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Fair, Unfair And Deceptive

With the announcement, earlier this year about the latest data additions to be included in all future HMDA reporting, the industry has been heavily focused on making sure that the necessary data is available within loan origination systems. Furthermore, the loan application form, commonly referred to as the 1003, has been updated to ensure that all this data can be collected from the borrower(s). This additional information, in conjunction with what is already collected, form the basis of regulators Fair Lending reviews.

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Fair Lending, is the federal regulation that requires all lenders to treat every applicant equally. For depository institutions, their lending patters must demonstrate that they offer mortgage opportunities in the communities in which they accept deposits. Additional analysis is also conducted on the areas in which a lender typically lends. This has traditionally been known as the lender’s footprint and is measured by racial population distributions within specific metropolitan statistical areas or MSAs. In other words, if an MSA is 50% Hispanic, regulators would expect to see that 50% of your applicants are Hispanic. This they believe demonstrates the “fairness” of your lending practices. There are however some very “unfair” issues associated with this analysis, many of which will more than likely be exacerbated by the collection of additional data and the scrutiny of the CFPB.

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The most obvious of these is the poor quality of the data. Although the submission process includes quality and validity checks, inaccurate and/or inconsistent data is rampant. While most lenders work diligently to ensure good data, there have been instances where manufactured and calculated data have been used. Furthermore, until this past week’s announcement, there has never been a way to identify if all required lenders have even submitted their data. If data is submitted late or corrected and resubmitted, the changes never make it into the overall HMDA database for the year. Imagine one lender’s surprise upon finding out that the entire LAR they submitted one year was not included at all.

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Unfortunately, even the bad and or missing data included in the HMDA database is used to analyze lenders. For example, not all applications have the monitoring data completed and since it is the borrowers’ prerogative to complete, few, if any lenders have all the race gender and ethnicity data for every application. This can lead to some very unfair conclusions. Recent comparisons of the number of loan applications compared to these completion of monitoring data found that these numbers just don’t add up. For example, if a lender has 10,000 applications but the breakdown by race shows that only 37% were minority, does that mean that 48% are white? If so, and the population is the MSA is 52% minority does this mean the lender is failing to meet regulatory standards? Without knowing the race of the remaining 15% of the applicants, it is impossible to tell. Yet this is a major part of the regulatory review. Isn’t this a bit deceptive on the part of the regulator?

Finally, regulators and lenders alike must reconsider the use of comparative footprints in conducting this analysis. When lenders and banks were primarily regionalized this may have made sense but with the expansion to nationwide lending and the use of electronic applications, this model is unreliable and in fact deceptive when reaching any conclusion. This must be changed if we are truly to identify any discrimination practices.

The issues identified here are clear indicators that the regulators are not accurately measuring a lender’s Fair Lending, but instead are conducting unfair and deceptive analytics themselves. To protect themselves, it in in every lender’s best interest to know more about their HMDA data then any regulator does.

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Consumer Evaluations Could Help Servicers

Recently the CFPB issued a proposed directive to servicers requiring the development of a rating system that would indicate to consumers how efficiently and effectively the servicer addresses complaints. They had suggested a five-star rating system which could be published and available to anyone interested. The response from servicers was quick and extremely negative. This idea to them was an anathema. However, before the issue came to a head, the current administration declared that any new regulations were to be withdrawn.

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However, one must wonder why mortgage servicers were so vehemently opposed to this idea. Was it because they have failed to address complaints appropriately in the past? Did they believe that this requirement would force them to expose negligent or unsatisfactory actions? Were they concerned that by allowing this information to be given out they would somehow diminish the value of their organization? Or is it because they still don’t recognize borrowers as their customer, believing instead that their sole purpose is to serve investors rather than consumers?

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The idea of a consumer rating system is not new. J.D. Powers is well known for its rating programs and awards given to companies who score well on these programs. The fact that a company has received such as award is frequently a central part of their marketing campaigns.   Quicken Loans continuously brags about the number and frequency of their J.D. Powers awards as does Delta Airlines and winners from other industries. What is so abhorrent about such a system for servicers?

