the trading process down. Only those decisions or prices that are statistical outliers are flagged for further investigation.
Using this process, valuable resources are maximally focused on specific loans where problems may exist, instead of monitoring for issues after the loan has been aquired. As with most risk, an ounce of prevention is worth a pound of cure.
Instant feedback
One additional benefit of front-end fair-lending reviews is the instant feedback at the point of acquisition. This critical feedback loop means front-line lending personnel can be held accountable and can be properly trained.
When a decision or a price is identified as potentially discriminatory, the underwriter is notified, as are the proper fair-lending and risk-management channels. This level of visibility translates to a further increased motivation of staff to proactively avoid even the appearance of acting as a repository for loans that have benefited from disparate treatment.
Instant review of programs and products can also proactively highlight and help to avoid disparate impact from policies and underwriting guidelines. This real-time information helps management better understand how policies and guidelines apply in active situations as opposed to on paper. The immediacy of the feedback allows for timely action to make these programs and products work while maintaining an impenetrable risk shield.
In a perfect world, all people would be treated equally and fairly when applying for a loan. All would receive fair terms and rates, which they could reasonably afford to pay. No one would be unfairly denied. Compliance data would be flawlessly managed and seamlessly incorporated into the due-diligence process. And community groups, the press and regulators would all accept this as truth.
Unfortunately, the world isn't perfect, and discrimination (both intentional and accidental) does occur. While there are many factors pertaining to loan underwriting over which a trader on the secondary market may have no control, there are powerful new tools to mitigate fair-lending violations before they become part of the portfolio.
By monitoring, analyzing and managing critical data at multiple checkpoints, infractions can be prevented before they happen. The key is a comprehensive fair-lending process along with a complete fair-lending management solution that can determine – in real-time – if a secondary market player is bringing on fair lending risk.
Sam Hawes is fair lending product manager for Wolters Kluwer Financial Services, Minneapolis. He can be reached at sam.hawes@wolterskluwer.com.
