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A view from the “C” Suite

Jan 18, 2010

A few months ago, I wrote metaphorically about the C-level executive who was looking out over the landscape of the industry from a high-rise corporate boardroom window pondering the storm clouds that were coming at the industry, and therefore, at their company. It is true that as C-level executives, we spend most of our time looking externally at the risks that could threaten our business. However, often overlooked are the hidden internal risks that can sink our “boats” … and there is nothing like the F-word that can do just that. For the mortgage lender, there is no greater internal risk to a company’s survivability than fraud. Using that very word as an acronym, allows me to highlight five areas every C-level executive should consider when examining internal risks. They are as follows: Financials Repurchases Accounting Underwriting Due diligence As a consulting firm with clients coast-to-coast, it is in these five areas where we see internal risk that has proven life-threatening to many mortgage companies. Financials Trusting in inaccurate or even fraudulent financials has been the undoing of many companies. In today’s world of computerization, it isn’t surprising that virtually every mortgage company uses some type of accounting software system to generate financial statements. Of all the software systems in the market, the one we see the most is Intuit’s QuickBooks. It is not because it is the best system … far from it. That said, it can and does work for thousands of mortgage companies today. No matter which system the company chooses, it comes down to the old acronym “GIGO” (Garbage In, Garbage Out). C-level executives need accurate financials to make critical business decisions. “Manage by the numbers” is the only way to effectively manage any business. Yet, most C-level executives are typically not known for their strong accounting skills. They are more entrepreneurial by nature with strong intuitive skills. But when you have someone with strong intuitive skills trying to apply them to the financial management of their company, the results can often be disastrous. This is the classic “flying by the seat of your pants” gone bad. It is analogous to flying an airplane with a faulty compass. Not knowing where “true north” is, could lead to disaster. You don’t necessarily need to know how a compass works to navigate an airplane. But you absolutely have to know how to read a compass. That may seem like an over simplification, but it works. Here’s where I am going with this … and I am going to expand upon this in the “Accounting” section below. Too many C-level executives have no clue if their financials are accurate. They are flying blind. When in this condition, they are unable to detect if there are things going on “below the surface” such as someone embezzling money from the company. You would be surprised to know how much of that is going on in companies across America. Repurchases There’s an old saying that has been circulated around the mortgage industry for years that goes something like this … “A mortgage lender never really ‘sells’ a loan to an investor … he merely ‘rents’ it to an investor until something goes wrong with the loan and then the investor makes them take the loan back.” Starting in 2007, more companies have been driven out of business by investor repurchase demands than almost any other single thing. It used to be that only mortgage bankers had to deal with repurchase demands. However, today, mortgage brokers are facing repurchase demands also, it seemed like this threat seemed to abate some until just recently. In recent weeks, we have seen another round of repurchase demands, but this time, with more increased intensity than ever before. That old saying seems to be more true today than ever before. The easiest and best way for a C-level executive to mitigate repurchase risk is to read all legal agreements before signing. If there is language in those agreements that represents undue risk, you have one of two choices: Not signing it or changing it. Unfortunately, many C-level executives wait until they are presented with a repurchase demand to read the agreement. Believe it or not, you can mitigate this risk by inserting and/or deleting language in the agreement. I know, to many of you reading this, that seems like a fantasy. Most of the investors that are demanding loans to be repurchased are claiming fraud as the basis for the repurchase demand. One of the most effective ways to manage repurchase risk is to closely manage your production operation. I don’t care how good someone might be at negotiating contracts, no investor in their right mind would agree to buy loans if the mortgage company would not indemnify that investor against fraud. We all know that the problem with many repurchase demands is that the investor is claiming “fraud” when no fraud was committed. The solution to this problem may seem over simplistic and “Pollyannaish” but it really isn’t. And the solution is two-fold. ► Mortgage companies that originate loans must have a demonstrated “zero tolerance” policy against fraud, and the definition of fraud needs to be clearly spelled out. ► Investors need to stop making ridiculous repurchase demands and inventing “fraud” where no fraud existed. The investors who intentionally do “forensic underwriting” to “discover fraud” are about as morally bankrupt as the originator that purposefully does something in the origination process that is fraudulent. Accounting In this article, we are primarily focusing on fraud … and now specifically, accounting fraud that involves embezzlement. This is the worst nightmare of every business owner. As a consulting firm, we are frequently asked by C-level executives, usually the business owner, to come into their company because he or she has begun to suspect embezzlement has or is taking place. And when we confirm that that there is or has been an embezzlement going on, more than 90 percent of the time it is being done by someone that the C-level executive trusted implicitly. There are not too many things worse than a trust violated. It can take years to recover financially and emotionally and many never do. Accounting systems such as QuickBooks are too easily manipulated. Frequently, accounting “irregularities” start off as innocent mistakes, but then when someone discovers a way to “creatively” resolve the mistake, they also discover how easy it is to manipulate the system. Therefore, someone with a “motive” (i.e., short on cash to pay their bills) can start “manipulating” the books to misrepresent the facts so they can “borrow” some money from