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One reason has been the lack of a standardized approach to evaluating responses to consumer complaints and/or inquiries. Unfortunately, developing a taxonomy that would grade responses cannot be developed until there is some standard acceptance of what should happen and in what time frame. After all, the Chinese say “Any road will take you there if you don’t know where you are going.” Right now, there appears to a consistent lack of understanding and/or agreement of what constitutes ‘doing it right”.   Once that is determined, levels of performance can be developed. For example, if it is agreed that satisfactory performance is responding to the consumer within the required timeframe with an answer to a question posed or information provided, then actions that are better and worse can be described and a positive or negative assigned.

Another statement that keeps popping up is the fact that consumers are not going to like what the servicer did or the answer to their question. Since this is bound to happen, the servicer will appear to provide unsatisfactory service when in fact they were just complying to the required servicing standards. Of course, every company expects this to happen. Delta hasn’t flown every airplane on time and without incident and there are ways to deal with one off issues when analyzing the results.

Recognizing that the benefits far outweigh the negatives must happen before any of this can get started. Having data on which consumer activities are beneficial and positive would allow servicers to determine how to duplicate this same approach on those that appear to be a problem. Living in a world where management is blind to the positives and negatives of their organization is ridiculous when an industry devised and properly managed consumer evaluation program can win loyal customers and maybe even impress investors as well as regulators.

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Mortgage Lending Is Suffering From Paradigm Paralysis

In researching material for topics of discussion I came across a phrase that really hit the proverbial “nail on the head.” This phrase was “paradigm paralysis.” What you ask, is paradigm paralysis and why was it such a revelation? The answer to those questions are simple.

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Paradigm paralysis is the condition where something, where an individual, business or culture, has an expectation of about how something should be done and something new is introduced that falls outside that pattern, we find it hard to see or accept. In other words, the actions that need to be taken to change accepted patterns are just not taken, even if these actions would produce a better result. Be it individuals, businesses or cultures, we are paralyzed. The reason it struck me as so significant is that this is what has occurred in the mortgage industry and most particularly in the adaptation of operational risk and the redirection of the quality control process.

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The basic mortgage process of evaluating the borrowers and collateral has been around since its inception in the 1930s. However, over the past thirty-five to forty years, it has expanded significantly with the focus on marketing these loan products through capital markets. In 1985, Fannie Mae introduced the first quality control requirements for lenders selling loans to them. The other agencies quickly followed. However, the paradigm they followed when doing so was one of loan inspections with reports providing a data dump that was supposed to help management resolve loan level problems.

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Because of the mortgage crisis that occurred in 2008 and the subsequent regulatory explosion, it was anticipated by many that we would see significant changes in the mortgage lending process. While there has been an escalation of technological support since that time, changes to help address some of the regulatory issues and some minor adjustments to industry processes, including quality control, there has not been any real progress in any of the process paradigms.

Of particular interest to me is the critical changes that are needed in QC. Without a doubt, the quality control standards in place during the build up to the crisis were a critical and significant factor in the collapse that followed. This was not because they weren’t followed but because they were inadequate and antiquated. Yet during this same time period, other industries in the US and around the world were implementing new quality control standards as part of an overall operational risk program. Once implemented, these programs focus on operational process analysis and provide a method to effectively price for the risk of poor controls and processes.

So, why hasn’t the industry moved in this direction? Unfortunately, we continue to have paradigm paralysis and have failed to make some progress in this critical segment of mortgage lending. Until such time as lenders are willing to take responsibility for the management, control and monitoring of the products they produce, the industry will continue to suffer. One can only hope that leaders of the industry will become brave enough to challenge this agency-caused paralysis and make a change for the better.

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Here’s What The Future Mortgage Process Will Look Like …

As we’ve been reporting on, for the sixth consecutive year, PROGRESS in Lending Association hosted its groundbreaking ENGAGE Event designed to engage the mortgage industry to discuss and find solutions to so many pressing  industry issues. This was a frank and thorough exchange of ideas and tips about how to solve the problems that face the mortgage industry.  We reported on what the speakers said about the future of mortgage regulatory compliance, the future of mortgage technology innovation, and today we’ll tell you how they see the future of the mortgage process itself. Here’s what they had to say:

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“The problem is that you e-sign here, submit conditions here, and you still get calls,” said Lionel Urban, CEO, founding partner and chairman of the board at PCLender. “That shouldn’t happen. You should be using as much machine-readable data as possible coming straight from the source, not the borrower, and that way the processor will only deal with exceptions. that’s how the process should work.”

