Automakers routinely track and measure the failure rates of everything from a car's brakes to air bags to power steering. Now banks and lenders are being forced to think much the same way about mortgages.
Strict Fannie Mae and Freddie Mac requirements are forcing lenders to identify and eliminate mistakes, both small and large, in home loans. Mortgage compliance, with its seemingly endless reviews, reports to senior managers and laborious changes to business processes, is often seen by lenders as an annoying money pit.
But compliance is not just costly. It is more critical than ever to the bottom line, and can save lenders millions of dollars and further regulatory scrutiny.
Julie Richtel, a senior vice president at $19.8 billion-asset EverBank, in Jacksonville, Fla., is aiming for a loan defect rate of just 1%. That means just 1% of the bank's loans should be considered high-risk, unable to be sold to Fannie or Freddie, or in need of some corrective action before being sold.
"Even though it's 1% that's a lot of loans per month," Richtel told a group of risk managers Sept. 8 at a mortgage conference in Miami.
A year ago, most lenders would have pegged their defect rates at 10% or more. But now Fannie, Freddie and the Federal Housing Administration are demanding that lenders produce higher quality loans with few mistakes.
Lenders have spent the past year testing not only against credit guidelines such as loan-to-value ratios and FICO scores. They also have to make sure loans comply with myriad mind-boggling regulatory requirements that can gum up the lending process.
"Compliance applies to everything," said Tom Wind, the executive vice president of home lending at EverBank, which created a "change management office" to bring control and transparency to the overall compliance process. "There's a whole different mindset you need to manage the business."
Lenders ultimately have to do the hard work of communicating the results to a wide range of employees, from loan officers to processors to underwriters, who then have to make changes.
"We do a reverse engineering process to determine what went wrong, what caused the defect and how we fix it so it doesn't happen over and over again," Richtel explained.
Banks and lenders also are required to give board members and senior managers detailed monthly reports on loan problems with a dashboard showing trends and corrective action plans. Putting the data into visually compelling and simple-to-understand charts is itself a challenge.
Some lenders are still struggling to accurately measure loan problems, to track them over time and to communicate to employees how to make changes.
"Action plans are where it can get tedious and challenging," said Rosemarie Wolfe, a vice president of quality assurance and investor repurchase at Bayview Loan Servicing in Coral Gables, Fla. "You communicate not just to the executive team but to supervisors, underwriters and sales. They have to understand what they're doing and how it relates to the bottom line. It really costs the company when you have defects."
Wolfe suggests that quality control staff be physically located away from a lenders' production staff, to provide autonomy. She also said managers will often "buy in" to compliance if they are shown how small mistakes affect a company's costs. If they are given suggestions on how to fix the problems, "it takes a huge load off their shoulders," Wolfe said. "You go from being a pain in the butt to a huge ally."
She also gave examples of how high-risk loans can eat into a financial institution's revenue, using the scenario of a hypothetical bank that originates $6 billion in loans a year with an average loan size of $200,000, or 30,000 loans per year. The lender might review a sample of 100 loans per month and find five to be high risk. If that 5% rate of high-risk loans is applied to the total monthly volume, the lender could be faced with 125 problematic loans, or $25 million in loan funding, at risk every month.
Using an estimated 10% loss rate to cover repurchase, carrying costs, discounts for resale and other expenses, the lender could ratchet up potential losses as high as $30 million per year.
In a second scenario, Wolfe outlined a smaller mortgage shop with $600 million in annual loan volume and a 4% rate of high-risk loans. Using the same average loan amount and loss rate assumptions, that small lender could be putting $2 million in funding at risk every month and incur annual losses of $2.4 million.
While lenders are grudgingly expanding compliance programs they also are pushing back.
Bill Cosgrove, the CEO of Union Mortgage in Strongsville, Ohio, said mortgage lenders should not have to buy back loans for simple mistakes. Doing so has had a chilling effect on lending.
"We are trying to develop a bucket where there are minor, middle issues and major repurchase triggers," said Cosgrove, the chairman-elect of the Mortgage Bankers Association.
"Today that system is not in place and lenders are suffering. When you have 'I got you' penalties, overlays come into play. When a loan goes delinquent, it has to be a material defect," to trigger a buyback, he said.
Lenders have adopted so-called credit overlays to reduce lending to riskier borrowers. Overlays are simply higher FICO score requirements above and beyond what Fannie, Freddie or the FHA allow.
Higher compliance costs come at a time when lenders are struggling with a drop in loan volume and tight profit margins. But Candace Kubida, the director of loan quality at Fannie Mae, said lenders can be smarter in how they test for loan defects.
"Risks are infinite and constantly changing," Kubida said. "Understanding the metrics coming out of a QC program is critical."
Since cost is an issue, Kubida suggests that banks and mortgage lenders focus on targeted reviews that are more effective at identifying riskier loans. Targeted reviews might include testing a sample of loans that were made to self-employed borrowers, were originated at new bank branch, or worked on a new processor or underwriter. Instead of doing 40 "full file" reviews, painstakingly going through a 500-page loan file, a lender might do 20 full file reviews and 60 targeted reviews, Kubida said.
"Doing a targeted review takes a fraction of the time because you're only looking at that component that causes heartburn in your organization," she said.