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The mortgage industry is grappling with the best ways to incorporate quality control (QC) processes into a qualified mortgage (QM) world. It’s a difficult, ongoing challenge for many lenders, and new regulations make the process even more difficult. To be sure, the market is more regulated today than ever before - and, as recent financial history has shown, the trend of increasing regulation is likely to continue.

By most estimates, the federal government today guarantees or insures - through government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, Ginnie Mae, U.S. Department of Agriculture, Veterans Affairs, and Federal Housing Administration (FHA) - more than 90% of all mortgage loans. The Consumer Financial Protection Bureau (CFPB) scrutinizes lenders and third-party vendors while the Federal Housing Finance Agency (FHFA) pushes the GSEs to transform the secondary market.

It’s short-sighted to assume, therefore, that the federal government will soften its regulatory grip on the mortgage market or abandon its drive to a new securities issuing platform. Many industry experts feel the new and difficult process to comply with regulations offers opportunities for lenders and other market participants to reduce costs, increase transparency, improve loan quality and maximize returns. The cost reductions and higher returns come when investor confidence grows because loan quality is improved, and the proof of such is transparent. The GSEs reward quality by not requesting repurchases, while private-label securities seem to be getting a boost from proven quality.

There are ample opportunities to improve quality to reach higher returns and get lower costs. The average suspense ratio - the number of times an originator pauses to review and fix an issue before locking in a loan - is 26 for government and conventional mortgages, according to a LoanLogics survey. In addition, the average time to fund a government loan is 22 days - while the average time to fund a conventional loan is 20 days.

With improved technology and the right blend of expertise, lenders can reduce the time spent in originating a loan, as well as reduce the average number of days required to fund a loan. This mitigates the lender’s risk while reducing its costs in the process - without sacrificing quality or capital. Good technology and the right people are keys for lenders - especially after Jan. 10, when the new regulations took effect. The new environment requires scalable resolutions that leverage the expertise of underwriting auditors.

Before that can happen, processes must become more formalized, standards for processing quality mortgages need to be updated and certification of processes will be required for every serious participant in the marketplace.

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Moreover, the enhanced presence - some would say, the “dominating role” - the federal government employs in the mortgage marketplace makes the QM component of the new rules one ignored at the lenders’ peril.

Efforts to ensure that quality control is in place throughout the life of a loan - from when the borrower makes a loan application, to when the loan pays off - not only fulfills the letter of the law, but also makes good business sense and happy investors. Over the long term, it will save money, mitigate risk and improve loan quality. That’s because failure to comply puts the lender at additional risk for buybacks and brings the potential for legal actions in federal court, putting additional financial pressures on the lender.

Are lenders willing to be exposed to that risk? Or, would they prefer to improve processes, upgrade technology, hire experienced compliance teams or outsource that work to trusted third parties to ensure that does not happen? They may even want to back the process with insurance, allowing them to reduce their repurchase reserves.

The CFPB never showed any willingness to extend the deadline for compliance beyond Jan. 10 - a cause of sleepless nights and nervousness among senior executives at many lending firms.

Even executives who think they have done everything possible to be ready - and believe they are in compliance - suffer nagging doubts: They wonder if they have overlooked some aspect of the regulation that will come back to haunt them. Others report with confidence that they are prepared - but they do not know how granular regulators will be in their evaluations.

For many, it requires thinking about the mortgage business in new and dynamic ways, seizing the opportunity to deploy forward-looking technology, and making some corporate cultural changes to ensure compliance with the rules to manufacture quality mortgages.

In the past, secondary marketing managers were too often not concerned with quality control. They priced, sold and delivered loans to investors as quickly as possible. By the time an investor identified an issue, the loan was older than six months, and the lender was no longer responsible - or so the lender thought. Recent events and investor repurchase requests on aged loans have changed such activity.

For most of the industry’s history, a loan that went delinquent was considered a servicing issue or a collection issue. The situation seldom rose to the level where a buyback was deemed necessary. That, however, has changed.

In today’s mortgage environment, lenders that do not take care to manufacture quality loans correctly and validate support for rep and warranty relief they provide under their sale agreements face a rude awakening under the tough new rules - and an expensive increase to loan production costs and in loan buybacks.

On the other hand, lenders that do things right will have the chance for some relief under their reps and warrants for, for example, the following:

But some reps and warrants will not sunset, such as loans that were approved due to “misstatements, misrepresentations, omissions or data inaccuracies.” In addition, the loan had to be originated in a manner compliant with the laws, under responsible lending practices, and had to meet product eligibility requirements.

That’s because the Dodd-Frank Act - the “new face” of quality control - requires documenting that a loan meets new QM standards. This will be a challenge for many firms, especially those that have not upgraded their technology and hired or trained a skilled professional staff required to stay compliant.

Past lending practices were too heavily reliant on subjective underwriting criteria that may not have been fully documented. All too often, the lack of documentation was the reason for false positive loan approvals that led to approving borrowers who lacked the ability to repay their loans.

Those days are gone - probably forever.