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From a lender’s perspective, Joe Dahleen, vice president of consumer lending at Axia Home Loans, points out, “You have to get to the data upfront. We as lenders should be able to verify the borrower, their income, their bank statements, etc. electronically from the source. Also, we are getting things like the appraisal and other information as XML. Similarly, we are being required to deliver more to the investor as XML. So, technology vendors need to offer lenders a way to easily store and search all of that XML because the LOS doesn’t do that today.”

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Meanwhile, Rebecca Walzak, founder of rjbWalzak Consulting, wants technology to focus more on risk so the mortgage process of the future produces quality loans 100% of the time. “Where is the technology to help lenders mitigate risk?” she asked. “I’d like the mortgage industry to be a real industry instead of just a follower of our peers or the regulators.”

Brian Koss, chief storyteller, executive vice president, national head of production at Mortgage Network, agrees.”Making changes in reaction to an outside event hasn’t worked,” he argued. “We, as an industry, have to start being proactive. We have been so busy just trying to comply with the latest rule that we haven’t stopped to take a breadth. We have to look at the process in a new way. The cost to originate a loan continues to go up, so what should we do? We have to hold the line and continue to fight to genuinely improve the process so we can lower cost. That has to be the focus of every lender.”

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Banal, Boring And Predictable

I recently attended the MBA’s Regulatory Compliance Conference and I’m not sure why. I know why I signed up in the first place. I wanted to learn how others were handling the implementation of all these new regulations, identify where the operational problems are with small and large lenders as well as figure the best approach for ensuring overall operational compliance while keeping costs under control. Unfortunately, it just didn’t happen.

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I guess I should have known better. While the names of the sessions teased the probable attendee with terms that indicated operational issues would be addressed, the reality was that attorneys and senior compliance staff spent most of the time telling the audience about the “law” associated with the regulations and believe you me, if you are not an attorney, this is enough to put you to sleep. Questions from the participants, even when they were about operations, were answered in very simplistic and ineffective terms. I repeatedly heard that lenders should have policies and procedures in place. Duh! Who doesn’t know that but someone should have been able to provide more detail about how that is done. There were also numerous mentions of the “CMS” required by the CFPB.   Hopefully if you were in the audience this acronym meant something to you. However, I never heard anyone discussing all the facets of such a program. For those of you who don’t know, “CMS” stand for Compliance Management System and is intended to require that all facets of the operations, not just regulatory compliance, are managed, monitored and improved in a systemic approach that ensures the reliability of the organization to produce and/or service mortgage loans.

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So what sould have been included instead? With all the expensive technology and regulatory technology resources available, lenders do not necessarily have to have an in-depth knowledge of each regulation. Regulatory compliance personnel should be focused on understanding their operational methodology and be able to discern what creates risk, in this case regulatory risk. From that perspective the conference should have provide direction on how to develop an implementation approach that is viable for the organization, including identifying the areas of weakness that may give rise to potential risk from the regulators. There should have been discussion, direction and recommendations on how to provide training for the staff on each new or changing procedure associated with the regulations. There should have been a comprehensive discussion on how the organization can monitor the effectiveness and reliability of the procedures meeting the regulatory expectations and most importantly, how to institute an effective management reporting and improvement process. None of this was provided.

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Another area that was never discussed was the costs associated with complying ith the regulations. Today many lenders spend way too much money on reviewing loan files in the hope of finding that one or two files that are non-compliant. This is a waste of time and money. Lenders, as part of a solid CMS should have developed a risk tolerance for process variation based on the reliability of the process to perform. Yet none of this was included was part of the discussion and no ideas or support was provided.

It is time for the MBA to step up, to stop presenting often repeated banter as meaningful and provide some strong support. If they choose to continue as they have been then the costs associated with attending these conference is wasted.

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HMDA Costs: $40 Million Per Data Field

Recently the CFPB published its projected one-time costs to lenders for modifying systems and processes related to the new HMDA regulatory requirements. After getting through all the numbers and the accounting rules the bottom line is this: It will cost the industry $40 Million (yes million) for each new field included in the revised requirements. While I am not an accountant, David Moffat of Mortgage TrueView is. His analysis and summary of the expected costs as published by the CFPB resulted in this astronomical number.

