There is a contest going on these days and it is not being played on a field on at a stadium. The prize is not a trophy or pictures on the news. This contest is to decide if the mortgage industry can survive outside the protection of the big banks; the ones “too big to fail.” Without a doubt those banks that were huge participants in the mid-2000s run up to the mortgage crisis have significantly pulled back from offering home loans today. Over the past few years we have seen the #1 lender, Wells Fargo reduce its lending from $125 billion in the fourth quarter of 2012 to $47 billion in that same quarter in 2015. J.P. Morgan Chase has had a similar retreat, going from $51.2 billion in the fourth quarter of 2012 to lending only $22.5 billion in the same period of 2015. This reduction in lending is driven primarily by the cost of capital and the associated cost of compliance which is not only regulatory changes, but stricter underwriting requirements as well. According to Chris Whalen, a consultant in the industry, bankers believe that “…making home loans to American families is not worth the risk.” So who is going to pick up the slack?
For many in the industry the answer lies in community banks and credit unions. These entities, which are primarily local and well-known to their communities now have the opportunity to step into the void left by the retreat of the big banks. Others however, believe that the “non-banks” will ultimately take charge of the industry. Statistics seem to support their position. In 2014 non-banks had 43% of market share which was up from 23% in the year 2007. Non-banks such as Quicken, Penny Mac Financial and PHH mortgage are rapidly moving in to fill the gap. However, community banks and credit unions are looking to increase their share of the market as well. In fact, the Credit Union National Association (CUNA) is holding an educational conference which highlights mortgage and other consumer lending programs at the end of April.
While these entities venture into capturing larger shares of the market it is most likely not a surprise to many. However, with the largest numbers of homebuyers divided into the Millennials and the Golden Boomers (those baby boomers who have reached their golden years), it is a toss up to see which draws the largest numbers and originates the greatest volumes. Those who study lending trends are convinced that the selection of a lender will be bifurcated along these age lines. For those Millennials whose life is wrapped up in their technology gadgets, it is expected that they will gravitate toward the non-banks whose approach is typically through technological applications. These same individuals also think that the more seasoned members of a community or profession will only be comfortable dealing with local bankers who provide a more personnel touch. There are however, a growing number of individuals who believe that this bifurcation may be exaggerated. Based on experience in dealing with both generations, they believe that while the Millennials may initially explore lenders that offer the best technology they will ultimately turn to their parents and elders for advice. These individuals are more likely to recommend a local bank because of the human interaction involved.
Over the past weekend the contest heated up even more as Quicken began advertising their “Rocket Mortgage” on television. In case you were wondering what a rocket mortgage is, it appears to be one that technologically collects, analyzes and makes the mortgage underwriting decision within minutes. Sound familiar? Didn’t we hear this same approach during the early 2000s? There are however, some issues that really aren’t rocket-paced and others that exclude a large percentage of those seeking mortgages from the process. For example, Quicken advises on their web-site for those seeking mortgages that “Products available on Fixed Rate Conventional Products only. No FHA, VA or Jumbo Products. No State Restrictions.” This obviously limits the opportunity for those seeking mortgages, especially first time homebuyers. The web-site for their Rocket Mortgage has a video that describes the process. The couple applying for a mortgage in the video talk the viewer through the process. First, they must answer a “few” simple questions. Then they are asked to “share bank statements and income.” But what if you aren’t a salaried borrower—it doesn’t say. A message then pops up to tell them that Quicken is verifying their information. The couple explains that Quicken obtains their credit report for no charge. But what about income and assets? Next thing you know, they are approved and the rate is locked in. Seems great, especially for those with limited knowledge of how the mortgage process.
The responses to these ads were swift. The majority of the industry members who commented were harsh in their comparisons of this process to the loan programs that caused the Great Recession and the subsequent myriad of new regulations that continue to plague mortgage lending. The appearance of the no verification loans was a scary sight for many. But were they the same and are the applicants as naïve about the type of loan products available under this program? After all the product available, it seems, is only for fixed rate loans; no hybrid ARMS or Pay-Option loans.
