Trust and reputation are not discretionary. They are as necessary in business as the people in whom they reside.
- Tony Alessandra
The theme of the Mortgage Bankers Association's (MBA's) Annual Convention this year is "Driving Change." There is no question that the landscape in financial services is changing, and rapidly, but one must wonder: Who, or what, is driving the change?
Agents of change in the current environment include demographics, economic cycles, politics, regulation and technology.
The congressional mandate to reshape the financial services industry has pushed regulatory compliance to the forefront as the primary driver of change. From loan officer compensation, licensing and registration to the latest round of Real Estate Settlement Procedures Act (RESPA) reform, and from the Dodd-Frank Wail Street Reform and Consumer Protection Act's underwriting and due-diligence standards to the futures of Fannie Mae, Freddie Mac and the private secondary market, the entire system is in a state of flux. The economic environment makes it more difficult to keep up with what seem to be daily regulatory transformation and uncertainties.
The primary stated motive behind the new regulatory scheme was the prevention of systemic risks to the economy in the future. However, when viewed in their entirety, the tide of laws and regulations sweeping over us reflect a deep mistrust of the financial services industry. It's evident in the imposition of stringent quality and due-diligence standards for loan originations and in the level of loan detail that must now be provided to the regulators and to secondary market participants.
It's the financial services version of "trust but verify/ and it's a necessary first step to restoring confidence in the industry.
Although implementation and ongoing compliance will be extremely challenging, the new regulatory scheme may ultimately represent the industry's salvation because it elevates data integrity and transparency to the top of the enterprise risk-management priority list. Prudent lenders would therefore be well served - regardless of the outcome of the Qualified Residential Mortgage (QRM) and Qualified Mortgage (QM) definitions - to focus like a laser on quality-control processes and procedures.
Data integrity is the foundation of successful mortgage lending. It is essential to restoring the trust of consumers, investors and legislators. When loan data is accurate, lenders are able to make fully informed credit decisions and sustainable loans.
Transparency is also critical because it allows market participants to examine and understand the loans they're buying or insuring and it ensures they don't exceed acceptable risk parameters. As they used to say in the early days of computing, "Garbage in, garbage out."
The dangers inherent in making loans based on inaccurate data are coming into sharp focus as a result of repurchase and rescission investigations into defaulted loans. Forensic file examinations are providing proof that fraud was, as the Federal Bureau of Investigation (FBI) warned in 2004, at epidemic levels during the boom. Whether it related to collateral valuations or borrower qualifications, the data used to support millions of loans were intentionally corrupted through affirmative misrepresentations and omissions, and that both sparked and exacerbated the economic crisis.
Nowhere was this problem more severe than in the stated-income and no-documentation loan programs. These programs were designed to facilitate loans to a specific niche market - self-employed borrowers with substantial assets and income. They became malignant products as housing prices rose and they began to be widely available for W-2 employees.
How did a beneficial niche product end up turning into such a defective product? The answer is through faulty data and inadequate underwriting processes and controls.
According to underwriting guidelines in place at the time, the income that was stated for the borrower in these programs had to be "reasonable" for the location and position. But somewhere along the way, that requirement was lost. Some brokers and loan officers began telling borrowers that they could state any amount of income because the banks didn't care.
Mortgage underwriters, under pressure to reduce turn times and incented to produce volume, were overly reliant on and frequently misused loan origination systems (LOSes). If the loan characteristics as represented on the application fit the program profile and were accepted by the LOS, the underwriter approved the loan with no further analysis of the application or verification of the accuracy of those representations.
The "news" is that these underwriters are often the very people who today staff lenders' loss-mitigation and servicing departments, and they're ill-equipped to do the in-depth analyses necessary to prevent excess losses in loan modifications and short sales. That's part of the reason that mortgage fraud is still alive and quite profitable for its participants.
Desperate times breed desperate measures. With mortgage origination volumes well below historical highs and fluctuating unevenly, professionals in financial services and related industries are feeling the economic pinch - and none more than those within the industry whose income relies on commissions and volume incentives.
The ethically impaired prey on desperate borrowers, target distressed properties and use their knowledge of the industry to complete their nefarious schemes.
As the FBI noted in its just-released 2010 Mortgage Fraud Report (www.fbi.gov/stats-services/publications/ mortgage-fraud-20io/2oio-mortgage-fraud-report# mortgage): "Mortgage fraud perpetrators using their experience in the banking and mortgage-related industries - including construction, finance, appraisal, brokerage, sales, law and business - exploit vulnerabilities in the mortgage and banking sectors to conduct multifaceted mortgage fraud schemes. Mortgage fraud perpetrators have a high level of access to financial documents, systems, mortgage origination software, notary seals and professional licensure information necessary to commit mortgage fraud, and have demonstrated their ability to adapt to changes in legislation and mortgage lending regulations to modify existing schemes or create new ones."