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Mr. Moffat, as part of his analysis finds that the reoccurring HMDA costs under the new rules detailed the number of institutions by reporting profile, in other words by the largest lenders to the smallest. While the associated costs for the largest lenders (of which there are four) may appear reasonable, this cannot be said for any other company. Their approach to such things as labor costs, how the adoption costs are presented as a percentage of non-interest expenses and the division of these costs between all segments of the lender population has led him to determine that the CFPB has created their own Regulatory Accounting Principles. So instead of GAPP, we now have a new basis of accounting “CRAP”. If this material has not yet been reviewed by the CFO of your organization, it may be wise to let them review this published information.

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While the cost of new regulations has traditionally been of concern to lenders, this comprehensive analysis begs for the answer to two questions: (1) What are we getting for our money and (2) Why haven’t lenders been yelling “foul”?

Keeping in mind that HMDA has been around for forty years or so with very little improvement in the distribution of home mortgages to each race, ethnicity and/or gender, what will this new data get us. After all, one of the rationalizations for the mortgage spree in the mid 2000s was the development of mortgage products that would provide accessibility to affordable housing. That just didn’t work out so well. So what will all these new fields do? Will they isolate the societal causes of why some people are paid more than others, regardless of race, sex or ethnicity and allow us to cure a deeply embedded segregation against the lower class? Will they explain why realtors repeatedly lure sellers and buyers into properties that are over-priced and intimidate appraisers to “bring in the value” or put an end to this practice? Are we actually going to get information from this data that will allow lenders to do what HMDA legislation was intended to provide—data that will tell lenders where they have opportunities to expand? Maybe there is some other overwhelming benefit that is yet to be discovered, but we better be getting some benefit for the cost we are paying.

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But what if we’re not? Where are the lenders and/or the MBA, ABA, Credit Union and Community Bank Associations? Should they not be publicizing this outrageous cost and calling members to fight back. After all, lenders have nowhere to get the funds to pay these costs but from consumers and isn’t the CFPB supposed to be protecting consumers? Where is the hue and cry from consumer protection groups? Are all of these entities so in awe of the CFPB that they don’t even question the costs? Since the announcement about these new fields the only news coming from the industry has been technology companies laying out the needed changes to LOS systems and the related costs as well as seminars on “Implementing HMDA Changes”. Seems everyone is making money but lenders.

At the end of the day I am tired of lenders literally paying penance for over 10 years. Even though low interest rates have been maintained for a long period of time, those seem likely to end soon. If volumes drop and housing prices rise how can we continue to pay these outrageous costs? Will it take the destruction of the entire mortgage industry for legislatures, advocates and consumers to realize that we have paid our dues and stop this nonsense?

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Progress Through Changing Industry Culture

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I grew up in western Pennsylvania. This is the part of the state west of the Allegany mountains and formerly the coal and steel center of the nation. Because of the mountains, most communities were small towns located in the low lying areas known as the “hollows” or as some say “hollers”. Towns named Crabtree, Red Onion and Hunker were located in my “neck of the woods” and those of us raised there were used to “reding up”, using “gum bands” and taking our lunches to school in a “poke”. Not only did I attend high school in this area, but graduated from a university is the same area. This was the American culture I knew, the shared values and patterns of behavior learned through the socialization process of that region.

Upon receiving my degree, I moved to the Washington D.C. area. It might well have been the moon for me. Every belief I had was challenged, the language was different and people inhabiting the area were from many different backgrounds and regions of the country. Their culture was totally different than mine and it took a while to learn to evaluate and appreciate the values, intellectual beliefs and moral faculties presented to me. Eventually however, the culture of the area became mine as well.

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Then I received an invitation to attend a high school class reunion and was shocked to discover that many of my fellow graduates still lived with the same cultural beliefs that were prevalent years ago. They still held to the beliefs, concepts and social structures that existed in that region of the country in the 1950s and 60s. After several discussions, and I admit, frustration on my part, it occurred to me that while they were aware of the changes in American society and the world, they had adapted only to those that were comfortable for them within their beliefs and behaviors. In other words, their culture.