the company “on a short-term basis” to “make ends meet” until “some other money (miraculously) can be found.” This is regrettably becoming increasingly more common given our country’s economy and the financial stresses being experienced by many. To understand how accounting fraud can be avoided, we first need to come to grips with the core of the problem … at least most of the time. As I said earlier in the “Financials” section, most C-level executives are not known for the in strong accounting skills. To them, diving deep into transactional details is on the same level as having a root canal … they hate details. They love the saying, “Don’t tell me about the labor pains … just show me the baby!” Even some of the biggest control freaks quickly delegate accounting details to a trusted “bean counter” type. However, the further away they get from the numbers, the more susceptible they are to accounting fraud that then leads to embezzlement. If you rely upon a Certified Public Accountant (CPA) firm to do your annual audit, think again. In every situation we are brought in where there was embezzlement, the CPA firm that did the annual audit failed to discover the financial fraud. All too often, the CPA firm that does the audit can become too comfortable with those people in accounting doing the fraud. It is a good idea to change CPA auditors every so often. You, as the C-level executive, should select the auditing firm. It is a conflict to have accounting staff select the CPA firm that does the audit. In almost every situation where we were called in to a company where embezzlement has taken place, we discovered these common denominators. ► The embezzlement was done by a highly trusted employee. ► It was someone they had known personally for a long time. ► It had been going on for a fairly long time. ► They trusted this person as if they were family. ► During the duration of the embezzlement, all normal “checks and balance” type controls had been removed or had never been in place. While there may be an opportunity for recovery by making a claim on your Errors & Omissions (E&O) insurance, oftentimes, the loss is so significant that it is a almost impossible to recover all the money stolen. The solution for most companies is to bring in an outside consulting firm that has depth in accounting and knows where and how to look at areas of the company that can create exposure. If interested go to our Web site,, and check out our CFO2Go services. Underwriting There are any number of directions I could go with this one, but here is one that you may not have considered. We all have been told that private mortgage insurance (MI) companies are there to pay claims in the event a loan goes into default. The problem today is that so many loans have defaulted that mortgage insurance companies have begun to renege on paying insurance claims, most likely for survival. I know this is hard to believe, but it is happening with increasing frequency. The scenario is that a when a home is foreclosed upon and resold, it is not uncommon for there to be a loss. When there is an MI policy in place, a claim is filed. With increasing regularity, MI companies are claiming that loans were inaccurately underwritten and/or loan fraud was involved. The end result is that the claim is denied. This results in a repurchase demand back to the company that originated the loan. As a consulting firm, we are often called to get involved. Here are the lessons we are learning. ► Contract underwriting via an MI company may not provide you the risk protection you thought. We are at a place that you need to select your vendors such as an MI company based upon something more than how good the MI rep is. ► Document your loan underwriting decisions thoroughly, especially those marginal transactions. Having a good paper trail could make all the difference when filing an insurance claim or defending a repurchase demand. Due diligence The most effective way to prevent fraud throughout your organization is through due diligence. What I am talking about is something broader than just the routine monthly quality control process. Due diligence can mean different things to different people, but basically it is a process of investigation that looks deeply into every aspect of an organizations operations. This can and should be done on an ongoing basis with your own internal staff, as well as bringing in a third-party consulting firm every six to 12 months. When our consulting firm does due diligence reviews, and we do a lot of them all over the country on companies of all shapes and sizes, it quickly becomes evident that this may be the first time anyone had done a thorough examination of all aspects of their operations. It opens the eyes of the C-level executives to the importance of doing this on a regular basis. Without fail, things are revealed that are surprising and somewhat embarrassing to the C-level executive. There are two basic benefits that come from doing regular ongoing due diligence reviews. The first and most obvious is catching things that are being missed in the normal day-to-day operations. The second and less obvious is this … just having an ongoing thorough due diligence review process can stop an employee from doing things that can cost the company precious capital … both time and money. The thorough due diligence review exposes weaknesses where fraud and embezzlement take place. As wise old Benjamin Franklin said, “An ounce of prevention is worth a pound of cure.” If you don’t get anything else from this article, I hope you give serious consideration to implementing an ongoing due diligence program within your company. When selecting an outside firm to perform due diligence, make sure they have hands-on operating experience of actually running a company like yours. Otherwise, how will they know where things can go wrong? We have a team of dedicated mortgage professionals that have owned and operated their own mortgage companies and are dedicated to helping C-level executives like you to do a thorough examination/investigation of your internal operations. Thank you for reading this article, and I welcome the opportunity to talk with you about your company’s needs. David Lykken is president, mortgage strategies and managing partner with Mortgage Banking Solutions. David has more than 34 years of industry experience and has garnered a national reputation. David has become a frequent guest on FOX Business News with Neil Cavuto, Stuart Varney, Liz Claman and Dave Asman with additional guest appearances on the CBS Evening News, Bloomberg TV and radio. He may be reached by phone at (512) 977-9900, ext. 101.
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