Schemes that target distressed properties and borrowers reflect this ability to adapt. Default-related schemes victimize desperate borrowers and create excess losses for lenders, and illicit profits for the perpetrators by leveraging intentionally corrupted data and forgeries to facilitate short-sale and loan-modification frauds and flipping in real estate-owned (REO) properties.
A partner at a major international banking consultancy here in Washington, D.C, recently said that a client's analysis of resale activity on short-sale and foreclosed properties "blew them away" when the client bank saw how much money had been left on the table. He also said that in a staggering 75 percent of transactions, the excessively low sale price was due to grossly inaccurate property valuations. While he specifically cited a dramatic lack of quality in broker price opinions (BPOs), Interthinx appraisal reviews also reveal valuation problems that can be attributed to unqualified appraisers' geographic incompetence, lack of experience in what is a very challenging market, and possibly intentional manipulation of critical information.
Another example of the data corrupters' ability to penetrate lender defenses relates to today's fully documented loan programs: Because current underwriting, loan-modification and short-sale guidelines now require supporting documentation, forgeries - from tax returns to bank statements, to hardship and payoff letters, and to deeds of conveyance and satisfaction - are cropping up on an alarmingly regular basis. Here, technology is the change driver because it creates documents that are visually indistinguishable from the rea] thing.
Servicing and loss-mitigation personnel and operations are highly vulnerable to today's schemes because detecting data-integrity issues and misrepresentations have never been part of their job descriptions. After all, until fairly recently, these personnel functioned primarily as back-office administrators - so there was little need for them to worry about it. That is no longer the case.
These departments are at the center of the fraud bull'seye. Interthinx investigators observe what they term "rebranding" - real estate agents, appraisers and mortgage brokers who are associated with fraudulent transactions from the boom times now have companies that specialize in loan modification and short sales, a strategy that puts the fox in charge of the henhouse.
They succeed because while servicing and loss-mitigation personnel are now required to essentially underwrite files, only a minority have underwriting experience, and those underwriters generally gained their experience during the boom when thoughtful analysis was not a priority. To protect against excess loss, repurchase and rescission expenses, and liability under the federal False Claims Act, that priority has to change.
Regardless of whether inaccurate data in mortgage applications are the result of honest mistakes or intentional misrepresentations, these loans, if closed, are defective. Inaccurate data have already cost lenders and insurers hundreds of billions of dollars, and we're not even close to reaching a final tally.
The cost of originating defective loans is increasing every day with each new regulation and its associated penalties. A well-thought-out plan can minimize all these risks. Here are a few suggestions to improve quality control:
* Create a more risk-aware culture that starts with corporate leaders.
* Support a commitment to quality through corporate governance that prioritizes the identification of weaknesses in operations and procedures, and that moves quickly to correct them.
* To avoid possible conflicts of interest, ensure that quality-control management reports directly to senior management and not to production or operations. If your institution's size does not allow for such separation, engage trusted and independent third parties to assist with quality-control operations and verifications of borrower-submitted data.
* Hire seasoned, experienced underwriters - not auditors or newbies - to staff the quality-control department. Support them with on-going training to identify the full spectrum of data-integrity issues, and equip them with the best risk-mitigation and compliance technology available to help spot problems. These tools, services and training should also be provided to loan processors, servicing and loss-mitigation personnel.
* If a sampling approach is employed, ensure that the selection process is not biased and that results are not suppressed.
* Channel quality-control findings throughout the Organization. Red flags for fraud schemes should be communicated to originations, loss mitigation and servicing. When procedural or process deficiencies are identified, corrections should be made, additional training provided and results audited to judge their effectiveness.
* Develop a method to determine acceptable prices for short sales (you'd be surprised how many lenders have no protocols for this).
* Know whom you're doing business with. Maintain a database of quality-control findings that allows personnel to identify trends and identify the tell-tale patterns indicative of problematic or criminally minded professionals (and employees) who are preying on your institution. When identified, take appropriate action to reduce further exposure, such as placing the bad and suspect actors on watch or exclusionary lists or altering your processes and procedures.
* Consider engaging valuation and risk-management services staffed with certified experts to extend your ability to develop actionable intelligence and to provide more confidence that borrowersubmitted data are accurate.
* If internal resources are not available, consider using outsourced advisory services for a staffing solution that is flexible, scalable and cost-effective.
* Consider a program to quality control your own quality control. If your quality-control program is underperforming, check into a way to use outside services to focus more on delivering speed, accuracy and transparency.
Data integrity is the key to loan quality and to restoring trust in the financial services industry. A renewed commitment to ensuring the highest level of data integrity is the first step on the road to recovery for the industry, and our country's economy as a whole.
Data integrity is the foundation of successful mortgage lending.
Ann Fulmer (based in Washington, D.C.) is vice president of business relations at Agoura Hills. California-based Interthinx. She can be reached at firstname.lastname@example.org.…