This got me thinking. Could the same thing occur within a specific organization or industry? Could an occupation such as teachers or an industry such as mortgage lenders have developed their own “culture”. Would this culture have characteristics, knowledge and behaviors that are unique to it? What if this culture’s beliefs were different than society’s as a whole? If so, can that culture be changed if necessary?

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The answers to these questions required some research and I started by searching the internet. On a site called “Live Science” I found this definition of culture “The characteristics and knowledge of a particular group of people…” and this as well, “Shared patterns of behavior that are learned by socialization.” It also included this rationalization of how cultures develop; “…the growth of a group identity fostered by social patterns unique to the group.” Merriam Webster defined culture as “A way of thinking, behaving or working that exists in a place or an organization.”

Where do we look to determine what an organization’s culture is all about? What will tell us about the industry, who belongs, what values they have and how they interact with others? One way is to become involved with them by joining the group, interact with them on a professional level or using the services they provide. Another way is to review what they have done, what has been written about them and what they claim are their standards and values. If we did this what would we find out about the culture of mortgage lenders?

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One thing is certain, we would find a lot of negative information based on the past 10 to 12 years. It is likely that not only would the problems of the mortgage crisis be heavily discussed, but it is very likely that much of the effort put into fighting regulations that came from that period would be included as well. Let’s face it, in the eyes of most consumers, mortgage lenders have not yet regained a trustworthy status. If asked, many consumers would indicate that they believe lenders are only interested in making money and many lenders, like the example given by Dan Ariely in his book Predictably Irrational, are representative of the industry itself. In this example a large bank was given the option of offering consumers a “self-control” credit card in order to prevent them from overspending and accumulating large amounts of debt. In doing so however, the bank would lose approximately $17 billion in interest paid on these accounts. The bank refused the offer putting the interest income above the benefit that could be gained by the consumer.

Do these examples really reflect the mortgage lending culture? Are we more likely to focus on the $300 Million loan package sale to an investor than the $100,000 individual loan? Are the loan officers we employ ignoring potential applicants asking for smaller loans or are products that are part of affordable housing programs in order to concentrate on larger loans? Even from an insider’s viewpoint the answer to this question seems to be yes. While the “originate and sell” focus that was so berated during the crisis investigation has been mitigated to some extent, it appears that the culture that created it has not changed much at all. Have we progressed in changing the culture that created the crisis in the first place? Have we endorsed the changes brought about by regulation and refocused on consumer interests? In the period since the mortgage crisis have we taken steps to change this culture?

Consumers and regulators must acknowledge that if looked at closely they would also see an industry that is trying to make itself more efficient by using technology to perform many of the tasks associated with its product as well as address the perception that consumers’ needs and concerns are not critical to the success of their industry. They would also discover that while there has been a tightening of credit in many products, there are still many options available to address their specific needs. They would see an industry that has added more staff to review loan files to make sure the regulations that were enacted are met. So do these changes reflect a better industry whose focus is the consumers’ satisfaction and investor confidence instead of their own profitability?

Rather than asking if these statements and examples accurately portray our culture, maybe we should instead ask ourselves what we want our culture to be? Are we truly interested in focusing on consumers; putting them first; meeting all the regulatory requirements, ensuring the quality of the loans by developing individual QC programs that accurately measure product quality, analyzing what issues really impact loan performance and developing better communications and loss prevention strategies? Haven’t we done enough already to change the culturally image of the industry? And if this negative culture still exists how do we go about changing it?

Based on previous experiences it appears that changing a culture is not something done quickly or by adding some new technology? All we have done to date is comparable to simply rearranging the deck chairs on the Titanic. If we want to make progress in the lending culture more effort is required.   Several years ago I worked with the MBA to rewrite the Code of Ethics for members of the industry. That may be a place to start. However, what we really need is the development of strong statements and actions that reflect our focus. We have to tear apart the very fabric of what we do and how we do it and in order to do that we must have some knowledge about the products and services we provide. Yet we have never taken the time to conduct a real analysis. For example, with all the defaults in Pay Option arms, there were some that performed yet there was never any analysis done on the loans that performed to identify what made the difference. Maybe if we had we would be able to identify if there are actually some opportunities for consumers to benefit. We have not analyzed our processes to determine what aspects of them, if done incorrectly, are more likely to result in a loan default. We make pricing decisions based on perceived risks such as product type, occupancy, property type, DTI and LTVs, yet those data points have not been analyzed in the context of process issues. As for Fair Lending, has anyone ever truly analyzed the HMDA data to determine if there are actual patterns or opportunities for expanding homeownership. For example, we are continually assaulted with the fact that approval rates for whites are higher than African Americans yet when you delve into the data the results show than almost 50% of the applications are for female borrowers and female borrowers of all races and ethnicity are denied at higher rates than their male counterparts.