Things have changed with more borrowers becoming more aware of potential issues at the same time they have become more sophisticated about technology. Will the Millennial generation be the first to actually benefit from this application process or will they be warned against using this technology by parents who were crushed by the debacle of earlier “easy application” mortgages?
Having said that, not all members of the Gen X and Baby-boom generations are accepting of the slow 60 to 90-day process that requires every piece of documentation that is available to the applicant. As one of my neighbors asked me when he was trying to refinance in 2010, “I just had a colonoscopy, do they want the results of that as well?” Many in fact, want a much faster approval and have found that going through a community bank or credit union is a very slow and laborious process. While many are using automated underwriting systems, the more comfortable approach is with the use of stricter guidelines and more documentation. After all they still have to deal with the capital restrictions and tougher regulatory oversight.
This, it seems, is where the great divide occurs. For non-banks the process still involves the originate and sell model. The non-bank lenders worry more about having investors for their closed loans knowing that they are passing the primary risk on. Community Banks and Credit Unions on the other hand, have to retain some, it not all of the risks associated with the loan origination. So as the home buying and home refinancing population becomes more about the Millennial generation and less about the less tech savvy generations, will the Community Banks and Credit Unions have fewer and fewer mortgage loans.
Unfortunately, what we have not yet realized is that this contest is less about technology and more about the ability to control the processes that produce the loans. The risk from the failure of people, process and/or technology has been shown over and over again to be the underlying cause of the Great Recession. This operational risk has been recognized for some time.
In 2007 an Operational Risk Score was introduced to the market. This product re-verified the majority of the data in a loan file and using a proprietary algorithm, calculated a measure of increased default risk. While the model had been tested and validated, lenders at that time were not interested in knowing about the quality of their underwriting. Then in the summer of 2009, two members of Moody’s Investor Service presented their findings on the impact of the poor quality underwriting attributable to loan performance. In “Underwriting versus economy: a new approach to decomposing mortgage losses” by Ashish Das and Roger M. Stein found that abnormal underwriting quality made a significant contribution to loan losses in vintages from 2004 Q4 through 2007 Q1. In other words, it does not appear to be just using technology that makes a difference but the additional risk created by a failure of the people, processes and/or technology. Yet neither non-banks or Community Banks and Credit Unions have done little to control or monitor that risk.
Controlling and monitoring operational risk lies primarily in the hands of an organization’s quality control group. This group is responsible for monitoring the quality of the underwriting and closing processes through data collection and analysis. These reviews, when properly analyzed can determine if there is a weakness or failure in a process that creates additional risk so that management can make changes. Unfortunately, this approach was not the required methodology during the years 2003 to 2009. When Fannie Mae recognized the need to change the program, they along with Freddie Mac and FHA introduced loan quality initiatives that were based on a far superior methodology. Following these changes, they announced that the “quality” of the loans sent to them were greatly improved. Of course the fact that guidelines were much tighter and product parameters were changed was not mentioned as a contributing factor. The reality is that most lenders have really not changed their approach. They throw in a couple of classifications and go on doing what they have always done. Some, especially some outsourcing firms have done nothing. Obviously we need technology support if this is going to change as the industry needs it to.
Where is the needed technology?
Having validated the impact of poor quality underwriting and the ability to model the risk it creates, we need technology to step up to the plate and create a quality control program that validates the acceptability of the underwriting and closing processes. Quantifying this risk benefits everyone in the industry. Lenders, knowing the risk, can make more sound business decisions, even to the point of proactively choosing to take on the risk. Investors will have a quantified measurement that they can incorporate into the pricing of loans rather than just assuming the underwriting process was done correctly. Regulators can easily determine the level of risk assumed by lenders and using that information ensure that capital levels are adequate. It’s a win-win for everyone. Yet technology companies have so far failed to take on the challenge.
It seems to me that the technology companies focused on this industry are too busy chasing updates that promise perfection in the name of regulation rather than looking for existing needs that require change. While they claim that they are trying to develop technology that will make the process better and cheaper, they ignore a process that is labor intensive, extremely costly and the bane of every production manager. Here they have the opportunity to change the face of the entire industry; make every company more effective and efficient and every potential borrower happier with the process. Yet they do nothing. Can’t someone step up to the plate and take on this challenge? It will make a difference in this newest survival contest.