Laudably, many banks are responding to the current economic situation by working with borrowers to restructure mortgages, avoid defaults, stem foreclosures, and keep people in their homes.
As they do so, credit risks are doubtless at the forefront of their attention, but banks should be wary of compliance risks, too. The good news is that compliance risks fall into four categories, and the steps for mitigating these risks are manageable.
Fair-lending. Banks risk reputational and regulatory consequences if their programs even inadvertently discriminate against borrowers on the basis on race or sex. Imagine — all the good will built up by a foreclosure avoidance program would be wiped out if it resulted in a disproportionate number of foreclosures against African-American or Hispanic households.
Recently, FDIC experts identified numerous factors that increase the risk of fair-lending rule violations — for example, discretionary credit policies. Foreclosure avoidance programs, by their nature, are likely to rely on significant discretion. That's because standard metrics of credit evaluation, such as loan-to-value ratios, credit scores, and payment histories, may be less useful in a situation where a borrower has been late in making payments on a mortgage that exceeds the home's value.
Other risk factors include the demographic characteristics of the market being served, as well as the newness of the programs themselves — the new processes, procedures, and systems they use, and the fact that they are staffed by employees who may be new to the role.
Truth-in-Lending. Given the widespread sense that borrowers may not fully have understood the terms of their original mortgages, banks that fail to disclose the terms of reworked mortgages will likely find little tolerance from regulators. Banks should avoid terms that are unduly complex and therefore liable to be misunderstood. Further, banks should strive to ensure that the terms of a new mortgage are disclosed and understood by the borrower.
There are also signs that banks will be held in the future to higher standards on suitability. It would be prudent for banks to ensure that the new mortgage is suitable for the borrower, even if the terms are simple and disclosed well.
Related risks arise where banks outsource foreclosure avoidance programs, particularly if nonbank employees have compensation structures that lead them to churn borrowers through an underwriting "mill" without any clear benefit to the borrowers.
Identity theft. Regulatory, consumer, and media attention on identity theft is already high as banks work to implement new rules promulgated under the Fair and Accurate Credit Transactions Act of 2003. And as economic conditions worsen, there are signs identity thieves are becoming more active.
Many of the inadvertent consumer data disclosures by banks occurred in the mortgage origination and underwriting process. Inadvertent disclosure is a high risk in the re-underwriting process, particularly if the process has been put together hastily to deal with unanticipated volume.
Identity theft is the last thing a family at risk of losing its home needs. Banks should take pains to protect them from it.
Money laundering. The last few years have seen a high rate of suspicious activity reports involving mortgage fraud or money laundering involving mortgages. The foreclosure avoidance process may present banks with evidence of fraud in the original or new mortgage. What was the source of the new down payment? Do inconsistencies in identification, employment, or income data cast doubt on the veracity of statements made when the original mortgage was made (by the borrower, a mortgage broker, or both)? Banks will need to remember their suspicious activity reporting obligations.
Several steps should be taken to mitigate these risks.
Banks should conduct a rapid risk assessment of their foreclosure avoidance program, particularly if it did not go through a formal or full approval process. The assessment should pay particular attention to fair-lending risks, drawing on recent guidance from FDIC experts. (See www.fdic.gov/news/news/financial/2008/fil08148a1.ppt.) Bankers should consider publishing a summary of the assessment for the program's staff.
Also, a foreclosure avoidance program's standards must be unambiguous — for instance, clear ratios of debt service to expected income and clear rules for establishing expected income are needed.
The standards should ensure that the process for selecting borrowers eligible for the program does not unwittingly target those in areas known to have a lower concentration of minorities or single-family households (which are more likely to be headed by women). They should narrow the opportunities for employees to use discretion, and where such discretion is inevitable, there should be robust controls on its exercise.
Next, managers should consider asking their internal audit providers to conduct real-time audits of the foreclosure avoidance program. It is better to find problems sooner rather than later, and it is much better if the bank finds the problem, rather than borrowers, the news media, or regulators.
In addition, managers should take the time to train employees who are staffing the program. This can be a challenge, since employees may already be struggling with heavy workloads, but spatial repetition — repeating messages over time and in different ways — is an important element of learning.
Many banks have made commendable, aggressive moves to establish and staff foreclosure avoidance programs. It would be a shame if they did so only to face criticism later that the programs did not anticipate compliance risks.