Servicing actions have also come under greater scrutiny which resulted in the perception of the servicing culture as one of “just get the money or foreclose”. While the changes in the loss mitigation efforts implemented through the new regulations and government policies initially indicated that there was not a significant change in performance, little has been discussed or analyzed about the impact in an improving economy.

Becoming a respected and valued industry in American society and its economy is something that we all want to achieve yet our efforts to date do not seem to be improving our culture. Technology, while important, cannot and will not address the problems that are generated from the culture that continues to exist today. Only thorough digging deep into the issues and making changes based on the knowledge that comes from real analysis will we be able to make some real progress in lending. One need only look at the auto industry to see what can happen. This industry was regarded as “dead” by many Wall Street analysts because of its approach to producing cars that was made them profitable. Once they realized that this culture was the primary source of their problems and they made radical changes in the approach to the design and product of their products were they able to recapture their prominence in the American economy.   It is a lesson that could benefit mortgage lenders.

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Closing Problems Lenders Can’t Control

It has been nine months since the TRID disclosure requirements were activated. During that time period the industry has had the opportunity to resolve issues such as the potential for delays in loan closings, problems with accuracy of the disclosures and the corresponding ramifications. Recently issues emanated from the secondary market concerning the potential of assignee liability for secondary market investors.

While all of these issues are generating numerous news articles and commentaries denigrating the requirements, forcing lenders to delay closings and increasing the overall costs of originating a loan, it has also exposed the fact that our partners in this process are less than knowledgeable, and in many cases, downright ignorant of the new disclosure requirements and documents. I had the pleasure, or rather the displeasure of experiencing this over the past several months as my daughter and her husband sold one house and purchased another. We all recognize that these new requirements are intended to provide accurate financial information to the consumers in order to ensure that they “know before they owe”, but is that really happening. Here is just one example of what borrower’s experience.

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My kids sold their then current home with no problem and found a home that they wanted to buy. Their loan officer was very knowledgeable in presenting various mortgage options and provided guidance to them for completing the application and they were able to understand the LE when it arrived. Now here I must admit that my daughter, having lived with a mortgage banker for most of her life, was much more knowledgeable than other borrowers. None the less, they found the LE very easy to understand.

The trouble began when the home inspection occurred and the inspector found a problem in the air conditioning. While this was obviously the sellers’ issue, the seller’s realtor increased the sale price of the property to cover the cost and told the kids that they could pay it with a personnel check at closing. Furthermore, she stated that if they didn’t do it that way, the lender was going to have to reissue the LE and that it would delay closing. Her reason she explained was because lenders had eight years since the mortgage meltdown and still couldn’t follow the new requirements. Of course, that didn’t happen.

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Once the loan was approved and scheduled for closing this same realtor called them directly to “warn” them that they better make sure their buyer had received her closing disclosure and that it was accurate or they would not be able to close on their current home. Meanwhile they had received their CD from their lender and using the amount they would have to pay, had made all the final arrangements. The call about the buyer’s CD created a panic when they were not able to reach their buyer and the buyer’s agent didn’t seem to know anything about a “required closing disclosure”. They finally got this straightened out only to get a call from the closing attorney with their “final figure” which of course did not match the CD. It seems that he had taken it upon himself to charge them for different “inspections” that their lender had not required or included in their fees because they were actually the sellers. After much back and forth discussions with threats from both the realtor and the closing agent, the CD was deemed correct. Confident that everything was now “OK” they proceeded to closing only to find out that the realtor fees were five thousand less than they had been told. So at the end of the day, despite the lender’s requirements to give these borrowers’ the exact amount of their closing costs, the overall amount required at closing was wrong. More importantly, it was wrong not because of the lender but because of realtors and closing attorneys. And here in lies the problem. The fact that these entities are ignorant of TRID requirements, have no regard for what is best for the buyer but are only interested in getting paid, and have no oversight but are free to manipulate buyers and borrowers, negates anything the lender is required to do. While I have been told that the realtor lobby is the strongest one on Capitol Hill it is time to stop harassing lenders and start requiring that these parties bear their responsibility in ensuring that consumers do “know before they owe.”

