REQUIRED READING: Sophisticated investors no longer take anything for granted when buying mortgage loans from originators and other sources. Over the last three years, there has been a renewed focus on loan quality control in the residential mortgage business, in particular as it relates to secondary market investments. The two issues of most concern to these financiers are income and compliance.
Accurate determination of borrower income was lost during the subprime era, when stated-income loans – also known as ‘liar loans’ – seemed to be the norm. Back then, there were many companies claiming they could verify and evaluate income. However, as we've seen with the record number of mortgage defaults and foreclosures since, they really could not. Today, true determination of income is back in fashion, but it requires a huge retraining of the industry.
Compliance is also a huge issue in the secondary market, as tens of thousands of loans have proven to lack proper ownership documentation, which makes it very difficult for investors to know what their holdings actually comprise. The ensuing chaos is evident in the foreclosure fiasco.
Many investors are putting their collective feet down, demanding that loan documentation and disclosures be done correctly. Investors, originators and servicers have learned that they should be auditing document compliance and compliance processes on a regular basis.
One of our colleagues, a risk professional at a top-five mortgage aggregator, told us about the bank's expansion of its correspondent/purchase loan assessment process to include a function called ‘Know Your Customer.’ She explained that, in the past, teams doing the buying looked primarily at numbers on the loan tapes and then did selective due diligence.
Now, the buying division separates the evaluation of the loan portfolio from the evaluation of the lender itself. A new department has been set up to assess originators and correspondents based on a subjective analysis of their quality control and compliance systems and processes.
As our risk professional colleague states, ‘We look at their written QC plans, evaluate their compliance management and assess their policies for managing fraud, credit risk and appraisals. If the executives don't really understand quality control and compliance, we won't purchase their loan portfolio.’ This new approach, which has also been adopted by other major banks, represents a fundamental industry change over the past couple of years.
Tougher underwriting
In the government-insured secondary market, four agencies that predominate – Fannie Mae, Freddie Mac, the Department of Veterans' Affairs and the Federal Housing Administration (FHA) – also have adopted tougher underwriting standards. These standards are similar, but there are subtle differences among them. For instance, each agency requires that originators review 10% of its post-closing volume and reverify borrower incomes, assets and credit.
The FHA currently insures up to 35% of all loans being originated – up from the low single digits during the subprime era. The FHA also has the most required paperwork of the four agencies. It has thousands of documents, depending on what type of loan it is, that originators must complete. If those requirements are not adhered to, the loan application will fall out or the FHA will not insure it.
Private secondary market investors have standards that are also very stringent. Some investors require monthly (as opposed to quarterly) quality-control checks. Still others require a limited QC on 100% of their loans.
Private investors often want loan information reverified two or three different ways, insisting that originators from whom they buy loans are taking quality seriously. Specific investors have their own, individual overlay of filters for QC reviews.Â
When it comes to FHA-guaranteed loans, more investors are peering under the hood to make sure the loans adhere strictly to the agency's guidelines, because failure to do so may mean that these loans are ultimately uninsurable by the FHA.
The bond-rating agencies are now also demanding more rigorous QC checks and due diligence, based on regulations passed in 2008. These private entities want an integrity check of the data tapes to make sure they are consistent from one loan origination system to another and that loans are underwritten according to the standards of the purchasing or guaranteeing entity (e.g., Fannie Mae or the FHA).
The rating agencies no longer accept a generic ‘paper checklist.’ Rather, they want to know that a loan originator, servicer or investor is using a software system that is equipped to perform ‘deep-dive’ QC reviews, and that the system is asking the right questions.
In particular, these agencies have become very insistent on understanding how loan information is reported back to them. For example, when Standard & Poor's reviews mortgage investments, it investigates the QC system. Because the rating agencies affect the secondary market, investors need to make sure that the loans they purchase are underwritten and closed according to the latest rating-agency requirements.
To help lenders benchmark themselves, the FHA maintains a Neighborhood Watch that enables authorized users to monitor mortgage delinquency patterns by geographic area, lender or loan details. This allows them to see how a lender's FHA loans are performing and to compare them to other lenders' performance.
This comparison score is one benchmark that the FHA uses to determine whether the loans being originated by a particular lender are of high quality at a national or local level. A 100% score means loans in a given local area are performing in line with other FHA loans, a higher number means they are performing worse (meaning a higher delinquency percentage) than the norm and a lower number means they are performing better than the norm (fewer delinquencies).
Effective results?
With all of these requirements being imposed by government purchasing agencies, government insuring agencies, private rating agencies and private investors, is loan quality actually improving?
There is no doubt that major changes have taken place on the loan-quality front over the past few years. For example, Fannie Mae's new Loan Quality Initiative (LQI), which went into effect in 2010 with the stated purpose of reducing repurchase risk, instituted a new requirement (among many others) that lenders perform quality-control reviews prior to funding. Historically, quality control has been done on a post-closing basis, with the results and trend analysis often not communicated back to the originating side until 90 or more days later – limiting their impact.
Now, the combination of Fannie's LQI and originators' own recognition that loan flaws not caught on the origination side are very costly later on, has led to an emphasis on pre-funding quality control.Â
Lenders are also doing a much better job of ensuring communication between their quality control and origination divisions. As the real estate market heated up prior to 2007, top executives at lenders and loan aggregators were focused almost exclusively on origination volume and viewed quality control and compliance as necessary evils. Now, executives at major lenders are emphasizing quality control throughout their organizations.
With a new understanding in the marketplace of the importance of quality control, the findings being generated by quality-control divisions are now, in many cases, used in real time to improve the origination side. The ‘material defect rate’ used by major lenders to measure the number of loans deemed defective by quality-control sampling has dropped dramatically. For example, according to executives at some of the top lenders, defaulting loans had ‘material defect rates’ of up to 70% back in 2006, and now that range has dropped down to 10% to 15%.
Some of this, of course, is driven by tighter underwriting standards and credit availability in general, but it is clear that all of the new guidelines and the emphasis on pre-funding quality control and data verification is having an impact. Even more telling, the ‘material defect rate’ is now a standard measure that affects the compensation being paid to executives on the origination side at many lenders.
Challenges to address
Although quality control and loan quality are definitely on the upswing throughout the industry, there are still challenges to overcome. A lack of standardization means that no two lenders do quality control exactly alike. Take, for example, ‘documentation of borrower income’ – a requirement of any quality control process today. To document income properly, lenders might ask several detailed questions regarding income, including the following:
- Was the borrower's monthly income calculated correctly compared to annual income?
- Does the borrower's Social Security number match on all documents?
- Were paycheck deductions taken into consideration against the borrower's debts?
- Is income rounded, which might indicate that the number is fraudulent?
We know of one company that asks over 20 detailed questions just to document income. Others might ask fewer, there is no single standard in place.
Similarly, important measurements, such as the ‘material defect rate,’ are defined differently by each lender. One lender's ‘material defect rate’ of 8% might be the equivalent of another lender's ‘material defect rate’ of 4% simply because it has tighter definitions around whether a defect is considered ‘material’ or not. Despite all the guidelines issued by the FHA and other agencies regarding quality control and data verification, there is no single industry standard regarding how to properly categorize and assess loan defects at the detailed level.
The bottom line is that in today's marketplace, there are still fundamental differences between the QC systems and processes of various lenders, with some ahead of the curve but many still far behind. As a secondary buyer, knowing the ins and outs of a lender's approach to QC is a very effective way to protect your portfolios against future losses.
Avi Naider is chairman and CEO of ACES Risk Management Corp., based in Fort Lauderdale, Fla. He can be reached at anaider@armco.us.
