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The Future of Mortgage Banking: Controlling Underwriting Risk

Apr 22, 2013

Future residential mortgage loan underwriting and approval processes will reflect the desire for greater transparency in the underwriting process, with a tight coupling of both what review was actually done, and the physical documentation to substantiate the process. The pace and extent to which underwriting processes evolve to incorporate the lessons learned from the crisis will depend upon the answer to a key question about pre-crisis originations: Were losses due to the failure of the whole mortgage industry to identify and provide early warnings for the systematic risks of 2004-2007 vintage loans? Firms that employ technology and best practices in re-underwriting legacy originations will have a leg up over competitors in building the transparent underwriting processes of the future. Residential mortgages and the process by which they are underwritten and ultimately approved have undergone significant changes in the post-credit crisis period. Going forward, there is a general desire for greater transparency in the underwriting process, with a tight coupling of both what review was actually done, and the physical documentation to substantiate the process. This is not a new phenomenon. Instead, it is a realization that there are things we can do better to integrate the data with the decision making process for enhanced transparency. This can be characterized as balancing the credit underwriting management with the operational risk of mortgage origination. Technology is a key component of providing the transparency needed in today’s mortgage marketplace. In this article, we will focus on the various components necessary for a satisfactory review of a legacy mortgage loan underwriting, and how a technology-empowered and expert-driven process can provide the necessary levels of audit and compliance. 2004-2007: Residential mortgage loan origination and due diligence environment Given the rapid economic growth in the U.S. (partially driven by global growth), the U.S. residential mortgage markets expanded rapidly. As a result, non-agency mortgage (Alt-A and sub-prime) guidelines and related underwriting processes accommodated more flexible and complex criteria. During this time, the due diligence function focused on verifying the key data points provided to the investors, inventorying key documents, and re-running basic underwriting tests (such as LTV and DTI) based on the provided data. The due diligence reviews were often used to include or exclude loans from the subject pool intended for purchase or securitization. These reviews generally focused on the information contained in the original loan file. The originators represented the various aspects of the underlying data to the extent qualified in the guidelines and other relevant documentations. Loans were usually newly originated, hence no historical loan performance were available. Some portion of the loan pool was also comprised of first time borrowers. Given expanded and more complex guidelines, typically some sample of loans from the general population were selected for review against the relevant guidelines. Samples were either “random” or “adverse.” Adverse samples were composed of loans with features perceived to be indicators of increased risk, such as high LTV/CLTV, non-owner occupancy, reduced documentation products, and lower credit scores. Each securitization shelf had its own methodology for determining sample pool size and selection. When reviewing conformance with the guidelines, if sampling is used it needs to be done to be reflective of the total pool and not just an "adverse" sample. Today’s transparent underwriting requirements Many current mortgage due diligence projects on legacy loan pools are designed to review the original loan attributes versus the historical matching underwriting guidelines to establish conformance. The re-underwriting efforts are in response to the subsequent non-agency RMBS losses and designed to discover if any portion of such losses are potentially attributable to underwriting flaws that occurred at the time the loan was originated. Today, a key question remains: Are the losses due to the failure of the whole mortgage industry’s market practice evolution (origination, due diligence, securitization, rating, investor credit analysis and desire for higher yields) to identify and provide early warnings for the systematic risks that transpired during the credit crisis? Given the importance of the questions to be answered, many firms are looking for disciplined mortgage credit and compliance re-underwriting providers that can manage a well-organized and targeted process. Though many companies provide re-underwriting services, it is important to realize that each company differs in terms of their individual process, their degree of customization, and the depth to which they go to recreate the original loan file and relevant guidelines. While it is convenient to make the assumption that underwriters perform a generic service and choose a provider on the basis of price, the wide-ranging nature of loan origination pre-credit crisis renders it necessary to find a provider who can recreate the original loan underwriting parameters and admissibility criteria. In recreating the original loan parameters, identification of the correct product guidelines and loan approval timing and delivery is crucial. Failure to apply the appropriate rules for the individual loan accounts for many unfounded allegations. The recreation of these key elements is a time consuming, exacting process for several reasons. First, in the peak years, large originators offered dozens of loan products and/or acquired loans from numerous sources. Second, underwriting guidelines changed rapidly during the same years. Third, guidelines and documentation type definitions were not consistent across originators and Loan Purchase Agreements varied, particularly relating to the effective date governing the application of the underwriting guidelines. Some agreements specified the date of application while others used the date of funding or date of final loan delivery. The company you choose should understand the entire process of evaluating and resolving these issues. They should be able to understand at the deal level the relevance of post origination data in performing the re-underwriting task. The provider must be able to identify potential remedial cures and assess the materiality of each defect in the loan. Since selecting the right mortgage credit and compliance re-underwriter can be the leading factor in winning a litigation case, the below will be useful in choosing between underwriters. What to look for in a mortgage credit and compliance re-underwriting provider Your first step is to find a company that specializes in effectively responding to or identifying, as the case may be, all allegations relating to loan quality. The company must fully understand, identify and recreate the appropriate guidelines and governing agreements that apply to each loan. The company you chose should understand the entire origination and securitization process and have experience in responding to and resolving these issues. The provider should be able to understand at deal level the relevance of post origination data, be able to identify potential remedial cures, and assess the materiality of each defect in the loan. The next step is to look at the credentials of the executives of the mortgage credit and compliance service provider being evaluated. How long have they been active in this space? What is their experience and expertise in the mortgage world? Are they seasoned in terms of seeing several cycles? Is the company experienced in litigation and loan repurchase matters? Once you have narrowed down several companies that specialize in mortgage credit and compliance services, inquire about their technology. A flexible technology system that can accommodate a variety of mortgage underwriting review processes and provide an integrated platform to manage process flow, data, and consistent analysis is critical. Absent such a system, any sizeable project quickly becomes unruly, with results dependent on the individual underwriter reviewing a given loan file. Key questions on technology may include the following: ► Does the system meet your needs for confidentiality and data security? ► Is it a self-contained system so that subject loan file, applicable guidelines, underwriter results and communications among underwriters and senior officers are housed in the same system? ► Does the system allow for the review process to be scripted and tested before a large number of loans have been reviewed? ► Does the system facilitate consistent and comprehensive review among a group of underwriters? ► Does the system facilitate real-time status updates of the overall loan-by-loan review results? ► Does the system facilitate real-time monitoring and quality control (QC)? ► Can the system be used to identify, collect, and package documentation to support the loan-level findings? ► Does the system provide customizable data capture and reporting? Once you are satisfied with a firm’s specialized credentials and technology in mortgage credit and compliance in the context of historical re-underwriting or new frontline origination, ask for a demonstration which can take place in person or live. This will allow you to see the technology first-hand in conjunction with various projects the firm has successfully completed. During your meeting, be certain to ask about customization of the review process, as some mortgage credit and compliance re-underwriting provider processes may put clients in the same bucket when in actuality each project situation may be unique. The future of mortgage underwriting Going forward, mortgage underwriting and approval processes will better integrate data and decision-making and balance credit underwriting management with the operational risk of mortgage origination. Firms which employ technology and a comprehensive view of underwriting risk in responding to or identifying, as the case may be, allegations relating to loan quality from legacy origination will be the most prepared to integrate best practices into future underwriting processes. Chad J. Burhance is head of NewOak Solutions. Burhance has more than 20 years of experience in financial services in roles spanning risk management, fixed-income trading and middle office functions. He may be reached by phone at (212) 209-0793 or e-mail [email protected].
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