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Beware Certain Technology

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Within the stories that are told to individuals and companies that are newly involved in Manufacturing Quality is the tale of the executive of a clothing manufacturing company. It seems he had been losing money on his clothing because his “cutters,” those individuals who cut the cloth that was used to manufacture the clothing, were very inconsistent. A rather large percentage of the clothes he produced failed to consistently conform to the manufacturing specifications. Despite his efforts at training these individuals the problem continued to exist.

He then hired a Quality Management Consultant who reviewed the problem and told the CEO that what he needed to do was install technology that cut the material. This way it would be consistent and he would eliminate the problem. The CEO followed his advice and at first was very pleased. Sales were up, rejects reduced and demand tripled. Subsequently he increased the amount of material he fed into the new “technological” tools. Soon however the problems returned. Very upset he called the consultant back into his office and angrily berated the value of his advice. The consultant then asked the CEO if he had seen the problems when reviewing his quality measurement results. He admitted that he really hadn’t looked at them because he had the technology in place and technology doesn’t make mistakes.

The consultant then went to the manufacturing floor and examined the cutting tools. What he found was that because of the demand level the individual’s positioning the material for the technical tool to cut the material had been adding more and more cloth to each cut. As a result, the tool actually spread out as it came to the bottom layers of the material. Hence the source of the problem. When told about this problem the CEO was distraught. “I thought this would solve my problem but since the technology was developed without the necessary calibrations, I have only made it worse,” he bemoaned.

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This story is told not to discourage the use of technology, but to warn management that technology is not the ultimate solution of all process problems. That these tools need to be monitored to ensure they are working as they were designed and that sometimes the intervention of humans is required to make sure this happens.

The same advice applies to mortgage lenders. In reviewing the process of approving loans underwriting was designed to evaluate loans in order to determine the probability that the borrower would repay the associated debt. Over time income levels, credit history and liquid assets became related to a high probability of performance along with the amount of cash invested in the property by the borrower. These findings became the lynchpin of the rules that make up credit policy. However, it also became apparent that not every borrower fell neatly into the “approve” or “deny” category. The reality was that many borrowers whose credit profile did not necessarily fall into the “acceptable” category were in fact as good as or better than those being approved. Reverse occurrences, where borrower’s with apparently acceptable credit criteria were not necessarily those that underwriters would approve also occurred. Thus began the recognition that underwriting was not necessarily as transparent as thought and that the “art” of underwriting was just as important as the science. This approach was predominant until the idea that the “science” aspect of the underwriting process could be “programmed” to analyze a borrower in a scientific fashion. The primary technology tool utilized in this program was known as artificial intelligence (AI). While there are several different methods of developing AI the one used in the automated underwriting system was rules-based which relies on a series of underwriting rules and data to determine the acceptability of a loan application.

The advancement of artificial intelligence has not abated since it was originally introduced in the 1990s by then dominant Prudential Home Mortgage. This program was quickly followed by Countrywide and then Fannie Mae and Freddie Mac. These programs, developed in order to allow “plain vanilla” loans to be approved without having underwriters actually review the files, quickly advanced into more complex underwriting programs. Any loans that could not be approved by the system were sent to underwriters for review and, if acceptable, approved.

These refer loans were basically deemed to be the loans where the “art” of underwriting was needed to evaluate those issues or variances from guidelines that were best done by an individual who was experienced in the risk relationships associated with loan approval.

Unfortunately, the industry recognized too late that the technology, while clearly a valuable underwriting tool had flaws. The realization of the need to ensure the data entered was consistent with the application, as well as validating that the data itself was accurate, came too late to prevent the abuse of the program in the run-up to the Great Recession.