It’s a natural outgrowth of the CFPB’s and FHA’s efforts to rein in what they see as the excesses of the bubble years. Their aim is to ensure that consumers are adequately protected and that investors feel confident lending to borrowers and purchasing the loans manufactured by lenders.

So how does the new mortgage world look? Imagine lenders relying on original documents to validate digital data that resides, for example, in the loan origination system. As the origination process advances, lenders will depend on technology to identify problems and experienced, well-trained people to resolve them quickly and inexpensively.

The technology stores original documents and forwards them to lenders - without delay. This requires a QC process that captures information, including the original, or true, documents. The platform makes it easy for an investor or a regulator to access the loans or documents that they are authorized to see.

That makes confirming facts about a loan - at any point in the loan cycle - easier and more accurate than in the past. The technology can perform that analysis in a blink of an eye, with no delay.

As a result, lenders are beginning to embrace a model that focuses on manufacturing risk with loans based on documentation quality, versus loans with credit risk. Traditionally, credit risk implicitly included the manufacturing - or rep and warranty - risk. Loan applications that are populated with inconsistent data are identified and checked against the true documents. As a result, most in the industry feel that underwriting will become more of a workflow process, with the emphasis placed on whether a loan meets the QM requirements.

Of course, a loan that - at the beginning - looks like a qualified mortgage may turn out not to be; in contrast, loans that look as if they are destined not to qualify may earn the QM designation. It’s all in the quality of the loan manufacturing process.

That leads to an interesting development. As the market evolves, we could be moving toward the creation of a “certified qualified mortgage.” Service companies, or perhaps a compliance company, would certify that a loan is a QM loan with either the safe harbor, or rebuttable presumption protection against an ability-to-repay defense raised by a borrower after closing.

Establishing QC processes and this certification is at the heart of restoring investor confidence in the mortgage market. The rep and warrant risk on which the market previously operated lacked the necessary capital to sustain the industry. The results were devastating: Fannie Mae and Freddie Mac went into receivership, lenders went out of business, and borrowers could not pay their mortgages. The market very nearly collapsed. The approach to extending credit had to change, and it has.

In the boom years, lenders often relied on QC processes that reviewed less than 10% of files, and then only after they closed. They failed over a period of several years to consider manufacturing issues, focusing instead on systemic risk. Now lenders are required to validate support for reps and warrants with data and documents, as well as provide an electronic paper trail that proves they met the required guidelines. Documentation on the loan quality is now as important as its credit quality.

In short, greater due diligence will be required across the industry. During the pre-closing audit, for instance, Fannie Mae will evaluate if lenders took adequate time to select loans and that feedback was provided to the originations staff. Also, the lender will have to ensure the accuracy of loan data and demonstrate adequate time was allowed for corrections and revisions.

In the pre-closing and post-closing audit phase, Freddie Mac’s requirements include that the lender verify the existence of files, validate information included in loan files and evaluate underwriting decisions.

In addition, lenders will be required to determine where additional training is needed, as well as conform to underwriting, insurer and investor requirements. Also, they will have to determine if regulatory requirements are met, as well as monitor overall quality of mortgage production.

The aim is to eliminate as many loan defects as possible at the pre-closing stage. LoanLogics randomly reviewed 3,700 loans and discovered that over 42% of all defects found in post-close audits could have been discovered in a pre-closing review. This suggests that all loans need to be looked at by technology prior to closing, with a selection of loans to be audited in post-closing, based on actuarial services.

At that point, the basis on which loans should be manufactured will be clear, but by failing that, there will be a higher risk of buybacks. Some say the GSEs will not follow their new guidelines and will still follow the adverse action model - that is, a loan will be requested to be repurchased only if it becomes severely delinquent.

Lenders selling to Fannie Mae are required to guarantee that their reps and warrants are true. If they lack adequate capital, to back their reps and warrants, lenders can purchase insurance or self-insure the process for three years. A common repurchase reserve is four basis points per loan. Manufacturing defects, however, are excluded. So, it leaves the lender having to prove its work and show that corrective action was taken.

Loans that fall outside the norm will cost more. For instance, the FHFA wants to see those loans charged more for insurance, and the U.S. Department of Housing and Urban Development may follow with a similar price structure.

So far, non-QM loans have not been defined, and that makes them confusing to many market participants. Over time, the industry will understand the factors that constitute a non-QM loan, and firms will emerge to offer those loans to the public.

With the passage of time, investors will gain confidence in the mortgage marketplace and create a market for non-QM loans, but only if the underlying facts about the borrower’s ability to repay are documented. Investors will expect lenders to provide data and original documents that support the decision to extend credit on non-QM loans.

Investors will no longer rely on trust alone via lenders’ reps and warrants - and if recent economic history has taught us anything, it’s that lenders need documented proof: “Trust but verify” will be the mortgage industry’s mantra.

 

Les Parker, CMB, AMP, is senior vice president of strategic business development at LoanLogics. He can be reached at les.parker@loanlogics.com.

Quality Control

The Challenges Of Quality Control In Today’s Qualified Mortgage World

By Les Parker

The CFPB’s new rules require lenders to improve their QC processes - but it’s to their own benefit.

 

 

 

 

 

 

 

 

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