Numerous other aspects of the loan origination and servicing processes followed the path of automated underwriting. New regulatory compliance tools, credit scoring technology, automated valuation models and servicing modification models were only some of the tools that emerged as part of the new technological approach to mortgage lending. These tools were quickly adapted into the overall process. In many cases, this scientific approach overrode the “art” that was a critical part of what we did, and how mortgage lenders were able to expand homeownership while keeping delinquencies low. While these tools are without question extremely valuable to the industry, where in the process did the evaluation that is the “art” of mortgage lending come into play? The answer to that is clearly in the Quality Control function.

Quality Control reviews conducted by knowledgeable mortgage underwriters, closers and servicing personnel were designed to be the measurement tool that evaluates whether the science that has become underwriting when evaluating applications, credit, appraisals and calculations correctly, was working correctly. In addition, this analytic process determines if the “art” of underwriting was used when necessary in order to ensure that loans meeting the organization’s risk profile were met. Without this measurement method, lenders could produce loans that were far outside the risk parameters due to such issues as errors when programming the rules, the use of inaccurate data or a general failure to follow guidelines. This loan and process analysis was the only measurement that could identify and report on fluctuations in the origination and servicing processes. Lenders’ failure to pay attention or their failure to act on the QC findings concerning the misuse of the AI technology became obvious in 2007.

Since that time new QC requirements have been imposed by Fannie Mae, Freddie Mac, FHA and VA. The new rules have added an analytic layer on top of the error identification by requiring that lenders risk rank the loans with errors based on the taxonomy they have developed. As a result, vendors who specialize in quality control software have seen this as an opportunity to enhance their programs and add another layer of technology, using AI, to the process. Some vendors have taken it upon themselves to dictate the specific process issues to be reviewed by quality control and establish risk ratings for each variation for those rules. All of this is done automatically and in order to change the risk rankings, the analyst must take action by physically going in and changing the rating.

This approach is one in which the level of the technological support is actually a deterrent to the efficiency of the process as well as hampering Quality Control’s ability to effectively provide accurate risk evaluations to management. Here’s why.

As discussed earlier, sometimes underwriting is based on the “art” of evaluation and not the “science”. When this is the case, the artificial intelligence is unable to adapt and supposed errors found in the loan may actually be acceptable or considered less risky that what has been programmed into the AI results. On the contrary, specific risk attributes that a lender believes are risker may be missed because “the system does it for me.”    Furthermore, as a result of these mistaken risk evaluations, the overall rating on the loan, which must be used to calculate the total error rate, could be inaccurate and relay a false impression to investors and/or regulators.

Another issue with this AI based QC programs is the inability to allow for unique products such as those for private investors or loans where the lender has secured overlays for the standard agency products. In addition, there are product types, such as jumbo loans that may have their own specific risk-related processes that have not been included in the AI rules. To further confuse things these vendors do not allow individual clients to add their own specific questions or risk ratings to the program based on their stated desire to maintain the “purity” of the resulting product. These issues make it impossible for lenders to get a clear picture of their individual process issues and product failures.

While I believe very strongly that the quality control process needs some level of standardization and consistency within its analytic function, I have grave concerns about any individual company dictating the risk related to individual errors when there is no evidence of how this rating will impact the overall evaluation of the loan. Furthermore, none of these tools have shown in any fashion how the ratings are related to performance and/or repurchase risk. I find it highly unlikely that any individual has the knowledge to decide the risk associated with an error is high or low without understanding this relationship.

These vendors are correct when they say this additional technology can make the process faster. This statement however, is dependent on the company using the program “as is” and the QC staff does not evaluate any specific issue in light of the overall loan file or the company does not have any unusual or unique programs or products. Ultimately however, the additional technology utilized in these QC programs is adding on uncalibrated technology. Furthermore, the technology does not allow for ability for individualization of the necessary calibration by those individuals responsible for the output and the risk associated with it. As a result, the analysis and reporting that is provided to management is still flawed and will once again prove as irrelevant as the current loan level findings which management finds unsatisfactory.

While I applaud these companies for developing products that support QC, having companies spend money on technological tools that do not provide results that resolve the problem as intended do nothing more than delay the necessary realization that QC standardization and calibration are critical to making Quality Control function as the industry desperately needs.

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Where Is The Technology We Need?

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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.

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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.

Controlling Operations

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.

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